The New Environmental Insurance Products: When Does it Make Sense to Buy Them?
Real estate transactions with environmental problems often founder on attempts to shift the liabilities from one party to the other. In transactions with other types of problems, insurance is a popular risk transfer mechanism, and is regularly used for that purpose, but it is used far less often when there are environmental risks. This so-called 'environmental insurance gap' in real estate transactions has often, and correctly, been attributed to the inadequacy of the old environmental insurance products. They failed to provide adequate coverage for the risks. Beginning about three years ago, however, the insurance industry began to offer, and is now aggressively promoting, some new products, which it says have risen to the occasion and can be used to save such environmentally-troubled deals. What are these new products, and how do they differ from, or improve upon, the old? When is it a good idea to buy them, and when to avoid them? Part I of this article will answer the first two questions; Part II will address the second.
What were the Old Products?
Up until very recently, the environmental insurance market was dominated by three companies, AIG, Zurich and Reliance (ECS), which issued essentially three products: a site-specific pollution liability policy, referred to as the 'pollution legal liability policy' ('PLL') or, alternatively, the 'environmental impairment liability policy' ('EIL'); and two policies designed for the environmental services industry, a contractor's pollution liability policy ('CPL') and an environmental consultant's errors and omissions policy ('E&O'). These three original products warrant a brief review, with their deficiencies set forth, before they can be contrasted with those that have replaced them.
The PLL Policy
The PLL policy was essentially designed to address third-party liability arising out of a pollution condition at a specified site. The basic insuring agreement of the PLL policy resembled Coverage A of the commercial general liability ('CGL') policy. Coverage A agreed to pay for damages because of bodily injury or property damage caused by an occurrence. The PLL policy agreed to pay for 'loss' - bodily injury, property damage and cleanup costs - because of a 'pollution condition'. A 'pollution condition' was virtually identical to the CGL policy's pollution exclusion ( a release, discharge or escape of pollutants into the land, water or atmosphere).
A basic difference between the PLL and CGL insuring agreements lay in trigger of coverage, that is, in what determined that a particular policy would be invoked. The CGL policy had a single trigger. It was the occurrence of bodily injury or property damage during the policy period. The PLL insuring agreement contained a 'double trigger': a claim made upon the insured and reported to the insurance company during the policy period. This double trigger ensured that coverage for environmental risk, a long-tail risk par excellence, would have no tail beyond the one-year period of coverage except for that provided under the limited 'optional extended reporting period' endorsement. And, if the policy was renewed, the double trigger made stacking, or coverage under more than one successive policy for the same claim, virtually impossible.
Another difference between the insuring agreements of the CGL and PLL policies involved the defense provisions. The CGL policy had a duty to defend, and defense costs were outside the limit of liability. The PLL policy had the right but not the duty to defend, and defense costs were included within the limits of liability.
Restrictive definitions and multiple exclusions seriously limited the scope of the basic terms, the pollution condition and elements of 'loss'. The pollution condition, unlike coverage under the exception to the CGL pollution exclusion, could be both sudden and gradual. It could also be pre-existing or current, occurring during the policy period. However, it could not be on-site. It had to originate, or be released, on-site, but the resulting environmental damage and cleanup costs had to occur off-site. This refusal to cover on-site pollution conditions and cleanup costs derived from the CGL policy's owned property exclusion and the idea that the policy was for third, not first- party, damages. Yet on-site conditions can be as much of a worry in contaminated property transactions as off-site ones.
Another serious limitation on the pollution condition was that, if pre-existing, it could not be known. The most prominent and troubling exclusion in the policy was for a pollution condition existing prior to the policy effective date 'if any named insured or employee responsible for environmental affairs reasonably could have expected that such pollution condition would give rise to a claim'. Perhaps because of the difficulty in determining what is known, particularly for older industrial facilities, this exclusion was the subject of many heated coverage disputes. And, obviously, in contaminated property transactions, known contamination is the very thing that needs to be covered.
The pollution condition was further curtailed by limitations on the types of pollutants that could fall within its ambit, such as acid rain and radioactive matter; upon the types of objects from which pollutants could be released, such as underground storage tanks, vehicles in loading or unloading or wells if oil were involved; and on the types of sites or locations from which the release could emanate. Superfund sites, non-owned facilities, 'off-shore facilities' as defined by the Deep Water Port Act or Clean Water Act and alienated properties were all excluded. Such exclusions eliminate many of those areas which are precisely in need of coverage today, for example potential Superfund sites in brownfields redevelopment projects.
The definitions of 'cleanup costs' and the requirement of a 'claim' in the insuring agreement meant that voluntary cleanup costs were not covered, a serious impediment in current brownfields or voluntary cleanup programs. The definition of property damage did not encompass diminution in value (third or first party) or collateral value loss for banks, thus precluding secured creditor or lender liability coverage. Some typical CGL policy exclusions limited coverage for products liability or completed operations pollution. Finally, damages did not include non-pecuniary relief, business interruption or consequential damages. There was a full contractual liability exclusion, obviously an impediment in transactions with environmental indemnification provisions.
The exclusion for intentional or willful violation of a statute seemed reasonable since liability insurance is supposed to apply to fortuitous events. But many of the rest of the exclusions, especially in the aggregate, gave the impression that what the right hand gave the left hand took away and that the policy covered everything except what needed to be covered.
Along with providing very narrow coverage, these policies were extremely expensive. In 1990, an average premium for an industrial facility, one site, one-year policy, $50,000 deductible, $5 million limits was $100,000 or above.
2. Explanation for Narrow Coverage and High Prices
This narrow coverage and high pricing was not just another nefarious plot by the insurance industry (c.f., 'The Rainmaker'). It was typical of a new and evolving insurance market. When 50-odd carriers entered into the environmental insurance market after the adoption of the RCRA regulations in 1980, they attempted to use traditional practices for underwriting and pricing CGL policies. This attempt had disastrous consequences, and, by 1984, all but one (AIG) were out of the market (although some are still paying claims). The reasons for the disaster were, first, the lack of history upon which to base underwriting decisions and, second, that those underwriting techniques were wrong. A PLL policy cannot be underwritten or rated in the formulaic way of CGL policies; the policies are individually risk rated by comparing specific Phase I's with what is known about other, similar sites. In the early 1980's, nothing was known about other similar sites. In addition, the environmental engineering upon which underwriting was based was unsophisticated. There was not much of an environmental engineering/remediation industry in the early 80's. Most important, the underwriters had no history or experience. Experience is what a company hangs its hat on. When there is little or no experience, high prices and restrictive forms serve as a crutch. The environmental insurance industry now has almost 20 years of experience, and, as shown below, has largely been able to throw the crutch away.
