Environmental insurance has undergone a dramatic evolution over the past
20 years through the expansion of coverages and implementation of new and innovative
applications. Up until recently, environmental insurance was mainly an effective
tool for managing unknown environmental
issues, but had limited solutions to manage known environmental liabilities. As often happens, the "gap" in the market is being
closed through the development of creative risk management tools. The emerging
tools in the marketplace now allow insureds to effectively cap or contractually
transfer their liabilities for known environmental matters. The implications
are significant, as there are an increasing number of tools available to manage
potentially catastrophic known environmental liabilities.
Historically, site owners purchased environmental insurance to protect themselves
from the risk of loss stemming from unknown environmental conditions. The basic
coverage would respond in the event of a governmental action requiring remediation
of an environmental condition or in regard to claims or suits from third parties
alleging damages from an environmental condition at an insured's site.
Though the use of traditional pollution coverage continues to grow and is
purchased by both the largest and smallest companies, we are seeing increasing
concern about the management of known liabilities. Several factors drive this
concern:
- The passage of the Sarbanes-Oxley Act in 2002 has led to a greater scrutiny
of the reserves for environmental liabilities in a firm's financial statements.
- The Securities and Exchange Commission (SEC) is increasingly enforcing
the proper and full disclosure of environmental reserves. We recently have
seen the SEC "comparing notes" with the Environmental Protection Agency
(EPA) in regard to reserves posted for potentially responsible party (PRP)
liability associated with Superfund sites.
- Shareholder activist groups are closely monitoring firms' financial
disclosures for any underreporting of environmental liabilities.
- Investment analysts and investors are also expressing greater concern
with a firm's environmental reserves as the surge of asbestos claims has
driven several large U.S. based firms to file for Chapter 11 bankruptcy.
The trend for environmental reserves among both insurance companies and
nonfinancial firms continues to develop upward despite numerous reserve
adjustments.
- Management of firms are increasingly anxious to rid themselves of both
the distraction and financial obligations of environmental liabilities from
divested operations or other non- (or under-) performing assets.
Fortunately, solutions are available to allow a firm to contractually transfer
its liabilities off their balance sheet and thereby remove a potentially perilous
liability. Though the solutions are often tailored to meet the unique needs
of the client in a given situation, they fall along a risk continuum depending
on the degree of risk transferred to a third party.
Remediation Cost Cap
One of the simplest means of transferring the risk associated with a known
remediation is to obtain a remediation cost cap policy. Though the terms and
conditions of this coverage have become increasingly restrictive, the policy
is effective in capping the costs associated with a known remediation. The policy
is written with a buffer of 10-25 percent of the expected remediation costs
before the risk transfer layer attaches. The policy provides coverage in the
event of a cost overrun associated with any or all of the following.
- Discovery of higher concentrations of contamination
- Discovery of a greater spread of contamination
- Changes in governmental regulations
- Failure of proposed technology
In this scenario, the titleholder of the property still "owns" the environmental
liability but is able to cap the expected cost of the remediation.
Fixed Cost to Closure
Historically, environmental consultants bid their projects on a time-and-materials
basis. This resulted in many change orders, significant cost overruns, and substantial
unbudgeted expenses as circumstances at the site often changed. Several environmental
consulting firms are now offering their clients a fixed cost through to the
point of achieving "clean closure." Closure is generally defined to be achieved
when the governing regulatory agency issues a "No Further Action Letter" or
comparable acceptance that the project's goals have been achieved.
The environmental consultant will generally issue a contractual assumption
of all costs to achieve closure. In certain cases, the contractual assumption
will be supported by the aforementioned remediation cost cap coverage. Issues
to consider in this scenario are the following.
- The financial strength of the environmental consulting firm
- The scope of the remediation cost cap coverage being offered by the
environmental consulting firm. Since there is no standard policy form, there
are significant differences in the coverage offered by each insurer and
for each transaction.
- Whether the rights under the insurance policy can be assigned to the
project owner in the event of default by the contractor.
- Who is responsible for payment of the buffer or any coinsurance provisions
in the remediation cost cap coverage
The guaranteed cost to closure option offers the site owner an additional
layer of security than offered by a remediation cost cap policy by inserting
a second layer of protection into the agreement with the client. By guaranteeing
costs to closure, the consultant is assuming liability for any cost overruns
beyond what would be covered by the remediation cost cap policy. The variance
may stem from items excluded by the remediation cost cap policy or beyond the
term of the remediation cost cap policy.
