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Environmental impairment: dealing with the legalities.

Environmental Impairment: Dealing With the Legalities

Interpreting environmental impairment liability (EIL) contracts has, to date, required a review of decisions concerning comprehensive general liability (CGL) and professional liability claims-made contracts. To a degree, courts will continue to draw from these decisions. However, a sufficient body of EIL case law is developing, one that will aid in evaluating EIL coverage principles.

In contrast to CGL insurance, EIL coverage is relatively straightforward. CGL policies for environmental impairment were offered before EIL insurance became available in the early 1970s. Many EIL policies cover claims made and reported during the policy period, whereas CGL policies cover occurrences, generally defined as accidents neither expected nor intended by the insured. Therefore, litigation over CGL policies as to whether an accident is sudden or gradual is irrelevant for EIL claims-made policies.

EIL insurance usually covers third party bodily injury and property damage, cleanup costs and defense costs. EIL policies provide that the insurer has "the right but not the duty" to defend the insured, which has been interpreted to mean that the insurer may defend the insured's suits but is not obligated to do so. Neither EIL nor CGL insurance cover damages resulting from the intentional release of hazardous substances that are understood to be harmful or from willful violations of law.

Effectively managed EIL programs can cope with the uncertainty and complexity of pollution control. However, legal and political uncertainties also exist regarding EIL coverage because of the adverse effects of pollution on public health and the environment. Offsetting these uncertainties through expert technical analysis of the underwrite through expert technical analysis of the insured industry, establish strict underwriting guidelines, rating methodology and premium levels and retain aggressive investigatory and cleanup capabilities to minimize costs. And because cleanup costs generally increase geometrically over time, the importance of the claims management function cannot be underestimated. Along with an aggressive response capability is the need for an understanding of legal and regulatory requirements, a cooperative relationship with the insured to provide risk reduction and cleanup and sound in-house technical, engineering and regulatory knowledge.

Insurable Environmental Risks

An insurable environmental risk is sufficiently homogenous, numerous and unrelated to allow risk pooling, creates no incentive by the insured to bring about the loss and projects determinable and sufficiently frequent losses to calculate pure premiums. Estimating the frequency and severity of these potential losses is difficult for the insurer due to legal and scientific uncertainties. For example, loss projection for third party bodily injury and property damage claims must consider the low public tolerance to these types of involuntary risks.

The process of adverse selection keeps EIL insurance properly priced because an excessive rise in premiums makes insureds believe they have few risks to convert to self-insurance. Insurers are subsequently left with a pool of insureds that are risky exposures, thus driving up the ratio of losses to premiums. As a result, insurers are reluctant to raise premiums even more because they fear that the cycle will repeat with more drastic results. Adverse selection also occurs when insurers do not differentiate risks among potential insureds.

A recent General Accounting Office report concludes that pollution liability policies are more expensive and harder to find. The agency attributes this to lack of profitability. However, a close look indicates that the problem is attributable to deficiencies in governmental financial assurance requirements, not to adverse selection or limited profits.

The report, which is based on data from hazardous waste facility operators, states that many land disposal facilities under the Resource Conservation Recovery Act (RCRA) shut down due to lack of insurance. RCRA financial responsibility requirements applicable to these facilities provide for $3 million limits per occurrence and $6 million annual aggregate for gradual pollution coverage. These levels are too low considering the many RCRA facilities that have become Superfund sites and the estimated $24 million average per site cleanup cost. Furthermore, the agency's rationale is even more misguided when one considers the federally mandated RCRA land ban. A major reason for the land ban was the substantial groundwater contamination from RCRA facilities. Based on these facts, and recognizing the fact that there are many sites with existing contamination, it is easy to determine why so few insurers cover RCRA land disposal facilities.

Benefits of EIL Insurance

EIL insurance encourages acceptable environmental risk management practices by insureds. Indirectly, premiums help determine the risks of hazardous substances. Because underestimating these risks incurs financial losses, EIL insurers are motivated to accurately assess them. If carriers overestimate risks, their products will be overpriced compared to their competitors; unlike some government bureaucrats, insurers suffer penalties for incompetence. EIL insurance thus supplements direct government regulation with market deterrence because premiums are largely based on expected losses which are sensitive to safety and risk reduction measures established by industry. The straight-forwardness of these policies compared to CGL policies allows courts to respect the sanctity of the insurance contract by upholding the reasonable expectations of the insured and the insurer's reliance interest.

Government requirements for financial responsibility eliminate insolvency as a means of avoiding environmental compliance and bridge the gap between private risk management with FTI insurance and socially acceptable environmental compliance. These requirements tend to stimulate the availability of insurance. For example, the Environmental Protection Agency's financial responsibility requirements for underground tanks has led to new carriers entering the market. The limit for government financial responsibility requirements should be set near the upward tail of the potential distribution of damages. In conjunction with insurance, these requirements also encourage the adoption of cost effective corporate risk reduction because the risks a company poses to the public reflect on its income and balance sheet, albeit with the assistance of insurance. Through this financial responsibility framework, incentives are developed for investment in specific loss-avoidance measures.

