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Even as Sarbanes-related liabilities loom, companies are discovering that environmental coverage can help property deals go down easier.
David M. Katz, CFO.com | US
September 9, 2004
While much hard science goes into the tidying up of a polluted corporate site, gauging the future costs of that job can involve skills that are a good deal softer.
Armed with varying and sometimes patented cleanup strategies, different environmental consultants can come in with cost estimates that vary by as much 500 percent on a given site, says David Dybdahl, president of American Risk Management Resources Network, a Chicago-based environmental insurance brokerage firm.
But the Sarbanes-Oxley Act, combined with pressure from environmentally minded shareholder activists, could place a much higher premium on precision in environmental reporting. "The stakes are higher under Sarbanes-Oxley," says John Nevius, an attorney who represents corporations for Anderson, Kill & Olick in New York. "The consequences if you get it wrong are greater."
Until recently, however, difficulties in predicting cleanup costs haven't mattered much to senior finance executives. That's because, under Securities and Exchange Commission rules and Financial Accounting Standards Board dictates, they've had the latitude to report the cheapest cost estimates. "There isn't much of a carrot associated with reporting," notes Dybdahl. "You increase your environmental reporting and you decrease earnings."
If there's not a carrot, perhaps Section 302 of Sarbanes-Oxley will provide a stick. Some say that Sarbox 302, which directs CFOs and their bosses to personally sign off on their companies' financials, could cause top executives to demand more scrupulous accounts of future costs from their environmental managers. Yet coming up with such estimates can often be a matter of hitting a very movable target. For example, in a recent review by Dybdahl of proposals by two consultants for a site with polluted groundwater, the cleanup cost had the potential to vary by as much as $40 million.
The first consultant suggested that the company take a conventional approach: pump the groundwater out of the soil, run it through treatment facilities, and continue the flushing-out process for 30 years. Estimated cost: $40 million.
The second consultant proposed bioremediation, an approach involving the use of bacteria, other microorganisms, or plants. The remedy would be to pump a common household item into the soil; that ingredient (which Dybdahl wouldn't reveal, since its use in bioremediation is proprietary to the consultant) would bond chemically with the pollutant in the groundwater and neutralize it.
If all went well, the cleanup would take just 10 years, and the cost would be a mere $20 million. If it didn't work, however, the tab could be as high as $60 million — $20 million for the failed bioremediation and $40 for the conventional pump-and-treat cleanup. Further, there could be more costs and other risks, since the bioremediation could turn the pollutant even more toxic than it had been.
In the end, the company chose bioremediation, largely because it might be faster. Since the situation on the site had become an issue in a local mayoral election, the owners felt it would be a good idea to present a plan to clean up the site as swiftly as possible, according to Dybdahl.
Indeed, the length of time to clean up a site is one of the biggest causes of variability in expense estimates. Besides changes in the political and regulatory climate, lengthy cleanups provide more time for pollutants to migrate offsite and cause damage in unexpected places. If a remediation lasts as long as 30 years, say experts, unexpected zigs and zags can crop up in a company's cost structure. That jibes badly with the short timeframes of quarterly and annual reports into which executives must cram their future pollution-liability estimates.
While the disconnect between environmental and financial reporting and the anticipated pressures for greater transparency spell possible woes for corporate polluters, however, they represent an opportunity for environmental insurers. Corporate managers — wary of signing off on inaccurately low estimates of their future pollution costs, the reasoning goes — will be moved to more fully acknowledge the risks of future pollution expense, and to insure for them.
Forms of Muzak
Buying coverage for the newly reported hazards could stave off a pretext for shareholder lawsuits, insurers and brokers argue. If a company reports a bigger pollution liability than in the past, and its share price subsequently plummets, investors might take directors and officers to court. The presence of environmental insurance could, theoretically, calm investor response to the added risk being reported.
What's more, since directors' and officers' liability policies typically don't cover lawsuits generated by environmental conditions, pollution insurance can help companies manage their D&O risk, contended Peter Gilbertson, director of marketing for AIG Environmental, widely thought to be the biggest carrier of the coverage in the market. (Other sellers of the insurance include XL Insurance, ACE Limited, Zurich North America, Arch Insurance Group, and Quanta Capital Holdings.) Gilbertson also asserted that covering the risk is already prompting some of the company's clients to report their liabilities in greater detail than "the vague, opaque, elevator music" that characterizes much current environmental reporting language in company 10-Ks.
