Dealmakers in Europe have grown increasingly accustomed to the use of warranty and indemnity (‘W&I’) insurance in M&A transactions as a means to move the risk of potential claims for breaches of warranties off their balance sheets. However, W&I insurance coverage is not complete: known risks are typically excluded, as are environmental liabilities. Given the potentially significant and long-term costs to address environmental pollution, this often constitutes a material gap in coverage. This is where environmental liability insurance comes in.
Environmental liability insurance is a tool that has developed slowly over the last couple of years but is conceivably raised more often than before (perhaps coincidentally with increasing regulations and heightened engagement towards sustainability and ESG targets). It is much more sophisticated and less known than other insurance policies used in a deal context and is often subject to misperceptions around feasibility and costs.
In any transaction with manufacturing sites, environmental liability insurance can help bridge one of the often most controversial points to be negotiated, where finding compromises is difficult due to the unpredictable and/or unknown risks associated with historic environmental conditions. Legal advisers can enhance the upside of an environmental liability insurance by scrutinizing the small print of the policy and ensuring that coverage and exclusions are clearly described.
What is Environmental Liability Insurance?
Environmental liability insurance (also known as pollution legal liability (‘PLL’) or environmental impairment liability (‘EIL’) insurance) is an insurance product covering environmental damage and claims resulting from pre-existing pollution conditions at specific sites, as well as related off-site contamination of soil and groundwater.
Scope of coverage
In summary, investigation and remediation obligations imposed by regulators as well as third party claims pursuant to the following are covered:
- Known pollution sufficiently below legally acceptable levels and concentration, which does not (yet) require clean up at the time of policy inception, but which may in the future (e.g., due to more stringent remediation standards).
- Unknown pollution which is identified later but already existed at the time of inception. This may also include substances not yet classified as a pollutant.
Covered are soil pollution, groundwater pollution and related environmental and property damage, damage to biodiversity as well as civil liabilities (including bodily injury).
Environmental liability insurance will cover liability for pollution as long as it was caused before the insurance was taken out (including under previous site owners). Remediation and third party claims due to a future change in law are also captured.
In terms of costs, environmental liability insurance policies generally cover reasonable and necessary clean-up and remediation costs, emergency / loss prevention costs, legal defense costs and, if elected, business interruption costs and loss of income.
Dealmakers need to expect certain standard exclusions:
- Known pollution at or above legally acceptable levels and/or concentration which do or are likely to result in remediation obligations.
- Certain pollutants, such as asbestos and leaded paint.
- Consequences due to the presence of underground storage tanks (‘USTs’).
- Remediation resulting from voluntary investigations, construction measures and insufficient maintenance of the site (meaning that insurance coverage often comes at the cost of limiting the development potential of the insured site).
Remediation resulting from a change of use of a site and construction of a building on insured sites used to be standard exclusions. However, in light of the increased use of environmental insurance policies by real estate developers when developing grey- and brownfields (an increasing trend), this is now often a coverable risk, whereby the policy and scope of coverage “develop” along with the site.
The terms of environmental liability insurance policies have varied over time and depend on the insured site’s risk profile. However, key terms to be expected are:
- Time limitation. Typically, policies will cater for a term of five years; ten-year terms, which used to be more common in the past, are becoming more difficult to obtain. Automatic extension is unusual, although roll-over mechanisms can be built into policies to ensure extension at acceptable financial terms.
- Limit, de minimis, retention. The policy limit depends on the site and its risk profile. Limits range anywhere between EUR 1 million and EUR 150 million (noting that capacity goes up to EUR 250 million), but the median lies between EUR 20 million and EUR 50 million. Contrary to W&I insurance, no de minimis applies. Retention is generally quite low and matching due diligence materiality thresholds (typically ranging between EUR 100,000 and EUR 500,000), although sometimes there are specific retentions for specific risks. The financial terms are usually higher for the heavy industrials, chemicals, etc. sectors, and on the lower end for pure real estate.
- Premium. The ultimate premium depends on many factors, but we have generally seen premiums equaling between 1% and 5% of the policy limit (although this can significantly go down depending on the risk and state of competitiveness of the insurance market).
The underwriting process to bind an environmental liability insurance policy is comparable to that of W&I insurance: testing of the insurance market by an insurance broker, NBI report, engagement of preferred insurer including entering into an expense agreement, actual underwriting and parallel negotiation and ultimately the binding of the insurance policy.
The insurer’s due diligence focus will of course lie on environmental matters, and parties should ensure that environmental due diligence receives sufficient attention, ideally both from a legal side as well as from a technical side. Preparing so-called environmental due diligence Phase I reports (and even Phase II reports, in case of identified pollution) is always helpful in order to obtain coverage. To allow underwriters to usefully prepare their NBIs, sellers will also be expected to provide information on known contaminations up front.
The underwriting process timeline can take anywhere between a few weeks to a few months and is ideally timed to run in parallel with the W&I underwriting process prior to the execution of a purchase agreement. However, given the complexity of environmental issues and the technical expertise behind the due diligence thereof, sufficient preparation time needs to be planned for. Underwriting for environmental liability insurance may therefore need to be frontloaded ahead of W&I underwriting. Occasionally, prudent sellers have also already explored environmental liability insurance options ahead of an anticipated sales process.
Impact on the deal
The environmental liability insurance policy in itself is typically stand-alone, i.e. independent of the terms of the purchase agreement (including the warranties given thereunder). As pollution is regularly excluded from coverage under W&I insurance policies, an overlap between the two policies is generally unlikely. The focus of review should lie on the manner in which exclusions are drafted in each policy and how these tie into the environmental and compliance with laws warranties under the purchase agreement. Legal advisers should ensure that the substance of such warranties is covered by one and/or the other to avoid unintended gaps between policies, especially where the limit on seller’s liability for breaches of warranties is nil.
Binding an environmental liability insurance policy in the framework of an M&A transaction has many benefits: this includes bid distinction (because the purchaser does not need to request environmental indemnities), alignment of party interests, protection of the seller-purchaser relationship (especially in case of continued business collaboration post-completion or long-term transitional services) as well as being a useful alternative to escrow and holdback mechanisms which have been traditional forms of risk allocation for environmental issues identified in the due diligence processes.
From a purchaser’s perspective, there is an additional, material benefit to binding an environmental liability insurance policy: it is bound not by the purchaser but by the target entity owning, leasing or controlling the insured site. This means that, in case of future divestment of the target entity, the policy transfers with it and the environmental risk associated with the site has previously already been boxed in (therefore reducing any adverse impacts on the site’s and/or the target entity’s valuation).
Further, environmental liabilities are long-term risks, and the related claims process entails a high administrative burden. By covering off these risks under an environmental liability insurance policy, a purchaser ensures that this is appropriately handled by a third party (i.e. the insurer) having the necessary experience and expertise.
We do not expect environmental liability insurance to necessarily become a standard product in most M&A transactions. However, knowing that the product exists offers an additional instrument to deal with environmental liabilities, which are otherwise often challenging to resolve in a transactional context.