Recently, much has been written on the topic of liability buyouts in the context of environmental risk. The heightened demand for a liability buyout transaction is being driven to a great extent by the increasingly sophisticated market for the assumption of such liabilities, thanks in part to the insurance community's array of products to facilitate such matters.
In addition, the passage of the Sarbanes-Oxley Act and other, more arcane financial regulations continue to underscore the need for transactions designed to transfer liability risks.
Dozens of corporations are now finding that the management of their environmental risk is no longer limited to the engineering confines of their environmental department. Managing environmental risk, these days more likely to be a collective exercise, is being driven in a multidisciplinary fashion by legal, real estate, finance and risk management professionals.
As solutions become available, the marketing of such products is focused across the corporate spectrum. In fact, many risk managers are now receiving calls from different groups within their firms, asking for more clarification of such risk transfer structures. But even with all of the attention bestowed upon the subject of liability buyouts, the definition of these transactions remains a mystery to many. Perhaps that's no surprise, given the inherent complexity of the concept.
Interpretations of what actually constitutes a liability buyout vary. The principle understanding, however, is that a liability buyout is an essential tool for a firm looking to contractually transfer their known environmental liabilities to a third party in exchange for financial and regulatory relief. The party assuming, or "buying," the liability can be one of a number of different types of firms.
Most likely, however, it is an environmental consulting firm or a boutique liability management company created exclusively to assume and manage environmental liabilities.
A firm considers a liability buyout when it is motivated by one or more of the following reasons: Management may want to remove, qualify or footnote a known environmental liability from its balance sheet. Or, management may want to eliminate the distraction of a legacy liability that devours more than its fair share of executives' time and attention. Or, it could be that management may simply want to close out liabilities from a divested location or operating company. Further still, management may want to cap the costs of an environmental liability to eliminate the exponential cost increases for which environmental projects are notorious. And finally, management may want to arbitrage known environmental liabilities by using a competitive bidding process to extract the best long-term solution.
The environmental insurance tools available for risk transfer today are numerous. Generally speaking, they fall into two categories.
The first, remediation cost cap coverage, is the foundation of many liability buyouts by management. On its own, remediation cost cap coverage is a risk transfer policy that caps the cost of a remediation project. Typically, it provides coverage for cost overruns stemming from the discovery of new contamination, the discovery of more toxins at an existing site or changes in regulatory requirements.
Whereas the remediation cost cap policy focuses on a known contamination, the second risk transfer tool, a fixed-site pollution policy, is designed to address the risk associated with unknown contamination at a site. Such a policy is generally designed to cover the remediation of any conditions that are discovered, as well as the associated third-party liability claims.
But be warned. Great care must be taken to coordinate the drafting of these two policies for the same environmental site. When done effectively, though, the morphing of the remediation cost cap coverage and the fixed-site pollution policy can seamlessly address liabilities associated with known and unknown contamination.
Together, these two policies make up the core of a liability buyout.
Essentially, the common understanding of what defines a liability buyout falls along a continuum of risk transfer. In its most basic form, a liability buyout is thought by some to be as basic as a fixed-price remediation.
Other firms will expand the definition to include a complete third-party assumption of liability.
The definition of a fixed-price remediation can vary from firm to firm, but is broadly defined as a guarantee that a predetermined remediation will be performed for a fixed cost.
That cost is then backed by either a remediation cost cap insurance policy or the financial wherewithal of the environmental consultant. There is no transfer of the legal liability associated with the site remediation, but the client is provided with a degree of protection from cost overruns.
With the second iteration, a guaranteed cost to closure, the client is typically offered a fixed price in order to achieve regulatory closure at the site. This is typically an expansion of a fixed-price remediation contract in that the guaranteed cost to closure is designed to cover a broader sitewide remediation and ensures closure--not just the achievement of certain remedial goals.
As with the first option, the environmental consulting firm does not contractually assume the liabilities but will guarantee the achievement of regulated costs for a fixed price. This guarantee is then typically backed by a remediation cost cap policy and/or the balance sheet of the firm.
The third alternative is the liability buyout option, which involves the actual contractual assumption of the known liabilities. A third party contractually assumes the known and potentially unknown environmental liabilities at an environmental site. Typically, the third party then stands in place of the responsible party with respect to managing the remediation, negotiating with the state regulators and handling future matters involving the cleanup. The assumption of the liabilities is performed in exchange for a cash payment.
The third party then backs the indemnity to the seller with an environmental insurance policy and another form of indemnity. In addition, to assure the seller that their funds will be used to pay for the remediation, the funds are directed to a blended environmental finite risk policy or an environmental trust.
Clearly, the key provision for the seller is the third party's ability to manage the remediation and support their indemnity. The failure of either can lead to an exacerbation of the site conditions, or compound the environmental liabilities and threaten the success of the risk transfer.
To protect the client, extensive due diligence on the assuming party is strongly encouraged, as well as assurances that the funds set aside for the environmental remediation are protected and available in the event of nonperformance by the third party. Great care must also be taken in structuring the insurance component, backstopping the indemnity to ensure that the insurance provisions are aligned with all the other contracts in place between the buyer and seller, and guaranteeing a seamless transfer.
Through the effective utilization of environmental insurance products, the seller is assured that their environmental liabilities are safely transferred to a third party while providing the requisite coverage.
The marketplace's solutions are allowing companies to focus on profitably growing their business while effectively shedding past liabilities.
With the environmental risk management hat worn by professionals in various departments today, it is imperative for each decision-maker to have greater awareness of the options available to mitigate that risk.
The evolution of liability buyouts is creating interesting alternatives for firms with legacy environmental issues to effectively transfer their risk. Ultimately, these liability buyouts play an important role in removing potential hazardous liabilities from the balance sheet.
The complexity of such solutions is not to be overlooked. Great care must be taken in structuring the contractual agreements and the associated environmental insurance policies. That's the only way to make sure risks are successfully transferred and all parties benefit.
DAVID W. BENNINK
is managing director of Aon Environmental and develops risk management programs for corporations. He is a 2006
Risk & Insurance®
April 1, 2006
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