When used correctly, finite re can fill environmental liability gap

Aon’s Bennink sees need for ‘tarnished’ product growing as property owners face mold effects of hurricanes

AUTHOR: By Andrew G. Simpson

Finite reinsurance has received negative publicity within the past year amid allegations of its misuse as an accounting rather than risk transfer tool.

But the product has its merits when used correctly and could be in even more demand as property owners cope with the environmental effects of Katrina and other hurricanes.

“Finite re can be used very effectively within an environmental program,” says David Bennink, senior vice president of Aon Reinsurance environmental group.

Bennink notes that so-called blended finite reinsurance is particularly useful in helping owners of brownfields bring some certainty to pollution-related liabilities and protect themselves against future cleanup, remediation and liability costs. The coverage also helps make lenders more willing to lend for brownfields projects.

Brownfields are sites, such as former gas stations, mines, military bases or chemical plants, which have been cleaned up but where the fear of continued pollution claims stifles use or development. Buyers, lenders and even merger prospects are often reluctant to get involved with such properties out of liability concerns so the properties may remain abandoned or underutilized as a result.

“There’s pretty active claims activity in this area,” Bennink notes. “It’s the nature of environmental claims.”

Owners or buyers of brownfields can purchase coverages to protect themselves against pollution claims related to pre-existing conditions and cleanup. They can also purchase protection that caps their liability in the event remediation costs exceed a retention level. Another policy protects lenders.

But forecasting these liabilities, costs and duration of remediation is not an exact science. The standard policies tend to be short-term. Yet some owners require protection in case these underlying policies come up short and if fixing the site takes longer.

This is when when a finite risk approach helps, usually on large projects where the remediation could take five, 10 or even 15 years.

Similar to cost overrun coverage, a blended finite reinsurance policy pays excess cleanup costs above a buffer. However, these contracts are structured quite differently. In a finite risk arrangement, the buyer must be willing to pay upfront the present value of estimated cleanup and other costs. The contract becomes a sort of profit-sharing deal.

The insurer assumes the risks that the cost and time estimates might be off, unforeseen liabilities might surface, and even that the remediation might be completed early and payment for the entire cleanup becomes due sooner than expected. The insurer makes money by investing the pre-payments. The buyer also pays a premium for the insurer’s assumption of the risk.

Bennink offers an example where an underwriter requires pre-funding for known $10 million remediation liability at present value. It charges an additional $3 million for the cost of assuming the risk. The policy has a $20 million limit, of which $10 million is the known risk transfer and the other $10 million is for unknown loss. In this case, the buyer expects to spend $10 million but agrees to pay an additional $3 million premium in the event there are surprises that could cost up to another $10 million.

Bennink is well aware, of course, of the allegations that American International Group may have improperly used finite reinsurance for accounting purposes rather than risk transfer. Although that controversy has tarnished the product’s image, Bennink is not worried.

“They haven’t hurt the business but they have drawn more scrutiny to the transactions,” Bennink says. “It’s actually proven to be a good thing.” When people forget about abusing finite reinsurance to manipulate earnings, they see the advantages and the product sells on its own, especially when pollution liability is an issue.

He also sees the need growing as mold emerges as a serious concern for property owners hit by Hurricane Katrina and the other storms. “Katrina has brought mold to the forefront,” he notes. “Risk managers in the past may not have paid attention to mold. Now they must be proactive.”

Topics Reinsurance Pollution