Captives and Other Cost Cap Alternatives Lessons from Accomplished - - PowerPoint PPT Presentation

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Fixed-Price Cleanups: How To Enter Them In The Post-Cost Cap Insurance Era Using Captives and Other Cost Cap Alternatives

Lessons from Accomplished FPCs, When and Why to Use CCAs, and the Mechanics of Using a CCA Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific WEDNESDAY, FEBRUARY 24, 2016

Michael O. Hill, Esq., Senior Counsel, Primmer Piper Eggleston & Cramer, Washington, D.C.

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Fixed-Price Cleanups in a “Post Cost Cap” World: Insurance and Contractual Approaches

(February 24, 2016)

Michael O. Hill, Esq. Primmer Piper Eggleston & Cramer PC mhill@primmer.com Washington, D.C. 20006

Overview

 Description of Fixed Price Cleanups (“FPCs”)

• Why/When to Use: Pros and Cons of an FPC, from perspectives of Owners

(holding/selling/buying or otherwise potentially liable), Contractors and Regulators.

• Mechanics of FPCs (best practices)
• Examples of FPCs (5 contexts)

 Economics of FPCs:

• Overview of Contractor economics (and relevance to Owner economics)
• Environmental insurance products (pre-2011 and today)

 Cost Cap Alternatives

• Captive Insurance as an Alternative to Traditional Insurance
• Other forms of CCAs
• FPCs as a possible tool in bankruptcies
• Vehicles to consider using with CCAs

 Questions

6

Description of Fixed-Price Cleanups (“FPCs”)

7

Fixed-Price Cleanups: Overview

 Not right for all sites. Best for cleanups estimated to cost:

• $5M or more (but can “portfolio” sites to reach >$5M); and
• $30M or less (but can divide larger sites into smaller projects to reach <$30M).

 Contractors assume environmental regulatory liabilities,

typically up to 2x expected costs.

 Insurer and/or other risk transferee may cover overruns

• f expected regulatory costs (through “Cost Cap” or Cost Cap Alternative); and
• from unknowns, regulatory and non-regulatory (through PLL).

 Not Fail-Safe.

8

Expected Cleanup Costs ($10M) Owner Excess Exposures ($10M)

$10M $10M

Benefits from Owner Perspective

Contractor ($2M) Expected Cleanup Costs ($10M) Limits in policy, escrow or

• ther risk

transfer instrument ($6.8M) Contractor ($1.2M)

$10M $10M

Without an FPC With an FPC

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Commutation Account (estimated clean-up costs)

Insurance (typically to where costs = 2x)

(with Contractor co-pay of, e.g., 15%)

Indemnity from Contractor? Not since mid-2000’s

Deductible/SIR (from Contractor, e.g., 20% of x)

Expected Cleanup Costs (“x”)

(e.g., $10M) (might held in an escrow account; QSF-qualifying trust account; by Court; by Captive; even by Owner) [1998-2007, Finite Insur. Possible]

Layers of Protection

Traditional Indemnities (e.g., from Seller); Traditional Return to Seller & Buyer

10

Owner Perspective (Pros & Cons)

Pros:

• Cost certainty increased.
• Costs frequently lower than expected (and can “Beta-Test” before

committing).

• Cleanups usually expedited.
• Potential tax and accounting benefits.
• Greater long-term protections.
• Limited commitment required.

Cons:

• Must give up chance of savings from cleanup completed

below expected costs.

• Up front transactions costs (set-offs or other compromises

possible).

• May need to switch from incumbent or otherwise preferred

Contractor (but may persuade that Contractor to convert to FPC).

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DOD Dep’t of Defense Findings

Of 41 Fixed-Price Cleanups:

• Lower Costs: Average costs were 21% below Independent

Government Estimates; 34% below estimated Costs To Complete.

• Faster Cleanups: Contractors in general are meeting or beating
• schedules. There is no indication that overall schedule completion will

be compromised.

• Better Quality: “At all installations, the quality of work has been

reported from good to going beyond requirements.”