Companies that use insurers with insufficient technical underwriting and cleanup expertise are not getting their money's worth. Besides depleting the self-insured retention or deductible, this expertise can lead to more expensive government regulatory involvement and third party claims. The results are high transaction costs and adverse public reaction to the insured.

Reinsurers require this expertise before contracting with insurers for excess coverage in the event of large environmental claims. Reinsurers should work with insurers to minimize environmental claims. Given the regulatory and political climate surrounding environmental cleanup, insurers without sufficient technical capability are probably abusing shareholder equity. To resolve environmental claims, the technical strategy must integrate with other factors.

According to a case study of technical support compiled by Michael Murphy, "Any [technical] path chosen is surrounded by outside influences involving legal issues, insurance considerations, cost effectiveness, community relations, and operational and management considerations on the part of the affected party. It is truly a challenge for a technical manager to compile objective and defensible data, preserve these facts, and essentially sell the technical solution to the regulatory agency and all of the interested parties."

It is essential for insurers and insureds to develop cost effective remedies that protect public health and the environment and convince regulatory agencies to adopt them. Otherwise, according to Edward Kleppinger in his environmental auditing study, "If you ask a regulatory agency what to do, they will answer everything, but we are not limited by that. If you ask for permission to do something, they will take years to answer and you will do it with paperwork. If you ask for a cleanup level, you will be told zero. And finally, remember that once on a regulatory agency list there is generally no way off."

Regulators frequently criticize company remedial actions, yet are incapable of independently developing such remedies regardless of their statutory responsibility to do so. Insurers neglecting this proactive approach may in fact be jeopardizing their reserves. From an underwriting and claims management standpoint, insurers must understand the evaluation of any past operations before acquisition, the potential for pre-existing releases from a facility, industry management practices, facility design and operation, environmental regulation compliance records and inherent hazards of involved chemicals. In addition, on-site hazards including pits, ponds, lagoons and tanks must be understood, as well as factors that cause releases, location and use of ground and surface water, environmental effect of contaminants, location of potentially exposed populations and potential for adverse health impacts from chemical exposures.

Risk assessment and potential damages caused by covered losses, appropriateness of site investigatory techniques and laboratory analysis, and groundwater and soil remediation measures and their cost and effectiveness must also be fully understood. Finally, insurers should know how to devise cost-effective remedial alternatives to protect public health and the environment, technical adequacy of pertinent environmental regulation and how and when to advise the affected community of technical and other issues surrounding the cleanup. How the community reacts to a release of pollutants into the environment can dramatically affect cleanup costs regardless of third party claims.

When Is Coverage Triggered?

How might insurance cover the claim? This question has been the subject of substantial CGL coverage litigation, and four theories have developed as a result: exposure, manifestation, multiple trigger and injury-in-fact. Logically, drawing distinctions among these theories is difficult due to scientific uncertainty and frequently unstated court policy decisions which weigh heavily on whether insurance pays for cleanup.

Cases giving rise to CGL coverage triggers are also quite different. They span asbestos coverage and the initiation of disease, to gradual long-term hazardous waste releases with difficult-to-construct evidence of causation. The theories of coverage triggered reflect technical intricacies of the cases and the policy decisions affecting how CGL policies are at risk. A review of the scientific principles on cancer formation by the White House Science Office underscores the difficulty in determining cancer causation and therefore explains why establishing a coverage trigger for chronic health effects is difficult.

To the benefit of insurers and insureds alike, trigger of coverage is more manageable and less uncertain for EIL insurance. The policy period provides a window of opportunity for the insured to file a claim. The insured may also purchase tail coverage or a reporting period that extends beyond the policy period. This is useful if the insured or insurer decides to cancel or not renew the policy.

EIL coverage need not be triggered only by lawsuits; threats of litigation such as EPA or state demand letters will suffice. However, most recent EIL policies require the claim to be made and reported to the insurer during the policy period. The Insurance Services Office's EIL forms state that coverage is extended for claims first made during the policy period. Although certainly not without precedent, this language has been ruled to be ambiguous in the EIL insuring agreements and therefore is construed against the insurer.

In situations where two claims-made EIL policies for different carriers provide primary coverage for a release of hazardous substances, a Michigan case held that each insurer's liability is pro rata according to each party's coverage limits. The court stated there should be no attempt to "divine the intent of the parties" and determine that the provisions of one policy must yield to the provisions of another. Accordingly, Michigan law disregards other conflicting insurance clauses such as "where other insurance is available, coverage will be afforded only in excess of that policy's limit."

EIL policies that insure environmental impairment in connection with the business of the insured have covered pollution created by the insured's predecessor at that business location. Regarding coverage on this issue for contaminated groundwater, a Michigan court ruled that "since the [company's] land was obviously necessary to support the structure [of the company's building], it was in connection with the business." An active role by the insured in causing the contamination is not needed unless otherwise excluded by the policy. For this EIL policy there was no such exclusion.

