General Insurance Spring Seminar

19-20 May 2003

Scarman House

Session G (Plenary)

Assessing, Managing and Insuring Pollution Risk

Dr Simon Johnson

Dale Lee (FIA)

Introduction and Agenda

• The Pollution Problem and How Insurers have been caught

• Legal Background - UK• Underwriting Practices• FRS12 and pollution liabilities• Case Studies• Summary and Questions

The Pollution Problem and How Insurers have been

caught

The Pollution ProblemThe Pollution Problem

Gradual Seepage of pollution into the environment over Gradual Seepage of pollution into the environment over many yearsmany years

Headline problems such as Love Canal increased public Headline problems such as Love Canal increased public awareness and prompted actionawareness and prompted action

In late 1970's claims began to hit premises/operations In late 1970's claims began to hit premises/operations coverage under Comprehensive General Liability (CGL) coverage under Comprehensive General Liability (CGL) policiespolicies

In USA CERCLA passed in 1980 - 'polluter pays' strict In USA CERCLA passed in 1980 - 'polluter pays' strict and retro, joint and several liability on PRP'sand retro, joint and several liability on PRP's

Superfund tax where no PRP or emergency clean upSuperfund tax where no PRP or emergency clean upLondon market hit on excess layers and reinsuranceLondon market hit on excess layers and reinsuranceInsurance risk not assessed and legal environment Insurance risk not assessed and legal environment changedchanged

Claim Triggers and Claim Triggers and ComponentsComponents

Triggers - Exposure, Manifestation, Continuous, Injury in Triggers - Exposure, Manifestation, Continuous, Injury in Fact - 'All Sums' Fact - 'All Sums'

Remediation costs - Design and implementation of Remediation costs - Design and implementation of (normally) long term clean up scheme. NB - scheme could (normally) long term clean up scheme. NB - scheme could failfail

Third party bodily injury and property damageThird party bodily injury and property damageDefence costs. Primary policies often costs in addition Defence costs. Primary policies often costs in addition with 'duty to defend'. with 'duty to defend'.

Coverage disputes leading to Declaratory Judgement (DJ) Coverage disputes leading to Declaratory Judgement (DJ) costscosts

Insurance Market ReactionsInsurance Market Reactions

Do not write pollution business - absolute pollution Do not write pollution business - absolute pollution exclusions - most common reactionexclusions - most common reaction

Design a separate new policy to cover pollution risk - i.e. Design a separate new policy to cover pollution risk - i.e. a new insurance producta new insurance product

ƒ Consult experts to understand the risk technically and legally - Consult experts to understand the risk technically and legally - each site is uniqueeach site is unique

ƒ Assess the risk financiallyAssess the risk financiallyƒ Historical - Ongoing differentiationHistorical - Ongoing differentiation

Pollution present as at date of inception - historical riskPollution present as at date of inception - historical riskPollution deposited after date of inception - operational riskPollution deposited after date of inception - operational riskClear policy wordings - claims made clear triggersClear policy wordings - claims made clear triggers

The Legal Background - UK

UK Environmental Legislation • Some key dates:

– Upto 1990• miscellaneous Acts e.g, Alkali Act & Public Health • Statutory Nuisance etc.

– Environmental Protection Act 1990 (EPA)– Environment Act 1995– Implementation of Part IIA of EPA 1990 in April 2000– 2003+ - influence and impact of ‘new’ EU

Regulations

Framework of Contaminated Land Law in England & WalesWaste

ManagementPart II EPA

Redevelopme

nt(Change of

Use)T&CPA 1990

Civil Liability &

Human RightsAct

Civil Liability &

Human RightsAct

WaterPollutionWIA 1991WRA 1991

(Amendments due)

WaterPollutionWIA 1991WRA 1991

(Amendments due)

EU Draft Directiveon Environmental

Liability

EU Draft Directiveon Environmental

Liability

HistoricalContaminatio

nPart IIA EPA

Industrial ActivitiesPart I EPA

(PPCA 1999)

