Using Environmental Insurance
Many owners and developers of contaminated property are seeking to complete remedial action and reach regulatory finality at minimum cost. Reaching regulatory closure requires the integrated delivery of engineering services, including agency negotiation, site investigation, risk assessment, engineering design, implementation and operations and maintenance. The ultimate cost of remediation is often difficult to predict with certainty because of a large number of unknowns. Fortunately, there are important new tools now available to help provide certainty: providing a ceiling on remediation costs through the use of cost cap insurance; and developing better estimates of the ultimate cost using expected value analysis.
Remediation Cost Cap Insurance
Remediation cost cap insurance can be a valuable tool for commercial and industrial property owners required to undertake remedial actions because the insurance vehicle places a maximum on the owner's actual expenditures to cleanup a particular site.
Cost cap insurance can also be an important financial consideration in the ownership transfer of real property, such as may occur in a merger or acquisition. When corporations divest contaminated real estate, they may also wish to divest any environmental liabilities associated with those properties, transferring any cleanup obligation to the buyer. The buyer accommodates the estimated cost of the cleanup by a deduction in the purchase price. Cost cap insurance provides protection to both the buyer and the seller by paying for cleanup costs that may exceed the estimate. So, if the cleanup costs exceed the expected value, the buyer seeks recourse from the insurance company rather than from the seller.
Cost cap insurance provides protection to both the buyer and the seller by paying for cleanup costs that may exceed the estimate. |
Cost cap insurance pays for investigation and remediation costs that exceed the "retention" and are incurred during the policy period. The retention is an amount equal to the estimated cleanup cost, plus a deductible that typically ranges from 10 percent to 30 percent of the expected remediation costs. It is often useful for the insured and its consultant to work with the insurer to agree on the retention amount as a way to keep this value as low as possible without increasing the premium.
Cost overruns typically covered by cost cap insurance arise from conditions where:
- Known contamination is found to be more widespread than originally anticipated;
- New types of contaminants are discovered that were not previously known to be present; or
- Changes in environmental regulations or policies, such as reductions in cleanup levels, require additional investigation and/or remediation.
In cases where the insured party is involved in the design or implementation of the remediation, the insurance company may require a co-payment. The co-payment, expressed as a percentage of the policy limits (usually 20 to 25 percent), is the amount that the insured shares in any loss covered by the policy. For example, a 25 percent co-payment would mean the insured would be responsible for 25 cents of each dollar of program costs that exceed the retention amount up to the policy limit.
Insurance companies have recently grown leery of entities deliberately underestimating future program costs, thereby substantially increasing the probability of a claim (i.e., costs exceeding the retention amount). Use of the co-payment strategy is the insurer's way to minimize the effects of this practice. Since the insured is sharing the risk with the insurance company, the insured party has an incentive to provide accurate cleanup estimates and to ensure the remediation work is completed cost-effectively.
Cost cap insurance policy periods are generally available for up to 10 years, although longer periods can be negotiated with some carriers. The policy period is usually set equal to the time period to complete the project, such as achieving site closure from the regulators, with an additional margin of safety.
The expected value analysis (EVA) maps and quantitatively considers a range of potential decisions and outcomes and calculates one expected value for the project. |
Policy limits are selected by the insured based on the potential magnitude and likelihood of a cleanup cost overrun, individual preferences for risk tolerance, premium cost and other related factors. For example, a higher policy limit can be set if the site owner wants to minimize the risk that escalating costs could result in the policy limit being exceeded. However, the cost of the premium would likely increase in this case. Limits may range from $1 million to $100 million. The insurer will only pay costs in excess of the retention amount up to the policy limit; any costs incurred greater than the policy limit are the responsibility of the insured. Therefore, it is important that the insured tries to set the policy limit at a value high enough to avoid the liability responsibility.
The insurance premiums (i.e., the cost of the insurance) are based on a number of factors, including retention amount (co-payments), policy limits and the policy period. Several more subjective factors are also used to determine the premium, such as the scope of remediation and the probability and magnitude of cost deviations. The premium will typically be three to six percent of the anticipated remediation cost and is payable in a single lump sum when the insurance is purchased.
