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Hazards of the Deal

As M&A activity breaks records, successful deals hinge increasingly on insurance against lurking environmental exposure.
Russ Banham, CFO Magazine
May 1, 2000

Last year, the deal consolidating six metals-finishing companies into Lombard Technologies faced a potential roadblock. The private equity firm funding the amalgamation, Miami-based HIG Capital Management, wanted assurance that any as-yet-undiscovered pollution problems wouldn't crop up one day and jeopardize Lombard's financial condition. "With pollution, you never know when it might rear its ugly head," explains Roy Chapman, CFO of Bethesda, Maryland-based Lombard.

To ease similar concerns in the past, transacting parties required sellers to put money in escrow, indemnifying buyers against future environmental liabilities. That strategy, however, didn't fit the Lombard consolidation, given the relatively small size of the six target companies and their respective desires to retain usable capital. Instead, the company tried a new tactic: It purchased environmental impairment liability (EIL) insurance. "If not for insurance," says Chapman, "this deal would not have gone through."

Owing to a combination of prolonged softness in the insurance market, a red-hot mergers-and-acquisitions market, and eye-popping legal settlements, EIL insurance has emerged into the front ranks of viable risk management products. Terms and prices are more favorable now than ever, say experts. But with demand for environmental coverage rising and insurance markets generally tightening, EIL may not remain favorable for long.

The issue is not so much known environmental liability costs as the unknown liabilities. When these jump out, the costs can be crippling.

The stakes are high, as one recent example illustrates. In the early 1900s, DuPont never imagined that the thousands of pounds of toxic chemicals it produced at its Pompton Works chemical plant in New Jersey would someday migrate into groundwater tables. In the spring of 1997, however, the Wilmington, Delaware-based chemical giant settled a lawsuit brought by 427 Pompton Lakes residents for $38.5 million, one of the largest civil settlements in an environmental case.

Often these unanticipated liabilities emerge when a company is acquired. Spirax Sarco Inc., a 90-year-old Columbia, South Carolina-based manufacturer of pumps, valves, and other steam-related products, wanted to sell off a 30-year-old property that had been the site of its manufacturing processes in Allentown, Pennsylvania. The buyer was R.D. Management Corp., a New York­ based real estate development company.

"Our sales deal with R.D. Management assumed a clean site subject to an environmental study," says Don Harrison, Spirax Sarco vice president and CFO. The study pinpointed the presence of TCE, a toxic chemical that Spirax Sarco would need to clean up before the transaction could go through. After a second study confirmed the extent of the problem and the regulations with which Spirax Sarco would have to comply, the company contacted the Pennsylvania Department of Environmental Protection to develop a mutually acceptable cleanup plan.

Since the site would not be developed into residential real estate and would be capped by a parking lot and Home Depot structure, the company was limited to hauling away only contaminated ground above five parts per billion TCE. That effectively took care of the compliance issue. But, there was still a potential deal breaker. "Our buyer wanted peace of mind in case an environmental problem developed down the road and caused it undue reputational and brand risks," says Harrison. "We did, too, since we'd have to pay for it." Harrison notes that Spirax Sarco was not confident that huge, uncertain environmental problems wouldn't arise someday. "However, you can't always be sure, and when you're talking about something that could represent a major hit to earnings, you don't want to rely on instinct alone," he says.

But Spirax Sarco's board didn't like the notion of putting money in escrow to cover such a possibility. "We wanted to have a clean balance sheet," Harrison explains. "Nobody likes to tuck away a lot of money for years." So it turned to Exton, Pennsylvania-based ECS Inc., part of the large Bermuda-based insurer XL Capital Co., to develop an insurance alternative, forking over a $200,000 annual premium to cover its known and unknown pollution liabilities spanning the next 10 years, giving it a $4 million aggregate cap limited liability over 10 years.

"We've protected both companies' shareholders from environmental uncertainty and avoided a messy balance sheet," the CFO adds. "Had we said to the buyer, 'Take the property as it is,' there would have been no deal. The insurance secured the transaction for us."

EIL insurance also helps sellers fence in environmental liabilities to make their companies more appealing to potential buyers. Clark USA Inc., a privately held St. Louis­based oil refiner, was purchased in 1997 by Blackstone Capital Partners, a New York­based investment group. Blackstone didn't want to inherit Clark's unknown pollution liabilities or spin it off to the public with those potential exposures intact.

While the 60-year-old company already had environmental coverage through its existing property and excess-liability insurance protecting its four U.S.-based refineries against sudden and accidental environmental exposures, the insurance did not cover pollution that could emanate from these sites and, over the gradual course of time, migrate offsite to cause damage or injury to third parties.


