Several recent accounts have attested to the usefulness of the new environmental insurance products in facilitating real estate transactions with environmental problems. 'Risk Management Considerations in Transactions Involving Contaminated or Potentially Contaminated Real Estate', by Rodney J. Taylor, in the Winter 1998 Environmental Claims Journal is such an account.1 However, it is seldom made clear precisely how to make insurance part of this process, where and when it should be involved. No one has adequately explained the process. Risk management professionals are trained to follow a rational, five-step, decision-making process for minimizing the adverse effects of losses.2 It is a process which incorporates insurance as a major risk financing technique. Environmental risk management professionals, especially those managing transactions, should do no less. This article will define the role of insurance in the process of managing environmental risk during a transaction. Insurance should figure at two points: at the beginning, in the risk identification and analysis phase, and in the middle, in negotiating the risk allocation provisions of the transactional document.
The Risk Management Process
In Essentials of Risk Management, George L. Head and Stephen Horn delineate a five step process for minimizing the adverse effects of losses.3
Step One: Identify and Analyze Loss Exposures
A loss exposure is 'a possibility of loss, or more specifically, the possibility of financial loss that a particular entity (organization or individual) faces as the result of a particular peril striking a particular thing of value'. 4 Financial losses that concern risk management can be categorized as :
- property losses
- net income losses
- liability losses
- personnel loss exposures.
According to this analysis, environmental loss exposures are liability, specifically statutory liability, loss exposures.
Step Two: Examine the Feasibility of Alternative Risk Management Techniques
Risk management involves either preventing losses from happening (risk control) or paying for those losses that do occur (risk financing).
Risk control techniques include:
- exposure avoidance, which eliminates entirely any possibility of loss by abandoning or never undertaking an activity or asset
- loss prevention, which aims to reduce the frequency (or likelihood) of a particular loss
- loss reduction, which aims to reduce the severity of a particular loss
- segregation of loss exposures, which involves arranging an organization's activities and resources so that no
- single event can cause simultaneous losses to all of them
- contractual transfer of an asset or activity for risk control, which is a transfer of both the legal and financial responsibility for a loss (e.g., by setting up a separate corporation).
Risk financing techniques are classified in two groups: retention and transfer.
Retention includes all means of generating funds from within a corporation to pay for losses, including:
- current expensing
- unfunded loss reserving
- funded loss reserving
- insuring with an affiliated 'captive' insurer
Transfer of the financial burden of losses from one corporation to another entails two different techniques:
- insurance purchased through an outside, unaffiliated insurer (commercial insurance)
- contractual transfer for risk financing, which covers non-insurance transfers (to a transferee other than an insurance company) through a type of agreement often called a 'hold harmless agreement' or 'indemnity agreement'.
Systematically examining alternative risk management techniques is a 'crucial, yet often overlooked, step in the practice of sound risk management. It is crucial because an alternative cannot be chosen unless it is recognized'. 5 Alternatives should not be restricted to the traditional options that management has always accepted, for example insurance. Rather, risk managers should identify as many risk control and risk financing options as possible and should try to imagine how each technique may apply to a specific loss exposure.
Except where exposure avoidance completely eliminates the possibility of loss, some combination of risk control and risk financing techniques for each loss exposure is required. 'Without risk financing, risk control techniques are not sufficient because some losses are almost bound to occur, and recovery from these losses must be financed. Without effective risk control, risk financing techniques alone do not constitute effective risk management'. 6
Step Three: Selecting What Appears to Be the Best Risk Management Techniques
After systematically considering how various risk control and risk financing options might apply to a particular loss exposure, the next step is to establish and apply criteria to determine what combination of risk control and risk financing techniques is best in serving an organization's objectives. This is a two-step activity consisting of forecasting the effects the available risk management options are likely to have on the organization's ability to fulfill its objectives and defining and applying criteria (usually financial) that measure how well each alternative technique contributes to each organizational objective in a cost-effective way. This two-step activity is accomplished through the use of probability and trend analysis techniques and by means of cash flow analysis.
Step Four: Implementing the Chosen Risk Management Techniques
Steps four, implementation, and step five, monitoring, obviously depend on the particular technique chosen and are dealt with by Essentials of Risk Management in the volumes that concern risk control and risk financing. In general, in the implementation stage, risk management professionals devote attention to both the technical risk management decisions that they must make to put a chosen technique into practice and the decisions that must be made in cooperation with other managers throughout the organization to implement the chosen technique. For example, if insurance is chosen to transfer a loss exposure, the appropriate insurer must be selected, proper limits and deductibles set and the purchase negotiated. In implementing risk control measures, the risk management department must often deal with managers on the 'front line', not subject to the risk manager's line authority.