Contaminated Land - A Lawyer’s Definition

“Land which appears to the Local Authority to be “contaminated” because:

1. Significant Harm is being caused or there is a significant possibility of such harm being caused; or

2. Pollution of controlled waters is being or is likely to be caused

Part IIA EPA 1990• First time Contaminated Land has been specifically

legislated– Remediation Notice served on ‘Appropriate Person’

– Appropriate Persons fall in two categories

– Class A - Caused or Knowingly Permitted

If no Class A can be found then– Class B - Current owner/occupier

• Complex rules for exclusion and allocation of liabilities• Few Sites Classified (so far) - about 50

Current Underwriting Practice

Underwriting Philosophy

• Gradual Pollution risks– experience rating - site specific assessment– use of experienced qualified environmental

professionals– information intensive - adherence to industry

good practice– site specific consequence analysis– assumed maximum event probability over policy

period

Environmental Policies• EIL - new and old gradual and sudden and

accidental pollution conditions• CLI/PLL/PARLL - site specific contaminated land

insurance (some new as well as old pollution conditons)

• CPL - Contractors Pollution Liability• Cost-Cap/Stop-Loss - for clean-up schemes• Property Portfolio and secured lenders

Policy Cover & Triggers (CLI)• Claims made Policy

– typically up to 10/12-years

• Policy responds to:– Notice under Part IIA of EPA 1990– any other Regulatory or third party notice alleging liability

• Policy indemnifies insureds against:– Regulatory liability - clean-up costs (including own site)– Third Party liability - including bodily injury– Legal and Technical Defence costs– Loss of rent receivable/Business Interruption

Risk Assessment - Sources, Pathways and Receptors

From ICE Design and Practice Guide - Contaminated Land 1994

Is Land Contaminated?

• Published guideline levels – background levels

– target levels

– intervention levels

• Quantitative Risk Assessment– RBCA - partly quantitative

– models - e.g. Risc Human, CLEA, etc.

Common Contaminants of Concern

• Organic materials– fuel oil, petrol, diesel, tars, phenols– solvents e.g. TCE

• Metals– e.g. lead, arsenic, mercury– coper, chromium, nickel, zinc

• Others– PCBs, pesticides, dioxins/furans, cyanide, corosives

Information and Documentation

• Phase 1: Desk Study– hazard identification (potential for contamination)

• Phase 2: Site Investigation– intrusive sampling, testing and analysis– risk evaluation

• Phase 3: Remediation– design of remedial startegy, setting objectives– remedial works– validation

Known Contamination - Long-term Risk• Missed Hot Spots

– require both a pathway and receptor - low risk /cost events

• Residual concentrations– residual levels recorded, land assessed (risk) as suitable for specified use in the insurance contract

– principal sources removed, reduced at clean-up

– residual levels and risk of contamination for many common contaminants should reduce with time

– low probability of retrospective clean-up being required

– can re-assess suitability for use

– any residual contamination requires pathway and receptor to complete the pollutant linkage

Unknown Contamination - Long term risk

• Unknown, unidentified and unexpected

• Identificati post-inception of insurance unlikely:

– expert assessment minimises unknown risk

– re-development risk excluded

– no known problems to date (many sites have been in a contaminated condition for many years)

• Unknown contamination risk - low as most investigations test

for a wide range of expected or possible contaminants

Approaches to Remedial Action

• The Source e.g. removal, treatment or neutralsation

• The Pathway e.g. interception or removal• The Receptor e.g. modification or removal

Most remediation schemes address either the Source and/or the Pathway

FRS12 and Pollution Liabilities

Introduction to FRS12

• New accounting standard effective for accounting periods ending on or after 23 March 1999

• Specific guidance on when / how to set up provisions

• Potential for major impact on the balance sheets of many companies : some additional provisions likely to be required; some existing provisions may be disallowed

• Extensive disclosure requirements

• Specific relevance to companies with contaminated land and other pollution liabilities and exposure

