Insuring Environmental Risks in M&A Transactions

1 Introduction

Environmental issues are an increasing risk due to a public focus on environmental protection, rapidly changing regulations and uncertainty surrounding historical pollution events. Particularly in M&A transactions, environmental risks can constitute obstacles, and even result in a deal breaker. Usually, the buyer has limited knowledge of historical site activities and the potential for future claims emerging from undetectable pollution, while the assessment of potential pollution liabilities can differ strongly between seller and buyer. Typically used within transactions for many years in the US, Pollution Legal Liability¹ (“PLL”) insurances have been adapted to Continental Europe requirements over the last years to cover costs and liability risks arising from pollution and environmental damages due to historical site activities.

2 Environmental Risks

Environmental risks can have different definitions in various international jurisdictions. Divergences between national legislations and their ongoing changes have led to varying liability risks among countries. Additionally, historically grown differences in the legal classification of environmental liability has led to varying definitions of pollution events. In principle, environmental claims can be categorized as follows:

Private law claims: Legal liability under private law for personal injury and property damage to third parties caused by the release of hazardous substances, contaminants or pollutants. This can be for instance unknown long term bodily injuries to residents caused by non-identified contaminants released in the groundwater used by private wells or emissions of hazardous substances through the air.

Public law claims: Mainly remediation orders for soil, surface- and groundwater applicable to any site that requires an environmental permit and is controlled by Environmental Agencies. Additionally, the European Directive 2004/35/CE on environmental liability with regard to the prevention and remedying of environmental damage and its incorporation into local law of each EU country since 2007. This includes liability for damage to water, soil and particularly biodiversity (protected habitats, flora and wildlife).

Although the extent of liability policies may vary among different countries in analogy to the different grounds of legal liability, in most countries, pollution is majorly excluded from general liability insurance. In the majority of cases in Continental Europe, it is possible to insure pollution risks by additional pollution liability coverages, whereas these policies basically insure operational malfunction events which have occurred since the policy inception.

Property insurance will also only cover pollution caused after the policy inception resulting from an insured peril (e.g. fire), by sudden and accidental events, and is usually sub-limited at an inadequate value.

3 M&A Context

Circumstances in a M&A transaction differ strongly from daily business operations. The risk allocation can obviously be individually negotiated in the purchase agreement. The buyer/investor will usually bring forward that the uncertainty surrounding historical events increases with longer past durations. Therefore, protection against environmental risks is required for historical pollution events without time limitation and without limitation of specific stipulations on how pollution has occurred and developed. In summary, the intention is to secure the transaction on a long-term base, including protection against changes in law.

This is the typical situation for PLL insurance used by the various parties as a risk transfer instrument. Depending on the contractual risk allocation, predominantly the buyer/investor who is taking over potential environmental liability exposures, would consider such insurance. Alternatively, sellers (increased attractiveness, less risk discount), banks/lenders (increase in collateral, creditworthiness) or developers (calculability of land development costs) can also have an interest in the transfer of the risk.

The limited insurance protection for environmental risks under conventional insurance policies can be additionally limited depending on the transaction form:

Fig. 1 • Impact of transaction form to existing insurance coverage

Source: Marsh GmbH 

In regard to environmental exposures covered by Warranty and Indemnity (W&I) insurance, the scope of cover is generally limited to compliance with environmental legislation and environmental permits and thus does not, in principle, cover soil and groundwater contamination resulting from historical site operations.

4. Pollution Legal Liability Insurance

Due to the blatant gaps of environmental coverage in conventional insurance, PLL Insurance is established and tailored especially for the requirements of M&A transactions.

4.1 Insured Risks

PLL insurance covers both the private and public law claims described above. The insurance cover includes coverage for costs applying to the following pollution related risks:

• Soil and groundwater pollution: Remediation/clean-up of contaminated soil and groundwater on-site and off-site as imposed by supervisory authorities
• Biodiversity damages: Restoration to the original state in accordance with the European Environmental Directive as imposed by supervisory authorities
• Third-party claims: bodily injury (including death) and property damage to third parties
• Legal, investigation, loss mitigation and rescue costs: Relating to the above-mentioned coverage elements
• Further elements of cover may also be added, e.g. business interruption losses due to on-site remediation or waste liability covers.

PLL insurance covers unknown pollution. This includes all unknown contamination but also identified contamination provided that it is below threshold values that require intervention. Pollution conditions above actionable levels are typically defined as known pollution which is generally not covered by PLL insurance in the course of specifically named exclusions.

4.2 Coverage in terms of time

PLL insurance can be taken out from the time of closing as retroactive cover. Go-forward cover can also be added. Both cover elements can be procured separately or combined in one policy.

Retroactive coverage: Affords coverage for historical contamination that is related to any event prior to policy inception, which will be identified or develop to a claim against the policyholder after inception of the policy. It is irrelevant whether the historical events were sudden and accidental, gradual or arose from normal operations – all pollution events with the exception of those identified at the policy inception as being above a remediation threshold can be insured. Depending on the insurer’s risk evaluation, certain further risks may be excluded. This is determined on a case-by-case basis and subject to negotiations with insurers. Retroactive coverage includes cover for future changes of statutory regulations during the term of the policy.

Go-forward coverage: Events occurring after policy inception can be covered as well. Depending on the jurisdiction, the cover of the PLL policy may be broader than the pollution cover under conventional policies. Accordingly, gradual losses and on-site remediation may be insured under PLL insurance. A further advantage of go-forward cover is the possibility to provide internationally uniform and comprehensive insurance cover. Traditional environmental insurance policies, even if they are installed at the headquarter level as part of an international insurance program, in contrast often decline ancillary local differences in cover and difference in limit extensions for local policies for environmental risks.

4.3 Key Parameters

The following capacities and conditions for PLL cover apply in the international specialty insurance markets (Fig. 2).

Fig. 2 • Key coverage parameters for PLL insurance

Source: Marsh GmbH

5 Summary

Conventional insurance policies typically do not address balance sheet and accountancy exposures related to pre-existing pollution conditions. Especially in the case of M&A transactions, considerable pre-existing pollution liabilities – both in soil and water as well as events that result in third party bodily injury and property damage – can shift from the seller to the buyer. With PLL insurances as a solution, environmental risks – both for past and future events – can be transferred to specialized insurers against a one-time premium. As its essential benefit, PLL insurances eliminate uncertainties, including exposures for on-site environmental contamination, surrounding the target business.