Most professional liability policies contain the following or a similar provision addressing settlement by an insurer and an insured’s consent to the settlement.

[Insurer] shall…not settle any CLAIM without the written consent of the NAMED INSURED which consent shall not be unreasonably withheld. If however, the NAMED INSURED refuses to consent to a settlement recommended by [Insurer] and elects to contest the CLAIM or continue legal proceedings in connection with such CLAIM, [Insurer’s] liability for the CLAIM shall not exceed the amount for which the CLAIM could have been settled, including CLAIMS EXPENSES up to the date of such refusal, or the applicable limits of liability, whichever is less. Freedman v. United Nat’l Ins. Co., 2011 U.S. Dist. LEXIS 25490, *2; 2011 WL 781919 (C.D. Cal. Mar. 1, 2011) (emphasis added).

Under the first sentence, an insurer can negotiate settlement directly with a claimant. However, any resulting settlement is subject to the consent of the insured. If the insured refuses to consent, that refusal must not be unreasonable. The second sentence also gives the appearance that an insurer can negotiate with a claimant to achieve a settlement. Under this scenario, if the insured does not consent and the litigation continues against the insured, the insurer is not prejudiced because its exposure for loss ceases on the date of the insured’s refusal to consent. This provision often is referred to as the “hammer clause” because of the power it gives an insurer to enforce a settlement. Essentially, insurers believe they have some control over a recalcitrant insured.

That belief is misplaced. A further review of these two sentences elicits a suspicion that there is some ambiguity between the two. The first sentence expressly provides that the insured’s written consent is necessary to any settlement. The first sentence also clearly sets forth that the insured’s consent cannot be unreasonably withheld. In contrast, the second sentence does not address whether the insured’s consent must be reasonable.

The harmonious interpretation of these two sentences was at issue in Freedman v. United Nat’l Ins. Co., cited above. In Freedman, an attorney tendered a legal malpractice action to his professional liability carrier. The claimant offered to settle within the policy limits, but the defendant attorney refused because he believed the action lacked merit. After the insurer invoked the hammer clause, the attorney still declined to settle and filed an action against the insurer claiming the carrier acted in bad faith by settling the underlying suit, which had no merit, over his objection and without his consent. The insured attorney advanced the following interpretation of the above provision: (1) an insurer cannot settle without the insured’s consent, but the insured cannot unreasonably refuse to consent to settle; and (2) if the insured unreasonably refuses to consent to settle, then the insurer’s liability is limited to the amount for which the insurer would have settled plus the cost of the defense up to the date of the insured’s refusal. Essentially, the insured argued that the insurer could rely on the hammer clause only if the insured’s refusal to consent was unreasonable. Conversely, the insurer in Freedman argued that the two sentences actually are separate clauses. The parties’ disagreement arose over whether the second sentence, standing alone, allows an insurer to limits its liability when an insured refuses to consent to a settlement, regardless if that refusal is reasonable. The court sided with the insured and held the policy was not ambiguous and the hammer clause may be invoked only if the insured unreasonably refuses to consent to a settlement.

The Freedman court based its ruling on a decision from the Court of Appeals for the First Circuit in Clauson v. New England Ins. Co., 254 F.3d 331, 337-38 (1st Cir. 2001). In Clauson, the insured attorney refused multiple offers to settle a malpractice action filed against him. The underlying action involved the attorney’s failure to attend a hearing in which a martial asset his client used for business was sold. After the client filed a malpractice suit against the insured, the client made several offers to settle during the pendency of the action which the insured rejected. The insurer twice informed the attorney that his refusal to settle was unreasonable and invoked a clause similar to that in Freedman which limited the insurer’s exposure to the amount of the rejected settlement. After judgment was entered against the insured in excess of the offers, the client filed a declaratory action against the insurer to recover the amount of the judgment in excess of the settlement offer the insurer previously had agreed to pay. The trial court held that the insured was reasonable when he refused to consent to settle, and thus, the provision limiting the insurer’s exposure did not apply. The Court of Appeals affirmed the trial court’s ruling that the hammer clause did not apply, and thus, the insurer was liable for the total judgment against its insured.

Pragmatically, the hammer clause is a provision which is intended to limit an insurer’s liability when an insured refuses to consent to a settlement. However, recent case law has eroded that veneer and revealed that the coverage defense actually rests on the conduct of the insured; specifically, whether the insured’s refusal to settle is unreasonable. Based upon the case law, the merits of the case and a legitimate settlement value alone may not determine if an insured acts unreasonably in refusing consent.