Zurich: Disclosure of Environmental Liability
Around the world, companies are being required to meet higher levels of disclosure of environmental liability. To assist them in making disclosures that accurately reflect future liabilities, many companies are turning to environmental stop-loss insurance, writes Lindene Patton, senior vice-president and counsel, Zurich.
In the United States, for example, the US Financial Accounting Standard Board (FASB) issued provisions in 2002 for accounting for environmental liabilities on assets being retired from service. The provision for accounting for asset retirement obligations required companies to reserve environmental liabilities related to the eventual retirement of an asset if its fair market value could be reasonably estimated.
The intent of the ruling was disclosure, but the conditional nature of estimating a fair market value caused corporations to take the position that they could defer their liability indefinitely by 'mothballing' a contaminated property. Companies effectively postponed the recognition of their environmental liabilities in the absence of pending or anticipated litigation.
Earlier this year, FASB clarified its intention by providing an interpretation that said companies have a legal obligation to reserve for environmental and other liabilities associated with the eventual retirement of manufacturing facilities or parts of facilities, even when the timing or method of settlement is uncertain. Among examples given by FASB:
- An asbestos-contaminated factory cannot simply be 'mothballed' without adequate reserves to cover the eventual cost of removing the asbestos
- Reserves must be established today for the eventual disposal of still-in-use, creosote-soaked utility poles
As a result of what may seem like a minor technical re-interpretation, companies may have to recognise immediately millions of dollars in liabilities in their income statements to comply with this change.
A WORLDWIDE TREND
In Europe, regulators have also initiated efforts to promote disclosure. In 2001, the European Commission promulgated tougher, non-binding guidance for disclosing environmental costs and liabilities, and various countries in Europe have issued additional requirements related to environmental disclosure. In 2002, the Canadian Institute of Chartered Accountants published voluntary guidance that stressed the importance of disclosing all material risks, including environmental liabilities, in companies' annual reports.
Some financial institutions have also pledged to adhere to tenets of international initiatives such as the Equator Principles, which factor environmental and social considerations into assessing the risk of a project. Also, a group of pension funds, foundations, European investors and US state treasurers have endorsed UN efforts to promote a minimum level of disclosure on environmental, social and governance issues.
Recognition of environmental liabilities may also soon emerge as an issue for companies in Asia. While environmental issues may have taken a back seat to rapid economic development over the past 20 years, that situation may change as legislation and regulation catch up with development.
The responsibility for disclosing future environmental liability is clearly a growing issue for companies around the world. However, accurately estimating cleanup costs is not an easy task due to unknown contaminants, legacy liabilities related to formerly operated property, regulatory changes or unexpected claims related to natural resource damage.
This uncertainty is spurring many businesses to seek added protection against the possibility of unexpected environmental liability. Remediation Stop-Loss (RSL) coverage, for example, is being used to limit cleanup exposure. Coverage is triggered when actual cleanup costs exceed estimated costs and a self-insured retention limit. Cost overruns up to the policy limits are then transferred to the insurer.
An RSL policy instils the process of estimating cleanup costs, key to accurate disclosure, with an increased level of certainty. Since policies are often written at some multiple of a company's reserve, investors have the added confidence that a company’s environmental liabilities will not cause a shock to the company's balance sheet, even if reserves fall short of actual cleanup costs.
RSL can also provide confirmation of a company's own cost estimates. This is because insurers perform independent risk assessments of the cost to remediate a property as part of setting the point at which their coverage would be triggered. The attachment point set by the insurer can help a company determine whether its cost estimates are on target or fall short of the mark.
For companies that decide to dispose of their impaired properties, RSL can provide similar benefits. This is because the sale of an impaired asset poses similar issues to those of a balance-sheet disclosure. The liability still needs to be estimated.
As a precaution, buyers have traditionally required the seller to set aside funds in an escrow account and/or to include an indemnity provision as part of the purchase agreement. The challenge for the buyer was that these protections were only as good as the seller’s financial strength. A bankruptcy years later could leave the buyer strained.
Even if the price of the asset is discounted, remediation-cost overruns could still be substantial. These unplanned expenses would have to be addressed by the buyer. As a result many deals have been hobbled early on.
A more straightforward alternative is to use RSL to limit a significant portion of the liability of an environmentally impaired asset, thereby giving reasonable assurance to buyer and seller that cleanup costs will be contained. This in itself can serve to circumvent lengthy negotiations and reduce delays. Should costs rise beyond estimates, the additional costs would be assumed by the insurer.
By removing uncertainty in estimating the liability of an impaired asset, RSL coverage can simplify disclosure requirements with which companies increasingly need to comply, or streamline the transfer of property. In today’s market, it may provide the edge that allows a company to focus on operations rather than regulation or negotiation.
Lindene Patton C.I.H.
Senior vice-president and counsel
Linden Patton serves as senior vice -president and counsel for the Zurich unit providing environmental and design professional insurance solutions. She manages the underwriting counsel and cost engineering staff, as well as overseeing the group that underwrites remediation stop loss and associated environmental impairment liability programmes.