Environmental Insurance
and the Real Estate Transaction
By Michele Schroeder, J.D, M.S.L
Insurance is no longer just for risk managers protecting a business’s bottom line. The parties in a real estate transaction, including sellers, purchasers, tenants, investors, lenders, managers, and developers, are finding that environmental insurance can neutralize the threat of environmental risk in real estate transactions and add positive value to the transaction and property ownership. Traditional environmental risk management tools utilized to address identified and potential environmental problems, including risk assessment, contractual indemnity or assumption of liability, designated escrow accounts to address cleanups of identified contamination, and other legal defenses and government releases from liability, are often incomplete, limited, contentious and costly solutions. Even when consensus is reached, such methods leave environmental risk in the transaction for the interested parties to bear and bring added new risks to the parties. Environmental insurance transfers all or part of the risk to a third party insurance company (insurer) who is not a participating party in the transaction thereby taking insurable environmental risk out of the transaction. Further, environmental insurance can add positive value to the transaction by bringing necessary risk identification and validation, and loss minimization and claims handling expertise to the transaction by virtue of the underwriting and claims management process, and add the financial strength and expertise of a qualified insurer. Insurance is often perceived by lenders, investors, developers, contractors, tenants and future purchasers as a positive assurance against environmental risk associated with the property allowing business relationships and financing to proceed more smoothly. In this way, environmental insurance serves as a business tool for the real estate transaction and property ownership.
This article will discuss: 1) typical methods of risk management utilized in real estate transactions and compare such methods with environmental insurance; 2) insurable environmental risk; and 3) key features and considerations when applying environmental insurance to a real estate transaction and future property ownership.
Environmental Risk Management in Transactions
Understanding environmental risks associated with a real estate transaction and the extent a risk management measure addresses such risks requires an evaluation of the past, present and future conditions of the property, the parties in the transaction, and the potential for environmental liability.
Parties who are otherwise disconnected from pollution releases and ownership of the property at the time of such releases can be held liable for responding to and remediating environmental problems because legal liability for response and remediation under environmental statutes is based upon retroactive, strict, joint and several liability.[1]For example, liability for environmental response and remediation can attach as a result of holding title to or exerting operational control over contaminated property even without any involvement in or responsibility for creating the environmental problem in the past. Parties may also have liability to public trustees under federal and state statutes for injury and damage to, and the restoration of, natural resources separate from liability for response and remediation costs.[2] Independent of statutory law, parties may have liability for remediation of contaminated property based upon the assumption of such liability in a contract or agreement even when such liability would not co-extensively exist under law. Finally, parties may have liability to third parties under common law nuisance, trespass and tort for: 1) property damage, including physical injury to property such as the costs of response and remediation due to migration of contamination, and costs associated with the loss of use of property or diminution in the value of property; or 2) bodily injury including mental anguish and emotional distress and the costs of medical monitoring to determine future injury arising from some level of exposure to contamination.
Whether or not: the property is designated as a brownfield property[3]; All Appropriate Inquiry (AAI) is conducted at the site and reliance is upon legal defenses to potential environmental risks[4]; suspicion of pre-existing contamination is present due to historical operations, location or migration of contamination; or there is current knowledge of an environmental issue with the property that must be addressed, the threat of environmental risk cannot be ignored in a real estate transaction because the parties coming to the property can be legally liable today for contamination that pre-dates the transaction as well as for new contamination conditions created during property ownership or operation. A variety of risk management choices concerning environmental risks in a transaction exist and the next section provides information concerning the effectiveness of such measures to address environmental risks.
Environmental Site Assessments (ESA)
Environmental risks can be identified by and through an Environmental Site Assessment (ESA) report prepared by a qualified environmental professional setting forth the current conditions and history of the site. Many purchasers will be eager to commission such investigations as necessary due diligence to gain an understanding of site conditions and as a basis for AAI and the pleading of innocent landowner statutory defenses to potential future liability such as BFP.[5] Sellers will choose to have ESA’s conducted at the property to satisfy required disclosure of the site’s environmental conditions to the purchaser or even the state where the property is located as required by state specific statutes. In other situations, sellers may not permit an ESA (or at least only allow less invasive Environmental Phase I reports which amount to a visual observation by walk around on the site) because property is to be conveyed “AS IS, WHERE IS” and, therefore, the purchaser is truly taking the property with all its risks and no recourse to the seller.[6]
Whichever situation is presented in the transaction, ESA’s, at best, are limited: 1) to the identification ofsite conditions; 2) to recommendations for response and remediation; 3) by the directed scope of work contracted for; 4) by professional error; and 5) by the lack of a risk transfer mechanism for protection against future environmental risk especially if the ESA report has revealed contamination or suspicion of contamination problems. Recovery upon an incomplete or inaccurate ESA because contamination was improperly characterized or missed which leads to a future claim requires making a professional liability claim against the professional conducting the ESA and proving that the professional breached its contract for the performance of the ESA, and a duty of care in conducting the ESA. Such claim can be made by the party in privity of contract with the professional[7]. Relying upon an ESA as a risk management tool for the eventuality of future environmental problems is incomplete, adversarial, costly, and does not provide protection to the suite of parties in the transaction.
