Insurance

Environmental liability insurance in a private M&A context

Introduction

Dealers in Europe have become increasingly accustomed to the use of warranty and indemnity (“W&I”) insurance in M&A transactions as a means of removing the risk of potential claims for breach of warranties from their balance sheets. . However, W&I insurance coverage is not comprehensive: known risks are generally excluded, as are environmental liabilities. Given the potentially large and long-term costs of dealing with environmental pollution, this is often a significant gap in coverage. This is where environmental liability insurance comes in.

Environmental liability insurance is a tool that has grown slowly over the past couple of years, but is likely being used more often than before (perhaps coinciding with increased regulations and an increased commitment to sustainability and ESG objectives). It is much more sophisticated and less known than other insurance policies used in a transaction and is often subject to misconceptions about feasibility and costs.

In any transaction with manufacturing sites, environmental liability insurance can help bridge one of the often most contentious points to negotiate, where finding compromises is difficult due to the unpredictable and/or unknown risks associated with historical environmental conditions. . Legal advisors can enhance the benefits of environmental liability insurance by reviewing the fine print of the policy and ensuring that coverage and exclusions are clearly described.

What is environmental liability insurance?

General

Environmental liability insurance (also known as pollution liability insurance (“PLL”) or environmental impairment liability (“EIL”) is an insurance product covering environmental damage and claims resulting from pre-existing pollution conditions at specific sites, as well as off-site contamination of soil and groundwater.

Coverage scope

In summary, investigation and redress obligations imposed by regulators as well as third-party claims under the following are covered:

  • Known pollution sufficiently below legally acceptable levels and concentrations, which does not (yet) require cleaning at the time the policy is put in place, but which may in the future (e.g. due to pollution standards) stricter remedies).
  • Unknown pollution that is identified later but already existed at the time of creation. This may also include substances which are not yet classified as pollutants.

This covers soil pollution, groundwater pollution and damage to the environment and property resulting therefrom, damage to biodiversity as well as civil liability (including bodily injury).

Environmental liability insurance will cover liability for pollution as long as it was caused before the insurance was taken out (including former site owners). Remedial actions and third-party claims due to future change in the law are also taken into account.

In terms of costs, environmental liability insurance policies generally cover reasonable and necessary clean-up and restoration costs, emergency/loss prevention costs, legal defense costs and, where applicable, business interruption costs and lost revenue.

Standard exclusions

Negotiators should expect some standard exclusions:

  • Known pollution at or above legally acceptable levels and/or concentrations that trigger or are likely to trigger remediation obligations.
  • Certain pollutants, such as asbestos and lead paint.
  • Consequences due to the presence of underground storage tanks (“UST”).
  • Repair resulting from voluntary investigations, construction measures and insufficient maintenance of the site (i.e. 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 were once standard exclusions. However, in light of the increased use of environmental insurance policies by property developers when developing brownfield and brownfield sites (a growing trend), this is now often a covered risk, with the policy and l scope of coverage “evolving” with the site. .

Policy terms

The terms of environmental liability insurance policies have varied over time and depend on the risk profile of the insured site. However, the key terms to anticipate are:

  • time limit. Generally, the policies will cover a period of five years; ten-year terms, once more common, are becoming more difficult to obtain. Automatic extension is unusual, although rollover mechanisms can be built into policies to ensure extension on acceptable financial terms.
  • Limit, de minimis, retention. The policy limit depends on the site and its risk profile. The limits vary between €1 million and €150 million (noting that the capacity goes up to €250 million), but the median is between €20 and €50 million. Unlike W&I insurance, no de minimis applies. Retention is generally quite low and corresponds to due diligence materiality thresholds (generally between EUR 100,000 and EUR 500,000), although there are sometimes specific retentions for specific risks. Financial conditions are generally higher for heavy industry, chemicals, etc., and lower for pure real estate.
  • Prime. The ultimate premium depends on many factors, but we’ve generally seen premiums between 1% and 5% of the policy limit (although this can drop significantly depending on the risk and state of market competitiveness of insurance).

Subscription process

The underwriting process to engage an environmental liability insurance policy is comparable to that of W&I insurance: insurance market test by an insurance broker, NBI report, engagement of the preferred insurer, including the conclusion of an expenditure agreement, actual underwriting and parallel negotiation and finally the undertaking of the insurance policy.

The insurer’s due diligence will of course focus on environmental issues, and parties should ensure that environmental due diligence is given sufficient attention, ideally from both a legal and a technical perspective. The preparation of so-called Phase I environmental due diligence reports (and even Phase II, in the event of identified pollution) is always useful to obtain coverage. To enable subscribers to usefully prepare their PNBs, sellers will also be required to provide upstream information on known contaminations.

The timing of the underwriting process can take anywhere from a few weeks to a few months and is ideally scheduled to run in parallel with the W&I underwriting process prior to execution of a purchase contract. However, given the complexity of the environmental issues and the technical expertise behind the due diligence of these, sufficient preparation time should be provided. The subscription of the environmental liability insurance may therefore have to be anticipated before the W&I subscription. Sometimes cautious sellers have also already explored environmental liability insurance options before an early sales process.

Impact on the transaction

Transaction documents

The environmental liability insurance policy itself is generally stand-alone, ie independent of the terms of the purchase contract (including the resulting guarantees). As pollution is regularly excluded from the coverage of W&I insurance policies, an overlap between the two policies is generally unlikely. The review should focus on how exclusions are written in each policy and how they relate to environmental and legal compliance warranties under the purchase contract. Counsel should ensure that the substance of these warranties is covered by one and/or the other in order to avoid unintended discrepancies between policies, particularly where the seller’s limit of liability for breach of warranties is nothing.

Added value

Taking out an environmental civil liability insurance policy in the context of a merger-acquisition operation has many advantages: distinction between offers (because the acquirer does not need to request environmental indemnities), alignment interests of the parties, protection of the seller-buyer relationship (particularly in the case of continued business collaboration after completion or long-term transition services) while being a useful alternative to escrow and holdback mechanisms that have been traditional forms of risk allocation for environmental issues identified in due diligence processes.

From the buyer’s point of view, there is an additional material advantage to taking out an environmental liability insurance policy: it is not bound by the buyer but by the target entity which owns, leases or controls the insured site. . This means that in the event of a future sale of the target entity, the policy is transferred with it and the environmental risk associated with the site has already been integrated (thereby reducing any negative impact on the valuation of the site and/or the entity target) .

In addition, environmental liabilities are long-term risks, and the corresponding claims process entails a heavy administrative burden. By covering these risks under an environmental liability insurance policy, a buyer ensures that it is properly managed by a third party (i.e. the insurer) with the experience and expertise needed.

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 tool to deal with environmental liabilities, which are often difficult to resolve in a transactional context.