Vol. 80, No. 5, May 2007
he insurance industry is creating new products that allow policyholders to shift financial responsibility for environmental liabilities in exchange for payment of premiums. Numerous factors have led to the development of these environmental insurance policies, including the accounting profession's recent adoption of a new standard known as FIN 47. This is a new interpretation of financial accounting standard 143 (accounting for asset-retirement obligations). FIN47 is an accounting guidance that requires inclusion of environmental liabilities in financial statements when a business decides to close a manufacturing facility. Lawyers need to be well-versed in this emerging insurance area, because this trend provides opportunities for the savvy business client and potential pitfalls for the unwary client.
This article provides a roadmap for potential uses of these new environmental insurance policies, highlights the important legal pitfalls for the unwary business client, and identifies the areas that business lawyers should address in negotiations leading to the purchase of these insurance products.
Factors Promoting Environmental Insurance Solutions
Several factors have given rise to insurance-based solutions after a less than satisfactory experience of parties involved in transactions involving contaminated property. Federal and state mandates to reduce agency budgets have resulted in staff cuts at the federal and state agencies responsible for implementing the command/control structure for overseeing the remediation on contaminated property. Due to these staff cuts parties are unable to obtain timely written evaluations and assurances from these agencies on the nature and extent of contamination that may exist on a property. Given the concerns about strict-liability statutes for ownership of contaminated property,1 buyers of such property face time-consuming and expensive due diligence inquiries to determine the nature and extent of contamination. Frequently, this due diligence requires the parties involved in a sale transaction to have adequately identified the nature and extent of contamination.2 For example, the Wisconsin Department of Natural Resources (DNR) has authority to assist a person to determine the person's rights and responsibilities regarding environmental pollution on a property. The DNR has authority to issue assurance letters regarding the liability of that person for contamination on the property, the nature, type, and extent of environmental pollution on the property, and the adequacy of any environmental investigation conducted on the property. Such agency assurances frequently are necessary to satisfy parties that the state agencies will not require expensive remediation that can affect the parties' assessment of the liability associated with ownership of the property. The reduction of agency staff has created greater uncertainties for property buyers and sellers, because agency assurance letters are more difficult to obtain in a timely fashion to accommodate redevelopment transactions.
Arthur J. Harrington, U.W. 1975, heads the environmental and energy practice at Godfrey & Kahn and is located in the Milwaukee office. He is the author of a book on environmental insurance: Environmental Liability and the Emerging Art Form of Transference (Aspatore Books, 2006).
Another factor influencing the use of insurance solutions is the development of more risk-based remediation clean-up standards by state and federal agencies. In the earlier history of the command/control structure, state and federal agencies established clean-up standards that were associated with the highest-risk use for the property given the level of contamination, whether or not the property would be put to such use.
One conspicuous example of the highest-risk use concept involves contaminated groundwater. In the early stages of development of the command/control structure for liability, state and federal agencies assumed that groundwater would be used for drinking purposes whether or not the groundwater on contaminated property was in fact used for that purpose.3 In this situation, the environmental agencies would require the contamination in the groundwater to be cleaned up to meet drinking water standards. This requirement imposed significant remediation costs, which could be mitigated if the need to clean up the groundwater for drinking water purposes could be avoided.
Recently, however, state and federal authorities have been more willing to apply a less restrictive clean-up standard process for property with contaminated groundwater if the property actually is served by a municipal drinking water system. In this situation, state and federal agencies have established risk-based clean-up standards that allow clean-ups to occur based on the actual risk factors associated with the contamination.4 Thus, the clean-up standards have been more flexible when remediation experts are able to predict the actual risk (as opposed to a theoretical risk) for contaminated property.
The development of these risk-based remediation clean-up standards has dramatically reduced remediation cost estimates and has created an atmosphere more conducive to developing insurance-based solutions for contaminated property transactions.
