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