For now, however, the pressure for deeper reporting represents only a potential source of growth in the use of pollution coverage. Insurers — having been hit with losses, a contraction of their reinsurance, and the prospect of new risks — have reportedly gotten picky about providing such coverage at all.
One threat that has spawned caution among underwriters is the possibility that many states will follow the lead of New Jersey and start pursuing "natural resource damage" claims, according to Ken Radigan, a senior vice president of AIG Environmental. Last year, New Jersey's Department of Environmental Protection decided to pursue 4,000 potential damage claims "for the lost use of natural resources caused by industrial pollution," according to a release issued by the department. Thus, if a company contaminated a river and killed its fish, the company's pollution insurance carrier could be responsible for paying for the restoration of the river to its original state as well as for the cleanup, says Radigan.
That current case of risk aversion has led pollution carriers to tighten policy conditions, increase underwriting scrutiny, and boost prices, brokers and insurers say. The long-term coverage needed to protect companies on those lengthy site cleanups has shrunk, for example.
Two or three years ago, companies could buy policies stretching out 15 to 20 years, and they could pick up as much as 30 years if they were willing to let insurers include a "finite risk" element in the coverage, according to Donna Sandidge, a managing director specializing in large industrial entities for Marsh Inc.'s environmental unit. (In a finite-risk approach, the buyer makes an upfront payment of most or all of the present value of the expected costs of a cleanup to the insurer. In exchange, the insurer assumes the interest-rate risk and the risk that the money will be needed sooner than expected.) Lacking such a pre-funded provision, buyers are now looking at policy terms of just 5 to 10 years, says Sandidge.
That might not be as alarming as it sounds. A decade of coverage is quite enough for most situations, says John Welter, president and chief underwriting officer of the environmental division of Quanta Capital Holdings. Although Welter notes that most cleanup costs are spent in the first five years, he acknowledges that the risk persists for longer-range remediation and that "the reinsurers have pushed back and cried 'no más' " in terms of policy lengths.
Yet even though environmental carriers are seeking to limit their risks, hefty amounts of coverage are still available. AIG, for instance, can supply $150 million of insurance for an environmental hazard. While there are many permutations of policies, there are two basic offerings for corporate buyers: cleanup-cost-cap insurance and environmental impairment liability (EIL) insurance.
The distinction between the two boils down to the difference between insuring known and unknown risks. Cleanup-cost-cap insurance covers the possibility of cost overruns on a planned remediation of one or more sites; EIL coverage (also commonly called pollution legal liability insurance) insures against lawsuits and government-enforcement actions resulting from unexpected or unknown pollution stemming from an insured's location.
Finance executives and risk managers in the market for cost-cap coverage, in particular, might well find their companies paying more than expected and assuming more risk. After some previously avid insurers got their "noses bloodied" by losses, says Kenneth Anderson, a managing director with Gallagher Environmental Risk and Insurance in Chicago, pollution cost-cap insurance prices rose 10 to 15 percent compared with last year.
Previously, commercial insureds would assume a deductible of 10 percent of the overrun above the expected cost of the cleanup, and the insured would pay for all costs above that, according to the broker. Now, deductibles have expanded to 15 percent, and insureds are being asked to cough up a percentage of the cost that exceeds the deductible. Insurers have added coinsurance provisions such as these, notes Anderson, to motivate polluters to curb their remediation costs. In addition, carriers who once signed off on drafts of work plans now often demand that companies provide final plans, preferably ones approved by government officials.
Market conditions for EIL are a tad more variable. Indeed, "schizophrenia rules" in pricing the product, notes Anderson, because there's a great deal of subjectivity in underwriting unknown risks. Recently, for instance, the broker says he shopped the risk of a multi-campus university to four different insurers; one provided an estimate that was a mere 35 percent of what the others expected to charge.
Insurers and brokers are also pushing finite-risk approaches for EIL, cost-cap, and a bevy of other products. AIG, for example, is offering a new "specialty litigation risks" program that would cover the costs of expected or threatened toxic-tort lawsuits. (In such suits, which are often class actions, plaintiffs claim to have been injured by contact with poisonous chemicals.) Under the finite-risk program, the insured would pay the insurer the net present value of its legal costs, plus a premium, said AIG's Radigan. If the outcome is better than expected, some of the money would be returned to the insured.
If regulators choose to require that corporations report their environmental risks more conservatively, finite-risk environmental programs might become even more prominent. Currently, users of finite-risk arrangements most often seek "to create an insurance asset that is used to offset environmental liabilities," Anderson wrote in a recent unpublished paper. It follows that if companies are reporting greater expected future costs, they'd want to show investors that they've also set up effective ways to fund them.