One of the most significant factors leading to environmental insurance solutions is the development of a new accounting standard. In March 2005, the Financial Accounting Standards Board (FASB) announced a new financial interpretation entitled, "Accounting for Conditional Asset Retirement Obligations."5 This guidance clarifies that a business is required to recognize a liability for the fair value of a conditional asset-retirement obligation when that liability's fair value can be reasonably estimated. This new accounting guidance also clarifies when a company would have sufficient information to reasonably estimate the fair value of an obligation associated with "retiring" an asset. Some of the examples included in the guidance are the cessation of manufacturing activities at an owned facility and the need to recognize a remediation obligation associated with the retirement of this asset.6
The underpinning of the accounting guidance is the FASB's belief that when an existing law, regulation, or contract requires an entity to take an asset out of productive use, the entity must include the liability in its financial statements, even if the activities associated with the obligation can be deferred indefinitely.7 In the context of environmental liabilities, the new standard requires the remediation obligation to be included in the balance sheet when a facility is taken out of active use. Therefore, the obligation to perform the asset-retirement activity is unconditional even though uncertainty exists about the timing and method of remediation that may be required in the future.
According to the accounting guidance, an asset-retirement obligation can be quantified if "an active market exists for the transfer of the obligation."8 The development of environmental insurance markets for such obligations almost certainly qualifies as "an active market … for the transfer of the obligation" within the meaning of the FIN47 guidance. Thus, environmental insurance will be an important financial tool to quantify the asset-retirement obligation relative to recognizing the remediation obligation for buildings taken out of service for companies subject to FIN47.
Overview of Contamination Legal Liability Policies
One of the new environmental insurance products created in response to these developments is generally known as the contamination legal liability (CLL) policy.9 The CLL policy was developed to provide coverage for environmental claims in much the same way that commercial general liability policies provide coverage for nonenvironmental third-party liability claims in the business-risk context. Generally speaking, with the inclusion of special endorsements, a CLL policy provides coverage of third-party claims for these environmental episodes:
- third-party claims asserted by an adjoining property owner for remediation necessitated by pollution migrating from an insured's property;
- claims for bodily injury caused by contamination migrating from the insured's property;
- claims for reduction in property value caused by contamination migrating from the insured's property;
- claims for business interruption loss caused by contamination migrating from the insured's property;
- claims for pollution asserted against the insured when liability is based on a contract to which the insured is a party and the contract is scheduled and approved for coverage by the underwriter;
- claims for damages arising from adverse impacts to natural resources caused by contamination;
- bodily injury claims arising from contamination on the property the insured owns if the exposure occurs on the insured's property;
- property damages sustained by third parties when exposure is caused by contamination located on the insured's property;
- claims for remediation expenses at off-property disposal sites where contaminants the insured generated at its property are taken for ultimate disposal; and
- claims for personal injury, property damage, or remediation resulting from the release of contaminants that occurred during transportation.
It is important to note that a CLL policy is a "claims made" policy. This means that actual claims must be asserted by a third party during the policy period to afford coverage under these policies.
The policy term is an important feature of these new insurance products. Generally speaking, these policies can be written for any time period from one year to 10 or 15 years.
Often such policies require payment of a one-time premium. This one-time premium normally is paid at the inception of the policy. Obviously, the amount of the premium will depend on the underwriter's view of the risk associated with contamination on property covered by the CLL policy. The policy premium also will depend heavily on the policy's face amount and the deductible amount the insured chooses.
These policies can be written to protect the current property owner, lenders, and tenants, and future owners and their respective lenders and tenants. The advantages afforded by these policies will depend on whether these parties are identified as "named insureds" or as "additional insureds."10
Generally, the minimum deductible for these policies is $10,000. The minimum policy coverage typically is in the range of $1 million. The full limit of the policy for coverage is negotiable and the limits of coverage have been available for upwards of $150 million.
General Exclusions for Contamination Legal Liability Policies
The form policies provide important exclusions for coverage for third-party environmental claims. The lawyer representing the proposed insured must be mindful of these exclusions and advocate for their selective removal when necessary to maximize the value of the insurance product. The general exclusions include:
- Fines. There is no coverage for criminal fines, penalties, and assessments.