So, Clark USA bought an EIL insurance policy through Marsh Inc., the New York­based broker that put together the Lombard insurance deal, and from American International Group (AIG), which, perhaps not coincidentally, has a significant equity investment in Blackstone. While Maura Clark demurs on the details, she does say, "We got good coverage at a good price. The insurance provided additional comfort to Blackstone."

Buyer's Market
Lombard, Spirax, and Clark have all tapped an increasingly competitive market. Once considered so costly and restrictive that only companies required by law bought the coverage, EIL is currently a buyer's market. Prices have dipped, coverage limits are up to the hundreds of millions of dollars, underwriting terms and conditions are nowhere near as stringent, and, best of all, this is only the beginning.

Roughly one quarter of EIL business now stems from corporate restructuring activity: companies engaged in mergers, acquisitions, divestitures, and consolidations. The insurance plugs the holes that threaten to capsize the deal and, typically, is underwritten over a long policy duration, up to 10 years or more. The costs to remediate defined environmental issues generally are set aside as a de facto deductible in the insurance policy, above which resides more than ample coverage for unexpected pollution problems.

Most major insurers selling EIL products, a select group that includes ECS, Kemper, Zurich, and industry leader AIG (Lombard's carrier) have formed units focused on transactional-based EIL insurance, as have the brokers. Their goal is to offer companies an alternative to more hidebound ways of managing their environmental liability risks in an M&A context. Apparently, companies are opting for the new strategy. "We'll underwrite in excess of $280 million in premiums by the end of the year, up from $205 million last year and half that of four years ago," says William Kronenberg, ECS president and CEO.

ECS evaluated more than 100 mergers and acquisitions for environmental impairment exposures last year, booking well over two dozen for the coverage. Those numbers are growing at a 10-percent-a-month clip, Kronenberg says. "We're finding that virtually every M&A transaction now involves some element of environmental insurance," he says. "Consequently, this has become a major aspect of our business."

This adjustment to the M&A market has occurred swiftly. In the early 1990s, transacting partners typically exchanged equity securities to obtain the benefit of so-called pooling accounting techniques, helping companies avoid the need to write off the substantial goodwill associated with buying a company at a higher tax basis. Consequently, any liabilities that materialized post-transaction (read: pollution claims) would be borne and shared by the two companies, settling out in the wash between two sets of shareholders.

Five years ago, EIL began life as a transactional tool, as stock-based transactions began to eclipse cash deals. What we have seen is a softening insurance market intersecting with a different method of acquiring companies. Even M&A lawyers, who once scorned EIL for its high cost and minimum coverage, now routinely tout it. "We had found these insurance contracts in the past to be fairly inflexible and not as responsive as we would have liked," says Scott F. Smith, head of the corporate group and partner at New York law firm Covington & Burling. "Our view has changed markedly."

The firm recently advised a merchant-banking client eyeing an acquisition that was threatened by environmental issues. "We anticipated this would be a deal killer, based on the limited indemnity [to cover unknown EIL risks] that the seller was willing to offer," Smith says. "We worked with Marsh to find a solution for these known and unknown liabilities, putting together a 10-year insurance contract with $50 million in limits, using the seller's [known] indemnity as the deductible. It saved the deal and protected nearly $1 million in transactional costs already invested by our client."

Saving Graces
Because of lurking environmental hazards, some M&A deals teeter at death's door until the subject of EIL insurance is introduced. "We just bound an environmental insurance policy 48 hours before the deal was to close," comments Joseph Boren, president and chief executive officer of AIG Environmental Inc., in New York. "The buyer's due diligence unearthed what it argued was an $18 million environmental problem at the facilities about to be acquired. The seller disagreed strongly, tabulating those costs at no more than $6 million."

The buyer threatened to walk out unless the seller put $18 million in escrow. "The seller didn't want the deal to crater, so it came to us," Boren says. "We agreed to cover the $18 million, using the seller's estimate of $6 million as the deductible. The deal went through literally at the last minute." The seller paid for the insurance, an amount equal to roughly 10 percent of the limits provided.

Why not just put the $18 million in escrow and save what is still a significant insurance premium? "Most companies would rather make a one- time, tax deductible insurance payment and keep their capital to do their own thing," Boren says.

Peter Walther, a managing director at Marsh, concurs. "The key thing for CFOs is to manage risk in such a way as to permit predictability of cash flows for investors, bankers, and shareholders," he says. "Not only does insurance provide a clean balance sheet, but you also avoid tying up a big chunk of capital for many years, money that otherwise could be invested in R&D, new products or services, and even additional acquisitions."


Lombard's policy is designed to provide expanding coverage as it acquires other metals-finishing companies. "We've got a security blanket for now, and have set the stage for the future," Chapman says.