FRS 12 Provisions

A provision should ONLY be recognised when:• An entity has a present obligation (legal or constructive) as

a result of a past event (an “obligating event”); and

• it is probable (more likely than not) that a transfer of economic benefits will be required to settle the obligation; and

• a reliable estimate can be made of the amount of the obligation (extremely rare that this is not the case) - but may be difficult where costs are volatile

The Obligating Event

Key points:

• Constructive obligation arises where the event creates valid expectations in other parties ( through an established pattern of past practices, published policies etc) that the obligation will be discharged

• No provision allowed for costs required for future operations i.e. the past event must exist independently of an entity’s future actions

• Changes in law or public company announcements may create an obligation that did not previously exist. Trigger point for new law is when enactment is “virtually certain”

FRS12 InsuranceFRS12 Insurance

FRS12 provides insurance opportunitiesFRS12 provides insurance opportunitiesLong term protection against:Long term protection against:

ƒ Inadequate provisionsInadequate provisionsƒ Emergence of contingent liabilities as FRS12 Emergence of contingent liabilities as FRS12

provisions in futureprovisions in futureƒ Other liabilitiesOther liabilities

Insurance provides support to long term Insurance provides support to long term management of balance sheet provision over timemanagement of balance sheet provision over time

FRS12 Case StudyFRS12 Case Study

UK chemical company purchased a US company with a UK chemical company purchased a US company with a polluted sitepolluted site

Site requires long term management of pollution problemSite requires long term management of pollution problemClean-up costs represent a balance sheet provisionClean-up costs represent a balance sheet provisionCompany wanted to control provision over timeCompany wanted to control provision over timeDetailed environmental consultant reports including initial Detailed environmental consultant reports including initial cost estimates and annual cost estimates for planned cost estimates and annual cost estimates for planned activitiesactivities

Consultants reports used to build a model of costs during Consultants reports used to build a model of costs during the policy periodthe policy period

FRS12 Case Study continuedFRS12 Case Study continued

Likelihoods, timing and amounts modelled to give a Likelihoods, timing and amounts modelled to give a distribution of the cost of the liabilitydistribution of the cost of the liability

Long term real rates of investment return modelled using Long term real rates of investment return modelled using Vasiceck model based on historical investment dataVasiceck model based on historical investment data

Deductible adjusted annually - a key featureDeductible adjusted annually - a key featureDeductible can be set at e.g. 80%, 100%, 150% of the Deductible can be set at e.g. 80%, 100%, 150% of the provisionprovision

Client set deductible at confidence level at which prefer to Client set deductible at confidence level at which prefer to retain riskretain risk

Pricing provides for premium structure - risk premium, Pricing provides for premium structure - risk premium, capital loading, expenses, investment riskcapital loading, expenses, investment risk

Client benefits from valuation control over time Client benefits from valuation control over time

Case Studies

Case Studies

1. US Inward Investor

2. Regeneration: Cokeworks

3. Former Industrial Site

4. Retail Development

5. Retail Portfolio

6. European Chemicals Company

Case 1 - American Inward Investor

• Distribution Depot• US investor• UK FTSE 350 vendor • £7.5m Indemnity by vendor - 12 years• Contamination risks• Legal exposure

Solution : Indemnity back to back Risk Transfer

Case 2 - Regeneration: Cokeworks

• Setting: Former colliery/cokeworks

• Objectives: Regeneration of site to produce a development platform for light industry. Remediation involved excavation and disposal on-site into a number of engineered cells leaving the rest of the site ‘clean’.

• Problem: Need to provide protection to future site owner against failure of engineered cells. Area of cells to be subjet to monitoring but otherwise used as managed public open space.

Solution: a long-term bespoke transferable environmental insurance policy for the current owner

Case Study 3 - Former Industrial site

• Setting: Site cleared but residual contamination from fill materials across site plus hotspots. Fill heavily contaminated with metals, hot-spots of hydrocarbons.

