Newsletter Sign-up

When AG Electronics in 2002 purchased El Camino Systems, a much larger and older competitor, it was justifiably proud of the progress it had made in less than ten years of operation. (The names of the companies have been changed.)

As a young electrical equipment manufacturer, AG seemed destined to become the next star of its market segment, and things went well, at least for a while. But in 2004, the first signs of trouble appeared--from an unexpected source.

The half-mile plume of perchlorate in the aquifer had reached two municipal drinking water wells, which have since been taken out of service. Not surprisingly, the water district that owns the wells has filed a claim against AG Electronics for property damage. In addition, the state of California has also demanded that AG Electronics, as successor to El Camino, clean up the soil and groundwater at a cost of $65 million.

All of this came as a shock to AG, which had barely heard of the fuse manufacturing operation and never gave a thought to any due diligence regarding environmental matters at its California site when the purchase was contemplated.

Even if it had been looking for a potential problem, perchlorate was not regulated during the entire period of manufacturing at El Camino as well as at the time of the acquisition, so there is little likelihood anyone would have raised this operation or the site as something requiring additional attention. Now faced with lawsuits seeking $55 million for the loss of two water supply wells, along with the multimillion dollar cleanup, AG is having second thoughts about the acquisition of El Camino.

Old general liability and excess liability policies issued to El Camino during the fuse manufacturing operations contained pollution exclusions with sudden and accidental exceptions for nearly all of the years during which the release of contaminants could have occurred.

These policies have been used for other product liability claims and the remaining aggregate limits are not large, considering the costs that are expected to arise out of these claims and cleanup demands.

Current policies purchased by AG contain total pollution exclusions and will not respond to any of the claims arising out of the perchlorate contamination.

CASE FAR FROM UNIQUE

This is not a unique situation for companies that are active in mergers and acquisitions. In fact, the potential liability associated with past activities of discontinued operations is a frequent source of claims not only for cleanup costs, but also for bodily injury and property damage, especially where historic operations used asbestos, silica and radiological materials as a part of manufacturing.

While insurers are aware of the risks associated with these materials after years of paying asbestos and environmental claims, business owners may be much less concerned about such risks and more focused on the potential additions to income, synergy of related manufacturing activities or elimination of a competitor when looking at acquisitions.

Even where the hazards are known or suspected, the reasons for making a purchase may be compelling enough to make the risks worth taking, so long as the costs associated with these risks are not a total surprise to the company.

In industries such as the energy and communications sector, it is common to purchase competitors to increase market share or geographic span of operations, with only a cursory look at liabilities that come along with the purchase.

The impact of a major acquisition on revenue, and in turn, on stock value may completely outweigh even the largest loss that could occur as a result of an environmental claim arising out of an acquired operation or its discontinued operations.

This was the case for a communications company that acquired a competitor that also had been in a past era manufacturing nuclear devices at several locations.

One of these sites turned into a nightmare for the buyer when residents within a two-mile radius of the plant filed a class-action suit alleging bodily injury and property damage, including diminution of the values of their homes, as a result of historic releases of radioactive dusts from the facility.

Claims are in the process of being settled for tens of millions of dollars on top of the legal defense costs. The cleanup is still under way and is nearing the $100 million mark. The end is just now in sight.

Even though the revenues of both the buyer and the seller are large enough to absorb these costs, they are not large enough to do so in a single accounting period. The magnitude of the dispute also requires reporting in the financial statements of the company, which can have an impact on the stock value and the firm's reputation.

SEARCHING FOR SOLUTIONS

Is there a solution to the problem of legacy liabilities associated with acquired companies that can provide alternatives to paying as you go and hoping for the best?

In some cases, the answer has been found in the use of environmental insurance programs to address liabilities associated with the newly acquired operations, and even with discontinued operations. Environmental insurers have been willing to write multiyear policies with substantial limits that can make it possible for risk managers of acquisition-prone corporations to sleep at night. These programs are highly customized to suit the specific needs of the client and take a considerable effort to develop and implement.

