By: Preston W. Brooks
Environmental insurance is finally coming of age. In many transactions where the environmental condition of the property is at issue, environmental insurance can resolve a stalemate and allow the transaction to go forward. It is only within the past one to two years that a handful of insurance carriers have begun offering meaningful coverage at a reasonable price.
The Problem
For example, suppose a developer seeks to acquire a shopping center, only to learn from the Phase I Environmental Site Assessment that the plant-on-premises dry cleaner presents a significant environmental risk to the property. The Phase I report may even speculate that, based on the existence of the dry cleaning operations on the property for the past 20 years, dry cleaning fluid may already have contaminated the soil and groundwater beneath the shopping center. On learning this information, the developer may balk at assuming the risk of a potential million dollar cleanup, particularly if the seller is unwilling or unable to provide a strong environmental indemnity. In addition, even if the developer is willing to assume the risk, the lender financing the acquisition may require more information about the nature and likelihood of a possible release of contaminants, or insist on other mechanisms to minimize any adverse impact to the real property serving as collateral.
What should the buyer do? Basically, if the buyer is still interested in acquiring the property, there are really only two options: (1) determine whether the dry cleaning operation has in fact impacted the subsurface, by performing a Phase II investigation (a program for the collection and analysis of soil and/or groundwater samples); and/or (2) determine whether environmental insurance will be available at the closing based on the then-current knowledge of the site. The choice of which of these paths to follow should be considered by the buyer at the earliest juncture, since there are potential liabilities to the buyer or existing property owner which might arise out of the environmental condition.
Performing a Phase II investigation may be the best choice for definitively ascertaining whether the property has been impaired. But a Phase II typically takes several weeks and cost substantial sums. Even then, the results may be less than conclusive, and may require several rounds of investigation before the true extent of any contamination is known. There is, of course, another major risk associated with the performance of the Phase II: if the Phase II yields negative information, such as evidence of widespread contamination, the ability to obtain environmental insurance will be significantly diminished or eliminated.
What the Policies Cover
As a result, many buyers and lenders are opting for environmental insurance before any Phase II work has been initiated. While coverage varies among the four major issuers of environmental insurance – Kemper, Reliance, Zurich and AIG – the policies essentially provide coverage that is both first party and third party in nature. A first party policy, such as property and casualty insurance, is one that allows a policyholder to make a claim directly to the insurance company when the policyholder suffers a loss involving his own property. Third party insurance, in contrast, is triggered only when the policyholder is sued because his actions have caused property or bodily injury to a third party. Environmental insurance combines both aspects by covering both environmental cleanup costs and third party claims for bodily injury and property damage. In addition, the policies typically pay for legal defense expenses up to the policy limits. Thus, in the situation where contamination emanating from the policy holder’s property has migrated to a neighboring property, the policy generally will pay for both the cost of remediating the contamination (whether on- or off-site) and protect against liability to the neighbor for resulting property damage or bodily injury.
As an add-on, many policies will provide business interruption insurance. This coverage is designed to pay for lost profits or extra expenses the policy holder incurs as a result of conducting a cleanup at the property. In the event that remedial activities cause a temporary shutdown of a tenant’s business, for example, the policy should reimburse the landlord for the lost rents. A variation on the business interruption insurance is the developer soft costs coverage, which provides protection in the event that discovery of contamination during construction of a building causes a costly delay in the construction schedule.
Finally, some of the policies have recently added coverage for contractual liability. This feature is designed to pay for compensatory damages the policy holder would be liable for as a result of a written contract, such as an indemnity provision. Thus, the insurance could be useful in backing up an indemnity the policy holder has provided to a third party, such as the lender or a prospective purchaser of the property.
Mechanics of the Policy
Coverage can be purchased for different lengths of time, but the initial term is typically for a period of five years. The policies provide coverage on a “claims-made” basis only, meaning that a claim must be made under the policy during the specified term; after the term, the policy essentially expires. The cost of obtaining such coverage will obviously vary significantly depending on the use of the property and the known environmental issues associated with the property. For a typical commercial property, such as a shopping center, with relatively minor environmental issues identified at the time of binding, the cost of the five-year policy ranges from $25,000 to $40,000, as an initial lump sum payment.
The policy contains two triggers for coverage: the first is if a claim is made against the policyholder alleging liability arising out of a covered pollution event. The second is if the insured discovers previously undiscovered pollution. The policy also usually contains a self-insured retention – typically $25,000 – which operates like a deductible, except that the policyholder must incur covered costs in that amount for each occurrence until the insurance is activated.
Negotiating the Form
Unlike most business insurance, environmental insurance is provided on a surplus lines basis only in California. Surplus lines means that the insurance, because it is somewhat specialized in nature, is intended for sophisticated purchasers of insurance products. As a result, the carriers are not licensed in the State of California, and the insurance is not regulated by the Insurance Commissioner. Therefore, certain remedies normally available to a policy holder may not be available, such as reliance on the state’s insurance fund in the event the carrier goes bankrupt.
However, the fact that the insurance constitutes surplus lines gives the carrier and the policy holder the opportunity to negotiate the language of the policy. This is typically done by way of endorsement, which modifies and amends the language of the standard policy. For example, some of the policy forms exclude “known” contamination, unless the existence of the contamination has been disclosed to the carrier prior to binding coverage. Thus, where known or suspected contamination is the primary issue motivating the policy holder to obtain the insurance, it is important to spell out exactly what information has been provided to the carrier prior to binding, such as the Phase I or other environmental reports. Additional endorsements the policy holder should consider obtaining include: (1) naming the lender, if appropriate, as an additional insured; (2) deleting the “divested property” exclusion contained in some policies, so that the policy holder may transfer the property without losing the insurance coverage; and (3) making the policy primary insurance, so that a policyholder does not have to tender to other carriers (such as those providing comprehensive general liability coverage) before tendering a claim to the environmental insurance provider. The carrier often will attempt to add its own endorsements, such as exclusion of underground storage tank coverage, or limiting cleanup coverage to government mandated cleanups or investigations. Therefore, careful consideration should be given to endorsements on both sides of the insurance contract.
Conclusion
The foregoing is intended to serve as an outline of the coverages afforded by the environmental insurance policies. Therefore, there are many details, particularly involving exclusions from the policies, that have been left out of the discussion. As these policies providing environmental protection evolve, however, they are likely to continue to demonstrate their usefulness in transactions involving environmental issues.
(Preston W. Brooks is a partner with the law firm of Cox, Castle & Nicholson LLP in Century City. He can be reached at 310-277-4222.)
“Reprinted with permission from the Daily Journal Corporation.”
This article was written in 1999.