mandating environmental liability insurance
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RICHARDSON.DOC 09/04/02 1:50 PM
MANDATING ENVIRONMENTALLIABILITY INSURANCE
BENJAMIN J. RICHARDSON*
For a number of years scholars and policy makers have discussedthe merits and dangers of imposing liability for environmental dam-age on banks lending to hazardous industries.1 Moves to make banksvicariously liable for the environmental behavior of their borrowersbegan in the United States in the search for deep pockets to fund theenormous costs associated with environmental cleanups demanded bygovernment authorities. While lender liability may encourage moreenvironmentally sensitive lending, it has been shown that variouseconomic inefficiencies may occur when banks are exposed to expan-sive liabilities in relation to the developments they fund.2 Amongother institutions in the financial services sector, harnessing insurancemarkets may provide a better means for promoting sustainable de-velopment and funding environmental damage costs.
In a range of jurisdictions insurers have become increasinglyconcerned about pollution liability risks.3 Insurance markets in theorycan enable effective allocation of environmental damage costs andprovide incentives to deter environmentally irresponsible behavior.Some commentators also believe that the contribution of insurance tothese policy goals can be enhanced when environmental liability in-
* Faculty of Law, University of Manchester1. See, e.g., ENVIRONMENTAL LIABILITY FOR BANKS (Joseph J. Norton et al., eds., 1995);
Richard Hooley, Lender Liability for Environmental Damage, 60 CAMBRIDGE L.J. 405 (2001);David Sarokin & Jay Schulkin, Environmental Concerns and the Business of Banking, J. COM.BANK LENDINGeb. 1991, at 6.
2. See, e.g., James H. Boyd & Daniel E. Ingberman, The Search for Deep Pockets: Is Ex-tended Liability Expensive Liability?, 13 J.L. ECON. & ORG. 232, 255-56 (1997).
3. See POLLUTION LAW AND INSURANCE A COMPARISON OF THE LEGAL REGIMES OFEUROPEAN STATES AND THE USA (Anthony Fitzsimmons ed., 1997) (outlining the legal posi-tions of numerous countries in regard to pollution liability); David Cohen, Historic Cover forEnvironmental Liability in the United Kingdom, INTL INS. L. REV., Feb. 1996, at 46.
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surance is compelled by the state.4 Indeed, in practice, to strengthentheir protection against liability claims, banks have increasingly de-manded liability insurance as a condition of financing, creating in ef-fect a mandatory insurance situation for borrowers engaged in envi-ronmentally problematic activities.5 Banks are also increasinglydiversifying their business into insurance services, further stimulatingthis trend.6
This Article evaluates the role of insurance markets in managingenvironmental risks, and focuses on the question of whether envi-ronmental liability insurance should be compulsory. A wide range ofenvironmental problems are addressed by insurance markets, includ-ing industrial accidents, contaminated land problems, climate change-induced damage and other natural disasters. Focusing on industrialpollution liabilities, the Article aims to show how insurance can facili-tate environmental care and compensation, and some advantages thatmay accrue from mandating insurance in relation to certain environ-mental risks.
II. MANAGING ENVIRONMENTAL RISK THROUGH INSURANCE
A. The Economic and Environmental Roles of Insurance
Insurance functions to spread the economic consequences of in-dividual events across many parties, and, thereby, reduce the poten-tially catastrophic effects of unforeseen events on individuals by hav-ing those consequences absorbed by a third-party (the insurer).Insurance is in principle utility maximizing, as it enables risk-averseparties to transfer their risks for a relatively small fee, and by so pro-tecting parties from exposure to costly liability allows them to pursuesocially beneficial ventures.7 Where losses occur, society is said to
4. See, e.g., Peter Jost, Limited Liability and the Requirement to Purchase Insurance, 16INTL REV. L. & ECON. 259, 270 (1996); Eberhard Feess & Ulrich Hege, Environmental Harmand Financial Responsibility, 25 GENEVA PAPERS ON RISK & INSURANCE ISSUES & PRAC. 220(2000).
5. See Eugene R. Anderson & Jordan Stanzler, Insurance Coverage for EnvironmentalCleanup, 72 J. COM. BANK LENDING, at 17 (June 1990); Eugene R. Anderson & Jordan Stan-zler, Maybe Youre Not Really Naked: Existing Insurance Policies May Protect You Against En-vironmental Liability, A.B.A. BANKING J., Aug. 1991, at 24.
