Environmental Liability

New Insurance Policies Can Help Protect Investors Against Unseen Risk.

Environmental liability may be the fastest-growing "killer" of real estate transactions in the United States. More than 200 state and federal statutes impose liability on owners, managers, and lenders of commercial and investment real estate.

In turn, these players seek to transfer that legal liability to someone else. Sellers want buyers to assume the liability; buyers want sellers to warrant that there is no contamination and agree to indemnify them if contamination is ever found; lenders want borrowers to indemnify them against environmental liability even if there is no personal liability on the loan. However, the U.S. Environmental Protection Agency (EPA) does not recognize indemnification agreements-it recognizes the closest deep pocket that can pay for remediation and the legal and engineering costs that accompany it.

Even if a buyer obtains an indemnification agreement, what assurance is there that the seller will be financially capable of paying a claim years down the road? Should the buyer insist a reserve be set up for this potential liability? If a seller does that, how is it treated on the financial statement or balance sheet? How will potential lenders react to that contingent liability?

The Growing Problem
The issues and considerations surrounding environmental liability are myriad and are unlikely to improve any time soon. A national study published in 1991 estimates that by the year 2020, 43,616 additional sites will be added to the current list of 37,500 sites for a total of 81,116 sites potentially in need of remediation. The study, published by the Waste Management Research and Education Institute of the University of Tennessee, estimated that 30 percent-a total of 24,335 sites-will require remedial action.

The report further estimates that the total number of sites not covered by federal clean-up funds will be from five to 15 times greater than the current National Priorities List-EPA's list of sites identified for long-term remediation. Costs, not including discovery, typically will reach $1 million per site.

Is It Worth the Risk?
Given the increasing number of sites and the rising costs of remediation, what is the most cost-effective method to protect against the possibility of an environmental contamination claim? The options are few. Many buyers and sellers-but not lenders-rely on a Phase I audit. Phase I is a historical review of a property's ownership and use. Typically, environmental databases are searched for potential contamination that may have occurred within a half-mile radius of the property. Any property uses that might have caused contamination are then researched specifically.

Yet how accurate are the Phase I audits? Recently, the New York Law Journal reported that a new survey of 33 environmental engineering firms nationwide found that 21 percent of their Phase I reports "have either overlooked serious environmental problems or have so neglected to document a property's history that a realistic understanding of the dangers of contamination is impossible."

The second option is to have a Phase II or Phase III audit conducted. Each of these is progressively more thorough-and more expensive-than the Phase I. While this reduces the risk, it does not eliminate it. Furthermore, an audit does not guarantee there is no contamination nor does it pay for remediation should contamination be found.

What does offer protection and payment are environmental risk liability insurance policies, which protect property owners, managers, and lenders against environmental liability in real estate transactions. Environmental risk liability policies protect the insured against liability from laws that obligate them to remediate the property. Current owners may not be responsible for the contamination, but they are responsible for clean-up. Lenders are also in the chain of liability and may get called upon if a current owner cannot pay. Hence, it is in everyone's best interest for current owners to have the insurance coverage.

What Are the Costs?
Environmental liability risk policies are written by financially strong insurance companies with proven track records. Leaders in this area of insurance are Zurich American Insurance Group, American International Group, and Reliance National. An environmental risk liability insurance broker can submit an application to one or more of these companies to find the best coverage and premium available.

The underwriting process for properties other than those known to contain contamination involves the submission of an application along with a Phase I audit of the property. If the application includes a number of properties, Phase I audits may not be required on all of the properties. On properties where contamination is known to exist, the more detailed Phase II audit is required, if it has not already been performed.

Costs of insurance coverage vary depending on limits of the coverage, the risk involved, and the insurance company. On the policy most often used in sale, acquisition, and financing transactions, the standard limit of liability is $2 million and the standard deductible is $10,000. Both the limits of liability and the deductible can be increased. The minimum term is three years and the minimum premium for this term is $6,000. Applicants know the costs of the premium before committing to buy the policy, and when compared to the risk assumed for the insured, the premiums are reasonable.

The "trigger" for a claim is discovery of contamination. This means that the costs of investigating and determining what the pollution is and what method of remediation must be used are covered expenses.

