Cotkin is not alone. “Arbitration is inherently inefficient in deciding disputes based purely on questions of law,” notes David Gauntlett, whose Irvine, California , law firm specializes in policyholder coverage issues. “There's no discovery, no appellate procedure and arbitrators just don't have the resources to conduct any kind of meaningful case research; overall it's just not the right forum for resolving many of the disputes that surface between insureds and insurers. There needs to be consistency and certainty in the law and ADR just doesn't cut it.”

The more frequently insurers impose ADR, the more its critics feel obligated to speak. In a single year, the American Arbitration Association conducted more than 4,800 consensual insurance-related arbitrations, up from 202 a decade before. Such numbers promise to swell even more as ADR clauses continue to push their way into various kinds of insurance contracts, including directors and officers liability, professional liability, excess and umbrella liability, employment-practices liability, commercial property and uninsured motorists policies.

“When analyzing the costs of processing claims, ADR just becomes a natural,” says George Friedman, national vice president for case administration for the American Arbitration Association in New York . Certainly this is true in some cases. But there is a dark side to ADR. To see it, however, one has to think carefully about the differences between arbitration and mediation.

The difference may not be clear because both arbitration and mediation are informal processes that generally do not faithfully follow the traditional rules of evidence or civil procedure, nor permit extensive discovery of facts by the opposing parties.

Arbitration calls for the disputing parties to submit their views to a neutral third party, who then chooses between the two positions. The right of appeal is generally limited to situations where there is arbitrator bias, fraud, misconduct or abuse of discretion. This finality has led arbitration to be the method of choice among insurers. Foreign-registered mutual insurance companies, like ACE and X.L. Insurance Co., tout their overseas arbitration clauses as a selling tool to buyers, pointing out they will never have to deal with the U.S. judicial system.

Mediation, on the other hand, is a problem-solving process in which parties who disagree have a neutral third party listen to their concerns and interests, and then assist them in fashioning a mutually acceptable settlement of their differences. If the dispute is not resolved, either party can walk away from the table and still have its day in court.

Despite the American Arbitration Association's enthusiasm, many risk managers, insurance industry lawyers and others in the industry are less impressed. “My overall view of ADR is negative,” says Tom Vance, director of risk management for the City of Anaheim, California. “We find that arbitrators just want to `split the baby' to make both parties happy,” Vance says. “That's just not in our interests. Why should we pay if we didn't do anything wrong just because somebody files a lawsuit?”

Ed Godwin, director of risk management for the Riverside Community College District in Southern California, agrees. “These attempts to reach compromise certainly don't accomplish my objectives,” says Godwin, also a former risk manager for U.S. Reynolds Co. “On large contracts, I'd just as soon take my chances in court,” he adds, noting the particular vulnerability of traditional deep pockets of government and large companies.

Despite ADR industry claims of cost savings, experts say it often can be as expensive as litigation.

“It really depends on the parties,” says John F. McCarrick of McCarrick & McCauley, an insurance defense lawyer in New York City . “Our preference is to streamline the process as much as possible,” he says, “but if you have obstreperous opposing counsel who are going to gear up and treat the arbitration like litigation, creating a paper war, that can force you into a reactive situation.”

Other concerns raised about arbitration include:

·   Arbitrators are not required to follow the law and their decisions generally are final, binding and not appealable.

·   Arbitrators have an economic incentive to make decisions that will generate repeat business rather than simply deciding the merits.

·   Arbitrators are often retired judges who do not have the up-to-date specialized knowledge often required by the disputes, or are practicing lawyers who bring their professional biases into the hearing room.

Jack Harding, who teaches ADR at the Pepperdine Law School in Malibu, California , and is program director for the school's Institute for Dispute Resolution, says he is not surprised to hear such concerns. “ADR doesn't work in every case,” he says, pointing to high-stakes cases and fraud situations as examples of poor candidates for ADR.

But the more insurers rely on mandatory arbitration clauses, the less flexible the parties can be in resolving their disputes. With binding arbitration, there are no other options. Still, some risk managers say they are not troubled by pre-printed ADR clauses. “We're not in the habit of suing insurance companies, and don't think litigation first,” says Cheri Hawkins, assistant treasurer and director of insurance at Weyerhauser Co. in Tacoma, Washington . “For me, arbitration is a means to effect a settlement if there is a dispute that we're delighted to have available to us.”

Such an argument simply misses the point, says Cotkin. “The parties can always agree to arbitration or mediation when a dispute in fact arises, rather than committing themselves to a procedure up front that may not be in their best interests,” Cotkin says, adding she generally counsels against ADR clauses. “I tell my clients to go back to the insurers and propose that clause be deleted, and if they balk, to make some alterations that will be more beneficial to the policy holder,” she says.

Just in the last year, the Los Angeles Daily Journal published several articles regarding an arbitration “horror story.” An otherwise well regarded arbitrator on the American Arbitration Association panel issued a record-breaking award of over $7 million against a group of attorneys in a partnership dispute. The arbitrator refused to permit direct testimony from the senior partner he found culpable, and otherwise appeared to conduct the proceedings in an overtly biased manner. He awarded punitive damages without regard to net worth and awarded compensatory damages in amounts far exceeding the assets of the partnership, all the while characterizing a routine business dispute as a conspiracy to defraud. It was only later that the injured partner learned that the arbitrator had been asked to leave his prior firm under circumstances similar to the matter before him (demonstrating personal bias), and that he was represented by the same attorneys who represented one of the parties in several prior litigations over unrelated prior arbitrations (this was a mandatory disclosure that was not made). The award has been attacked in a motion to vacate and reconsideration of the motion is pending. Unfortunately for the injured litigants, wrong on the facts and wrong on the law is not a basis to question the unconscionable award.

