Financial risk assessment
Financial Risk Assessment and Management for Contaminated Land
Today, the business of transferring, developing, or managing land, property, or assets harbours myriad opportunities for environmental liabilities that can ultimately result in significant financial exposure. Regardless of whether the exposure is realised as an immediate and actual cost, such as clean up and associated business interruption, or represents a potential future liability, the value of the asset is at risk.
Owners of contaminated land, in particular, face financial exposure beyond the obvious and direct costs of investigation and remediation. Financial liabilities can come in the form of third-party claims and regulatory actions both before and after any remediation has taken place—as contamination that has previously migrated from the site may not yet have manifested as damage to human health, property, or the environment (including ground and surface waters). Where claims arise then in addition to the of remedying any physical damage and personal (human health) injury claims, there are often significant associated costs all, or any, of which can greatly exceed the cost of remedying the initial (physical) damage including:
Financial Risk Management Tools
Various tools, techniques, and products can be used either singly or as part of an integrated programme to manage, cap, control, and mitigate financial exposure to environmental risks. The tools listed here are discussed in the context of the financial risk management process:
The Financial Risk Management Process
Technical and financial risk modelling can form a solid foundation for subsequent design and implementation of financial risk management and risk transfer programmes, often building on, and from, an initial strategic analysis and review. Depending on the risk, an appropriate model is built to value in terms of probable outcomes for the financial exposure created by one or more different scenarios leading to a loss or costs greater than anticipated or planned. A common tool used to achieve this is stochastic modelling, which replaces deterministic inputs with probability distributions.
Typically, the focus would be on environmental exposure, including long-term variability and volatility of, for example, clean-up costs and other contingent environmental liabilities across a portfolio of land, property, and/or businesses. Applications include support for long-term pollution management programmes, regulatory and compliance management (current and new regulation), and financial planning.
A typical application for modelling would be an actuarial review and valuation of the financial exposure of an international chemical company to environmental liabilities. This could include:
· collation of environmental and relevant financial data;
· determining and evaluating the veracity of key model assumptions
· assessment of financial reserves or provisions, which may need to meet the accounting requirements, for example Financial Reporting Standards or International Accounting Standards, e.g. FRS12 or IAS37 in the UK and internationally. There is also increasing concern in relation to Corporate Governance that there is a consistent approach to financial disclosures against environmental liabilities;
· an assessment of long-term strategies and options to ensure sufficient reserves; and
· a preliminary review of Risk Transfer options, including an underwriting risk review to support applications for specialist environmental insurance.
Where appropriate, the modeling would support a review of long-term capital requirements to support environmental exposures in accordance with regulated financial standards (e.g. the Financial Standards Agency, FSA in the UK) and prudent self-insurance schemes.
Self Insurance - Risk Retention
A certain amount of any risk will usually be retained; even if the risk is insured (see Risk Transfer), there will be a deductible or self-insured retention that the insured has to pay before the insurance attaches. In some cases, and depending on the probability of loss, the company may decide to retain more or less of the risk. Where risks cannot be transferred through insurance, there may be no readily available alternative to self insuring. Internal risk funds and financial provisions against future losses are a couple of techniques that can be employed in these cases.
Risk is transferred at a cost (the premium) from the owner of the risk to a third party who is in a better position to assume the risk, such as an insurance company.
A “Captive” Insurance Company is an insurer formed to provide insurance to its parent organisation or to a specific generic group, which is normally tied by some common bond, either economic, trade or social. In most respects a Captive operates as a typical insurance company, although generally it only accepts risks from the parent organisation. Many organisations have set up Captives to insure a variety of risks, including environmental risks. Captives can use reinsurance to provide protection against very high (or catastrophic) losses.
Warranties and Indemnities are contractual means used to transfer risk between two or more parties to a contract, for example between a buyer and seller, often as part of the sale and purchase agreement. Contracts such as these create an insurable liability (see Environmental Insurance).
Alternative Risk Finance
Also known as Alternative Risk Transfer (ART), Alternative Risk Finance (ARF) is a ‘catch-all’ used to cover all non-traditional types of risk transfer.
In terms of contaminated land schemes, the new breed of Liability Buy-Out schemes blend finite risk and risk funding with cost-cap and long-term liability insurance to provide a comprehensive, insurance-backed approach to risk transfer for the client. Typically, the client is provided with an indemnity, and the indemnifier takes on, at a suitable premium, the liability for all or specific environmental issues, including the cost of remediation, usually for a specified period of time.
The difference is that the indemnifier in this case does not have an interest in the land or property beyond the environmental issues and is usually the environmental company or contractor doing the remediation works.
Other approaches include more straightforward finite risk programmes and blended risk funding and risk transfer schemes, also known as liability wraps. In these cases, and in simple terms, the known risks are risk funded, taking advantage of any ability to discount future costs and the unknown, fortuitous risks covered by a more traditional environmental risk transfer/insurance products.