Step Five: Monitor Results
Once implemented, a risk management program must be monitored to ensure that it is achieving the expected results and to adjust the program for alterations in loss exposures and availability or costs of other, alternative techniques. This process requires establishing standards of acceptable performance (despite the absence of consensus on what constitutes standards for judging risk management performance), comparison of actual results with these standards and correction of substandard performance.
The Environmental Risk Management Process
When the risk management process as described above is compared with the environmental risk management process as practiced today, certain differences leap out. Step one, risk identification and analysis, and the first part of step two, risk control, are far more technical and complex than in general risk management. This is probably due to the technical nature of the risk itself, which has produced a whole new science and engineering discipline. Whatever the reason, the result has been that environmental risk control has overwhelmed environmental risk management and has almost completely divorced itself from environmental risk financing.
Step One is More Complex
The identification and analysis of environmental risk is a much more complex and technical affair than the identification and analysis of other liability risks. Environmental risk is not the ordinary liability risk; it has a first party as well as third party liability component. It also contains a physical component in addition to the legal liability component, both equally complex. Once the physical and legal components are identified, the process of analyzing them is also more difficult than usual at this stage. The result is that step one of the 'environmental risk management process' will divide into at least three, equally complex, sub-parts -- Risk Assessment, Legal Assessment and Risk Analysis:
Risk Assessment. The physical aspect of environmental risk needs to be identified through some kind of due diligence process, usually consisting of a non-intrusive investigation (Phase I) and/or an intrusive investigation (Phase II). In general, the objective of the Phase I is to identify 'recognized environmental conditions' which may be associated with current or historic property uses and establish whether further inquiry into these conditions is warranted. As defined by the American Society for Testing and Materials (ASTM), recognized environmental conditions are situations which indicate the release, or threat of release, of hazardous substances or petroleum products into structures, soils, groundwater or surface water at a property.7 The Phase I usually consists of a records review (regulatory records and data base searches), site reconnaissance and interviews. The Phase II includes the same elements but some soil and/or water sampling as well.
A Phase I is essentially concerned with past conditions and is to be distinguished from a compliance audit, which deals with future conditions. Compliance audits evaluate operations of an existing facility for compliance with applicable occupational as well as environmental laws and regulations. Elements reviewed can range from permits associated with stormwater runoff to in-plant noise levels to hazardous waste disposal practices. An acceptable audit report will describe in detail each operation and practice subject to regulation or permit, its compliance status, and, when needed, will give recommendations for procedures necessary to bring the facility and each operation into compliance with applicable regulations. A compliance audit therefore is as much of a risk control technique as it is a risk assessment tool.
Legal Assessment. Determining applicable laws and regulations is an important component of environmental risk identification and can be just as complicated as assessing physical risk. The applicability of local, state and federal laws; permits and certifications; pending enforcement actions, claims, litigation and liens needs to be determined. Local, state and federal agencies, not necessarily all of them environmental, may have simultaneous jurisdiction over environmental risks; the environmental agencies may have different departments based on various environmental criteria; the overriding federal environmental laws may seriously conflict or overlap. Then, there may be various programs, such as Brownfields programs, state voluntary cleanup programs or multi-media programs that come into play (although it is usually an aim of such programs to simplify matters).
Risk Analysis. In order to make the property marketable, and for purposes of property valuation, a financial risk analysis based on the site and legal assessments often needs to be done. This may be extraordinarily difficult with regard to liability for historical contamination, for such loss may take years to develop and may develop unseen, underground. However, known contamination can be remediated (a risk control technique), and the costs of remediation can be estimated, using financial risk analysis techniques similar to those described under step three of the risk management process, above.
It is worthwhile to consider insurance at this initial stage of risk analysis for several reasons. Insurance underwriting can perform the financial risk analysis; and can do it once, thus saving time and money. The existence of insurance will change, and probably enhance, the property valuation. In the event of known contamination, a cleanup cost cap policy can be purchased based on the risk analysis cost estimate to contain cleanup costs and transfer liability. Finally, since insurance underwriting, like all financial risk analysis, is based on the risk assessments, the client will be best protected in this way, because what is known can be defined by what is in the Phase I.