• Problem: Proposed redevelopment for warehousing and distribution. Remediation of hot spots plus encapsulation (engineered cover) of fill. Residual contamination from fill and any ‘missed’ hot-spots.

• Deal Driver: Transfer of liability. Funding requirement. Deal stalled.

Solution: Environmental Insurance to protect ‘new’ owner having bought with information and facilitate the deal and allowed ‘new’

owner to obtain institutional funding

Case Study 4: Retail Development

• Setting: Former gasworks site - South of England Town Centre. Non-food and food retail development, multiple occupancy.

• Problem: Residual contamination both known and unknown in a highly sensitive groundwater environment.

• Deal Driver: Indemnity required of purchaser from seller (and original polluter). Residual liability as new owner/occupier.

Solution: Bespoke Environmental Insurance covering the Indemnity risk as well as the liability of the new owner. 12-year

policy, £5m Limit of Indemnity

Case Study 5: Retail Portfolio• Setting: Portfolio of both in-town and out-of-town retail outlets

across the UK.

• Problem: potential exposure to environmental liabilities, particularly on older sites and out-of-town sites on remediated brownfield land.

• Driver: Protection of asset value; corporate governance; corporate reputation; and balance sheet protection.

Solution: Bespoke Portfolio Environmental Insurance for a 3-year fixed term allowing new properties subject to agreed due diligence

to be added automatically to the policy

Case Study 6: Chemical PlantCase Study 6: Chemical Plant

International chemical company selling a business in International chemical company selling a business in GermanyGermany

Located on large polluted industrial complex with Located on large polluted industrial complex with numerous other businessesnumerous other businesses

Transaction involved sale of factoryTransaction involved sale of factorySite ownership remained with clientSite ownership remained with clientClient was contributing to on-going clean up costs across Client was contributing to on-going clean up costs across the whole complex the whole complex

Under Sale and Purchase Agreement Client retained Under Sale and Purchase Agreement Client retained liability for long term environmental exposuresliability for long term environmental exposures

Client required professional valuation of liabilities for tax Client required professional valuation of liabilities for tax purposespurposes

Case Study: Chemical plant (2)Case Study: Chemical plant (2)

Client is exposed to the following liabilitiesClient is exposed to the following liabilitiesƒ Clean up costs arising from buyer choosing to increase Clean up costs arising from buyer choosing to increase

the capacity of the businessthe capacity of the businessƒ Business interruption costs arising from increasing Business interruption costs arising from increasing

capacity of the businesscapacity of the businessƒ Volatility of client contributions to scheme costs Volatility of client contributions to scheme costs

including increases arising from insolvency of other including increases arising from insolvency of other contributerscontributers

ƒ Failure of buyer to meet financial obligations as Failure of buyer to meet financial obligations as specified in the Sale and Purchase Agreementspecified in the Sale and Purchase Agreement

ƒ Client's contingent liabilties under the Sale and Client's contingent liabilties under the Sale and Purchase Agreement Purchase Agreement

Case Study: Chemical plant (3)Case Study: Chemical plant (3)

Provision was assessed using a model of the Provision was assessed using a model of the exposures including:exposures including:

ƒ Volatility of long term clean-up costsVolatility of long term clean-up costsƒ Economic factorsEconomic factorsƒ Credit risk of other businesses on the complexCredit risk of other businesses on the complex

Added Value to client approximately E20mAdded Value to client approximately E20m

Summary• Insurers have been caught in the past as the pollution risks were not assessed

on a site or project specific basis and by experts• Uncertainty about contaminated land liabilities and exposure gives rise to

unacceptable risks to companies, organisations and individuals - change of law and risk perception

• Risk Management is key to maximising environmental and pollution opportunities

• Aim to maximise value and minimise long-term environmental exposure• A multi-disciplinary strategic management approach is recommended, using

technical, legal, financial, insurance and commercial management skills

• Effective Risk Management requires broad Environmental Consultancy and Insurance Service support