*Source: U.S. Army Environmental Command, Tracking Performance on the Army’s Performance-Based Contracts, at 4, 24, 31

(May 16, 2006) (included in webinar handouts). While broader data is difficult to obtain and distill, R. Durant, The Greening of the U.S. Military, 1, 4 (Georgetown Univ. Press, 2007), states that “the DOD inspector general has found that average cleanup costs at closing bases are typically 60 percent higher than estimated originally.” See also EPA IG, EPA Should Increase Fixed-Price

Contracting for Remedial Actions, Rept. No. 13-P-0208, at 14 (March 28, 2013). 12

v

13

Pros:

 Avoid barriers to cleanup commencement (litigation, etc.).  Generally expedite cleanups (without sacrificing quality … all

remains subject to regulator approval)

 Not losing a PRP (only 2-3 non-de minimis exceptions).  Greater certainty of completed cleanup:

• Greater certainty of funding
• Greater certainty of Contractors keeping costs at or below expected costs.

Cons:

• ?

*Article: M. Hill, A Tale of Two Sites: How Insured Fixed-Price Cleanups Expedite Protections, Reduce Costs, and Help the EPA, the SEC and the Public, published by Chem. Waste Litig. Rptr., then reprinted with permission by National Ass’n. of Attorneys General, and ABA (2003) (included in webinar handouts).

Regulator Perspective

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Multi-Party Superfund Site

 Cleaned up at 40% below expected costs ($15M v. $25M).  Completed in 19 months (v. 8-year national average).  Began in 2000; by 2002, town soccer fields and open space.

References:

“[TRC’s] Maine Experiment May Point The Way To Ending Tangle Of Litigation Around Superfund Law” (WSJ, 4/29/98); “[TRC’s] arrangement is ‘revolutionary’ . . . A ‘new model’ for reducing cleanup and litigation costs” (BNA Daily Envir. Rptr., 6/8/00, quoting Maine DEP official). 15

Redevelopment of Brownfield

• Two conventional estimates, with no

guarantee: $15-$20M.

• Insured FPC done for $10.1M.
• City contributed $5M via Brownfield

grants and Tax Incremental Financing, and received title to property from Owner essentially for free.

• Owner exited for lower cost ($5.1M) and

greater goodwill.

*Reference: C. Olson, R. Bursek, and M. Jones, Urban Renaissance: From Brass Manufacturing To Uptown Brass Center, Air & Waste Mgt. Ass’n. (Dec. 2005).

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Sale/Purchase of Subsidiary

 Cleanup of 23 sites done for <$8M (<$300K each).  >20% below prior estimates.  Construction completed within 3 years (80% within 18 months).  Sold sites at full “market value” (that is, without premium due to the uncertainty of environmental costs).

17

Sale/Purchase of Operating Facilities

 Cleanup of pre-existing pollutants at an operating refinery.  Guaranteed and insured for 13% below anticipated costs.

18

FOSET Transfers (“Finding Of Suitability for Early Transfer”)

CERCLA § 120(h)(3)(C) (federal facilities cannot be transferred pre-NFA absent prior determination by Governor (and, if on NPL, also by EPA Administrator) that the cleanup will not be substantially delayed).



Parcel C6 ($11M; 62 acres). First privatized cleanup via FOSET (2007). Also the first completed (2009).



FOSET #1 ($14M; 545 acres) (2010).



FOSET #2 ($16M; 528 acres). CCA used. EPA Administrator and CA Governor approved (2013).



FOSET #3 (>20M; 207 acres). CCA used. EPA Administrator and CA Governor approved (2015).

Reference: M. Hill, Insured Fixed-Price Cleanups: Still Possible Even After Commercial Insurers’ 2011 Exit from the Cost Cap Market, 70 CWLR 955 (Oct. 2015) (included in webinar handouts).

19

Economics of Fixed-Price Cleanups

20

Contractor’s Cost Risk Profile

Deductible ($2M) Expected Cleanup Costs ($10M) Limits in policy, escrow or

• ther risk

transfer instrument ($6.8M) Co-Pay ($1.2M)

Contractor’s Incentives/Risk Profile

(assumes 13% margins … i.e., cost to do $1M in work is $870K)

Cleanup cost range $6 to $8M $8M to $10M $10 to $12M $12 to $20M Rough odds of ending in this range 20% 50% 20% < 10% Margins if reach NFA within range $0.78M to $1.04M $1.04M to $1.3M “Windfall” if reach NFA within range $4M to $2M $2M to $0M Net Losses incurred during range $0 to -$1.74M $0 M to -$.16M Net overall Profit/Loss if reach NFA during range $4.78M to $3.04M $3.04M to $1.3M $1.3M to -$.44M (with $11.49M the point at which net profits disappear)

• $.44M to -$.60M

21

22



Financial Incentives Help Ensure (And, If Necessary, Later Defend) Accuracy Of Estimates:

• Contractors incentivized not to over-estimate because won’t be awarded the contract (assuming

competitive bidding).