Remediation Is Very Complex
Certain environmental risk control techniques, notably remediation and compliance, are unique to environmental risk and are uniquely complex. Compliance audits are described above under Risk Assessment. Remediation breaks down into a series of remedial action alternatives which should be considered and may include active or passive methods, or some combination thereof, including: source removal, treatment and containment technologies, natural attenuation, exposure pathway elimination, engineering controls and institutional controls. Remediation techniques may or may not be risk based and may differ according to statute, e.g., corrective action under the Resource Conservation and Recovery Act (RCRA) versus remedial action under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA).
Overlap and Confusion Between the Steps
As elsewhere in the environmental area, bright lines are not always easy to draw. We have already mentioned some overlap between the steps, as between risk assessment with risk control, because of the dual role of compliance audits. This overlap has led some people to confuse environmental risk assessment itself, or more specifically Phase I assessments, with environmental risk control. Elaborate financial risk analysis, which according to 'risk management' comes into play in step three, selection of the best techniques, also figures importantly in step one of environmental risk management. Another example of overlap between the steps would be groundwater monitoring, which can be an assessment as well as a monitoring technique.
Risk Control Has Overwhelmed the Process and Has Been Divorced From Risk Financing
The complexity of environmental risk, risk assessment and risk control has led to its removal from the purview of corporate risk management departments and placement under the aegis of separate environmental departments. These environmental departments have strictly focused on risk assessment and risk control to the exclusion of risk financing and insurance, while the risk management departments have focused on risk financing, excluding altogether matters environmental. The result is that environmental risk control has overwhelmed environmental risk management and divorced itself from risk financing. A corollary of this result is that environmental risk managers seldom systematically examine all feasible techniques, both risk control and risk financing, as vigorously recommended in Essentials of Risk Management.8
Another reason for the disappearance or submergence of environmental risk financing has been the unavailability of adequate environmental insurance policies. However, because of the availability of the new products, discussed below, it is now time for environmental risk financing to reassert itself and to become re-integrated with environmental risk control. There is now no reason why risk managers, versed in these products and the differences between risk management and environmental risk management, cannot follow a rational and integrated, five-step process in managing environmental risk.
The Environmental Risk Management Process in Transactions
How does the environmental risk management process, as practiced now when a transaction is involved, differ from the process recommended above? First of all, the initial step in the process, risk identification and analysis, is even more complicated. Second, while environmental lawyers directing a contaminated property transaction usually adhere to something like the first three steps of the outline set forth above, they do not typically consider or select insurance as a risk financing technique in the transaction.
Risk Identification and Analysis - Still More Complicated
For two reasons, the risk identification and analysis step will be even more complex where a transaction is involved than where it is not involved. First of all, risk analysis can serve a variety of other purposes in the transaction in addition to those already discussed, valuation and marketability. Second, in addition to the complexities of legal assessment described above, it is necessary, for purposes of the transaction, to determine the buyer and seller's objectives based on their environmental liability concerns
Risk Analysis. If a transaction is involved, risk analysis can serve several purposes in addition to valuation and enhancing marketability. It can alert the buyer or lender to any present or future problems that may be managed after closing. It can be used to document conditions at closing and to allow financial risk to be managed and allocated as part of the deal. It can allow those financing the project to make determinations concerning the acceptability of the financial risk and make proper disclosures in offering documents. Finally, it can allow insurance underwriters to determine the acceptability of the financial risk, determine specific insurance needs and set appropriate premiums.
It is particularly important to bring insurance into the process at this point of a transaction. As stated previously, insurance underwriting can serve as the one, all-purpose risk analysis, thus saving money and effort; and, in a transaction, one risk analysis can serve many purposes. Unlike the situation with risk assessments, described amusingly in 'Send Me a Copy of Your Phase I' in the BNA Environmental Due Diligence Guide,9 there is no need for different parties to repeat the risk analysis process.
Environmental Liability Concerns. In a transaction, one of the main issues preliminary to negotiation of the purchase and sale agreement is determining the objectives of the parties based on their environmental liability concerns. Sellers may be liable under CERCLA for (1) disposal of any hazardous substance on the land which occurred while they owned it or (2) discovery of contamination on the land during ownership and failure to disclose it to the buyer. Thus, sellers usually have sought to sell the property 'as is' with full releases and indemnities from prospective buyers and with as little impact on price and central terms of the deal as possible. Buyers may become liable under CERCLA for pre-existing environmental liabilities as the current owners of the property. Therefore, buyers have often sought to purchase the property free from all environmental liabilities arising prior to the closing and with an indemnity from the seller for such conditions. Because of these conflicting objectives, sometimes sales cannot be made.