Indemnities, Assumptions of Liability and Escrows
Identified environmental risks in real estate transactions generally become a point of negotiation and the subject of contractual allocation among the parties in the transaction agreements. Generally, the seller agrees to indemnify, defend and hold harmless the purchaser from future environmental liability resulting from pollution events or conditions that pre-date the closing of the transaction. Additionally, a response to or remediation of an environmental problem funded by escrow money can be made a part of the transaction agreement with an identified party taking responsibility for control over the response or remediation. These risk management measures attempt to resolve by contract current and potential future environmental problems associated with a site but fall short of a comprehensive risk management tool for future claims and loss associated with the risk. The shortfalls include: 1)the costly and time consuming nature of negotiating mutually acceptable contract provisions among the parties; 2) the viability of the indemnitor over time - will the indemnitor entity be present and solvent if and when indemnity is triggered, especially if the indemnitor seller is divesting property and winding down operations; 3) the length and scope of indemnity whichoften become an impasse to resolution or which, as negotiated, results in limitations on the scope of indemnified damages and time available for indemnity; 4) the lack of expertise of the indemnitor in managing the indemnity process which often includes providing legal and technical experts to defend and negotiate on behalf of the indemnitee; 5) the limited reach of the indemnity to apply to all transaction parties including current and future investors, lenders, affiliated companies, developers, property managers or tenants at a site; and 6) the lack of protection in these measures for newly created pollution conditions whether as a result of exacerbation of existing or new pollution conditions.
Reliance on Statutory Defenses and Other EPA Release Agreements
Even purchasers who are approaching the transaction with utmost caution, cognizant of pleading innocent landowner defenses and conducting AAI into potential environmental risk to preserve the “innocent landowner” defense or “bona fide purchaser” defense, are left with the direct riskof future claims and lawsuits by government agencies and private parties – these precautions are only defenses to liability, not releases of liability, and even if successful are not applied as defenses against third party property damage or bodily injury.[8] Further, a litigation risk exists that a party pleading the defense has not complied with the requirements for AAI, defeating application of the defenses. The costs of defense against claims and lawsuits, including pleading defenses requiring technical and legal experts and historical analysis of property and events, are high even when statutory defenses may ultimately apply and prevail.
Lenders may have strong defenses to liability under statutory law[9] in the status of lender but potential environmental liability concerns lurk in large part from the future possibility that such lender may need to exercise rights of preservation of collateral (site control) upon default and take ownership of collateral property upon foreclosure (where title reverts to the lender) where such defenses may not apply.
The legal defenses are generally inapplicable to parties who are not taking ownership of the property such as property managers, developers, tenants, investors and lenders who will bear environmental risk associated with operational control and responsibility for exacerbation of pre-existing pollution conditions or creation of new pollution conditions during property operations or management, development, expansion or renovation. Even if such parties do not exert direct operational or management control over the property, they may be the target of claims and litigation because of mere association with contaminated property.
Environmental risks that appear resolved through environmental agency review and written release (e.g. covenants not to sue or no further action letters or other similar designations) provided either to sellers or purchasers are limited in that the release of liability applies only to the agency party providing the document. The release: may not bind other agencies and government entities[10]; may be subject to re-opener for further action due to new information or changes in science invalidating the release; and, like legal liability defenses, do not apply to third party claims for migration of contamination due to exacerbation of pollution conditions or creation of new pollution conditions. Similarly, closure letters from environmental agencies indicating that response and remediation actions have achieved all performance goals at a site or indications that institutional controls when part of the remedy at a site are operating properly and successfully are complete releases from liability. Circumstances at or around the property, such as changes in future land use or development plans, or failure of the institutional controls to perform properly and successfully over time, could cause new agency action with respect to such closed matters and serve to re-open such matters for more investigation, response and remediation. In such circumstances, it is the current owner (new purchaser) who will bear the liability for re-openers of released or closed matters; often sellers are no longer viable parties to such matters.
