The collateral loss value coverage parts of the five policies differ significantly from each other in their treatment of trigger of coverage and method of payment. The direct liability coverage parts differ somewhat less from each other. The four carriers have very different approaches to what they will do when there is a desire for combined coverage, i.e., coverage for the borrower as well as the bank. The premiums for such combined coverage and for separate SC policies can vary widely, although SC policy premiums in general are significantly lower than pollution liability policy premiums for the owner or borrower with respect to the same property.
Lenders can purchase two types of portfolio programs - a blanket policy applicable to a portfolio of loans, and portfolio insurance that can be used for securitization purposes. It is these portfolio programs that have been marketed as a substitute for due diligence. Environmental insurance can never be a true 'substitute' for due diligence. The two provide an entirely different form of protection and are natural complements of, not substitutes for, one another. However, it may be possible for banks to use SC portfolio coverage as an alternative to the banks' due diligence programs with regard to the bank's liability for collateral loss value. The rating agencies have recently concluded that this can be done for conduit or small loans if certain of their concerns are mitigated: continued reliance on due diligence in certain contexts; the company's Best's rating; its claims-paying record; and, most crucially, the policy form. While all of the policies contain provisions that the rating agencies criticize, the carriers are generally flexible about tailoring policy language to the requirements of a particular deal, provided someone competent represents the lender in negotiating those changes.
The two preceding issues of this journal have offered two excellent articles that address important aspects of lender liability environmental insurance. In the Autumn 1999 issue, Michelle Schroeder of Zurich thoroughly analysed the lender's environmental legal liability as well as coverage for that liability afforded by the new lender policies. In the Spring 2000 issue, Janet Moylan and Richard L. Calvert of AIG broadly illuminated the creative business uses of environmental insurance, with particular emphasis on the use of lender insurance for securitization of a loan pool. This article will address two important aspects of the insurance that the earlier articles only touched upon. First is the issue of how the policies provided by the four major environmental carriers compare with each other. The Schroeder and Moylan/Calvert articles naturally tended to focus on the Zurich and AIG policies and programs, respectively, yet there are significant differences among the policies of the four carriers. (For one thing, they all have different names; this article will use 'Secured Creditor' ('SC') policy for all such forms.) The second issue is more controversial. AIG and Zurich have marketed their portfolio programs as a less expensive alternative to a bank's customary environmental due diligence program. [footnote 1], and the environmental engineering community has taken a dim view of this position. [footnote 2] This article will attempt to clarify the differences between all of the SC policies now on the market, and to resolve the thorny due diligence dispute.
The first environmental policy for lenders appeared at the end of the 80's as an outgrowth of the original environmental impairment liability ('EIL') or pollution liability ('PL') policies as they are now known. During the '80s and early '90s, the EIL or PL policy covered on-site pollution conditions that arose at specified sites and gave rise to off-site or third party cleanup costs, as well as third-party bodily injury and property damage. As is often true of any new and emerging coverage, these policies were markedly restrictive and expensive. For example, they only covered off-site conditions, and they were only sold to owners of the sites.
At the end of the 80's, some cases, and one in particular, generated concern that lenders needed protection for their environmental liability. (United States v. Fleet Factors Corp., 901 F. 2nd 1550 (11th Cir. 1990). The cases and the concern led to creation of the original lender liability or first party property transfer policies. These policies protected buyers, sellers, and lenders of potentially contaminated real estate, and their concept was a good one - to use a site assessment as a guaranty or warranty that no environmental conditions existed on the property, somewhat in the manner of title insurance. They did not sell, however, but they are the forerunners of today's SC policies and, to some extent, of today's new and improved PL policies.
