The Expanding Role of Environmental Insurance in Lending Transactions

Environmental insurance increasingly is being used as a tool to help lending deals close and is fast becoming one of the hot topics in commercial lending today. Environmental insurance can make the difference between a deal successfully completed and a deal blown apart by the prospect of environmental risk. By placing a large, well-rated insurance company in between the environmental risks and the lender whose money is on the line, environmental insurance significantly reduces a lender's exposure to those risks. If the loan is slated to be involved in a securitization, such insurance can also enhance the loan's profile with the financial rating agencies who rate securitization deals.

Environmental insurance comes in several basic types, but with almost infinite variation within each type in the precise scope of coverage, the triggers for coverage, the length of time for which coverage is available, the amounts of coverage and the exclusions and limitations applied to the policies. Coverage is issued by various insurance companies, but the four primary carriers are AIG, Kemper, ECS and Zurich American.

For purposes of lending transactions, the two primary types of coverage are "owners" coverage and "lenders" coverage. An owners policy -- which one company calls a "Pollution Select Legal Liability" policy -- typically covers environmental claims asserted against the property owner including demands for governmentally-required cleanups and related legal fees. It is quite common for lenders to be named as insureds under owners policies, but the owners policy is oriented toward environmental obligations facing the borrower.

Lenders policies, by contrast, do not cover environmental liabilities facing the borrower, and borrowers are not named as insureds under lenders policies. This type of policy -- sometimes called a "Secured Creditor Impairment" policy -- is oriented toward the concerns of lenders. Specifically, they generally cover (1) the loan balance in the event of a default, (2) any environmental claims asserted against the lender and, in some cases, (3) cleanup costs expended by a lender that has already foreclosed on a loan.

Each policy has its own advantages and drawbacks. Owners policies:

• Protect the borrower against liabilities it may face;
  
  

• Do not guarantee the lender, even when named as an insured, repayment of the loan in the event of an environmental condition that leaves the borrower unable to pay, although by protecting the borrower they presumably minimize the likelihood that such conditions will actually leave the borrower unable to pay;
  
  

• Because their coverage includes environmental liabilities of property owners, who are not protected by statutory secured creditor protections against liability under the environmental laws, are generally written to stricter underwriting standards than lender policies;
  
  

• Require more lead time to underwrite;
  
  

• Are more likely to include carve-outs or limitations on existing known environmental conditions; and
  
  

• Cost significantly more than lenders policies.

Lenders policies, on the other hand,

• Leave the borrower exposed to environmental liabilities (unless the borrower purchases an owners policy as well; many borrowers, once purchasing insurance, also want protection against risk);
  
  

• Are specifically geared toward repayment of the loan balance in the event of a default, thereby giving lenders the protection most important to them;
  
  

• Because of the statutory protections that already help insulate lenders against environmental liabilities, can be underwritten more easily;
  
  

• Can be underwritten very quickly (often an important factor in lending transactions);
  
  

• Can be more comprehensive in the scope of their coverage (i.e., insurers will often agree to protect lenders against certain risks that they would exclude from an owners policy); and
  
  

• Cost less than an owners policy.

Both types of policies, by reducing the environmental risks facing the lender, can reduce the risks in making loans, enhance the lender's ability to sell or securitize the loan, and therefore allow deals that might otherwise fail to proceed successfully toward closing.

Some lenders acquire environmental insurance on a loan-by-loan basis to address specific gaps or environmental issues in particular deals. In some deals, for example, the existence of an environmental issue may be expected to raise concerns for a loan purchaser or financial rating agency even though the issue is unlikely ever to pose a risk of a material liability. In such circumstances, insurance companies may be willing to cover those risks, removing them as issues for the lender and rating agencies.

Some lenders or loan-sellers buy environmental insurance on their entire loan pools or segments of their pools. For example, in pools on which less-costly Environmental Transaction Screens ("ETS") are performed instead of full "Phase I" investigations (such as some franchise loans), loan sellers have sometimes bought environmental insurance to offset the real or perceived additional risk posed by the lack of complete Phase I reports.