Finite Risk Policy
The blended finite risk policy not only provides protection for remediation
cost cap and all other first- and third-party environmental liabilities, but
also provides discounted funding techniques as a means of "pre-funding" the
anticipated cost of the remediation. The insurer writing the finite risk policy
offers a premium that includes the risk transfer costs as well as the present
value of the remediation. The funds to be used for remediation are then segregated
in an interest-bearing account from which all remediation expenses will be paid.
In the simplest model, once the loss fund is depleted, the insurance will
attach. The finite risk policy also typically allows that any funds remaining
in the loss fund at the completion of the project will be returned (along with
all earned interest) to the client (or their assignee). In this way, all parties
to the contract are given incentive for the remediation project to be completed
on time and on budget.
Liability Buyout
In the continuum of risk transfer, the next option is referred to as a "liability
buyout." In this scenario, a third party contractually assumes the ownership
of the known environmental conditions. In exchange for a cash payment to a third
party, the third party will assume all obligations for remediation and liability
associated with known conditions. The assuming party will then:
- Complete all required remedial activities
- Negotiate with the EPA or other regulatory bodies
- Provide a full indemnity to the "seller"
The benefits for the "seller" are numerous, but most evidently include:
- Assumed ability to remove the liabilities from their balance sheet
- Transfer the stigma of an environmental condition to a third party who
is experienced in the associated remediation
- Remove the distraction to upper management and the board of directors
of lingering environmental liabilities
Procedurally, the contractual assumption typically requires that the assuming
party purchase an environmental insurance policy to backstop their indemnity.
Thus, the ceding company will be protected in the event of the failure of the
indemnitor. To protect the funds transferred to the third party, the insurance
provisions typically dictate the use of a finite risk insurance policy.
Great care should be taken in reviewing the strength of the indemnity offered
by the "buyer." The strength of the indemnity offered runs the entire gamut
from a thinly capitalized limited liability corporation to the balance sheet
of the buyer. Since under the Comprehensive Environmental Response Compensation
and Liability Act (CERCLA) the liability for an environmental condition ultimately
lies with the generator (or "creator") of the environmental condition, the financial
creditworthiness of the buyer is the most critical component for a seller to
consider. The seller's concerns are numerous but include the following.
- The risk of bankruptcy of the buyer
- The likelihood that the transferred liabilities will be determined by
the courts to be transferred back to the seller
- The ability of the buyer to fund any retentions or premium payments
for an environmental insurance policy
- The financial or credit rating of the buyer's financials—the landscape
has been littered with the bankruptcy of many environmental consulting firms
over the past years
Transfer of Real Assets
The contractual transfer of liabilities is the last possibility for dealing
with known environmental liabilities. In this option, not only are the liabilities
transferred to a third party but the corresponding real assets are transferred
as well. According to FAS 5, a full deduction (or write down) of the environmental
liability (and costs of associated insurance) is possible when the risk of the
liabilities coming back to the seller are "remote."
When a transaction is properly structured, the real assets are transferred
to a third party who then contractually assumes the liabilities for both known
and unknown preexisting conditions. These indemnities are then backed by the
finite risk policy. The buyer of the site assumes all negotiations with the
regulatory agency and responsibility for all remediation. The finite risk policy,
if structured correctly, should effectively backstop many of the indemnities
offered.
Benefits of Contract Liability Buyouts
- Firms may divest of sites and transfer contractually environmental liabilities to a third party
- For pre-transaction real estate marketing efforts, firms may transfer environmental liabilities contractually making the property more marketable to potential buyers.
- Businesses may be able to remove the environmental liability reserves associated with the site(s) under contract from the balance sheet.
- By entering into this type of transaction, firms may be able to divest of non- or under-performing assets
- Businesses will benefit from the transfer of all responsibility for future remediation, monitoring, and operations and maintenance costs associated with the site(s) under the contract.
Drawbacks of Contract Liability Buyouts
- Cost of cleanup of known pollution conditions fully funded up-front by the seller into an escrow account either with cash from closing or other means if a transaction is not involved. Therefore, cost of capital is a factor to consider. Would you rather retain the liabilities and fund the cleanup over time to retain working capital or would you rather fund for the cleanup activities up-front into an escrow account?
- Frictional costs involved need to be evaluated.
- Risk of financial stability of the transferee and of the insurer backing the contract brought by the transferee needs to be assessed.
- Auditors may question deduction for liability transfer if associated real property is not transferred to third party as well.
David Bennink is director of Aon's international Environmental practice. In addition to participation
in the leadership of the Group, he is actively engaged in working with many
of Aon's clients to manage their environmental exposure. Mr. Bennink has been
involved in many of the larger environmental placements done in the industry
and continues to work closely with clients and underwriters to develop new products
and applications. He is based in Aon Environmental's Philadelphia office and
may be reached at (215) 255-1861.