The one environmental insurance product I have never used is the secured creditor policy. There are several fundamental problems with this policy from my prospective. The first problem is that it protects just the bank and leaves the customer out. The customer pays for a policy that only protects the interests of the bank and only pays if the customer defaults. (If the policy pays in it’s most simplistic representation.) Secondly, there are issues with the time value of money, accrued money and controlling the manner in which a problem loan is worked out. Whether the insurer will pay at all, may be impacted by whether the environmental issue is a primary or secondary issue with a default. The current worsening downturn in commercial properties will provide a true market test of the product.
Collateral can be environmentally impaired and not at all saleable with known or suspected contamination, but without an order from the regulators. These policies do not pay for “grey” problems. In the current market, any impairment may be perceived to be material. Priority with state and or federal regulators is also becoming a bigger issue. Regulatory resources are limited especially in this time of state budget shortfalls.
In the secured creditor policy the interests of bank and borrower are at odds with each other. It is in the Bank’s interests under the insurance policy to push for regulatory investigation while the customer is still viable. A Phase II site investigation would have to be performed at the first sign of deterioration when the borrower is trying to reduce expenses. Does a bank have liability for reporting a customer to the regulators if there is no eminent endangerment to the public or workers? How about forcing a borrower to search for a problem that ultimately resulted in a loss of property or the business? What is the price and renewal risk for portfolio policies? These are all questions the current credit environment will ultimately answer. With twenty-twenty hind sight, it appears that lending pools are better served by performing an appropriate level of due diligence on the portfolio. Though at the moment, there appears to be no market for collateralized loan obligations. Without individual property information, it is impossible to break up and sell a busted pool of commercial loans.
If it actually comes to a cleanup under a policy, the insurer or their representatives will negotiate the level of cleanup. Interests of the regulators, bank, community and insurance company are often at odds. At least when a Bank negotiates a clean up level they should be thinking of selling the property and residual liability issues that may make a more conservative cleanup more desirable. The insurance company, however; will perform the cheapest cleanup that it can get past the regulators. It practically goes without saying that risk based clean-ups; institutional controls and land use covenants will be used to reduce the costs of remediation. This level of cleanup does not best serve the marketability of a property or compliance with these covenants and controls.
At commercial properties and multi-residential properties that do not have ongoing oversight there are simply no mechanisms to ensure compliance with these restrictions. Exclusionary permanent zoning just does not exist. There is no way to assure that a cleanup that did not meet industrial clean up goals and required the maintenance of a site cap and land use covenants does not end up as a daycare center with playground. Without a mechanism to recall and enforce them, land use covenants and institutional controls and the insurance products have been an excuse for regulators to approve second-rate cleanups. Most entities are just not geared up to maintain ongoing knowledge of these types of controls. There is no insurance product to make sure that the intent of these controls is met.
In addition, depending on the policy, if a foreclosed site is cleaned up under the insurance policy then sold; does lender loose their lender protections under the law? And if land use covenants and institutional controls are used is the lender responsible for ensuring these controls remain in place. If the cleanup is bad enough then do banks purchase another insurance product to protect them from the ramifications of the first insurance product? How do regulators actually determine that land use covenants and engineering controls are actually being enforced? I hope the regulators are not intending that the insurers are checking, because remember it’s the cleanup order that invokes the insurance policy.
The size of the project and type of user still determines how cost effective a policy actually is. As we learned with site characterization, there are fixed costs involved with characterizing a site, and determining the appropriate balance of remediation, exposure control and liability control mechanisms for a particular site.
The existence of insurance products is not a substitute for site investigation or prudent action. Insurance properly used is a powerful liability control mechanism. Their use can have an impact on the form of financing for a project and on the property cost and value it’s self. However, the full scope and magnitude of the contamination must be known. Not just that there is contamination. Otherwise, it is impossible that a cost estimate can be given, and it is unknown if the property is worth more than the cleanup cost. The full cost to remediate the site needs to be estimated. This way the bank knows that there are adequate funds to pay for the cleanup and a cost cap insurance policy can be properly used. Regardless of insurance, I do not feel Banks should be involved with transactions that do not make economic sense. Those kinds of transactions are much too likely to result in litigation.
Remembering that in normal market times only 1%-2% of commercial loans actually default and less than 25% of these loans actually have any environmental issues, environmental insurance is actually designed to be a backstop. The current economic climate will severely test these products as the real estate downturn begins to impact commercial real estate loans in the coming year or two. Overly broad promises and a failure to use common sense and appropriate due diligence could result in risk shifting to a degree that may cause the product to fail to perform.