The most basic problem in designing an insurance program for acquired operations is to know what is being insured. In cases of large acquisitions or where numerous purchases are made over a long period of time, it is not uncommon for the buyers to have no comprehensive list of the properties they have acquired.

The situation is worse when it comes to identifying and assessing risks associated with sites that were owned or operated at one time by the acquired entity, but are no longer part of the operations at the time of the purchase.

For one Tennessee-based footwear manufacturing firm that had gone on a poorly timed and unsuccessful diversification kick, it was thought that they had owned or operated about 100 plants that were involved in making shoes or involved in a business related to textile and apparel manufacturing.

Once an inquiry began, it was discovered that the company had touched more than 400 locations over its 60-year history, any of which could be the source of claims for environmental damage or injury. With an all-out effort at due diligence, information was developed on about half of these sites. Still, it was far from the kind of data usually available on sites that are owned by manufacturing firms.

With this data, the risk manager and broker met with insurers and negotiated a 10-year environmental policy with limits of $10 million per occurrence, and $40 million in aggregate to address the risk of environmental claims associated with the 400 locations.

Once done, the policy was broadened to include any unknown locations at which liability was alleged or proven.

Similar policies have been written for a single site or a single environmental risk where the acquiring entity is seeking relative certainty with respect to the costs they might incur for a specific historic risk in a year or over a period of years.

For example, the successor to a Pennsylvania foundry operation that used silica and asbestos in casting operations, which had been sold years earlier, needed this type of environmental risk solution to free its risk manager from the day-to-day drudgery of dealing with bodily injury claims associated with events that occurred more than 25 years earlier at locations he had never seen. Using a statistical model, the number of persons exposed to the hazardous products was extrapolated.

From this analysis, the exposed group was broken down into the following: (1) those who would die from asbestosis or silicosis; (2) those who would suffer measurable injury, but survive; and (3) those who would never experience any ill effects in spite of periods of exposure.

The results were compared with the claims already filed and a range of costs was developed for potential claimants in each group. Death cases were worth $200,000 each, illness claims were assigned a value of $24,000. Defense and settlement costs for noninjury claims were set at $3,200 each. The statistical model also produced a time distribution of the expected claims that was used to estimate the net present value of future costs.

Finally, the known claims were subtracted from the universe of potential claimants and an insurance cost to transfer the risk was established. An insurance policy was negotiated to insure the bodily injury risks associated with the discontinued operations and the program was implemented.

CRAFTING THE RIGHT POLICY

The art of developing a solution to legacy environmental liabilities depends upon the skill and credibility of the modeler, the appetite of the insurer to take on the risk and the ability of the broker, risk manger and underwriter to craft policies that embody the risk transfer mechanisms necessary to address areas of exposure.

The policy may be a hybrid of an existing form or it may be customized using only a framework that is familiar to the insurer and the insured. Where risks cannot be demonstrated to fall within a given range of future costs, it may be necessary to exclude a location or operation from the policy.

High-risk locations or operations may also be kept on the policy but subject to different limits, self-insured retentions or terms of coverage. The crafting of a successful policy typically takes time and requires the input from in-house or outside counsel of the insured as well as the risk manager. Review of the final product may go to the chief financial officer or even the board of directors of the insured entity.

These solutions are the product of a sophisticated underwriting process and require skill on the part of those developing estimates of future costs for environmental events.

The persons applying computer-based models must not only understand the mathematical issues associated with probabilistic models, but must also have experience with environmental conditions that give rise to the types of claims associated with releases of contaminants that can cause bodily injury or environmental damage.

This indeed is serious risk management decision-making and few brokers or consultants have the required skills let alone the credibility to present the insured's case to underwriters.

RODNEY J. TAYLOR is managing director of Breitstone & Co., Ltd., a Cedarhurst, N.Y.-based brokerage and consulting firm.

April 1, 2006

Copyright 2006© LRP Publications