A California appeals court rejected EIL insurance coverage of soil and groundwater cleanup of solvents from a leaking underground tank at a semiconductor fabrication plant, because the insured falsely denied knowledge of the problem on the EIL application form. The court found no ambiguity in the EIL clause excluding coverage for loss "arising out of the correction of any known pre-existing conditions at premises owned, occupied, rented, used or in care, custody or control of insured. ..." The insured answered no on the application to the question, "At the time of signature are you aware of any circumstances which could give rise to a claim under this policy?" One month prior to signing the application, the insured knew of holes in its underground tank causing solvent contamination exceeding state standards in soil and groundwater. The EPA has approved the use of this pre-existing contamination exclusion for RCRA treatment, storage and disposal facilities and underground storage tanks.

A similar exclusionary clause in Cordova Chemical Co.'s EIL policy was determined to not exclude coverage for contaminated ground-water but to exclude coverage for soil at its Michigan facility. False statements on the application were not at issue. Following the Michigan U.S. Aviex Co. v. Travelers Insurance case interpreting a CGL policy, the court determined that one may not interfere with a neighbor's reasonable use of groundwater.

Based on the priority given to protecting reasonable use of groundwater in Michigan, the EIL policy was held to exclude costs for remediation of contaminated soil, but not groundwater. The court's reasoning was based on the percolating nature of groundwater and its movement underground. The court stated that remediation of both soil and groundwater at the same site would have to be examined on a case-by-case factual basis to determine if the EIL policy would cover the cost of soil remediation associated with groundwater cleanup. In light of the obvious need for soil cleanup to prevent groundwater contamination, other courts may cover on-site soil remediation.

Contract Rescission

Insurers may also rescind the contract for undisclosed material conditions such as those occurring in Redwing Carriers v. American Empire Surplus Lines. American Empire issued EIL insurance policies for Redwing's bulk tank operations, including oil separation systems, underground waste oil and tractor wash-rinse tanks, tractor wash-down facilities, underground pipes and septic tanks. Redwing signed the application stating that it was unaware of any circumstances that would cause claims. However, Redwing failed to disclose a trespass and nuisance suit filed by a neighbor alleging continuous discharge of chemicals onto its yard. The suit led to a State of Alabama non-compliance order for wastewater discharges and to mandated RCRA groundwater monitoring, which revealed groundwater contamination originating from waste ponds.

American Empire's action for rescission of the insurance contract was upheld based on Alabama statutory provisions allowing rescission where misrepresentation, omissions, concealment of facts and incorrect statements are "material either to the acceptance of the risk or to the hazard assumed by the insurer; or the insurer in good faith would either not have issued a policy or contract at the premium rate as applied for, or would not have issued a policy or contract in as large an amount or would not have provided coverage with respect to the hazard resulting in the loss if the true facts had been made known to the insurer as required either by the application for the policy and contract or otherwise."

The court decided that failure to disclose the lawsuit, the resulting compliance order and the testing revealing groundwater contamination are material to the insurer's risk. If known, the insurer would not have, in good faith, extended coverage at the same rate or amount. The insured was obligated but failed to disclose facts that would cause a reasonable insurer to make an inquiry that would have uncovered the truth about the insured's operations.

Alleged fraud regarding the insurer's statements about coverage was also an issue. The court ruled that when there is no detrimental reliance by the insured, the insurer does not commit fraud and misrepresentation due to statements by its investigator to the insured that there was coverage later denied. The court also concluded, but without explanation, that there was no detrimental reliance by Redwing on American Empire's investigator's representations to use the less expensive method of cleanup. At the time, American Empire had written a reservation of rights letter on coverage witholding any commitments until the investigation was complete. Although all the facts on this issue are not in the opinion, it appears that an insurer's statements that adversely affect cleanup could be prejudicial to the insured.

The Right Approach

EIL insurance must be based on sound underwriting and expert claims management in cooperation with the insured. Using this approach, environmental risks can be underwritten. Without it, insurers can suffer substantial losses because of the scientific and legal uncertainties of pollution and the overwhelming public support for cleanup. EIL insurance encourages effective corporate risk management and covers the insolvent insured. Government financial responsibility requirements in conjunction with EIL insurance can also help provide coverage for high-risk activities.

Legal interpretation of EIL claims-made policies tends to be less complex than CGL policies. One reason is that coverage is triggered when a claim is made and reported during the policy period. EIL policies have been judicially upheld to not cover pre-existing contamination known but not disclosed by the insured. Absent late notice and misrepresentation by the insured, companies needing environmental coverage can recognize that "the protected man doesn't need luck" because effective EIL coverage provides a safe harbor.
COPYRIGHT 1990 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Italiano, Michael L.
Publication:Risk Management
Date:Aug 1, 1990
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