When environmental lawyers are involved in a transaction from the beginning, there usually is a process resembling the first three steps of the 'risk management process'. In the beginning, prior to negotiation of the transactional document, risk assessments will be done, along with the handling of other threshold issues such as preliminary and pre-closing agreements. Next, risk control and risk financing techniques will necessarily be considered and selected together, as recommended for step two and three of the general process, because decisions about how to control contamination must be made at the same time as the environmental provisions in the main document are negotiated. These environmental provisions - the representations and warranties, the covenants and, most importantly, the indemnities - are essentially techniques for allocating the financial consequences of environmental risk. However, environmental lawyers do not usually consider all feasible risk financing techniques at this point; they pretty much stick to indemnification as a risk transfer technique and ignore insurance, which is the reverse of the situation for general risk management, where insurance is the predictable risk financing choice and other methods are neglected.
Risk Transfer Provisions in the Transactional Document
Insurance and indemnification are the two major risk transfer techniques. Insurance, along with indemnification, can be used as a standard provision for transferring environmental risk in transactional documents.
Indemnification. An indemnification provision is generally considered a commitment by the indemnitor to protect the indemnitee from third-party claims against, and/or other specified liabilities suffered by, the indemnitee. Contractual indemnities have been a popular mechanism to allocate environmental liabilities between buyer and seller in a transaction but have always had have inherent limitations. First of all, an indemnity is only as good as the financial worth of the indemnitor. Second, the legal effect of contractual indemnities for environmental liabilities may be unclear, depending on the nature of the liability and choice of law. Third, the drafting of indemnity provisions can be fraught with dangers and difficulties. It is dangerous, at least for the indemnitor, to accept broad, all encompassing indemnities in the environmental area ( all claims and liability arising out of a site forevermore). On the other hand, the increasing complexity of the agreements, with cross indemnities and parsing of specified liabilities, also makes for drafting difficulties.
Environmental Insurance. Environmental insurance is in many ways preferable to indemnification as a method of risk transfer because of the inherent limitations of indemnification and because of some inherent advantages of insurance. First, insurance companies are in the business of assuming risk and are ordinarily considered more reliable about payment than indemnitors. Second, insurers can provide certain services such as loss control and claims handling. Third, insurance may be a more complete form of risk transfer than indemnification since it often includes the defense obligation. Fourth, insurance, like holdbacks and letters of credit, can support the indemnity provision.
It makes sense to make environmental insurance a risk allocation provision of the purchase and sale agreement. The provision can be a bargaining chip in the transaction. Moreover, this kind of thing is done all the time in other types of contracts, not involving environmental liabilities. Generally, whenever one party agrees to hold another party harmless for certain liabilities, the risk management professional approving the agreement must be satisfied that the first party has purchased adequate insurance to meet his or her obligations. This step has been neglected in the environmental area, except for contracts involving environmental contractors and consultants, because of the lack of adequate insurance coverage for environmental liabilities arising at specific locations.
What are the risks in a transaction that need to be covered by such insurance? They include the following losses when caused by pre-existing or future releases of pollutants from or at a specific site:
- Cleanup costs, whether on-site or off-site
- Third-party bodily injury and property damage (including diminution of property value)
- Legal defense expenses
- Business interruption and costs of delayed construction
- Collateral value loss for banks (or first-party diminution of property value for owners)
- Cleanup cost cap or stop loss (cost overruns above an estimate)
Coverage for these risks was not widely available until approximately two years ago. Prior to that, three companies dominated the market: AIG, Zurich and Reliance; their policies were narrowly drafted and their premiums high. However, in the last two years, there have been some very favorable changes in the environmental insurance market, including substantial capitalization, realistic pricing, broadened coverage and the emergence of two new companies, Kemper and United Capitol.