Columbia Energy Group is in the process of negotiating a similar master pollution program to transfer the EIL risks of its future acquisitions. The novel policy would provide up to $100 million in coverage above a self-insured retention layer, a deductible of sorts that Columbia manages through its corporate-owned captive insurance facility, Columbia Insurance Group Ltd., in Bermuda. "EIL insurance is an important tool for us in our ongoing acquisition strategy to protect against [targets'] known and unknown environmental exposures," says Michael O'Donnell, senior vice president and CFO of the Herndon, Virginia-based diversified energy company.

Columbia's captive is used to manage the known environmental risks of acquired companies. "If we agree that the known environmental liabilities are, say, $6 million, our captive will insure that for a $6 million premium," says Nick Parillo, Columbia vice president of risk management. "If losses develop favorably over time, we will credit back the seller a specific percentage of the premium paid." Above the captive sits the $100 million insurance policy for unexpected pollution losses.

Prior to inking the master program, Columbia used EIL insurance in several acquisitions, including the purchase last year of Carlos Leffler Inc., a Harrisburg, Pennsylvania-based heating oil and propane distributor. Columbia's outside environmental consultant, Chicago-based Dames & Moore, had analyzed Leffler's eight facilities for environmental contamination and found several with significant migration issues; that is, hazardous materials beginning to seep onto other properties.

The cost to remediate was estimated at $7 million, the figure ECS used as the deductible for a $100 million policy covering third-party personal- injury and property damage. The cost for the insurance was only 3 percent of the coverage limit — a great bargain, says Parillo. "We were so pleased by what we got that we decided to go full bore with a master program," he adds.

Parillo is most amazed at the rapid maturation of the EIL market. "Five years ago, I searched for insurance to cover our environmental risks, and there was nothing, absolutely nothing, there worth a dime," he says. "Each year, I take another peek and am amazed at the improvement. Who knows what I'll see next year?"

Russ Banham is a contributing editor of CFO.

Old Ways Die Fast
Insurers now scramble for business where once they feared to tread.

Five years ago, the environmental impairment liability (EIL) market was a no-man's-land of insurance. Not only was the insurance rarely considered a deal-saving alternative to escrowed funds, it was barely considered at all. Few companies bought the insurance, other than those that were in the business of environmental services, such as landfill operators and waste transporters. These companies were required by federal and state regulations, including the Resource and Conservation Recovery Act; the Comprehensive Environmental Response, Compensation, and Liability Act; and the 1980 Superfund law, to show evidence of financial responsibility for pollution liability. Insurance often was the simplest recourse.

More mainstream companies, including manufacturers, real estate firms, oil and chemical companies, and myriad smaller concerns, from dry cleaners to hospitals, elected to forgo the coverage. Instead, they relied on their comprehensive general liability (CGL) insurance policies to pick up pollution risks. When the environmental movement was born in the 1980s, following the Love Canal debacle in upstate New York, these companies began filing claims against their CGL insurers alleging property damage and bodily injury losses attributed to pollution causes. Lots of litigation followed, much of it won by insureds. The result: CGL insurers carved an absolute pollution exclusion into their policies beginning in 1985.

Although this development compelled companies to cover environmental exposures with stand-alone EIL insurance, introduced by American International Group (AIG), in 1979, the underwriting requirements were so restrictive few gave it serious consideration. Hundreds of forms had to be filled out, and applicants had to pay for an audit of their pollution exposures by environmental engineers before insurers would even pick up the phone. Such surveys typically cost $10,000 per site, a sum worthy of Croesus for a multisite manufacturer.

What's worse, companies could buy no more than $5 million in coverage limits to absorb their environmental exposures, a pittance compared to the overall risk, and only after a hefty deductible and a 20 percent premium were paid. No wonder few plunked down the pennies. Given the high cost, onerous underwriting requirements, and scant coverage, who could blame them?

Along the way, however, other insurers entered the EIL market, and injected a dose of competition into the stagnant business. As these insurers gained underwriting experience, distinguishing the differences between risk classes, EIL insurance limits perked up. The underwriting requirements, such as the need for buyers to conduct and pay for their own environmental assessment studies, gave way. Insurers now routinely perform these analyses at their own cost. Meanwhile, the few hundred forms to fill out have dwindled to a four-page report, and, most important, prices have avalanched, down 70 percent in the past five years.


Today, a manufacturer can expect to pay between 6 percent and 10 percent in premiums for literally hundreds of millions of dollars, a far cry from the days of $5 million insurance limits. Kemper Environmental, in Princeton, New Jersey, offers $200 million in insurance capacity; AIG and ECS offer $100 million; and Zurich and Chubb, $50 million. Stack the limits of these insurers with others offering more modest capacity, advises Peter Walther, a managing director at New York­based broker Marsh Inc.




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