Policies for the Environmental Services Industry
In addition to the site-specific PLL policy, the environmental insurance marketplace has for many years offered two types of policies for the environmental services industry. The primary providers of these policies were, again, AIG, Zurich and Reliance (ECS), in addition to several 'niche' insurers, some of which no longer exist, including United Coastal Insurance Company, United Capitol Insurance Company, the Home Insurance Company, ERIC, ECS, Inc., Freberg Environmental (Denver), Credit General, American Safety, Commercial Casualty, Gotham Insurance Company and American Empire.
1. Contractor Coverage
The following types of coverage have been used for several years to protect contractors against claims resulting from operations such as remediation, abatement, and construction for third parties.
a. The Contractors Pollution Liability ('CPL') Policy has protected environmental contractors against claims for third party bodily injury, property damage, or cleanup costs arising from pollution conditions, sudden or gradual, caused by insured remedial action operations. (Early policies only covered sudden and accidental pollution.) The insuring agreement resembled that of the PLL policy (originally, contractor coverage was an endorsement to the PLL policy); it agreed to pay for bodily injury, property damage and cleanup costs caused by a pollution condition and the result of claims first made and reported during the policy period , with this difference: the pollution condition had to be caused by specified operations. There was no contractual liability exclusion (or a limited one), and, except for a few companies, no completed operations exclusion (or a limited one). Unlike the PLL policy, these usually had retroactive dates. There were, in addition, Superfund, radioactive matter, waste disposal site, asbestos and underground storage tank exclusions.
b. The Lead-Based Paint and Asbestos Abatement Liability Policies protected the insured against claims for bodily injury or property damage by third parties arising, respectively, from asbestos or lead based paint incidents at scheduled projects. Both policies could be written on an occurrence as well as claims- made and reported basis. The lead or asbestos incident had to result from the insured abatement operations performed during the policy period; the incident and the operations were defined very narrowly in order to ensure all of these connections. There was usually some completed operations coverage. Air monitoring and analytical tests in the area of such operations and reporting and documentation of such tests were usually required before, during and after such operations as a means of documenting incidents. Some policies provided coverage for incidents during transportation of the material; others did not. Bodily injury to employees, sub-contractors or relatives was usually strictly excluded.
2. Consultant Coverage
The second type of policy for the environmental services industry was the consultants' errors and omissions or professional liability policy ('E&O'). It was specifically directed at environmental consultants, engineers and laboratories. Its insuring agreement was patterned on that of the architects and engineers errors and omissions liability policy. The policy therefore paid damages caused by negligent acts, errors or omission in the performance of professional services rendered or that should have been rendered by the insured. The professional services were specified in the Declarations. The basic difference between this and other E&O policies was that it had no pollution exclusion; professional liability in connection with pollution was covered. This coverage was usually written on a claims- made and reported basis, with both a retroactive date and an exclusion for claims arising out of pollution pre-existing and known prior to the policy effective date. One difference between this policy and the CPL policy was that, like most E&O policies, it did not specify the type of injury or damage being compensated, whereas the CPL policy specified bodily injury, property damage and cleanup costs.
This policy had most of the typical exclusions found in other, non-environmental E&O policies, such as for ERISA, businesses owned by the insured, personal injury (false arrest, libel, and so forth), Securities Act, and dishonest or fraudulent acts.
3. Combined Form
Several carriers offered a form combining the CPL and E&O policies into one, typically with an insuring agreement for the professional liability coverage and another insuring agreement for the CPL coverage. The exclusions section combined those of the CPL policy with those of the E&O policy into one massive section.
4. Scope of Coverage and Pricing
Unlike the PLL policy , these policies generally covered what they were supposed to cover. They were not, perhaps with the exception of those that had no completed operations coverage, notably restrictive contrasted with CGL policies issued to ordinary contractors or E&O policies issued to architects and engineers.
However, they were very expensive. For a typical carrier with an extensive contractors' book of business, the average premium in 1990 for a combined CPL and CGL occurrence policy was $100,000. This was for a one-year policy, with $1 million limits and a $5000 deductible. The early CPL insurers had some of the same problem as the PLL insurers. While the underwriting technique for CPL policies was the same as for CGL policies covering non-environmental contractors - pricing was based on size of the company, sales or receipts - the CPL underwriters also suffered from lack of experience or history. What history they had was non-environmental or based on claims under the CGL policy which covered sudden and accidental pollution. (This is why the first forms only applied to sudden and accidental pollution, and then, as experience accumulated, were expanded to apply to gradual pollution.) This lack of experience explains why prices were so high.
How do the New Products Differ?
The old PLL policy was clearly much too restrictive for current contaminated property transactions. Two new site specific policies, the cleanup cost cap policy and the new, multi-part PLL policy, have been developed in the last two or three years in order to rectify this situation. They were written with brownfields or other contaminated property transactions very much in mind. The two policies are currently offered by AIG, Zurich, ECS, Kemper and United Capitol and are targeted at the following parties and situations:
- Site Owners/Developers
- Potentially Responsible Parties (PRP's)
- Brownfields Redevelopment Projects
- Real Estate Transactions
- Both of these policies can be issued with coverage periods of as long as ten years. Policy limits available in the market range from $15 to $100 million at any one company. With facultative reinsurance, these limits can climb as high as $200 million. The minimum premium is generally $5000 and the minimum deductible $10,000. The discussion below of each specific policy will attempt to give a range for what an average policy might cost.
1. The Cleanup Cost Cap Policy
The cleanup cost cap policy, an entirely new and highly innovative form, goes a long way towards solving a central deficiency of the PLL policy: lack of coverage for known pollution. It is not a liability coverage. Rather, it is a stop loss or finite risk policy, which addresses the situation in which the known pollution has already resulted in a claim and a cleanup has already been ordered. It essentially covers cost overruns above an estimated or guaranteed cost.