Effective environmental risk management in real estate transactions and property ownership should consider residual risks remaining after applying the risk management method successfully as well as the potential for failure of the mechanism to minimize or avoid future claims and loss.
Environmental Insurance
Environmental insurance is a risk transfer method that shifts risk from the transaction parties to a third party insurer through the issuance of a contract referred to as an environmental insurance policy. Each insured party has a direct beneficiary relationship with the insurer and is entitled to a direct duty by the insurer for the defense, settlement and payment of claims. The policies provide coverage for thestatutory, common law and contractual liability that attaches to theinsured.Generally, the purchaser of real estate in the transaction is the first named insured, which is responsible for payment of premiums, and coverage will also includeas additional insureds affiliated companies and current and future lenders and investors. Coverage for lenders and other investors is often a key item in securing financing from lenders and avoiding unnecessary delays in closing deals.[11] Sellers, tenants, property managers and developers[12] can also be considered for inclusion as additonal insureds to the policy. The historical nature of the site will be a key factor in determining whether the seller is included as insured on the policy and the extent to which the insurer will accept the seller as an insured on the policy. Sellers of property with historical industrial operations and a legacy of environmental claims are generally not included for coverage and such would not be advantageous to the purchaser when the policy contains one aggregate limit of liability for all parties to share. However, sellers of property with little material environmental claims legacy may be considered for coverage and such inclusion can be a key negotiating point for the purchaser in a transaction in terms of price and closing the deal. Careful evaluation should be paid to whether tenants who have operations that create direct environmental exposure (e.g., chemical or waste management) as opposed to indirect exposure (e.g., storage and warehousing) are to be added as additional insureds. Similarly, the professional liability exposure property developers and managers bring to property should be evaluated carefully when adding such entities as insureds to the policy. Conceptually, the material risk insured is that of the first named insured purchaser and owner who typically pays the premium, and the suite of parties added as additional insureds have ancillary risks associated with the purchaser’s ownership. Thus, in designing an insurance program and determining adequate limits, careful attention should be given to the insured parties’ potential for liability separate and apart from the purchaser which, if disproportionately high, can deplete limits to the detriment of the first named insured. An environmental insurance submission should include a complete disclosure concerning the transaction parties and contracts, and it is critical that the scope[13] of coverage applicable to such parties be discussed with, and confirmed and secured from, the insurer.
Most environmental policies offer a broad range of coverage including coverage for pre-existing contamination as well as for new pollution events or conditions and for a broad spectrum of loss. The policies pay on behalf of the insured for response and remediation costs and loss for property damage, bodily injury and natural resource damages arising both from claims by third parties including government agencies or for discoveries of pollution made and reported to the insurer without government enforcement.[14] Coverage can be purchased for risks solely related to the transaction property or additional coverage can be purchased for risks associated with contamination off site (e.g., non-owned disposal site, and other off site operations including transportation). Coverage can also be purchased for the insured’s loss of business or rental income due to the performance of necessary cleanup covered under the policy. Under certain circumstances, other first party economic type damages such as lost profits and increase in development costs due to performance of necessary cleanups have been added by endorsement to policies. The customized nature of environmental insurance has resulted in a variety of transaction-specific coverage that does not apply on a standard basis in the marketplace. This type of customization underscores the necessity for practitioners representing parties in environmental insurance transactions to be experienced and knowledgeable about environmental insurance and risk.
The policies are provided on a claims made and reported basis requiring claims to be made against the insured or discoveries of pollution events or conditions to be made during the policy period, and such claims and discoveries are to be reported during the policy period or any applicable extended reporting period. An aggregate limit of liability applies for the entire suite of insureds on the policy, and the costs of legal defense erode the aggregate limit of liability with some availability for an extra defined limit for legal defense on a percentage of limit basis. Insurance can operate in place of indemnities in the transaction agreement, or in some instances--for example when the seller is providing an indemnity— insurancecan apply excess of or upon the failure of the indemnity to apply within the terms and condition of the insurance policy. In this way, the insured’s first avenue of recourse is to the indemnity recovery and then insurance.