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RISK TRANSFER USING ENVIRONMENTAL INSURANCE

Environmental insurance is a risk transfer mechanism that compliments a properly conducted environmental due diligence evaluation. Financial lenders as well as borrowers can take advantage of both in reducing exposure to environmental liabilities.

Environmental insurance policies for lenders were initially developed in the late 1980’s as an evolution of the Pollution Liability policy originally offered to property owners. At that time these policies covered some third party liability for on-site pollution conditions. In addition, the policies tended to be overly restrictive and expensive. Lender concern fueled by litigation led to the initial Lender Liability or first party property transfer policies around 1990, which found weak market support. However, these policies were the first specifically written to protect buyers, sellers, and lenders of potentially contaminated real estate. The concept also used environmental due diligence (e.g., Phase I Environmental Site Assessments) as a guaranty or warranty that no previously existing environmental conditions existed on the property. The Lender Liability policies evolved into the current Secured Creditor policies and, to some extent, current Pollution Liability policies.

Secured Creditor policies emerged largely in response to Brownfields Law. Based on evidence collected by the Urban Institute, they concluded that environmental issues while in many cases were important, were never the single critical obstacle on failed property development ventures. In most cases other non-environmental factors (e.g., potential demand and cost) were significant as well depending on local circumstances. In addition, the immediate environmental costs, rather than the potential risk of liability for future claims, were developers' predominate concern.

Typically a Secured Creditor policy contains stand-alone coverage parts for the loss of collateral value due to a pollution condition, which is a lender’s primary concern. They also have coverage parts for the lender’s direct environmental liability for cleanup costs, bodily injury, or property damage arising from a pollution condition, which prior to foreclosure is of lesser concern to the lender. These policies can be issued on a pooled basis applicable to an entire or partial portfolio of loans.

A lender’s primary environmental liability concern is typically the borrower’s inability to repay a loan due to a pollution condition. Secured Creditor policies usually have coverage parts that address this concern, usually referred to as collateral loss value coverages. However, these coverage parts can differ significantly from each other in activating coverage and payment method. In general though, most require a default and the lender’s discovery of a pollution condition.

As a lesser concern, lender’s also typically consider direct environmental liability. This liability potentially exists under CERCLA and amendments, most notably after foreclosure. If a lender becomes an owner as a result of foreclosure, the lender may be subject to the same direct liability for such damages that an owner would have. Typically, direct environmental liability policies take two forms depending upon carrier, one being very similar to Pollution Liability policies and the other a more complimentary coverage to collateral loss value. Lenders can also gain equivalent coverage as being named an additionally insured party if the borrower already has Pollution Liability coverage on the property.

The Secured Creditor policy form is also important, specifically exclusions to avoid. The policies should not include exclusions for certain types of environmental risk and coverage only of conditions that violate environmental laws. They should not include exclusions based on knowledge of the insured or which require that the conditions be unexpected and unintended from the perspective of the insured or any other party, as those potentially lead to coverage disputes.

Environmental insurance should not replace environmental due diligence. Due diligence is the identification of risk and is a critical step in the risk management decision making process. However, a lender’s due diligence extends beyond environmental into the borrower’s ability to repay, ability to foreclose and take title.

For parties with direct liability, or for example a lender that potentially may have direct liability such as following foreclosure, environmental due diligence is also the basis of the innocent purchaser defense to CERCLA liability. The ASTM Phase I Environmental Site Assessment was designed to address the innocent purchaser defense and is currently an acceptable all appropriate inquiry by the U.S. EPA.

Insurance is a risk transfer mechanism that relies upon the proper identification of risk. Insurance does not remove or suggest the absence of liability. Accordingly, an insurance policy cannot in general substitute for a Phase I. On the other hand, a Phase I is not a substitute for insurance. Insurance transfers financial consequences of the exposure to another party, while Phase Is identify the exposure. Insurance and Phase Is therefore complement one another.