More specifically, the policy indemnifies the insured for cleanup costs that exceed the anticipated cost of cleanup at a covered location and pursuant to a remedial action plan. Coverage is provided for remedial activities that are at, from, or adjacent to the location defined in the remedial study, or are discovered in the course of conducting the cleanup. Such insurance usually covers remediation cost overruns for:
- Actual contamination greater than estimated
- On-site cleanup costs pursuant to the remedial action plan
- Off-site cleanup costs if the pollutants originated from those in the on-site cleanup
- New-found contamination, provided it is discovered within the area of the remedial action plan
- Change orders required by governmental authorities that are incurred during the policy term
- Most of the policies have a single trigger of coverage -- reporting and/or discovery (one has a claims- made and reported trigger). Maximum coverage periods are ten years.
Generally, these policies are drafted similarly, but there are certain terms to look out for. Most define cleanup costs to include only actual remediation. However, some carriers are willing to define 'cleanup costs' to include monitoring and investigation. The policies should always have language dealing with change orders. Some are more restrictive than others in this regard. Most, but not all, policies appear to require that costs be incurred during the policy period. That might only be a problem if 'cleanup costs' has the more expansive definition such that actual cleanup might not commence until late in the policy period. Some policies have, or had in the past, exclusions for professional liability exposure, which can be very problematic.
The cleanup cost cap policy will be assigned a retention level that is equal to the total cost of cleanup plus an adequate buffer or additional retention level. For instance, a $1 million cleanup may require a $100,000 retention. This means that coverage under the policy attaches after $1.1 million has been spent on the covered remediation project. Pricing credits are granted to insureds who elect to co-insure above the retention level. Coverage periods can be for as long as 10 years.
This policy has proven to be of enormous value in contaminated property transactions, brownfields redevelopment projects and even in the settlement of Superfund litigation. First, it addresses the problem of known pollution; second, it is a way of capping and controlling cleanup costs; third, the cost estimates required for underwriting these policies can be used in making the property valuations; and fourth, the policy enhances the property value itself. This policy has become very useful in contaminated property transactions.
So What Does It Cost? The premium is based on a percentage of the guaranteed cleanup costs, in combination with the limits, i.e., assuming the limits are almost equal to the cost of cleanup. The range is generally 4.5% to 7% for a cleanup of up to $10 million. For a recent policy, involving $1 million limits, a $100,000 retention, and a very small cleanup, the premium was $35,000.
It cannot be stressed enough, however, that each risk is unique, and this formula and these generalizations may not apply to a specific situation. There can be great variation in the prices quoted for the same risk by different carriers (as well as some difference in the scope of coverage), which is why brokers should market each risk to several companies at the same time.
2. Site-Specific Pollution Liability Policy
All five of the main environmental carriers have designed a new pollution liability form to substitute for the old PLL policy. This policy differs from the old PLL policy both in form and scope of coverage.
a. Form. The PLL policy had one insuring agreement that covered third party bodily injury, property damage and off-site cleanup costs arising out of a pollution condition. The new PLL policies all have more than one coverage part, ranging from as few as two to as many as twelve. These coverage parts break the basic elements of the old PLL insuring agreement pollution condition down in various ways, some more minutely than others. Two policies have merely two coverage parts, one for on-site cleanup costs and another for third party bodily injury, property damage and off-site cleanup costs. Another two carriers issue a series of separate stand alone policies with a menu of insuring agreements for any two or more of the following:
- bodily injury and property damage
- contract damages
- cleanup costs
- legal defense expense
- business interruption and extra expense
- cleanup cost cap
- collateral value loss reimbursement
The last policy breaks the elements of the old PLL insuring agreement down even more, distinguishing not only between on-site and off-site cleanup costs but also between pre-existing and current cleanup costs and between on-site and off-site bodily injury and property damage. It has separate insuring agreements for:
- on-site cleanup of pre-existing conditions
- on-site cleanup of new conditions
- off-site cleanup of pre-existing conditions
- off-site cleanup of new conditions
- third party claims for on-site bodily injury and property damage
- third party claims for off-site bodily injury and property damage
In addition, this policy has coverage parts for claims arising from non-owned locations, business interruption, transported cargo and remediation cost cap.
The three policies with the more extensive menus affirmatively cover, in their menus, all or most those liabilities that may require coverage in contaminated property transactions. These are bodily injury and property damage, cleanup costs, legal defense expense, contractual liability, business interruption and collateral value loss. The two policies with only two coverage parts will address the additional liabilities by means of endorsements or separate stand alone policies.
The reason for the break-downs and menus of coverages was to make the policies useful in the context of transactions, where tailoring the insurance to the specific terms of environmental provisions in purchase and sale agreements is often required. Breaking the coverages down makes that easier, because the insured can pick and choose what is really needed - coverage only for pre-existing conditions or for current conditions, coverage only for on-site cleanup costs or for off-site cleanup costs as well; coverage only for cleanup costs or for bodily injury or property damage. These breakdowns and menus, however, are not usually sufficient to do all the tailoring required. It is usually necessary to draft manuscript endorsements to further refine the coverage, and many of the carriers are amenable to such manuscripting. Another problem with the menus is that they can become overly complicated, too much like a Chinese menu, with resulting difficulty in understanding just what the insured has paid for.
b. Scope of Coverage. By and large, these policies do not undermine their basic coverage grants by a series of exclusions and definitions. The holes noted above in the PLL policy are largely, although not entirely, filled in.
All of the five policies remove most of the restrictions on the original pollution condition in the PLL policy. We have already seen that the cleanup cost cap policy affirmatively covers known pollution when it is already subject to a claim or cleanup order. The new liability policy expands coverage for known pollution when it is not already subject to a claim by adding discovery language to the pre-existing condition exclusion, which now typically reads:
This Policy does not apply to 'environmental incidents': based upon or arising from 'pollution conditions' existing prior to the inception of this Policy, and reported to or known by any officer, director, partner or other employee responsible for environmental affairs of the 'insured', unless all of the material facts relating to the 'pollution conditions' were disclosed to the Company in the application and other supplemental materials and information prior to the inception of this Policy.