The first of the newer SC policies appeared three or four years ago at the same time as the other new environmental policies, largely in response to the brownfields movement. The new SC policies were at first primarily designed for portfolios of loans and were marketed as a much less expensive alternative to a lender's environmental due diligence program. The last two years have seen several articles by environmental engineers criticizing banks for requiring their borrowers to buy these policies, which, after all, only protect the lenders, not the borrowers, instead of doing the necessary due diligence.[footnote 3] Recently, however, both Fitch and Moody's have given approval to the use of environmental insurance for lenders as a means of securitization of loan pools, without traditional due diligence, in certain circumstances and if certain concerns were met. [footnote 4]
Secured Creditor Policies and Coverages
The four major environmental carriers all have a separate, stand-alone SC policy for lenders and banks, and one of them - AIG - has two. Each of these policies has a different name. AIG's two SC policies are 'The Secured Creditor Impaired Property Policy - Loan Balance', and 'The Secured Creditor Impaired Property Policy - Lesser of Loan Balance or Cleanup Costs'. Zurich's is the 'The Lender Environmental Collateral Protection and Liability Insurance'. Kemper's policy is called 'Creditor Reimbursement for Environmental Damages Insurance', and ECS's policy has the name, 'The Real Estate Lender's Policy'. All of these five stand-alone policies contain coverage parts for the loss of collateral value due to a pollution condition, a lender's primary concern. They also have coverage parts for the lender's direct environmental liability for cleanup costs, bodily injury, or property damage arising from a pollution condition, of somewhat lesser concern to a lender than a borrower, particularly before foreclosure. All the companies will issue these policies on a pooled basis applicable to a bank's entire or partial portfolio of loans.
Coverage for Collateral Loss Value
The environmental liability that must have the lender's most rapt attention is the borrower's inability to repay a loan due to a pollution condition. The SC policies of all of the four companies each have coverage parts or insuring agreements that address this concern, usually referred to as 'collateral loss value' coverages. These coverage parts differ significantly from each other in how they treat of trigger of the coverage and the method by which they provide for payment. For trigger, all require a default and the bank's discovery of a pollution condition. However, the AIG loan balance policy is triggered merely by default and first discovery of on-site pollution conditions. Its 'lesser of' policy requires foreclosure as a trigger if the cleanup costs are less than the outstanding loan balance (which is usually the case).
Once coverage is triggered, four of the five policies will pay the lesser of the outstanding loan balance or the cleanup costs. As indicated by its name, the AIG loan balance policy lacks this typical payment pattern; it simply indemnifies the bank for the outstanding loan balance after default and upon discovery of a pollution condition without regard to the amount of cleanup costs. The Zurich policy pays the lesser of cleanup costs or the outstanding loan balance, as does the AIG 'lesser of' policy. The Kemper and ECS policies pay the lesser of the outstanding loan balance, the cleanup costs, or - a third element -- the fair market value of the property.
Coverage for Direct Liability
Coverage for its direct environmental liability is of lesser concern to a lender than the borrower's inability to pay due to a pollution condition. Nevertheless, the liability is potentially there, particularly after foreclosure. Under CERCLA and similar laws, anyone who is a former or current owner, a generator or a transporter to a Superfund site is potentially liable for cleanup costs, bodily injury, and property damage as a result of contamination at that site (42 U.S.C.9601, 1980; and SARA amendments, 1986). If a bank becomes an owner as a result of foreclosure, it may be subject to the same direct liability for such damages that any owner would have.
In addition, a lender can have liability as a non-owner under the 1996 Asset, Conservation, Lender Liability, and Deposit Insurance Protection Act (42 U.S.C. 96014 (20) (F) (IV)) whereby Congress, subsequent to the brouhaha generated by the 'Fleet Factors' case, clarified how a lender might 'participate in the management' of hazardous materials under CERCLA's secured creditor exemption. Because of this clarification , a lender's direct environmental liability for environmental damages pre-foreclosure is considerably more contingent than a borrower's.
In the Kemper and ECS policies, coverage for direct environmental liability is similar if not identical to such coverage under those companies' PL policies. Their direct liability insuring agreements pertain to claims for bodily injury and property damage, to cleanup costs, and to defense costs and are basically separate from the policies' collateral loss value coverages. The direct liability coverage parts of the AIG and Zurich SC policies differ more from those companies' PL policies, and interact somewhat more with the collateral loss value coverage parts of the SC policies. Each of their three SC policies has a coverage part for first party or on-site cleanup cost that is triggered by the insured's discovery of a pollution condition and reporting of it to the carriers. There is no coverage under such first party coverage part if a claim has been made under or reported under the collateral loss value coverage part. These policies also have a coverage part for third party bodily injury, property damage, and third-part or off-site cleanup costs, triggered by a claim made and reported in the policy period.