- Contract liability claims. There is no coverage for third-party claims arising under contracts unless the contracts are specifically scheduled in the policy.
- Intentional violation. There is no coverage for claims arising from intentional noncompliance with environmental laws.
- Insured's expenses. There is no coverage for internal expenses that the insured incurs (such as for supplies or services performed by the insured's employees) in connection with liabilities associated with pollution conditions.
- Asbestos and lead paint. There frequently is no coverage for claims arising from asbestos or any asbestos-containing materials or lead-based paint installed or applied in any of the insured's buildings or structures. However, it is important to note that this exclusion can be modified by negotiation to provide coverage for specific asbestos or lead-based paint liability exposures.
- Insured's employee claims. There is no coverage for employees' claims for personal injury arising out of employment by the insured.
- Nondisclosed claims. There is no coverage for claims arising from pollution about which the insured had prior knowledge and which the insured did not disclose during the application process.
- Underground storage tank claims. There is no coverage for third-party claims arising from pollution conditions resulting from releases from underground storage tanks. However, it is important to note that coverage - in the form of either endorsements or a separate insurance policy - can be negotiated specifically for claims arising from underground storage tanks.
- After-acquired properties. There is no coverage for properties that are acquired after the policy's inception date unless specific endorsements are provided for these after-acquired properties.
- Insured's products. There is no coverage for claims arising from products the insured manufactured if the insured no longer has possession of the products.
Note that the above is a list of standard exclusions provided in the specimen policies issued by the underwriters for CLL policies. Many of these exclusions can be reduced or eliminated during the negotiation process leading up to the issuance of a binding policy. However, the negotiated elimination of one or more of these standard exclusions can result in a higher policy premium. Insureds must understand the importance of any of these exclusions under the specific facts presented by a potential environmental risk for which the environmental policy is considered a hedge.
Obligations of the Insured
To receive the coverage benefits of the CLL policy, the insured must fulfill several obligations. The business lawyer should be aware of the duties the policy imposes on the insured when considering how to negotiate with the carrier before purchasing a policy. Several of the insured's more important obligations under this policy include:
- Timely notice. The insured must notify the insurance company of contamination events by providing timely notice of the service of formal claims that it believes are covered by the policy. The insured also has an independent obligation to notify the insurance company within a reasonable time after the insured becomes aware of circumstances that could give rise to a claim in the future.
- Mitigation obligation. A standard provision in the policy imposes a legal obligation on the insured to mitigate exposure that could give rise to third-party claims by remediating pollution conditions to the extent required by environmental laws.
- Duty to cooperate. The insured must cooperate with the insurance company and offer reasonable assistance in the investigation and defense of claims.
- Voluntary settlement. The insured is prohibited from voluntarily making any settlement or voluntarily assuming any obligation unless the insurance company approves the payment or assumption of obligations.
- Right of access and inspection. The insured must provide the insurance company or its authorized representative with the right of access to and inspection of its property. This obligation includes making the insured's employees available for interviews and the property available for inspection at any reasonable time during the policy period. The same obligation applies to information within the insured's custody or control that the insurance company believes may be relevant to defending against third-party claims.
The insured's failure to perform any of the material obligations described above may have drastic results, including loss of coverage for third-party claims under the policies. For these reasons, the insured should review these obligations and attempt to negotiate more limited obligations, as appropriate, under the particular facts of an environmental risk situation for which the policy is issued.
Other Coverage Issues under the Contamination Legal Liability Policy
Several other contractual aspects of the CLL policy must be recognized and, if the circumstances warrant, renegotiated. Some of these contractual provisions include:
- Subrogation rights. Payments under the policy give rise to subrogation rights for the insurance company. Generally, this means that the insurance company stands in the shoes of the insured and may seek any rights of recovery against any responsible persons when the insured normally would have such rights of recovery. For buyers and sellers of contaminated property, this could be an important provision that may need to be addressed as part of the policy negotiation. For example, a seller may choose to sell the property "as is" and the parties may agree to obtain an insurance policy providing third-party coverages naming the buyer and the seller as insureds under the policy. If the seller caused contamination on the property, and the insurance company made payment on third-party claims, this subrogation provision might give the insurance company the ability to sue the seller for contribution. If the parties intend to avoid this result, the subrogation provision may need to be renegotiated before the policy is issued.