The intent of this language is to cover known conditions disclosed in the site documents unless specifically excluded by endorsement. This amendment to the old exclusion, adding the disclosure language, also has the virtue of clearly defining what is known by what was in the Phase I and other supporting documents.
Another way of covering such known conditions is the 'government reopener endorsement'. This endorsement covers known pollution in situations where response costs are either not likely to be required, or they have been required in the past but are not likely to be revisited, usually where some kind of no further action letter, liability release or covenant not to sue has been issued. Whichever of these methods is used, coverage for liability for known pollution is appropriate under the pollution liability policy when the risk is that of a claim being made. If there is an ongoing claim or loss of some kind, then the cleanup cost cap policy is more appropriate. Otherwise, the argument can be made that the liability policy is attempting to insure a known loss.
Many of the exclusions for types of pollutants or sources of their release have been scuttled or curtailed. The acid rain exclusion is gone, the radioactive matter exclusion has been limited, and the broad form nuclear endorsement is usually eliminated. The new policies often have exclusions for asbestos and lead; however, if a particular transaction necessitates coverage for these pollutants, the underwriters are generally open to modifying or eliminating the exclusions.
Most of the exclusions for various objects or locations from which pollutants may be released have been eliminated. The Deep Water Port Act exclusion is gone, including the part of it which excludes releases of oil from wells. The underground storage tank exclusion is either gone, or will be eliminated in certain situations. (Certainly, these policies are now designed to be used by gas stations and the oil and gas industry.)
Most of the policies still contain some kind of vehicle or loading and unloading exclusion; however, one policy provides transported cargo coverage. The Superfund exclusion is gone; the non-owned waste disposal facility exclusion is largely gone. The alienated or divested property exclusion is absent from some policies and has been modified in others.
Most of the policies have retained the same broad definition of 'pollution conditions' as in the old PLL policy or the old CGL pollution exclusion. However, one carrier made that definition narrower by requiring that the pollutants be 'hazardous substances'. Since the government may require cleanup of pollutants that are not hazardous, either because they fail to reach certain levels or because they are not listed under CERCLA as hazardous, this definition is one to watch out for.
All of the policies have a duty to defend, at least with respect to third party bodily injury, property damage, and off-site cleanup costs. Defense costs, however, are still universally included within the limits of liability.
The coverage period is no longer limited to a year; carriers will issue policies of as long as ten years. With the longer coverage period, the claims- made and reported trigger is less of a problem, particularly for bodily injury and property damage. Some carriers have found various ways of providing a tail, first through using a single trigger and secondly through a provision that allows for reporting of potential claims. The industry is clearly moving in the direction of an occurrence policy and may arrive there within a couple of years. One carrier has already used an occurrence form in special situations.
There is broader coverage for types of property damage including cleanup costs. Some of the policies explicitly cover voluntary cleanup costs by stating that costs incurred not only under governmental authority but also pursuant to the American Society of Testing and Materials Standard Guide for Risk Based Corrective Actions, or other similar standards, will be covered. Some policies have changed the definition of 'property damage' to include diminution of value, or underwriters say that they treat the definition as including it. (Needless to say, it is far preferable to have the term specifically included in the definition.) Contractual liability is now affirmatively covered by some policies, and the old contractual liability exclusion modified in others.
It should be stressed that many of the carriers are now vastly more flexible about revising their pre-printed forms through manuscript endorsements than they used to be. This is another way in which they have responded to the need for policies which will be useful in transactions. Some carriers have made their basic policy forms much broader than others but are less flexible about changes; other carriers whose pre-printed forms are narrower than others may be more open to on-the-spot revisions. It is a buyer's market, a soft market. However, while the carriers are more flexible and while there are fewer traps in the basic policies than in the old days, there are still traps, and informed negotiation with the underwriters will go a long way towards ensuring that the ultimate policy has adequate coverage.
So, How Much Does It Cost? The caveats about pricing generalizations apply even more to the liability policies than to the cleanup cost cap policies. These liability policies are rated on the basis of individual risk, not according to a formula. Premiums can vary greatly depending on the nature and extent of contamination, and they can vary greatly for a specific risk from one carrier to the other. However, underwriters from several different companies agree that for the average policy these days -- one location with some existing contamination, $5 million limits, a five-year term and a $50,000 deductible -- the premium would tend to run between $35,000 and $45,000.
This, of course, is less than half of what a one-year policy would have cost in 1990. It should not be surprising that the prices have gone down. They will probably continue to go down as the industry gathers more experience. Every month or year is a significant addition to the statistics base. Environmental insurance is an evolving market; as it evolves, it will take on more and more of the characteristics of a traditional insurance market.
3. Policies for the Environmental Services Industry
Policies for the environmental services industry are still being written by the same companies listed earlier, except for those now defunct. (St. Paul has been added to the list.) These policies still consist basically of the E&O and contractor coverages (CPL, lead-based paint abatement and asbestos abatement liability policies). These policies are being sold to a broader range of types of contractors and consultants, probably because the environmental services industry has further specialized. Available limits are the same as for the site-specific coverages: ranging from $15 million to $100 million, and $200 million with reinsurance. Minimum premiums are $1500, and even less, and minimum deductibles are $1000.
There have not been many changes in form or scope of coverage in the original policies, because they generally had fewer holes in coverage than the old PLL policies. It is more common now to combine the CPL and E&O forms in one policy, frequently with an additional CGL coverage part. One important change and improvement in CPL coverage is that an occurrence as well as claims- made form is offered by most of the carriers; however, it is not yet being offered to tank contractors. Most of the E&O policies, at least those of the five major carriers, are still both claims-made and reported and still have both a retroactive date and pre-existing known conditions exclusion. However, one policy at least has only a single trigger, reporting of a claim, and only a retroactive date to limit coverage for pre-existing conditions.
So, What Does It Cost? As the industry has gathered more experience concerning the CPL and E&O policies, as with the PLL policy, the prices have gone down precipitously. A typical policy for a relatively big contractor, e.g., $10 million in sales, comparable to the one discussed above - one-year, $1 million limits, $5000 deductible, with combined CGL occurrence, CPL and E&O coverage parts -- would be about $15,000 to $20,000. The same caveats about pricing generalizations apply here as to the site-specific coverages.