Combined Coverages and Price
Another difference in and among these policies is what each of the carriers will do when there is a desire for combined coverage, i.e. coverage for the borrower as well as the bank. One question is whether there is ever a need for both coverages or policies at the same time. All of the insurers who issue these policies will usually, if asked, provide coverage to borrowers for the same property under a separate PL policy. Some underwriters at some companies believe that there is seldom a need for both, since the lender can be added to a PL policy as an additional insured with respect to direct environmental liability. They believe that if the borrower is covered for such direct liability, there is little chance that a pollution condition will impact the borrower's ability to repay a loan. One carrier, AIG, believes that the coverages are separate and entirely different and that only the SC policy protects the bank if there is a default. AIG will accordingly issue an SC policy at a substantial discount if both coverages are requested, assuming it considers the risk insurable. Zurich will not provide a discount, and the other two will provide a discount but possibly less than AIG's.
The price for such combined coverage will probably be substantially higher than for an SC policy sold to a bank alone, or for a PL policy sold to a borrower alone. A typical PL policy sold today - i.e., for one, somewhat contaminated, site, with a five-year policy period, $5 million limits, and a $50,000 deductible -- would probably cost between $35,000 and $45,000. A typical SC policy for the same site would cost at most half of that. Both the lower price and an occasional lack of willingness to cover the borrower as well as the lender would result from the belief that the lender's direct environmental risk is more contingent than the borrower's. In underwriting SC policies, underwriters may therefore tend to examine the environmental risk less thoroughly than when they are underwriting PL policies or coverages for a borrower.
Even with respect to the same type of policy and coverage, there can be vast difference in price among the quotations of particular underwriters from different companies on the same risks. That can be due to several factors: the essentially subjective nature of environmental underwriting; the substantial differences in coverage among the policies; and the fact that this coverage is generally evolving. In recent months, new companies have initiated new programs, old companies have revised old policies, and both types of companies are planning to make further revisions.
The following case study illustrates the great differences in coverage and price that may result from marketing the same risk to a number of different carriers. This risk was marketed several months ago, when five carriers were providing SC coverage, the four discussed above and United Capitol, using United National paper. [footnote 5 ]
A shopping center in up-state New York had leased part of its property to a gas station for many years. The previous gas company/lessee had caused and cleaned up a spill, resulting in a no further action letter. The current gas company/lessee was dragging its feet about cleanup up some new contamination that it had clearly caused - and the lease agreement lacked a clear indemnification clause. The bank was threatening to cancel the loan, so the goal was to convince the bank that the pollution condition did not threaten its security interest. Hence, the need for environmental insurance.
The risk was marketed to all five carriers. One, carrier A, declined to quote at all, but the other four gave premium indications for a 10-year policy. Carrier B offered a $15,000 premium but with a very restrictive policing including a foreclosure requirement. Carrier C offered a $20,000 policy without a foreclosure or even a default requirement. Carrier D quoted at $30,000 and carrier E at $35,000 with coverage fairly similar to that of Carrier C. Subsequently, when it appeared that the gas station was willing to indemnify the owner properly, Carrier C offered to issue a PL policy to the own with an endorsement covering the bank for its collateral loss value exposure - for the same original $20,000. .
Lenders can purchase two types of portfolio SC programs. A retail banker can purchase a blanket policy applicable to the bank's existing loans, with a provision to add new loans as they come in. It is also possible to purchase portfolio SC insurance for securitization transactions. As this is writer, the premiums on the portfolio policies are running very low, about $100 to $600 per loan for low risk properties and $1000 to $1400 for higher risk properties. The due diligence issue is the main difference among these programs among the companies. Two of the companies, AIG and Zurich, have been marketing the programs and policies as an inexpensive and efficient alternative to the bank's due diligence program; the other two, Kemper and ECS, have note. The latter companies require either Phase I's or transaction screens on all submissions, whether 'one-off' or under a portfolio.
Can the SC Policy Be a Substitute for Due Diligence?