- Cancellation rights. The insurance company has the right to cancel the policy for the insured's failure to comply with material terms and conditions or contractual obligations under the policy. This provision may need to be renegotiated to ensure that any right of cancellation is very limited. For example, the right to cancel could be limited to apply only to the insured's failure to perform obligations that give rise to significant increased exposure for the insurance company.
- Other insurance provisions. This provision requires the insured to first seek coverage under any other insurance policies for the environmental claims for which the insured is seeking coverage. There is much litigation involving policy holders seeking insurance coverage under old, occurrence-based, comprehensive general liability (CGL) policies.11 The insured may have an interest in preventing the CLL insurance company from seeking recovery under the insured's old CGL policies, especially when the insured has paid a significant premium for coverage under the new environmental policy. For this reason, this other-insurance provision must be carefully addressed and, if necessary, renegotiated and modified as part of the discussions leading up to the issuance of coverage.
- Prohibitions on actions against company without full compliance with the policy terms. The standard specimen policies for the CLL policy contain a provision that requires the insured to be in full compliance with all terms of the policy before the insured can take legal action against the company for coverage. Because the insured has many obligations under the standard specimen policy, this provision should be renegotiated to ensure that it is limited to only those obligations that are directly relevant and material to the claim for which coverage is being sought.
- Arbitration. Typically the specimen policy provides that all disputes between the insured and the insurance company must be resolved by binding arbitration. This provision should be carefully analyzed and, if necessary, renegotiated. For example, if an insured is sued by a third-party claimant and the insured believes coverage is available, the insured probably would desire to have the coverage issues resolved in the same legal proceeding. An arbitration provision, if not renegotiated, may require the insured to have such matters of coverage resolved in a separate arbitration proceeding.
- Separation of insureds. As mentioned previously, the failure of an insured to fulfill an obligation under the policy can result in loss of coverage under the policy. When there is more than one insured listed under the policy, it is important that the insurance policy contain a provision that separates the obligations of each of the insureds. This is necessary so that the failure of one insured to perform his or her obligation will not undermine the ability of another insured to receive coverage for third-party claims.
- Distinctions between "named insureds" and "additional insureds." Insureds and their lawyers must analyze any distinctions made in the policy between the parties identified as named insureds and parties identified as additional insureds. Generally, the rights of the named insured are greater and more significant than the rights of the additional insured under the policy. For example, an additional insured will have coverage only if the additional insured is named as a defendant in the same action in which the named insured is named as a defendant.
- Deductible responsibilities. Generally, no insurance coverage will be activated unless a deductible amount has been exceeded. If more than one party is listed as a named or additional insured, these parties need to negotiate among themselves to determine who is responsible for paying the deductible. The higher the deductible is, the lower the premium will be. Issues surrounding deductibles and who is responsible for paying them need to be addressed between the named insured and the additional insured in agreements executed outside of the policy.
- Known pollution conditions. CLL policies often will not provide third-party claims coverage for known environmental conditions unless such conditions are specifically scheduled as part of the policy. For example, if there is a known groundwater contamination plume, but no claims for personal injury or property damage have yet been asserted, the insurance company will argue that there is no coverage for third-party claims that later arise under the policy period because the contamination was a known condition. Such issues should be addressed as part of the negotiation, and coverage should be specifically scheduled for known conditions if the insured wants the policy to mitigate such risks.
The contamination legal liability policy is not the panacea for hedging all environmental risks for a lawyer's clients. Nonetheless, these policies are an important option that business lawyers should consider for appropriate environmental risk situations and are another contractual device that lawyers need to consider for their business clients in a world filled with liability pitfalls for the unwary.