Summary of Part I
The coverage forms and prices for the site-specific policies have greatly improved. The policies generally cover the items that need to be covered. Glaring holes have been filled in: known pollution, cleanup costs of all kinds and in all locations, property damage including diminution of value, the duty to defend, the duration of the coverage period. Some of the policies have tails; and, although none available at present has an occurrence trigger, that is clearly coming. Prices have gone down precipitously and will continue to decline as the market evolves (and remains soft). However, each risk is different, each policy is different and some carriers are in the midst of changing their policies. It is therefore important to market individual risks to several carriers to get the most complete coverage and the best price.
Part One of this article addressed the question, 'What are the new environmental insurance products?' by contrasting them with those previously available. The old products, issued mainly by AIG, Zurich and Reliance until about 1996, consisted basically of a site-specific pollution liability policy (PLL) and coverages for the environmental services industry: the contractors' pollution liability policy (CPL) and the consultants' errors and omissions liability policy (E&O). Coverage under these older policies was restrictive and the premiums were steep. These limitations are typical of new and emerging insurance markets. Since 1996, however, two new companies, Kemper and United Capitol, have entered the market, and all carriers are offering significantly broadened coverage under the new versions of the PLL policy and the entirely new cleanup cost cap policy. In addition, premiums for all policies have declined precipitously. Some carriers offer broader coverage under their pre-printed policies, while others have the advantage of being more flexible and willing to change their wording. For the most part, now, affordable policies are available which actually cover the liabilities that need to be covered in the typical contaminated property transaction. Part Two of this article will now answer the question: how does one decide whether or not to buy these policies?
Deciding about Insurance in General
There is a well-accepted method for deciding about insurance in general. It is based on what risk management experts describe as the five-step risk management decision making process. There are also well-accepted maxims which contrast insurance with other methods of risk financing. The thesis of this article is that decisions about environmental insurance should follow the same, well-trodden path. and should apply the same maxims and truisms to the choice between insurance and other risk-financing options.
The Risk Management Decision Making Process
According to risk management theory, choosing any risk management technique, including insurance, should be part of a five-step decision-making process for minimizing the adverse effects of loss.1
1. Identify and Analyze Loss Exposures
The first step is to identify and analyze loss exposures, i.e., 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'.2 Financial losses that concern risk management are categorized as:
- property losses
- net income losses
- liability losses (including environmental liability losses)
- personnel losses
2. 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). As part of Step 2, risk managers are advised to examine all feasible risk control and risk financing techniques that might apply to a loss.
a. Risk Control Techniques. Risk control techniques consist of:
- 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, including: incorporation, leasing, contracting for services, suretyship and guaranty agreements, and waivers
b. Risk Financing Techniques. Risk financing techniques fall into two classes, retention and transfer.
Retention includes all means of generating funds from within a corporation to pay for losses. Risk management experts distinguish between active and passive retention, or planned and unplanned retention. 'Passive or unplanned retention occurs when an organization retains any exposure of which it is unaware or for which it has chosen to make no plan for financing potential losses'. 3 Planned or active retention requires thorough recognition and careful analysis of a given exposure and the conscious choice to retain a given amount of the potential loss from that exposure.
A risk manager may plan to use any one of the following specific retention techniques:
- current expensing
- loss reserving (funded and unfunded)
- insuring with an affiliated 'captive' insurer
Transfer involves generating funds from outside the corporation. There are three forms of risk transfer:
- commercial insurance (i.e., purchased through an outside, unaffiliated insurer)
- contractual transfer for risk financing (i.e., non-insurance transfers, to a transferee other than an insurance
- company, through a hold harmless or indemnity agreement)
- contractual transfer for risk control (usually considered a risk control technique and discussed above under risk control)
c. Important to Examine All Feasible Alternatives. Risk management scholars particularly stress the importance of systematically examining all feasible, alternative risk management techniques.4 Alternatives should not be restricted to the traditional options that management has always accepted, e.g., insurance. Instead, risk managers are advised to brain storm, creatively identify as many risk control and risk financing options as possible and try to imagine how each option may apply to a specific loss exposure.
3. Selecting What Appear 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. This activity consists of : 1) forecasting the effects the available risk management options are likely to have on the organization's ability to fulfill its objectives; and 2) defining and applying criteria, usually financial, that measure how well each alternative contributes to each objective in a cost-effective way. Probability, trend analysis and cash flow analysis techniques are used to accomplish this two-step activity.
4. Implementing the Chosen Risk Management Techniques
In the implementation stage, risk managers 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. For example, if insurance is chosen as a risk financing technique, 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 seek cooperation from managers on the front line, not subject to the risk manager's particular authority.
5. Monitor Results
Once implemented, a risk management program must be monitored to ensure that it is achieving the expected results. There must be opportunity to adjust the program for alterations in loss exposures and for the availability or costs of other, alternative techniques. This process requires establishing standards of acceptable performance, comparison of actual results with these standards and correction of substandard performance.
Insurance Versus Other Risk Financing Alternatives
Insurance is inevitably (except in the environmental area) one of the risk financing options considered as part of Step 2, Examining the Alternatives. But neither insurance nor any other risk financing option should be chosen heedlessly. There should be a risk financing plan, for, without it, a significant exposure may end up being retained unawares. This plan should consider, as applied to the particular exposure, insurance versus retention, insurance versus non-insurance contractual transfers, and insurance as used in combination with other techniques.
1. Insurance Versus Retention
The choice of insurance versus retention depends on the characteristics of the loss exposures, the characteristics of organizations and the characteristics of markets.5 Characteristics of loss exposures include loss frequency, loss severity and loss claim and loss estimation patterns. (Loss estimation patterns are based on forecasting the timing and amounts of payments that will need to be made for a particular type of accidental loss.) Exposures with high loss frequency and low loss severity are typically the most attractive for retention. 'Exposures generating high-severity losses, with a low frequency, are the least desirable to retain. Insurance is best suited for financing the often catastrophic losses from high-severity, low-frequency exposures...' 6
Insurance is also more appropriate for large, unpredictable losses, because for all but such types of losses, it is a relatively costly source of funds. 7 Insurers properly charge their operating expenses and profits for those essential services, especially loss control and claims management, that they provide in connection with catastrophe protection. Thus, 'for any loss exposures that might generate large losses, insurance should be a part of almost every organization's risk financing program'.8
Another characteristic of a particular risk is whether it is a liability, property, net income or personnel risk. 'With relatively rare exceptions, liability exposures do not lend themselves to full retention for two reasons. First, most liability losses are not self-limiting and can reach or exceed an organization's net worth, thus bankrupting it. Second, beyond payments to claimants, liability exposures also entail outlays for legal defense, which is something most organizations can only acquire through insurance'. 9
It is probably relevant at this point to note the four characteristics of an ideally insurable exposure: 10
- A large number of similar independent units should be exposed to the risk and controlled by persons interested in insurance protection.