Although a deductible is included in each policy, the insurance carrier becomes involved immediately when a claim is reported. This places the financial, legal, and engineering resources of that company out in front at the beginning.

In addition to the cost of remediation, insurance also covers bodily injury/property damage on third-party claims. This is referred to as "environmental impairment liability" and, in the past, has only been available for industrial properties. Bodily injury claims represent an area of liability that is not fully appreciated at this time because most legal action to date is focused on property clean-up.

The insurance carrier's limit for all expenses is the limit of coverage stated on the policy. As in all matters of insurance, it is necessary to estimate what the cost can be and to buy limits of liability that are high enough to cover the exposure.

Types of Coverage
Environmental risk policies are written on an occurrence basis or a claims-made basis-an important distinction, because it may not be possible to determine when the contamination occurred. An occurrence-based policy offers coverage for events that occur during the time the policy is in effect, regardless of when the claim is filed. An expired occurrence policy will pay a valid claim, even if it is made years after the expiration date. On a claims-made approach, the policy in effect at the time the claim is made provides the coverage.

Environmental risk liability policies provide protection to buyers, sellers, and lenders in a number of situations. Below is a brief summary of the types of coverage available.

Sale, Acquisition, Financing. Although the standard environmental risk liability policy can be purchased at any time, it is used most often at the time of a sale and/or financing of a property. Written on a claims-made basis, this policy protects owners and lenders against liability that may arise from any state or federal Superfund-type environmental statute when contamination is discovered after the policy is purchased.

An important provision extends coverage to changes made in these laws after the policy is issued and before contamination is found. This unusual feature is necessary because the liability comes from specific environmental legislation.

Coverage also applies to:

  • contamination that existed but was undetected at the time the policy was issued;
  • contamination migrating on site from another property;
  • contamination from underground storage tanks, ongoing commercial operations, and "midnight dumping" by third parties;
  • pollution caused by a tenant; and
  • accidental pollution caused by the property owner.

This policy pays "on behalf of " the owner; legal and engineering expenses are covered, which can sometimes equal the cost of the remediation process. This coverage may also prevent a situation where the collateral securing a loan is suddenly found to be insufficient because of contamination.

Asbestos Contamination. Used for protection before a removal program is implemented or where removal is difficult or impossible, this policy is written on an occurrence-form basis because asbestos-related diseases do not normally appear until 20 or 30 years after exposure. Owners' liabilities are covered forever if the policy was in force at the time of exposure and if the policy was kept in force for one full policy term.

This policy includes coverages in five important situations that may result from exposure to or release of asbestos:

  • bodily injury to third parties-such as tenants;
  • property damage to third parties;
  • business interruption (for removal of contamination) expense to third parties;
  • liability from release caused by subcontractors who do not have asbestos liability coverage; and
  • defense cost for suits filed by third parties due to long-term exposure or to sudden, accidental release. Coverage includes suits filed by employees of subcontractors.

This policy can be transferred to a new owner, and lenders and management companies can be named as additional insureds.

Remediation. When a property is known to be contaminated and must be remediated, the liability risks are different but still pose a threat to property owners. Asbestos abatement, lead-based paint abatement, underground storage tank removal, and PCB remediation are situations where this coverage can be useful.

Typically, the property owner requires the contractor to add the property owner as an additional insured. However, if the contractor ends up with claims on more than one job, the insurance amount is diluted; the property owner has no way of knowing specifically what amount of insurance will be available if a claim arises on his remediation project. A better approach is for the property owner to buy his own coverage and have specific policy limits for his exposure, which gives broader protection and costs less.

Cap on Remediation Costs. The total cost of remediation is the greatest fear a property owner has, because it is often difficult to determine the extent of remediation required. This policy establishes maximum costs from remediation, the deductible, and the policy premium before remediation begins. The owner then can proceed with the clean-up without fear of financial ruin. A sale or financing of the property can proceed with this protection in place.

Post Remediation. This coverage protects the owner from subsequent governmental action requiring additional clean-up. Properties have been remediated to comply with the standard required at the time, only to have the standard changed and additional clean-up required. This policy also provides coverage against statutory liability for other, pre-existing contamination that was undetected at the time the policy was written.