6. See Gunter Dufey, The Changing Role of Financial Intermediation in Europe, INTL J.BUS., Spring 1998, at 52.
7. Economic efficiency is enhanced if risks are allocated to those parties who are best ableto bear them. Louis Kaplow & Steven Shavell, Fairness Versus Welfare, 114 HARV. L. REV. 961,981 (2001) (arguing well being is generally increased by the availability of insurance).
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benefit through the indemnification for unexpected loss and the res-toration of resources for productive purposes.8 By determining ex antethe party that will intervene if an accident occurs, insurance alsopromises reduced transaction costs for all involved.9 Besides theseeconomic functions, insurance may have environmental policy bene-fits.10 Insurance can be construed as an instrument for reflexive styleregulation, providing a framework for communicating to economicactors the nature and cost of environmental risks, and offering incen-tives for firms to behave more carefully.11 Through the setting of pre-miums and coverage conditions, insurance markets may induce im-proved safety measures and offer effective protection against thefinancial consequences of such accidents, which is particularly impor-tant where the responsible party is impecunious.12
Generically, there are two basic types of insurance. One typeserves to compensate damage caused by the insured to other peopleand property. Known as third-party liability insurance, it can alsoserve to protect the injurer from excessive claims that could finan-cially cripple their business. Under liability insurance the insurer be-comes responsible for not only guaranteeing compensation for dam-age, but also ensuring that sufficient incentives remain for parties totake due care given that insureds are not subject to the full extent oflegal liabilities. Alternatively, there exists first-party or personal in-surance, which aims to compensate for example the costs incurred bythe insured in remedying (historic or future) pollution on their ownsite, including externally generated harms.
Typically, an insurance arrangement arises when a firm proposestheir risk to an insurer, who evaluates the risk and stipulates condi-
8. See KENNETH S. ABRAHAM, ENVIRONMENTAL LIABILITY INSURANCE LAW 15-17(1991) (arguing that economic incentives drive the use of insurance by business).
9. See Goran Skogh, Mandatory Insurance: Transaction Costs Analysis of Insurance, in 2ENCYCLOPEDIA OF LAW AND ECONOMICS, 521, 529 (Boudewijn Bouckaert & Gerrit De Geesteds., 2000).
10. See Anna Amarandos & Diana Strauss, Environmental Insurance as a Risk Manage-ment Tool, 15 NAT. RESOURCES & ENVT. 88 (2000); Stephan Schmidheiny, Eco-efficiency andSustainable Development, RISK MGMT. July 1996, at 51(focusing on the relationship betweeninsurance markets and sustainable development).
11. On reflexive law techniques, see STATE, LAW, AND ECONOMY AS AUTOPOIETICSYSTEMS: REGULATION AND AUTONOMY IN A NEW PERSPECTIVE (Gunther Teubner & Al-berto Febbrajo eds., 1992); Eric W. Orts, Reflexive Environmental Law, 89 NW. U. L. REV.1227, 1268 (1995) (stating that the reflexive aim is not to constrain or dictate behavior, butrather to provide mechanisms or structures to increase the amount of self-reflection and socialcommunication concerning serious environmental issues).
12. See James W. Broderick et al., Environmental Risk Management and the Role of Envi-ronmental Insurance, ENVTL. QUALITY MGMT., Autumn 2000, at 4.
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tions to reduce the likelihood and scope of potential loss.13 Addition-ally, the insurers policy will specify the price (premium), and any ex-clusions and limitations on the amount to be paid in a claim (knownas maximum possible loss). Not all risks can be insured. Ideally, thefeatures of an insurable situation are: (i) the insurance contract iseconomically feasible for the parties, in terms of the cost of insurancerelative to the potential loss; (ii) the prospective insurer is able to ac-curately calculate the probability of the loss and the possible magni-tude of the damage should the accident occur; (iii) there is a suffi-ciently large number of insureds sharing a similar risk exposureprofile, so that the insurer can use past experience to predict accu-rately the risk faced by any individual; (iv) the insurer is able to de-termine the circumstances of the loss so as to decide if the loss waswithin the terms of the insurance contract; and (v) only a small pro-portion of the group should be exposed to the risk of a loss at any oneoccasion so that the insurer is not prone to numerous hefty claims si-multaneously.14
Environmental damage has emerged as an important risk issue toinsurance markets.15 The escalation of claims associated with naturaldisasters and contaminated site repairs has driven insurers to scruti-nize their policyholders according to standards often well beyondgovernment regulatory requirements. The environmental perform-ance of prospective policyholders ca