- The loss - and thus the insurer's liability -should be definite or determinate in time, place, cause, and amount.
- The aggregate insured loss expected over some reasonable operating period should be calculable.
- The loss should be accidental from the insured's viewpoint.
Few currently insured exposures actually meet all four requirements. Most that are considered insurable come close to the ideal either inherently, or because certain safeguards have been introduced. Such safeguards involve the importance to the public of providing protection against the peril, social pressures or the expectation that the exposure will become insurable in the near future.11 A case in point is the aviation risk, a questionable exposure at first, but one that was expected to become insurable and did.
An important characteristic of organizations is management's tolerance for uncertainty. The traditionally cautious or risk-averse senior executive tends to sleep better with lower levels of retention and higher limits of insurance. The executive who can endure more uncertainty will tolerate higher aggregate retention levels and less insurance.12
One characteristic of property-casualty insurance markets is that insurance premium rates tend to move in cycles. When the market is 'soft', the rates fall and coverage is added as insurers compete for new insureds. Insurance is more attractive as a risk financing technique, and retention becomes correspondingly less cost-effective. In a 'hard' market, the opposite is true. When rates rise in the opposite phase of the underwriting cycle, organizations tend to adjust retention levels upward and to narrow coverage.13
2. Insurance Versus Non-Insurance Contractual Transfers
Insurance transfers are generally considered more reliable than non-insurance contractual transfers, which are subject to the following uncertainties:14
- The transferee/indemnitor may not have insurance or other financial resources to meet its obligations.
- A court may not enforce the agreement either because the agreement does not adequately define the transferred exposure as intended or because it is held to be unduly harsh or unconscionable.
Insurance companies, on the other hand, are thought to be more reliable than indemnitors because they are in the business of assuming risk, while indemnity agreements are only as good as the transferee's ability and willingness to pay. In addition, an insurance contract contains certain collateral benefits not typically found in an indemnity agreement. These include loss control services, claims handling services, and the defense obligation.
On the other hand, a risk financing transfer to a noninsurer can be highly reliable and can provide dependable protection for the transferor when the following conditions exist: 15
- Some loss characteristic puts it outside the scope of typical insurance contracts, for example, when the typical insurance agreement might exclude the peril causing the loss.
- The transferee's commitment to fulfilling its business contract terms with the transferor motivates the transferee to provide full indemnity in situations where the insurer might question the indemnitee's right to payment.
- The transferee is specially equipped to evaluate the transferred risk, for example in maintenance agreements and guarantees for services.
Non-insurance contractual transfers, in short, may be appropriate, but only when a party wishing to transfer the financial burden of a potential loss can find an 'appropriate, financially responsible and willing transferee'. 16
3. Insurance in Combination With Other Techniques
Insurance, while perhaps the most evident and widely used of all risk management techniques, is said to be best when used in combination with other techniques. In fact, it is often called the 'last resort' in a sound risk management program, the alternative used when no other technique or combination of techniques will suffice. 17
a. Insurance Combined With Retention. Risk managers commonly attempt to balance retention with transfer, including insurance transfer. One of the chief benefits of insurance, and other reliable risk financing transfers, is to replace the uncertain cost of retained losses with the more predictable outlay for insurance premiums.18 One of the chief disadvantages of insurance is that it increases the long-term cost of paying for losses, since premiums include protection not only for losses but also for the insurer's operating expenses and anticipated profit.19 As a result of these mutual advantages and disadvantages, risk managers frequently balance insurance with retention for different types of exposures. They do so in particular for liability exposures, which, as noted above, do not lend themselves to full retention.
b. Insurance Combined With Non-Insurance Contractual Transfers. It is extremely common to combine insurance with non-insurance contractual transfers. Many contracts in which the indemnity provisions cover (non-environmental) liabilities also include provisions requiring liability insurance to support the indemnity. Risk managers of the indemnitors in such contracts are instructed to follow these basic guidelines with respect to insurance: 20
- Make sure the indemnitor can fulfill its commitment financially. In view of some court decisions, it is almost imperative that the commitment be backed by insurance of at least $1 million per occurrence. 21
- Require a certificate of insurance for contractual liability coverage before contract operations begin.
- Be named as an additional insured in addition to obtaining a subrogation waiver.
Reasons Not to Buy Particular Policies
While commercial insurance is generally the most reliable form of risk financing, the following significant uncertainties can face an insured under a particular insurance contract: 22
- The insurer may become insolvent or refuse to meet its policy obligations for some other reason
- The insurer and the insured may disagree as to whether a loss is insured or as to the amount of the loss
- The amount of the loss may be so large that some portion of it exceeds the applicable limit of insurance
- The insurer may have a policy of not paying claims
Of course, precautions can be taken to reduce these sources of uncertainty:23
- Careful selection of financially sound insurers, in addition to the availability of state guaranty funds for meeting the obligations of insolvent insurers
- Insurer/insured discussion (documented in writing) of the meaning of the insurance contract in particular situations
- Proper selection of coverage limits
- Careful selection of insurers with a good claims-paying record
If, however, these precautions do not suffice, the insured can always decide not to buy the policy.
Deciding about Environmental Insurance
Insurance is Suitable for Environmental Risk
Based on the characteristics of the exposure and the characteristics of the market, insurance is suitable and, in many ways, preferable to retention for use with environmental risk.
