With the legal goal posts constantly moving, environmental risk is hard to manage, warns David Thomas.

The success of any commercial venture depends on the effective identification and management of risk. Allocation of risks between parties is a critical factor when any commercial transaction involving property assets takes place. Environmental impairment liability (EIL) risks, particularly historic contamination, are among the hardest risk issues to accurately quantify, verify and therefore manage.

The legal goal posts are constantly moving as regulatory frameworks evolve across the globe - further adding to the uncertainty. The development of the EU directive on environmental damage is a current example, and many industries face the possibility of strict liability for unquantifiable damage to the environment. In addition, changes to accounting procedures, such as FRS12 in the UK, increasingly require the polluter to make environmental liabilities visible to shareholders, financiers and purchasers of business assets.

In many cases, the perceived exposure to environmental risk may be greater than the reality. However it can still result in significant business impact. This may include difficulties in establishing new plants because of planning objections, impairment of the purchase price when assets are traded, or the availability and cost of financing.

Demonstrating effective management of environmental risk is therefore a governance obligation and a key priority for companies wishing to reassure stakeholders and actively manage their corporate reputation.

Many have established reserves for known environmental obligations, or capital budgets for improvements. For example, a company may know that a factory is contaminated and that it will have an obligation to restore the land when that factory closes. Unfortunately, however, the financial risks associated with pollution or land contamination are impossible to predict with any certainty, and such provisions may therefore prove inadequate.

Upgrading of pollution control procedures and continual improvement of environmental management systems reduce the probability of a significant environmental loss, but they cannot eliminate it entirely. The discovery of unexpected contamination, the impact of tightening legislation, and increasingly strict enforcement could lead to unanticipated liabilities. Such uncertainties can have a material effect on a company’s liquidity, which may in turn undermine investor confidence.

Managing the consequences
It is important that companies plan how to manage the financial consequences of environmental impairment.

General liability insurance policies usually either exclude cover for pollution risks, or limit coverage to incidents that are sudden and unforeseen. Even where they provide limited pollution cover, they generally restrict it to third party damage claims. Conventional insurance would not address obligations possibly arising from known problems or variations in anticipated costs.

With the growing need to address uninsured exposures, corporate risk management strategies increasingly incorporate specialist environmental insurance policies. These can be designed to dovetail with the company’s general liability programme and can cover operational pollution risks, historic contamination liabilities and associated contingent exposures. The overall objective is to develop an optimal balance of physical risk control and financial risk management.

Before considering the types of insurance that can address environmental liabilities, it is important to identify what the significant environmental risks are for most organisations. They take many forms and can include the following:

  • operational pollution risks - for example the use and storage of potentially polluting materials
  • the legacy of pre-existing contamination resulting from historic day-to-day operations
  • contingent losses associated with the above issues, such as business interruption costs.

Operational risks, typically arising from sources such as industrial plant, transportation, fuel and chemical storage or waste products, tend to lead to future liabilities. Historical risks generally relate to past industrial activities, which may have left current owners with a legacy of dormant or active pollution. In both cases, the sources of risk can generate liabilities because of numerous knock-on effects. Examples include:

  • toxic air emissions
  • aquatic releases
  • soil and groundwater pollution
  • individual site damage and decreased property value
  • mitigation costs and consequential loss
  • business interruption
  • regulatory notices and legal costs
  • capital upgrade requirements
  • stakeholder pressure
  • investigation and remediation costs.

The assessment of historic liabilities routinely forms part of the due diligence process during corporate transactions. Real or perceived environmental risk can affect the progress of such transactions or even stop them altogether. It can certainly affect the value of the transaction. For both the seller and the purchaser, an understanding of the impact that environmental liability may have is a key to the negotiating stance to be taken.

Risk transfer
Whether concerned with future operational risk or addressing the legacy of the past, using environmental risk transfer mechanisms to manage liabilities is becoming routine. Insurance products are typically used to:

  • fill the gap in general liability policies for operational exposures
  • remove deal breakers
  • reassure financiers
  • ensure a ‘clean’ exit when assets are disposed of
  • underpin indemnity agreements
  • demonstrate to stakeholders that the risks have been considered and addressed in the same way as other operational exposures.

One of the real benefits provided by these policies is the ability to cover risks associated with future changes in legislation or remediation standards. Environmental insurance can also respond without the need to prove fault. Further, coverage is generally backed by large financial institutions with bankable credit ratings.

Vendors are using environmental insurance policies as an alternative to indemnities, to drive deals forward and to avoid discounting the purchase price. More commonly, however, insurance is being used to ring fence and transfer unacceptable balance sheet exposures upon completion.

In Europe most environmental insurance cover currently purchased relates to corporate deals and the management of historic liabilities. However, the fastest-growing segment of the market is predicted to be renewable operational cover, as the limitations of general liability policies become recognised.

Global environmental insurance premium income is estimated at over $1.3bn, the vast majority of deals being placed in the US. So, although EL is still a relatively small proportion of the total liability market, it has been growing fast. It remains dominated by a small number of large US and European based insurers. In Europe, local markets are developing and pollution pools have been in place for a number years in some countries.

