Finite re can fill environmental liability gap

Finite reinsurance has received a lot of 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 it 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,” said David Bennink, senior vice president of Aon Rinsurance’s environmental group.

Environmental liabilities stemming from properties can harm a company’s financial performance and wreak havoc on its budgeting, especially in the Sarbanes-Oxley era of financial disclosure and scrutiny. Finite reinsurance allows buyer and seller to use an insurance policy to bring some certainty to those liabilities, according to the Aon executive.

Brownfield solution
Bennink noted that so-called blended finite reinsurance is particularly useful in helping owners of formerly polluted properties or brownfields 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, that have been cleaned up but where the fear of continued pollution-related costs and liabilities stifles use or development. The properties may remain abandoned or underutilized as a result.

Buyers, lenders and even merger prospects are often reluctant to get involved with such properties out of concern that the remediation might be found to be insufficient, or there might be lingering pollution liability. The concerns include whether the site assessment has been thorough, whether there might be additional contamination on another place within the site, and whether neighbors might claim a diminution in their property value as a result of the contamination.

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

Standard coverage
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 a remediation program’s costs exceed a retention level. Another policy protects lenders, making them more willing to provide capital from brownfields projects.

But forecasting those liabilities, costs and even the length of time for a remediation plan is not an exact science. Those standard insurance policies tend to be short-term, usually no longer than five years. Yet some owners require protection in case the underlying policies and estimates prove insufficient, and if the whole process of getting the site back into business takes longer.

That’s when a finite risk approach helps, usually on larger projects where the remediation could take as long as five, 10 or even 15 years.

Similar to cost overrun coverage, a blended finite reinsurance policy pays excess cleanup costs above a buffer. However, those contracts are structured quite differently. Unlike typical environmental insurance, in a finite risk arrangement, the corporation must be willing to pay upfront the present value of estimated cleanup and other costs. The contract becomes a sort of profit-sharing deal between the owner and the insurer. The insurer assumes the risks that the cost estimate might be inaccurate, other unknown liabilities might surface, and even that the remediation might be completed earlier than thought and payment for the entire cleanup would become 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. The premium reflects the amount of risk transfer, length of policy term and exposure type. The contracts also have incentives for buyers to have their remediation come in under budget, in which case they can get back some of the original deposit.

Bennink offered an example where an insurance underwriter requires pre-funding for known $10 million remediation liability at present value. It would also charge an additional $3 million for the cost of assuming the risk. The policy would have a $20 million limit, of which $10 million is the known risk transfer and the other $10 million is for unknown loss. In that case, the reinsurance 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.

Helpful scrutiny
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,” he said. “It’s actually proven to be a good thing.” Bennink said that 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 of last year. Mold is considered a pollutant because it’s excluded under standard policies. “Katrina has brought mold to the forefront,” he noted. “Risk managers in the past may not have paid attention to mold. Now they must be proactive.” He also sees the need growing as mold emerges as a serious concern for property owners hit by Hurricane Katrina and the other storms of last year. Mold is considered a pollutant because it’s excluded under standard policies. “Katrina has brought mold to the forefront,” he noted. “Risk managers in the past may not have paid attention to mold. Now they must be proactive.”

Topics Reinsurance Pollution