1. Characteristics of the Exposure
As a liability risk, environmental risk is one that should be transferred, not fully retained. It is also a particularly large and unpredictable risk - a low frequency/ high severity, or catastrophic risk. CERCLA liability helps to make it both large and unpredictable. Superfund cleanups average $30 million, which is catastrophic by any standard. CERCLA retroactive and joint and several liability, together with the fact that we usually cannot tell what is happening under ground, both contribute to the unpredictability of the risk. It is the archetypal high severity/ low frequency or catastrophic risk.
In the past, environmental liability has been considered ill suited for insurance. Several articles were written to that effect in the late 80's and early 90's.24 CERCLA liability, especially retroactive and joint and several, was said to make such risk overly unpredictable to insure. However, the key problem involved risk estimation. At the time, many insurers required environmental audits for site-specific insurance. Inspection costs raised the already exorbitant costs of premiums. Secondly, environmental risk was not considered determinable in amount or calculable in the aggregate sufficient to set premiums accurately. Currently, however, insurers rely on existing Phase I's rather than requiring new site assessments as part of the premium. The ability to estimate cleanup costs has greatly improved, and, as discussed in Part One, the industry, like the aviation industry, also once viewed as uninsurable, has acquired sufficient experience to calculate premiums and predict the magnitude of probable losses.
Favorable changes in the environmental insurance market make now a particularly good time to buy environmental insurance. As noted in Part One, there are now five companies writing site-specific insurance, and more will be entering the market. Environmental insurance capacity has increased greatly. Environmental insurance coverage is much broader and more flexible than in the past, and premiums are strikingly lower due to a combination of increased experience and the softness of the market. The estimated premiums for this market have grown from $75 million in 1985 to several billions in 1998.
Who Needs to Buy Environmental Insurance?
Who has this exposure, who should buy, and who is already buying environmental insurance? The market for the environmental insurance industry includes: transporters of hazardous waste who carry auto liability coverage, including pollution; facilities that carry pollution liability coverage and/or on-site cleanup cost cap coverage; and contractors and consultants who carry pollution liability and professional liability (including pollution) coverage. Increasingly, the parties to contaminated property transactions, including brownfields redevelopment projects, are also buying PLL and cost cap coverage.
Originally, treatment, storage and disposal facilities (TSDF's) were the only types of facilities that purchased pollution coverage. Today, however, facilities of all types are recognizing their environmental exposures and buying pollution coverage. These may include:
- Environmental facilities such as landfills and TSDF's
- Manufacturing facilities
- Dry Cleaners
- Golf Courses
These facilities face both known and unknown environmental exposures arising out of current operations or historical practices from air emissions, aboveground and underground storage tanks, hazardous waste materials, raw materials and waste waters. Pollution claims typically involve cleanup costs and third-party bodily injury for fume inhalation or contaminant ingestion, and property damage for trespass of pollutants and soil and groundwater contamination. To the extent that these are older facilities, pre-dating 1980, the exposures resulting from historical practices are all the graver and the need for environmental insurance all the greater. Owners of these facilities are purchasing PLL and cost cap policies to transfer these liabilities to insurers.
Environmental contractors and consultants continue to need and buy coverage for pollution and professional liabilities arising from operations performed at these facilities. General and specialty trade contractors also have considerable environmental exposures from their operations (bringing products onto the job site, hitting pre-existingcontamination or sewer lines), owned premises, transportation liability for refueling vehicles and Superfund liability for past disposal practices. These general and specialty contractors need to buy environmental insurance but are not in general doing so.
Beginning about two years ago, parties to transactions involving contaminated or potentially contaminated property have increasingly purchased environmental insurance. Such transactions include (but are not limited to):
- Real Estate Sales
- Mergers and Acquisitions
- Brownfields Redevelopment Projects
- In addition, parties involved in Superfund and environmental coverage litigation have recently been purchasing environmental insurance in order to settle the litigation.
Parties to these transactions and law suits face all the liabilities mentioned above. To the extent residential housing is involved, they also face 'green building' liabilities such as asbestos, lead paint, radon and lead in the drinking water. These transactions in the past have failed because of difficulties in attempting to transfer such liabilities by indemnities or hold harmless agreements. Now, PLL and cost cap policies are being purchased in the context of transactions to deal with these costs and liabilities in addition to CPL and E&O policies for contractors and consultants, asbestos and lead in place policies and asbestos and lead abatement liability policies.
How to Decide About Environmental Insurance -- The Environmental Risk Management Process
It follows necessarily that, for those facilities, industries and transactions with exposure, environmental insurance should be part of an environmental risk management process. As a particularly significant exposure, it is one that needs to be managed and to which the five-step environmental risk management process should be applied. Corporations would not ordinarily want to retain such a risk entirely. Certainly, they should not want to retain it passively. Therefore, they need an environmental risk financing plan as part of an environmental risk management plan. As discussed below, making environmental insurance part of such a plan can also save a transaction which would otherwise founder in the face of environmental concerns.
However, for many facilities, industries and transactions with environmental exposures, there is neither an environmental risk management plan nor the awareness that insurance should be part of such a plan. Certainly, most corporations do not adhere to the five-step risk management process discussed above with respect to environmental risk. The environmental departments of larger corporations deal mostly with risk control and may ignore risk financing. Their risk management departments concentrate on risk financing and may ignore environmental risk. Thus, any risk management plan that exists will focus on risk control and will not include plans for financing a possible loss.
Smaller corporations may simply ignore the fact that they have environmental exposures, with no plan at all for managing environmental risk. Only a small fraction of the industrial facilities discussed above are currently buying environmental insurance. An even smaller fraction, next to none, of the general and specialty contractors with environmental exposures are buying environmental insurance. These corporations either think that they do not have the exposure or that their general liability policies will cover the risk. They are mistaken in both regards. These corporations are retaining the risk passively and unawares, and they may be in for an unpleasant surprise. Similarly, their brokers and other advisers may be held accountable for not alerting them to their risk and its proper management.