• Contractors incentivized not to under-estimate because won’t have sufficient funds to accomplish

the cleanup.

• Insurers’ incentives not dissimilar.
• Ongoing Financial Incentives Help Ensure That The Initial Estimate Will

Not Be Exceeded And Cleanup Will Not Be Delayed

• “Carrot” to complete under budget
• “Stick” to avoid completing over budget
• Carrot and stick also encourage prompt cleanup (by accelerating income and avoiding risk to

Contractor)

• Important to Sellers, Buyers, PRPs, Investors, Debtors, Creditors and Courts

23

Economics (Incentives) Help Quantify, Reduce and Manage Costs

Environmental Insurance Products

 Pollution Legal Liability (PLL):

• Unknown contamination discovered outside of course of executing RAP.
• 3rd-party (non-Gov’t.) claims (e.g., bodily injury, property cleanup, reduced property

value, medical monitoring).

• Other (new releases; natural resource damages; business interruption; disposal sites and

transportation thereto; re-openers).

• Remains an important component of many FPCs … possibly most (but

generally much less expensive because risks are much lower).

• Cost Caps (now, CCAs):
• Overruns in addressing knowns (e.g., via Remedial Action Plan).
• Unknowns discovered in course of executing RAP (i.e., addressing knowns).

 Post-10-Year Products (for operation, maintenance, land use controls, etc.):

• Formerly possible via “finite” policies (1998-2007) (Iron Mountain; PBWO; Fort Ord, 2007).
• Past-attempted solutions: E.g., Guardian Trust; R-PAT.

Possible with CCAs (e.g., McClellan CCAs extend until NFAs for entire site).

24

Environmental Insurance: A Surplus Lines Product

• Unlike 99% of policies – where insureds negotiate only the

deductible, premium, limits and a few other terms – environmental insurance is a “surplus lines” product. Sold by companies that are “not admitted” to sell.

• Surplus lines policies are:
• individually negotiated contracts, with no government review; and
• not backed by State guaranty funds (which protect against Insurer insolvencies).
• Counsel must read (and negotiate) the policy no less (and possibly

more) than other contracts.

25

Cost Cap Alternatives

26

Broad Description of Cost Cap Alternative (“CCA”) Like Cost Cap insurance, except:

 Owner, Captive, or other (e.g., seller and buyer

collectively) assumes 68% of cost overrun risk (Contractor

continues to self-insure 32%, same as with traditional Cost Cap).

 Access to “limits” is governed by traditional contract

and/or by captive insurance policy.

 Claims review is by independent third-party or by

Captive.

• Wait times and transactions costs likely lower.
• If third-party, incentives likely better aligned.

27

Purely Contractual CCAs

 Explicitly a non-insurance contract between different parties (e.g., Owner,

Buyer, Contractor).

 Fund Processing Agreement (“FPA”) replaces policy language.  Cost Overage Fund (“COF”) replaces insurance reserves.  Escrow agent and/or third-party handles claims.

28

Post-2011 Commercial Markets

• One or two non-captive Insurers stepping back into what some have

described as the Cost Cap market.

• As currently written, policies not as expansive as Cost Caps (e.g.,

template excludes increases in pollution amounts or concentrations).

29

Captives as a CCA

• Captive Insurer replaces Traditional Insurer.
• Customized policy, underwriting, claims and other processes.
• Other differences described below.

30

Captives Emergence and Growth

• Insuring risks that were otherwise uninsurable (or only at unreasonably high cost).
• Modern-day concept emerged in the late 1950’s. Mostly off-shore.
• By early ‘80’s, still <500 worldwide (nearly all owned by large global companies).
• VT passed 1st statute, in 1981. Today, over 30 states have statutes (most

since 2000). In 2002, IRS issued 2 “safe harbor” rulings.

• Post-2007, increased use as commercial coverage has “hardened.”
• By 2014, >7,000 captives worldwide (over 90% of Fortune 1,000 companies

have captives, as do many smaller companies, non-profits, and associations).

• Today >50% of all Property & Casualty premium is written through

captives.

31

• Misc. Req’ts. and Characteristics of Captives (p. 1 of 2)
• Must be a valid insurance company, formed for valid business purpose

E.g., obtain otherwise unavailable coverage, reduced premiums, better (or less expensive) claims process, gain access to reinsurance market. Not just for tax purposes.