Experts stress the importance of considering some of the more important elements of an ADR clause in light of one's own objectives in considering whether to use or accept ADR clauses in contracts. This is because most ADR clauses are mandatory and remove all other options. These important elements are:

The Type of ADR Method

While ADR usually means arbitration or mediation, some policies contain a combination of the two. For example, mediation may be required as a preliminary step to arbitration. Experts say the real concern is whether one wants to dramatically limit the rights of appeal.

Paula Tanguay, pool manager for the Alliance of Schools Cooperative Insurance Program in Los Angeles , offers a rule of thumb: “The more complex the case, or higher the stakes, the less likely you would want to be before an arbitrator.”

The Selection of the Arbitrator

The selection of the decisionmaker can pre-ordain the outcome, and can be the most controversial element of any ADR clause.

The two most common forms of arbitration are the single individual and the three-person panel. Single-arbitrator provisions typically call for a mutual selection process, and are the general rule for arbitrations in cases of less than $250,000, according to often-invoked rules of the American Arbitration Association. Three-arbitrator panels are standard for larger cases, and commonly provide for each side to select their own arbitrator, and for those two to select a third neutral, often called an umpire or a chairman.

Regardless of which process the ADR clause calls for, the presumed neutrality of the arbitrator is a critical factor. “If the decisionmaker is biased, you're looking at a problem, because it's very difficult to get that decision reviewed after binding arbitration,” says Tanguay.

Where some clauses take pains to assure neutrality, others take equal pains to ensure partiality. For example, the clauses offered in some D&O policies have earned a national reputation for lopsidedness. Under such clauses, each party is permitted the right to name an arbitrator, but they require that “each arbitrator shall be a present or former insurance company executive.” “With a panel like that, the deck may be so stacked against the insured that there is little point in even raising a claim,” says Cotkin.

Home Insurance Company, one of the D&O insurers that offered such provisions (and which has since ceased doing business), defended the provision. Jane Keller, who had been the national ADR coordinator for Home, said such charges are not necessarily fair. “Whenever you're trying to select a neutral (party), you want to make sure that you're selecting someone who has particular expertise to really assess the situation,” she said. “Just because they're coming from the insurance industry doesn't necessarily mean they are going to be biased. For example, lots of people leave insurance companies to go into consulting, both for insurance companies and for insureds.”

The Location of the Hearing

Choice of location can also be the source of manipulation, as an inconvenient forum can prove to be a powerful barrier to plaintiffs.

The most pro-plaintiff clauses call for arbitration in the place where the insured lives, while others set venue where the claim arose. It is more common, however, for clauses to specify the location of the insurance company's home office, or U.S. base, as the place where arbitrations will take place.

Clauses that tilt in favor of the insurer, on the other hand, often include language requiring the use of New York law in the arbitration, such as that found in the AEGIS Insurance Company's D&O policy. New York law is considered more favorable for D&O insurers, in part because it generally does not require insurers to advance defense costs during the litigation.

Some policies go even further, however, mandating that the arbitration take place in other countries. For example, the D&O policies offered by the Bermuda-based X.L. Insurance Company Limited and ACE Insurance Company Limited, which are off-shore policyholder-owned mutuals, require arbitrations to be held in London, England, applying New York law under the terms and conditions of the English Arbitration Act of 1950.

“The English Arbitration Act is very good about limiting appeals, and the thought was to have it in London to have a more final ruling than would be available in U.S. arbitration,” says Thorn Rosenthal, an attorney with Cahill, Gordon & Reindel in New York , who drafted the clauses.

Rosenthal said U.S. arbitration laws vary by state and provide for awards to be overturned or set aside on such grounds as abuse of discretion and fraud. The English Act, however, does not provide for any means to overturn an arbitration award. Moreover, he said British arbitrators “tend to be more respectful of what the parties wrote down than U.S. law.”

One offshore mutual official, speaking on condition of anonymity, offers another rationale for requiring foreign venues: it discourages arbitrations. “If you make things too accessible, disputing parties don't try to act like adults in resolving their differences,” the official said. “This way we both have to get on a plane. In fact, from that standpoint, maybe arbitrations in China would be even better.”

The high-end excess D&O policies offered by ACE Insurance Co. and its subsidiary, Corporate Officer and Directors Assurance Ltd. (CODA), are similar. They require arbitration in Bermuda, the companies' home base, under the Bermuda Arbitration Act, which is virtually identical to the English system. Richard Heydinger, risk manager for Hallmark Cards, Inc. in Kansas City, Missouri , says his company was a charter member of the ACE group, and wasn't bothered by the foreign venue for arbitration. “We're an international company, so it's no problem for us because we just take the papers with us,” he said. “Besides,” he added, “I'd rather deal with the transportation issues than with the courts in California or Texas .”

For some risk managers, that's a win-some-lose-some, it-all-evens-out kind of result they can live with.

But as arbitration clauses come to dominate insurance-related disputes, look for fewer insureds willing to accept such tradeoffs. Godwin observes, “My sense is that there are a lot of people enamored with ADR, who have bought everything they have been sold, and who are going to be unpleasantly surprised down the road.”