Environmental lawyers, in managing transactions, usually follow what amounts to an environmental risk management process or procedure. Such a process may include consideration of both risk control and risk financing alternatives, since remediation is a risk control technique, and non-insurance contractual transfers (indemnifications) are often the focal point of such transactions. However, contaminated property transactions are sometimes managed by real estate lawyers, real estate brokers or other non-environmental professionals. In these cases, there is often no environmental risk management plan at all. Those in charge may even fail to require due diligence or risk assessment as a necessary first step or may omit it altogether. The results are not always pretty. 25
When to Buy Environmental Insurance
It is devoutly to be wished that an environmental risk management process will always be in place. If it is, environmental insurance can come into play at two points in the process: at the beginning, during the risk identification and analysis stage, and at step three, as one of the risk financing options selected in combination with other techniques such as retention. If a transaction is involved, environmental insurance can be combined, during step three, with other risk allocation methods as one of the environmental provisions in the transactional document.
1. Risk Analysis and Quantification
After site assessments have been performed, environmental risk often needs to be analyzed and quantified for purposes of property valuation. If a transaction is involved, such analysis and quantification can also alert the buyer or lender to any present or future problems, allowing financial risk to be managed and allocated as part of the deal. Since this is also what environmental underwriters do, that is, analyze and quantify risk, they can do it once for a number of purposes, thus saving time and money and avoiding unnecessary duplication.
2. Selection of Environmental Insurance With Other Techniques
For those entities and transactions with environmental exposures, environmental insurance will often be used in combination with other risk management techniques, just as ordinary insurance combines with other techniques for other types of exposures. If remediation, a risk control measure, is required, a cleanup cost cap policy may be selected to cover cost overruns, with amounts up to the estimate being retained. For environmental liability exposures, the corporation will also want to balance retention and transfer in the context of a PLL policy.
If a transaction is involved, the corporation will need to combine contractual risk transfer with transfer through environmental insurance. The transaction may not succeed if too much reliance is placed on contractual risk transfer to the other party. Problems and uncertainties about ordinary indemnities are magnified for environmental indemnities. Such indemnities raise questions about the ability to shift CERCLA liability, and drafting them can be difficult and complex. Environmental insurers may be even more reliable, in relation to indemnitors, than are ordinary insurers, since environmental underwriters usually understand this complex and technical risk a lot better than do indemnitors.
The transaction is an optimum time for the corporation with environmental exposures to select environmental insurance as a risk management option and make it part of an environmental risk management plan. At other times, the insurance may be seen as an unnecessary expense. At this time, it is seen as vital to the success of the transaction by removing environmental liability from the equation, or by providing support to other methods of risk allocation.
Environmental insurance is applied in contaminated property transactions in exactly the same manner as ordinary insurance in ordinary transactions. An environmental insurance covenant becomes one of the risk allocation provisions of the purchase and sale agreement, along with the representations and warranties, the other covenants and the indemnities. In particular, the environmental insurance covenant is tied to the terms of the environmental indemnities. This provision can be used as a bargaining chip in the deal and, as in other types of transactions, as a way of ensuring that the indemnitor will be able to meet its financial obligations.
When Not to Buy a Particular Environmental Insurance Policy
The caveats about buying particular insurance policies apply with even more force to buying particular environmental coverages. Most environmental policies are written by the carriers' excess and surplus lines, or non-admitted, companies. Excess and surplus lines companies are not regulated to the same degree as admitted companies. Their rates and forms are not filed with the state insurance departments, and there is no guaranty fund protection other than in the state of New Jersey. Consequently, it is even more imperative to consider the financial stability of the company offering environmental insurance than otherwise.
It is also doubly important that the meaning of the environmental insurance contract in particular situations be discussed and verified, because 1) the forms are generally not filed with state insurance departments, and 2) the technical nature of the risk and the complexity of the regulations create drafting difficulties and may make the policies difficult for the lay person to understand. While, as discussed in Part One, the policies have broadened markedly and glaring holes in coverage have been filled, there are some differences between the pre-printed forms of the various carriers, and the oddities of some state statutes and regulations often necessitate some tweaking of the policy language. Some carriers are much more flexible than others about modifying their language in order to inspire confidence that the risk is fully covered. For example, in a recent case involving a statute that allowed risk based cleanups, policy language requiring claims, as traditionally defined, posed a problem. Four carriers quoted on the risk. Two were rigid and two were flexible about the language. It should be no surprise that the risk was ultimately bound with one of the more flexible carriers (which was also the one with the lowest premium quotation).
Those facilities, industries and transactions with environmental exposures should use environmental insurance much more pervasively, in combination with other risk management techniques, and as part of an environmental risk-management decision-making process. Environmental risk is the type of catastrophic liability risk to which insurance is ideally suited. It is not the type of risk to be fully retained, and, used in combination with non-insurance contractual transfer, environmental insurancecan save many a deal from extinction. There are affordable products available now that actually cover this exposure. Assuming these products are scrutinized carefully before purchase, good coverage is available, so there is no longer any reason to exclude these products from the process.
- Head, G.L. and Horn, S. Essentials of Risk Management. Insurance Institute of America (June 1991), 3rd ed., vol. I, ch. 1.
- Id., p. 10.
- Head, G.L., Elliott, M.W. and Blinn, J.D. Essentials of Risk Financing. Insurance Institute of America. 3rd ed., vol. I, p. 94.
- Essentials of Risk Management, vol. II, p. 1.
- Essentials of Risk Financing, vol. I, pp. 110-126..
- Id., p. 111.
- Id., p. 43.
- Id., p. 44.
- Essentials of Risk Management, vol. II, p. 37.
- Essentials of Risk Financing, vol. I, pp. 235-36.
- Id., pp. 237-38.
- Id., pp. 122-23.
- Id., p. 125.
- Essentials of Risk Management, vol. II, pp. 39-40.
- Essentials of Risk Financing, vol. I, p. 366.
- Essentials of Risk Management, vol. II, p. 40.
- Id., p. 41.
- Essentials of Risk Financing, vol. I, p. 37
- Id., pp. 398-99.
- Id. P. 398.
- Essentials of Risk Management, vol. II, p. 41.
- Abraham, K.S. 'Environmental Liability and the Limits of Insurance', 88 Colum. L. Rev. 942, 1988; Nash, J.R., 'Environmental Law: An Economic Approach to the Availability of Hazardous Waste Insurance'. 1991 Ann. Surv. Am. L. 455, 1992.
- Landow-Esser, J. M. and Ferren, A.J., 'Environmental Due Diligence', Real Estate/Environmental Liability News. March 6, 1998 and March 20, 1998, vol. 9, numbers 9 and 10.