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Hedge Funds: What is a Hammer Clause?

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Hammer Clause

The Hammer Clause

You may have heard of a clause in an insurance policy known as a hammer clause.  It’s found in management and professional liability policies such as D&O, E&O / Professional Liability, Employment Practices Liability, Cyber, and similar coverages.

The intent of the hammer clause is to give the insurance company the power to compel the insured to settle a claim against them.  It is unique to management and professional insurance because these policies provide the insured the right of consent to settlement.  Unlike general liability and auto liability where, in most of those policies, the insurance company preserves their right of settlement.

Now you may be saying, why is there a hammer clause?  Isn’t it obvious that both the insured and their insurer would want to settle a claim and not let it drag on and cost more in legal fees?

Not necessarily.

There are times when the insured wants to take the extra steps to prove they were right in a legal dispute in order to protect their reputation and to stave off future lawsuits.  Even if that means paying extra costs to prove that.  And, in essence, this is why a hammer clause exists.

Let’s use an example.

Hedge Fund X has been engaged in a lawsuit with an investor group alleging wrongdoing by the fund manager.  The Hedge Fund’s insurer has been paying for defense costs and they see an opportunity that they may settle the dispute for about $400,000.  They come to the insured; the Hedge Fund general partner and discuss settlement negotiations.

The GP flatly refuses that settlement, indicating that they stayed within the bounds of their investment guidelines, performed their duties solidly, and did not breach their duties to the investors.  The GP’s parting words are: This particular group of investors are just greedy and I refuse to settle.

This puts the insurer in a precarious position.  They’ve already exceeded the insured’s retention point (meaning the insured has already spent their deductible) so any further payments beyond the $400,000 potential settlement are coming fully out of the insurance company’s pocket.

Insurers are loathed to spend a penny more on claims than they must.

So what does the insurer do?

They go back to the insured Hedge Fund and say:

“That’s fine, we will reject the settlement, but under the terms of your insurance contract, be aware that you will be responsible for every dollar of cost above the anticipated settlement  $400,000 settlement”

And that basically describes the aptly named hammer clause.

It gives the insurer the hammer to hold over the insured’s head to say, that they will participate in the costs above the agreed to settlement amount.

Now, in this example of the insured paying everything above the anticipated settlement is known as a hard hammer clause.  A very hard hammer indeed, but it’s less common today than it was in the past.

What we see most frequently is the insurance company’s willingness to share the risk above an anticipated settlement with the insured.

Common risk-sharing hammer clauses or coinsurance hammer clauses are:

50/50 where the risks are split evenly above the anticipated settlement between the insured and insurer.

70/30 and 80/20 clauses where the insurer takes on the majority of the excess risk, and the hedge fund is responsible for the 20% excess of the original settlement amount.  These are known as  soft hammers.

Which is right for you?

That will depend on a variety of factors, the biggest of which are market conditions and your fund’s loss history, but your insurance broker should be negotiating this important clause to your benefit and within your premium expectations.

The bottom line is that no two hedge fund management and professional liability policies are the same, which is why you need a skilled broker to find the right insurer for your circumstances and then faithfully negotiate terms and conditions tailored to your needs.

Have other questions, issues, or concerns you’d like to discuss?   Please feel free to reach out by phone or email and let’s chat.  I’m located in NY but work across the U.S. with a variety of financial service firms from Hedge Funds to Private Equity to private lenders and more, and I love helping finserv firms with their insurance issues.

Thanks!

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