While pollution insurers are hoping that pressure for more accurate reporting will translate into corporate demand for their products, one area of environmental insurance is hot right now. As it has for a number of years, experts observe, this coverage is playing a key role in the transfer of polluted land via mergers, acquisitions, divestitures, property sales, and outright donations.
Environmental coverage can be used as a way to get the buyer and seller to agree on future cost estimates. Unlike unsold polluted sites, for which the true cleanup costs won't be known for many years, "in a merger or sale, the buyer forces the actual reflection of the expected costs," according to Dybdhal.
Despite the often wide range of estimates for future cleanup costs on a site, the buyer and seller have to lock in on a fixed price, says Dybdhal. Exacerbating the problem is that in preparing their estimates, the parties tend to perch on polar extremes. "The seller will always gravitate toward the best-case scenario...to maximize the sales price," he adds, while the buyer will hire engineers to scour the terrain for the gloomiest possible outcome.
The purchase of insurance by the seller can help bridge the gap between the two estimates by covering the contingency that the seller's estimate is too low. Environmental impairment liability insurance, for instance, "provides comfort to buyer and seller that a third party will come in and deal with any unknowns," says Robert Colangelo, executive director of the National Brownfields Association in Chicago.
A brownfield, according to the Website of the Environmental Protection Agency, is "a property, the expansion, redevelopment, or reuse of which may be complicated by the presence or potential presence of a hazardous substance, pollutant, or contaminant." Brownfield sites — typically abandoned, idle, or underused — often show good potential for upgrading and for other uses, say advocates for their development. And indeed, both EIL and cost-cap coverage are being used in many brownfield transactions.
A particular challenge for companies in brownfield programs is managing the future liability risks of a site they no longer own. To assure buyers and sellers that the land will be clean and that unexpected legal costs will be covered, some insurers are offering "liability buybacks." In such arrangements, the insurer acts in tandem with environmental consultants and engineers to take over the assessment of a site, manage its ongoing cleanup, and insure the company's liability. In the case of Quanta Capital Holdings, the technical pollution people work for divisions of the company.
Early this year, for example, a Quanta unit agreed "to assume environmental liability" from Acordis Cellulosic Fibers Inc. for a rayon plant in Axis, Alabama, that had been shut down in 2001. With profits in the rayon business in the United States and Europe flagging because of stiff competition from Asia, the company wanted to achieve "an elegant exit" from the Axis plant, says Wayne Currie, the health, safety, and environmental director of Acordis Group, the Netherlands-based parent company of Acordis Cellulosic.
The company's solution was to enter the approximately 580-acre site into the Alabama Department of Environmental Management's brownfields program, remediate its pollution, and donate it to Mobile County.
Cleaning up the plant and its grounds under the state's voluntary remediation program provided the company with a way of divesting itself from the site "in an open and transparent manner," says Currie. And if the state productively redevelops the land, he believes, it could provide jobs for some of the 400 workers the company laid off when it shut down the plant.
Mobile County coveted the 10-million-gallon-per-day wastewater treatment plant and other buildings on the site, according to a Quanta summary of the project. Up until 2000, however, the rayon mill "was the biggest producer of toxic air emissions in Alabama and one of the top producers of toxic air emissions in the country," the Mobile Register reported in 2002. To be sure, toxic air releases dropped from about 11 million pounds in 2000 to under 4 million pounds in 2001, when the mill ceased operating, according to EPA figures. Further, Environmental Strategies Corp., now a Quanta subsidiary, found that the risk of ground and groundwater contamination was low, notes Currie.
Mobile County officials, however, didn't want to assume any pollution liability or plant-contamination costs, according to Quanta. "Having donated the site to Mobile County and entered [it] into remediation, we needed to deal with those risks of which were aware," says Currie. After Environmental Strategies assessed the site, Acordis placed "multimillions" of dollars into a trust fund to finance the entire anticipated cost of the cleanup, he adds. (Currie would not specify the exact amount the company placed into the fund.) Quanta Liability Transfer of Alabama contractually assumed the responsibility for managing the remediation. Acordis also bought cost-cap coverage from Quanta and pollution legal liability coverage from AIG.
Despite the company's tightly wound risk-management structure, Currie acknowledges, the company can never truly transfer all its liability for its activities on the site. Even though Acordis no longer owns the property, he notes that government authorities retain the ability to press criminal charges against the company.
While insurance can be a "hell of an asset" against future hazards, adds Quanta's Welter, "after Enron, no one's going to eliminate that liability."