Recently, some insurance companies have proposed and some lenders have adopted an innovative new application of environmental insurance -- the use of insurance in lieu of environmental due diligence by the lender. Typically, in such applications, the borrower is required to fill out an environmental questionnaire on the property addressing such issues as the current and former uses of the property, the presence or absence of underground storage tanks, the history, if any, of environmental enforcement actions against the facility, the on-site usage of chemicals and the borrower's knowledge of any environmental issues concerning the property. The insurance company then runs environmental database searches on the property such as might typically be performed as part of a Phase I or an ETS. The policy underwriting is based on the information in the questionnaire and database search report, as well as information about the lender.

At first, reactions by lenders and rating agencies alike to environmental insurance -- either as a supplement to typical due diligence or instead of it -- was cautious. In part, it appears that the financial community's views may have been affected by the insurance industry's history of vigorously contesting environmental insurance coverage under normal comprehensive general liability ("CGL") policies. Unlike CGL policies, of course, environmental policies are specifically written to cover environmental risks. Nonetheless, environmental insurance -- especially of the lenders variety -- is a fairly new product and there has not been a lengthy time for the industry to develop a "claims history" to which prospective policy purchasers and rating agencies can look for assurance that the environmental insurance policies will be there to cover claims when needed.

Policy language also has been a focus of attention for policy purchasers and the financial rating agencies, and there has been and remains considerable evolution in the language of the policies. Specific issues that have attracted attention by policy purchasers and rating agencies alike include the following:

• Coverage of Existing Known Conditions -- Lenders and rating agencies generally want to ensure that all existing conditions -- known and disclosed to the insurance carrier as well as unknown conditions -- are covered, but policy language sometimes leaves this important issue ambiguous;
  
  

• Payment of Loan Balance -- Secured creditor policies at first were written to pay, in the event of a default on the loan accompanied by the existence of a "Pollution Condition," the lesser of the outstanding loan balance or cleanup costs. Coverage under the "lesser of" form can leave the lender in a position in which it needs to perform a cleanup before it can foreclose and recover the value of its loan. In response, insurers began offering purchasers the choice of a form that simply pays the outstanding loan balance. The outstanding loan balance form is somewhat more expensive but may offer better protection for the lender;
  
  

• Coverage Triggers -- An environmental condition may exist on or under a property that adversely affects its value and the borrower's ability to repay the loan even though there is no violation of law and no governmental agency has demanded the performance of a cleanup. Therefore, the specific coverage triggers under a policy are important;
  
  

• Length of Coverage -- It is generally desired that the policy remain in effect at least for as long as the term of the loan, and generally with a "tail" thereafter to cover any claims that may be asserted against the lender after repayment or foreclosure;
  
  

• Foreclosure -- As first written, some policies required the lender to foreclose before it could seek payment, thereby exposing the lender to the risk of environmental liability as a predicate to coverage. Generally, the requirement to "foreclose first" has been dropped from secured creditor policies;
  
  

• Subordination -- Policies that pay the lesser of the outstanding mortgage balance or cleanup costs, and leave the lender to foreclose to recover its principal, do not work if the policy subordinates the lender's rights against the borrower to the insurance company. Many current policy forms address this issue; and
  
  

• Coverage for Subsequent Loan Purchasers -- Given that loans frequently are destined for sale, most lenders want to ensure that environmental policies cover subsequent purchasers -- including securitization trustees and servicers -- without consent of the insurer.

In response to comments on these issues and others, the insurance companies have been aggressively revising their policy forms to satisfy lenders and the rating agencies. Despite the revisions, however, issues remain and often are resolved by policy endorsements. Policy buyers must be aware that the policies are in a constant state of flux, that the policy terms can be critical to coverage, and that the insurance companies have heretofore been willing to modify provisions to address concerns raised by knowledgeable policy buyers.

As a consequence of the insurance companies' responsiveness and the prospects for limiting the environmental risks facing loans, lenders and rating agencies alike are beginning to see the significant transactional benefits offered by environmental insurance. At least three of the agencies -- Fitch IBCA, Moody's and Duff & Phelps -- have issued criteria and policy statements acknowledging that environmental insurance can offer credit enhancement in some circumstances.

The lending industry will be waiting and watching to see how environmental insurers deal with claims as they are filed. Nonetheless, it seems virtually certain that environmental insurance can and will play an increasingly important role in lending transactions. Insurance is not a cure-all, however, and careful attention to the circumstances in which insurance makes sense and the particular policy terms can mean the difference between success and failure. *

Laurence Kirsch is a partner in the Firm's Environmental Group who advises on environmental issues in lending and other corporate transactions.