Owners of contaminated properties can customize their coverage to meet specific needs of their situation, such as protection against additional remediation in the future. This risk is specifically engineered and rated and can be the security needed for the continued ownership, sale, or financing of a property.

Pollution Legal Liability. This coverage provides third-party liability coverage, bodily injury, and property damage, including defense costs for pollution emanating from the insured property. This policy can be used when remediation coverage on the policyholder's property is not desired.

Underground Storage Tanks. This policy provides both first- and third-party coverage of pollution from underground storage tanks. It can be used to protect owners of property where petroleum products are sold or used, such as gas stations and automobile garages.

Finite Risk. This coverage can be structured for long-term remediation programs to assure a funding mechanism and management that will see a project through to completion. This can sometimes include a tax-deferral feature.

Who Pays?
The question of who pays for the insurance policy is negotiated-just like other expenses in a real estate transaction. In determining who will pay, look at who will benefit. For example, one solution is for the seller to pay for the original term (three to five years) in lieu of giving an indemnification and for the buyer to pay the premium thereafter. For a fixed cost, the seller eliminates the potential of a future unknown liability of unlimited cost.

If a seller is giving a long-term indemnification, it is to his benefit to buy the insurance and let it stand in front of that indemnification, thereby protecting his assets. In situations where the indemnification has already been given, it may be possible to go back and replace it with the insurance protection or get an agreement that the insurance will stand first. The financial strength of the insurance company will greatly exceed that of most sellers and buyers.

The emergence of environmental risk liability policies is an example of the marketplace operating at its best. Insurance has long been accepted as the solution to dealing with any problem that might arise on the title of a property. The extension of this widely accepted product into the arena of environmental liability has been met with success. In the short time since these policies were first written, rates have been reduced and coverage has been broadened as acceptance has grown.

Jim H. Dunn, CCIM, CPM

Jim H. Dunn, CCIM, CPM, is president of Keystone Realty Services in Nashville, a commercial realty office that also handles environmental insurance. You can reach him at (615) 366-1112 or through his company\'s World Wide Web site at http://www.keystonerealty.com. Environmental Insurance in Action Environmental risk liability insurance has solved the question of "who\'s responsible" in real estate transactions of all sizes. As is quite often the case, new solutions are first sought and used in large transactions because the size magnifies the exposure. What follows are examples of where insurance was used to move transactions along: An institutional seller used insurance coverage in a sale to an institutional buyer in which the buyer did not want to acquire the potential liability and the seller did not want to book a contingent liability and have it affect its reserves for years to come. The insurance policy solved the problems on both ends of the transaction. An investment entity that controls a large number of properties uses the insurance coverage to avoid exposing its investors to the potential liability for remediation and to give its lenders the protection they require. This eliminates the need for an indemnification agreement to their lenders. In a large real estate mortgage investment conduit involving more than 100 properties, environmental risk liability insurance enhanced the indemnification given by each borrower. In this situation, if a foreclosure should occur on any property, all parties in the chain are protected against the cost of potential remediation. Buyers and sellers in transactions involving a single property have accomplished these same objectives: The site for a parking garage was contaminated at a low level, requiring some soil and groundwater to be removed and disposed of at additional expense. The developer was willing to accept this expense but was concerned about the possibility of regulation requiring additional remediation. An insurance policy covered this exposure and the exposure of any undetected contamination. Groundwater coming from a nearby site contaminated a shopping center. To facilitate a sale, an insurance policy was issued with no exclusion for the known contamination. If regulators require the owner to remediate, the policy will pay. Insurance covered the buyer and the lender of a remediated industrial property with ongoing monitoring. The policy excluded monitoring costs but covered any additional contamination found. The partnership lender on a refinancing told the general partners of a limited partnership that they must give personal indemnification on environmental liability for the partnership. The general partners provided an insurance policy naming the lender as an additional insured to protect themselves in the event of the discovery of contamination. In all cases, the insurance eliminated the need for an indemnification agreement or was placed ahead of the personal indemnification, assuring buyers and lenders of the protection required to make the transaction feasible.