• Policy terms can be expanded/customized (and language simplified):
• E.g., longer terms; greater limits; exclusions tailored … reduced or increased.
• Simpler and customized language may help avoid disputes.
• Direct access to re-insurance market.
• Premiums lower.
• Investment returns inure to benefit of Owner (or agreed alternative)
• E.g., Contractor; Developer).
• Investments are inherently long-term and potentially significant.
• If no claims, premiums returned.

32

• Misc. Req’ts. and Characteristics of Captives (p. 2 of 2)
• Lower premium tax
• E.g., in VT, .38% for captive premium v. 3.0% on commercial surplus lines policies.
• Surplus lines tax and fees in other states are typically 3 - 5%.
• Lower underwriting and claims costs.
• Claim reviewed by captive personnel or mutually-agreed, 3rd party.
• Premiums possibly deductible.
• To achieve tax advantages, must meet, inter alia, risk shifting and

distribution requirements of insurance. Extensive body of law (statutory, regulatory, Revenue Rulings, case law).

Reference: N. Jacobson & J. Johnson, Fundamentals of Captive Taxation (Feb. 24, 2016) (included in webinar handouts).

33

CCA Mixtures

• Captive supported with reinsurance: Captive pays portion of premium

to Reinsurer to cover portion of the risks.

• Captive fronted with traditional insurance: Provides greater familiarity

to regulators and other stakeholders. Provides second contractual commitment.

• Mixtures: Pure contracts; traditional; captive (with or w/o reinsurance
• r fronting)

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Some FPC-Specific Advantages of CCAs

(Captive and Non-Insurance Contractual)

• Greater ability to customize language and terms.
• Avoid uncertainty and delay re. terms or even availability. (Bidding

FPC Contractors know up front what the “hedge” will be; Owners and Contractors avoid delay from “two-step” process).

• Avoid expiration of quotes.
• Avoid “down-selection” of Contractors by Insurers, so best Contractor

wins.

• Greater PLL competition (>10 Insurers sell PLL; only 4 also sold Cost

Cap).

• Given Contractor cost curves, may be possible for Owners, etc. to

negotiate unilateral right to terminate if initial estimates are exceeded. Note: not possible in many contexts (e.g., Superfund or other enforcement; FOSET transfers; Bankruptcy; insurance regulators).

35

FPCs & Bankruptcies

• Need full payment and certainty
• Cleanup costs of Debtor’s facilities are generally “administrative expenses”; must cover fully.
• Not dissimilar from FOSETs in terms of need for “belt and suspenders.”
• More efficient and more accurate quantification of costs:
• “[N]o dispute that accounting reserves for environmental costs do not purport to be useful in a UFTA solvency

analysis.” In re Tronox Inc., 503 B.R. 239, 310 (Bankr. S.D.N.Y. 2013).

• 40,000 hours spent just by Plaintiffs’ XP and his firm. Reports over 2,500 pages, covered just 372 of the over

2,700 sites. 34-day trial, 6 years to resolution.

• Bankr. Court’s range: damages between $5.15B and $14.17B. Settlement: $5.15B.
• Arm’s length
• District Court’s Nov. 2014 approval of settlement. No. 14·cv·5495 (S.D.N.Y. Nov. 10, 2014) (key factor: “the

extent to which the settlement is the product of arm’s length bargaining”).

• Lower costs, and better long-term protections.
• Market incentives translate to lower cost estimates; long-term incentives help ensure the estimates are not

exceeded.

• Reference: A. Davis & C. Retallick, Managing Environmental Liabilities In Bankruptcy, Aspatore Publishing (2010).

36

 Qualified Settlement Fund?

• GM Decree ¶ 83 (“Trustee must ‘seek to have the Trust treated as a qualified settlement fund’ as

… defined in Treasury Regulation section 1.468B-1”)

• IRC § 468B (established pursuant to order of U.S. Gov’t. and subject to its continuing

jurisdiction; established to resolve contested claim(s) under CERCLA; a trust under state law or its assets otherwise segregated)

 Investments; taxes; accounting; employees (contracts, etc.); separation

from Debtor/NewCo); budgets (environmental and

• ther/administrative); insurance and other risk transfer (non-

environmental) and environmental (indiv. reserve accts.? cushion accts.? CCAs? CPLs [contractor pollution liability]? OCIPs [owner controlled insurance

policies]?)

 Transparency (cleanup status; $ spent/remaining; properties sold; jobs

created; salaries, fees, and other compensation).

37

• Misc. Issues in Creation/Operation of Environmental Trust

Questions

38