Branching out: the expanded use of environmental insurance covers mergers and acquisitions risks, stimulates property redevelopment and helps corporations offset environmental liabilities

Risk & Insurance, Oct 1, 2003 by James C. Herrmann

Many risk managers would be surprised at the multiple uses for environmental insurance these days. Beyond the textbook definition of the coverage and the obvious protection it provides, environmental coverage is an essential component in financial transactions, real estate deals, property redevelopment, and in securing commercial loans. A principal use for environmental insurance is to replace or strengthen the environmental indemnity, or "carve out," in a transaction. The parties use environmental insurance to cover risk that one party doesn't want to assume at the outset, or doesn't want to hold onto after the sale.

Then, too, there are environmental liabilities that corporate boards need to be aware of to protect themselves and their shareholders against the financial impacts of environmental claims.

This is more evident today than ever before. Look at the heightened scrutiny and raised expectations of the Securities & Exchange Commission and other regulatory bodies in the wake of a host of recent corporate scandals.

The way the accounting rules now work, once a corporation realizes an environmental liability, it must account for it. The old "blind wall" (if we don't know it's there, it's not an issue) doesn't work anymore.

Examples of environmental liabilities a corporation may face include leaking underground storage tanks, any operation involving oil or petroleum hydrocarbons and chemicals, and degreasers. Simply owning real estate has even become more of a high-risk investment strategy due to the current mold litigation crisis embracing our legal system. Companies need to be aware of their current and past operations, of what they have and have not done and of the properties they own now and have owned in the past. In assessing these exposures, environmental insurance can provide significant relief in backing up exposures with a mechanism that allows for the safe and efficient transfer of environmental risk.

Prior Contamination

In cases where a property is contaminated, the insurance industry offers an insurance product known as "cost cap" or "stop loss," which is basically pollution clean-up cost overrun protection that pays expected claims plus cost overruns. This coverage can be blended into combined policies with pollution legal liability insurance, or it can be used in what's known as a "finite insurance" policy. This type of policy combines cost cap and pollution liability, but allows for the insured to receive a return premium, should the cleanup cost less than expected.

Cleanup cost-cap policies are typically used when there is an environmental cleanup with potential pollution conditions, combined with a desire by the responsible party to transfer the risk to a third-party insurance carrier.

For example, say the responsible party and the insurance carrier's engineers agree that a cleanup will cost $10 million. The owner has expressed a concern that there may be other conditions that they don't know about, or that the cleanup may exceed $10 million. The insurance company issues a finite policy that covers the cost of the known, anticipated cleanup plus any cost overruns that may occur, with a limit of $20 million. The carrier collects a premium of $11.5 million. Any balance remaining upon completion of the cleanup is returned to the insured.

In addition to the risk transfer, there may be substantial tax and accounting benefits to using a "finite" approach, but that should be discussed with a tax professional.

Surety Bonds

In addition, environmental insurance products also can be used today as an alternative in situations that require financial assurance due to the declining availability of surety bonds from traditional markets.

Stepping into the void, the insurance marketplace has come up with ways to use finite and other types of insurance to assume risk and provide surety bonds in certain areas. In the past, a company would buy a bond and clean up the property, and then the bonds would be released.

If 100 percent of collateral is required, and the collateral is the cash that was intended for the cleanup, how does a company generate a second pot of money to provide collateral and clean up the property?

A finite insurance policy can be placed in conjunction with the bonds to solve this dilemma.

Yet another example of the vital role environmental insurance plays is in the so-called "brownfields" arena. Brownfields are contaminated properties land that once held a gas station or a paint factory, for example--that now lie fallow, off the tax rolls because there is insufficient municipal or public funds to clean them up. Those responsible for the contamination are often bankrupt, with few assets.

The National Brownfield Association has been active in working with state and federal regulators to jumpstart brownfield redevelopment in the United States. As a result, the federal government has passed a measure that helps municipalities, through the use of grants, to identify brownfields and determine the extent of pollution at these sites. The federal program also provides other tax and financial incentives to attract developers. But one thing is lacking: money. The end result is that many of these properties sit dormant when they can be redeveloped and returned to the tax rolls. Environmental insurance can play an important role in brownfield redevelopment. Commercial lenders stand ready, with the assistance of environmental insurance, to lend money to help the public buy, clean and redevelop these properties. And state brownfield bills need to address this issue, like the federal law, through subsidies or tax credits. No significant brownfield redevelopment will happen in any state that doesn't encourage private commercial lenders to enter their market.