The idea that SC policies or programs can function as a substitute for Phase I's or due diligence has come under considerable fire from environmental engineers during the last year or so.[footnote 5] The engineers maintain that, historically, banks have required Phase I's on all properties, providing an inducement to borrowers to conduct proper due diligence. They are now presumably being discouraged from doing so, since some banks are requiring borrowers to pay for insurance (that protects the lenders alone) instead of the historical due diligence. One article even claimed that banks were thereby violating a public trust, their special duty to protect borrowers in this regard.
Naturally, it can be claimed with some justice that the engineers have an 'axe to grind' and are concerned about losing Phase I business. That does not invalidate their arguments, but not all their arguments are persuasive. The idea that banks have a special duty to protect and forewarn the borrowers about their own due diligence does not survive the laugh test. (The borrower's lawyers are the ones who have the duty.)
But there are better arguments against substitution. Environmental insurance can never be a true 'substitute' for due diligence. To substitute means to take the place of, to serve the same function. Due diligence is the identification of risk or of loss exposure, the first step in the risk management decision making process, and in the environmental area usually consists of site assessments such as transaction screens, Phase I's, which are non-invasive, and Phase II's and III's, which are invasive. A bank's due diligence extends beyond the environmental and into the borrower's ability to repay.
For parties with direct liability, environmental due diligence is also the basis of the innocent purchaser defense to CERCLA liability. Such parties include both the bank and the lender, but, as argued above, the latter has less fear of direct liability than the former, particularly before foreclosure, and is therefore less in need of the defense at that time. The ASTM transaction screen and Phase I were designed with the innocent purchaser defense in mind. If performing these standard guides properly fails to uncover a 'recognized environmental condition', and an environmental condition is subsequently discovered, then the responsible party should be able to assert the defense successfully. Of course, there is no guarantee. The operative word is 'should'. But there is no denying the fact that, without appropriate due diligence, i.e., the transaction screen or Phase I, there will be no innocent purchaser defense to direct liability.
Insurance, on the other hand, is a risk financing, more precisely a risk transfer mechanism, which, like all risk management options relies upon the proper identification of risk. Insurance does not make the liability go away, or prove that it was never there. Accordingly, an insurance policy cannot in general stand in for or substitute for a Phase I. By the same token, a Phase I is no substitute for insurance. Insurance transfers to another party the financial consequences of the exposure, while Phase I's merely identify the exposure. Moroeover, Phase I's are only good for a year or so, while SC policy periods can extend to 20 years. The two provide an entirely different form of protection. As a general rule, insurance and Phase I's are natural complements of one another, not substitutes for each other.
This does not mean that certain types of coverage can never be used as an alternative to due diligence in certain situations. The situation where they cannot be used as such is where the borrower or owner of a potentially contaminated property (including a bank that has foreclosed) needs protection with respect to its own direct liability. In that situation, due diligence must be done, and lawyers (not banks) advising such borrowers or owner need to apprise them accordingly. Articles and marketing pitches that vaguely offer 'environmental insurance' as a substitute for a Phase I give the false and dangerous impression that the insurance can substitute for the borrower's or owner's Phase I with regard to the borrower's or owner's direct environmental liability.
On the other hand, it may be possible in some circumstances for banks to use the insurance as an alternative to their due diligence programs with regard to their own liability for loss of collateral value. Fitch and Moody's have essentially concluded as much. Their recent reports state that lender environmental insurance can be an acceptable substitute for due diligence, without negative credit implications, or with credit enhancements in certain circumstances and if certain concerns are mitigated. [footnote 6] The circumstances generally involve pooled SC policies, especially their collateral loss value coverages, used as a form of securitization for the loan pool. The rating agencies conclude that the SC pooling programs can be used most appropriately in this manner for conduit or small loans involving low risk properties or older industrial properties, but only upon mitigation of their concerns.
These concerns include the following: Due diligence should not be entirely eliminated. The insurer's program should include its own due diligence, including data base searches, which will reveal whether or not there is contamination, and a need for further due diligence. A Phase I must be done upon default. If the property is clean, then and only then can the lender foreclose. [footnote 7] Other concerns include traditional criteria for choosing one insurance policy versus another, i.e., the rating of the insurance company and the company's good claims-paying record.