Cost Cap Insurance Example
The environmental liability for a property due to subsurface soil and potential groundwater contamination is estimated to range from $300,000 to $2.5 million, with an expected value of $1 million; remediation may require two years to complete. A typical cost cap insurance policy would have a retention amount of $1.2 million, a 25 percent co-payment, a policy limit of $1.3 million, a three-year policy period, and a premium of $50,000.
Expected Value Analysis (EVA)
Accurately estimating future investigation and remediation costs is an important factor in determining the cost and coverage for remediation cost cap insurance. Developing reliable estimates can be a very difficult and frustrating chore. Attempts to develop these costs are complicated by numerous levels of uncertainty including less-than-perfect information regarding:
Policy limits are sleceted by the insured based on the potential magnitude and likelihood of a cleanup cost overrun, individual preferences for risk tolerance, premium cost and other related factors. |
- Nature and extent of contamination;
- Agency-required cleanup levels;
- Length of time required to operate a remediation system to reach prescribed endpoints; and
- Effectiveness of chosen remediation systems.
There are a number of ways to plan for this uncertainty. A typical approach has been to consider a range of costs. Although this may be the easiest strategy to implement, it does not provide one value of future costs that can be used by management to estimate financial liability. To avoid this situation, a most likely cost can be calculated, potentially to include a contingency. However, this single value estimate does not reflect the potentially small yet finite probability that actual costs could greatly exceed the single estimate, such as in the case where a contaminant plume requiring treatment is much larger than originally thought.
The best way to avoid all these difficulties is to calculate the expected value of future costs. The expected value analysis (EVA), also called decision tree analysis, maps and quantitatively considers a range of potential decisions and outcomes, and based on the probability of the likelihood of each outcome, calculates one expected value for the project. Additionally, the EVA will determine the probability that actual project costs will be less than or greater than specified values. This feature can be important to business managers who may make risk management decisions because it quantifies the probability of the financial risk.
An EVA is advantageous because it:
- Systematically manages complex situations where considerable uncertainties are involved;
- Quantitatively considers a range of potential decisions; and
- Provides a quantitative basis for making strategic pricing decisions.
The EVA is used not only for remediation cost estimates, but is also routinely used for Superfund potentially responsible parties settlement and cost allocation agreements, insurance litigation settlements, and calculating financial reserves. It is also one of the proposed methods to estimate environmental liabilities in the draft American Society for Testing and Materials (ASTM) "Standard Guide for Disclosure of Environmental Liabilities."
There are generally seven steps to completing an EVA:
- Identify the environmental issues at the site.
- Map the logical sequence of major events, activities or decisions that must be made to resolve the issues.
- Estimate the probability of each potential event.
- Estimate the cost of each potential event.
- Calculate the expected value (typically using an off-the-shelf software package).
- Plot the probability distribution of potential costs (using the same software package).
- Conduct sensitivity analysis (if necessary) to test major assumptions.
Completing the EVA typically requires less than two to three weeks and may cost less than one percent of the calculated expected value price.
In practice, there are many points of uncertainty and a host of decisions to be made. Computer software is available to run the relevant calculations. One of the most useful applications is the development of a curve showing the probability associated with different potential cost outcomes. This curve is useful in determining the level of risk associated with a particular cleanup cost.
The insurance premiums (i.e., the cost of the insurance) are based on a number of factors, including retention amount (co-payments), policy limits and the policy period. |
Conclusion
Using remediation cost cap insurance can be a valuable tool for capping the potential environmental liability associated with remedial actions for commercial and industrial properties. Expected value analysis is a powerful yet easy means of estimating future costs of complex investigation and remediation programs.
This article orginally appeared in the June 2001 issue of Environmental Protection, Vol. 12, No. 6, p. 42.
This article originally appeared in the 06/01/2001 issue of Environmental Protection.