In the UK, the market has developed rapidly over the past five to 10 years. Most of the premium income is currently split between AIG and XL Environmental.

The insurance market as a whole is going through a volatile phase, with dramatic cost increases and contraction of capacity. EL has not been immune to this. Rates have been progressively rising, and underwriting is becoming more selective. However, this sector of the market has not seen the extremes experienced elsewhere and remains an increasingly used option.

Coverage options
Environmental insurance typically protects the insured against losses associated with pollution conditions. In particular, the cover generally extends to the following:

  • third party claims for damage or bodily injury
  • mandated clean-up costs - on or off site
  • legal defence costs, cost of investigation.

In the context of corporate transactions the insurance is usually arranged for liabilities associated with pre-existing contamination, which is often the issue of contention between the parties. Periods of up to 10 years are readily available. Longer periods of up to 20 years and more are now more difficult to obtain than they were a few years ago.

Operational pollution risks cover (for example from fuel storage) focuses on future exposures and fills the ‘coverage gaps’ in general liability programmes. These renewable policies are becoming more popular as companies seek to optimise their risk management strategies and protect themselves against catastrophic losses. In some cases, they can include an element of historic cover, and often form part of a captive-based programme. For example, the captive may write cover for variation in anticipated costs on known pollution conditions, or even the timing of anticipated capital expenditure, while the risk of further unidentified contamination coming to light or new pollution being created can be transferred to the environmental insurer.

These policies can be extended to cover contingent risks such as business interruption or economic loss associated with contamination (for example, loss of rental income, costs of relocation, diminution in property values). If the policy is facilitating a development project, it can be augmented with a delayed start up extension (or advanced loss of profits) to cover certain soft costs that might be incurred in the event of a delay to the completion of the project.

The market can put forward substantial capacity (£100m or more from a single carrier) and policies can be written on a single site or portfolio basis.

In addition to these, other types of environmental cover are available. Cost cap policies can be used to cap the clean up cost of known liabilities, and more sophisticated composite structures (blending insurance with discounted funding techniques) can transfer both known cost obligations and the associated unknown risks into the insurance market. My own company recently introduced a facility - Active Transfer - based on this concept in the European market. It is an approach which allows companies to permanently transfer their historic environmental liabilities to a third party backed by an insurance mechanism from a highly-rated insurer. This allows companies to take environmental risk off the table in a transaction negotiation, or to outsource past problems in an operational context to allow management to focus on the future.

Adding value
Environmental insurance plays an increasingly pivotal role in integrated risk management programmes and the facilitation of commercial transactions.

EL cover is a very cost-effective tool, but still represents a significant cost, as it covers potentially enormous loss scenarios. It is therefore important to have the help of a professional adviser with the experience to interpret complex environmental risks, design appropriate risk transfer solutions, secure appropriate cover and negotiate the best deals.

The EL market is still developing, and and there is increasing awareness within organisations of the value that environmental insurance can add. It is likely to become an essential consideration in most commercial transactions in the very near future.

David Thomas is executive director, global markets, Willis Limited,

Tel: 020 7975 2774,

E-mail: thomasda@willis.com

The Waste and Emissions Trading Act, which was granted Royal Assent in November, aims to enable the UK to face two of the biggest environmental challenges - climate change and the need to move towards more sustainable management of waste. It provides the legislative framework for trading schemes that allow required reductions to be made where it is most cost-effective to do so, whether in biodegradable municipal waste going to landfill or in emissions of greenhouse gases to the atmosphere.

The UK already has the world’s first economy-wide greenhouse gas emissions trading scheme, and the Act puts on a statutory footing penalties for direct participants in the UK Greenhouse Gas Emissions Trading Scheme who fail to comply with their emissions reduction targets. It will also enable the provision of penalties for future emissions schemes, ensuring that the markets for these schemes work effectively.

In addition, the Act introduces what is thought to be the world’s first waste first trading scheme. This will help to achieve the UK targets under Article 5(2) of the EU Landfill Directive for reducing the amount of biodegradable municipal waste sent to landfill. Waste disposal authorities will be able to trade their allowances with other disposal authorities, and to find the most cost-effective way of diverting waste from landfill, which reflects their local circumstances. Waste disposal authorities will also be able to save unused allowances (bank) or bring forward part of their future allocation (borrow).

The CBI has criticised EU commissioners for not doing enough to make new chemicals regulations workable for business. The REACH proposals, announced in October, will require companies to disclose information on the production and use of all chemicals. A new system of registration, testing and authorisation will apply to more than 30,000 substances produced in, or imported into, the EU.

CBI director of business environment, Michael Roberts, said: “Protecting the environment and people’s health is vital, but this proposal will achieve little at huge cost. Everyday items made in this country, ranging from cars to paint to curtains, will become more expensive compared with products imported into the EU. This is a recipe for exporting jobs out of Europe to countries where environmental standards may be less stringent.

“We welcome the modifications made to the proposals and the support of the UK government, with France and Germany, in securing them. But we still need to see a system that prioritises those substances that pose the most risk, rather than those produced in the largest quantities.”