The old pollution legal liability policies written by the original three essentially covered off-site cleanup costs, off-site property damage and third party bodily injury arising from an on-site release; the release had to occur in the future or, if pre-existing, had to be unknown. Also, the policies had a 'double trigger', i.e., were claims made and reported, and the coverage period was only for one year ( yet pollution is, surely, a 'long-tail' or delayed manifestation risk). The claim requirement meant that voluntary cleanup costs were excluded, and the policies usually had the right but not the duty to defend. In short, the old policies did not cover all the risks that needed to be covered, as listed above, particularly those items that need to be covered in a Brownfields transaction or one involving contaminated property.
All the five companies now offer in their pre-printed forms site-specific coverage for at least on-site and off-site cleanup costs, third-party bodily injury and property damage and legal defense expenses growing out of pre-existing, unknown or future releases. They also will offer the following features at least some of the time:
- Multi-year policies
- Single trigger of coverage (usually, reporting of a claim)
- Voluntary cleanup costs
- Duty to defend
- Cleanup cost cap coverage
- Governmental claims for pre-existing, known pollution (also known as 'government reopener')
- Collateral value loss
- Business interruption and delayed construction costs
The companies are also much more flexible about policy amendments. They are particularly prone to 'manuscripting' in the context of transactions because the pre-printed forms often need to be tailored to the particulars of the transaction.
Notwithstanding this flexibility and broadening of coverage, it is important to take care that the policy purchased actually covers the risk. Unless environmental professionals are involved in obtaining and reviewing the coverage, it is all too easy to go wrong. Brokers should be familiar with environmental risk, besides being aware of how the policies are underwritten and the meaning of the coverage forms. Environmental coverage lawyers experienced with these particular types of policies should review the final forms to ensure that the wording is satisfactory.
Case Study. Some environmental lawyers have successfully used an environmental insurance provision in their purchase and sale agreements, to support otherwise unacceptable indemnities as recommended above. For example, in the recent sale of some industrial property, a pre-existing, underground storage tank spill was in the process of being cleaned up pursuant to state order. The seller was willing to take responsibility for this known, pre-existing pollution but wanted the buyer to take responsibility for what was pre-existing and unknown. It was a take it or leave it situation. Transactions often break down at this point. However, the buyer really wanted the property, which was ideal for his corporate headquarters. Therefore, the environmental lawyer representing the buyer asked if it was possible for the buyer to obtain insurance covering and supporting the indemnity. It was.
Two provisions were put in the contract: one in which the buyer indemnified the seller for pre-existing, unknown pollution (with certain exceptions, e.g., for resulting bodily injury); and an environmental insurance provision, or covenant, in which the buyer agreed to pay the premium, at closing, for an environmental insurance policy which would cover the terms of the indemnification provision, for which the seller would have final approval and which would be attached to and become part of the purchase and sale contract.
This provision required considerable negotiation with the insurance underwriter as well as the seller. The seller wanted the policy to be non-cancellable, including by the insurer. Ultimately, he agreed that the buyer would not cancel it, and the insurance company could only cancel it for fraud. The policy could not exclude something that the indemnity covered. For example, 'radioactive material' was excluded by the pre-printed policy but included in the transactional document definition of 'hazardous substances'. Therefore, the exclusion had to be rewritten..
This transaction would not have been completed without the environmental insurance provision. It made the difference in the deal. Ultimately, the closing took place, the five-year premium was paid and all the parties were satisfied.
The environmental risk management process in a transaction should adhere to the five step process of traditional risk management, and environmental insurance should play a role at two points in the process. Insurance should be considered very early, during the risk analysis phase. In this way, insurance underwriting can be a way of analyzing the risk for other transaction purposes; and the client will have the most protection, since what is known can be based on the risk assessment documents. Then, during negotiation of the transactional document, insurance should be considered and often selected as a risk transfer technique through an environmental insurance provision. In this way, the policy will be integrated into the transaction, and insurance into the risk management process.
- Rodney J. Taylor, 'Risk Management Considerations in Transactions Involving Contaminated Property',
- Environmental Claims Journal, vol. 10, no. 2 ( Winter 1998).
- George L. Head and Stephen Horn II, Essentials of Risk Management, Insurance Institute of America, 2nd ed. (1991).
- Id., vol. I, at 10.
- Id., vol. II, at 1.
- Id., at 42.
- ASTM Standard E 1527-94, 'Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process', and E 1528-93 'Standard Practice for Environmental Site Assessments: Transaction Screen Process'.
- Essentials of Risk Management, vol. II, at 42.
BNA's Environmental Due Diligence Guide, vol. I, at 231: 631.