The policy form is of crucial concern. Both agencies take the position that if these policies are to be used as securitization of a loan pool, they 'should provide for the full payment of the loan balance and the related outstanding obligations without requiring the trust to take possession of the property through foreclosure or requiring any estimate of cleanup costs'. [footnote 8] The policies should not include exclusions for certain types of environmental risk, e.g. lead and asbestos [footnote 9], and coverage only of conditions that violate environmental laws. [footnote 10] They should not include exclusions based on knowledge of the insured or which require that the conditions be 'unexpected and unintended' from the perspective of the insured or any other party, as those may lead to coverage disputes. [footnote 11]
AIG and Zurich, the two companies that have offered their programs for securitzation of loan pools, fulfill the rating agencies' due diligence requirements. Their underwriting processes subject all loans to internal due diligence performed by the insurance company, which usually includes a questionnaire comparable to a transaction screen and data base search. These are also highly rated companies. AIG has a Best's A++ XV rating, and Zurich an A+ XV rating..
The Moody's and Fitch form requirements provide a basis upon which to evaluate the policies in terms of the meaningfulness of their coverage, as well as their sufficiency for purposes of rating. On balance, the AIG loan balance policy probably provides the broadest and most meaningful coverage of all five policies, because it is the only one that pays the loan balance without requiring a cost estimate. However, many of the off-the-shelf forms have the sort of exclusions and definitions that the rating agencies criticize. Kemper's policy is the only one that defines 'environmental standards' to include ASTM's risk based corrective action standard in addition to environmental laws and regulations. This means that Kemper's is the only policy that clearly covers voluntary cleanup costs. Both the AIG and the Zurich policies, unlike the other two, have exclusions for 'intentional' acts as opposed to intentional violations of statute, i.e, that raise the problematic knowledge issue. (Of course, it is highly unlikely that the lender would have committed such an intentional act, unless it has foreclosed and owns the property.) All the policies have lead or asbestos exclusions. However, the insurers are often flexible about tailoring standard policy language to the requirements of a specific transaction. The lender will need the assistance of an environmental insurance expert, usually a broker, who can negotiate such tailoring on its behalf.
As Janet Moylan and Richard Calvert correctly maintain, these SC policies, like all of the new environmental insurance policies, have some extremely valuable business uses. They can be used to facilitate individual transactions involving contaminated property, where they may be a substantially cheaper alternative, or may be a relatively inexpensive addition to, PL coverage for the borrower. They can apply to a bank's entire portfolio, where they are an even less expensive alternative. And they can serve as securitization of a bank's loan pool for conduit or small volume loans, if certain of the rating agencies' concerns, particularly those involving the form of the policies, are met. Those policies that meet the rating agencies' concerns about form are most likely to provide the broadest and most meaningful coverage. In preparing these policies for approval by a rating agency, as well as for use in individual transactions, a lender would be well advised to retain an expert broker who understands the differences among the forms, and who can negotiate appropriate modifications with the insurer or rating agency.
1. For instance, 'Environmental Insurance Offers Alternative for Loans: Insurance Intended to Replace Required Phase I Assessments for Commercial Real Estate Lending', Dallas Business Journal, August 20-26, 1999, quoting a broker marketing the Zurich program.
2. See, 'Phase I Professionals Question Whether Banks Requiring Lender Protection Insurance Violate the Public Trust', Environmental Site Assessment Report, Vol. IV, No. 1 (January 1999); and John P. Bachner, 'New Environmental Insurance Policy Poses Grave Risks if Misused', ASFE News, March 22, 1999.
4. 'Criteria for Use of Environmental Insurance in CMBS', Fitch IBCA, June 8. 1999; 'CMBS: Noody's Approach to Secured Creditor Environmental Insurance', Moody's Investors Service, June 4, 1999.
5. United Capitol/United National have temporarily withdrawn from the market and therefore were not included in the article's overall analysis.
6. See note 4.
7. Fitch, p. 3; Moody's, p. 3.
9. Fitch, p. 5.
10. Moody's, p. 3.
11. Moody's, p. 5.