Pollution Liability Insurance Ab 7.05.10

8/8/2019 Pollution Liability Insurance Ab 7.05.10

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Pollution Liability Insurance and Catastrophic Environmental RiskAuthor(s): Martin T. KatzmanSource: The Journal of Risk and Insurance, Vol. 55, No. 1 (Mar., 1988), pp. 75-100Published by: American Risk and Insurance AssociationStable URL: http://www.jstor.org/stable/253282

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Pollution Liability Insuranceand Catastrophic Environmental RiskMartin T. Katzman*

AbstractPublic concern with catastrophic consequences of chemical releases into the

environment resulted in the passage of RCRA and Superfund legislation, whichestablish financial responsibility requirements. These acts encourage the creation of amarket in pollution liability insurance for purposes of risk spreading, safety regulation,and victim compensation. This article analyzes policy alternatives for regulatingcatastrophic risks, the insurability of pollution liabilities, factors contributing to therise and fall of the market, and conditions under which markets could be resuscitated.

IntroductionThreats to human health from chemical releases into the environment arereported with increasing frequency. While biomedical evidence casts somedoubt on the matter [6; 57], the public perceives chemicals in the environmentas a major cause of cancer and heart disease [80]. Regardless of the locus ofexposure, toxic chemicals may engender a low-probability of long-term injury

to large numbers of victims. In this respect chemicals in the environment areindistinguishable from those in the workplace or in consumer products (suchas drugs or food additives), although they come under different regulatoryand legal frameworks.In response to an apparent mass disaster, Love Canal, Congress passed twoacts which introduced insurance as an important instrument of environmental

*Professor of Economics and Environmental Sciences, University of Texas at Dallas andSenior Economist in the Energy and Environmental Systems Division, Argonne NationalLaboratory. He was awarded a doctorate in economics from Yale in 1966. This project wassupported with grants from the Huebner Foundation for Insurance Education, the CPCU-HarryJ. Loman Foundation, and Resources for the Future. The author benefited considerably fromdiscussions with J. David Cummins and Robert C. Witt, Jr. and from comments on earlier draftsby Anthony M. Champagne, Howard Kunreuther, Murray Leaf, Michael Murray, Joe G. Moore,Jr., Emilio Venezian, and two anonymous referees. Prof. Katzman held a GuggenheimFellowship in 1980 and won the 1985 research award from the Risk and Insurance ManagementSociety. He served on the advisory board of the GAO hazardous waste insurabilitystudy.


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76 The Journal of Risk and Insurancepolicy. These acts rely more on market incentives and less on traditionalproscriptive or prescriptive strictures than any other regulatory statutes.Under the Resource Conservation and Recovery Act (RCRA), owners andoperators of facilities that treat, store, and dispose of hazardous chemicalsmust demonstrate financial responsibility for third-party damages. Forsudden accidents, the levels of responsibility are $1 million per occurrence and$2 million annual aggregate, exclusive of defense costs. For nonsuddenoccurrences, the corresponding levels are $3 million and $6 million. TheComprehensive Environmental Response, Compensation, and Liability Act(or "Superfund")extends these requirements to transporters (Sec. 108(a)) andgenerators of hazardous chemicals (Sec. 108(b)). Several states have raised therequired financial responsibility beyond the federal level. Unless a firm canmeet a test for self-insurability, financial responsibility must be met byinsurance.'

Superfund anticipated a major role for the insurance industry in theregulation of chemical hazards. Acknowledging the limited ability ofregulators to assess the risks from complex technologies, this act called uponinsurers to advise the President on the appropriate limits of financialresponsibility for generating facilities. These limits were to be established inthe 1985-1990 period.When RCRA was passed in 1976, several London insurers had beendeveloping liability policies for nonsudden pollution accidents. By the timeSuperfund was passed in 1980, a few American insurers began offering suchpolicies. Despite the misgivings of many underwriters [77], at least a dozenprimary insurers were offering pollution liability policies by 1983 [49]. Inaddition, more than 40 insurers and reinsurershad established a pool [43, pp.83-85]. It appeared that the Congressional initiative toward market-basedenvironmental risk management might succeed.By the end of 1984, the pollution-insurance initiative lay in shambles.London reinsurers withdrew from the market, carrying along many existingand prospective insurers. The number of pollution insurers operatingworldwide was about eight, most of whom insured "light risks" like gasstations and dry cleaning establishments. Only two insured the "heavy" risks,from which catastrophes are most likely to result. By mid-1985, only oneinsurer offered coverage for nonsudden occurrences [19]. Many waste-siteoperators were unable to meet the financial tests, so Congress twice extendedthe original deadline (January 1, 1985) for demonstrating responsibility [9;23]. By the end of 1986, two-thirds of waste facilities had failed to obtaininsurance [30], and no progress has been made in establishing financialresponsibility requirements for generators. In response, Congress ordered theGeneral Accounting Office to undertake a major study of insurability in the'A facility can self-insure against third-party liability if it passes several tests of financialstrength, such as having tangible net worth greater than $10 million and a current ratio exceeding1.5 [76].


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Pollution Liability Insurance 77Superfund Amendments and Reauthorization Act (SARA, Sec. 208), enactedin December 1986.What has gone wrong? To what extent does the collapse of the pollutionliability market reflect a general disequilibrium in the reinsurance marketrather than a specific problem with this line? These questions raise thebroader issues of: 1) public policy alternatives in the regulation ofcatastrophic risks, 2) the insurability of pollution liability, 3) factors reducingthe viability of a pollution liability market, and 4) strategies for resuscitatinga competitive market. This analysis suggests that, after a difficult transitionperiod, a workable chemical risk management system is likely to emerge fromcomplementary developments in liability insurance, statutes, and tort law.

Public Risk Management PolicyAdvanced industrial economies both eliminate and create risks. The vaccinethat saves millions from infectious disease may cause brain damage to anunlucky few. The insecticide that saves masses from starvation may explodeduring its production, as in Bhopal. Commercial enterprises internalize manyof the benefits of these risk-reducing activities through higher profits. Thecosts of the risk-creating activities are not invariably internalized.Where risks are knowingly taken by a consumer or by a worker, the costs of

accidents are at least partially internalized. For example, if workers demandhigher wages for more dangerous jobs, employers have an incentive toundertake marginal safety expenditures that cost less than the marginalcompensating wage differential [78]. Similarly, consumers may be willing topay more for a safer tool, and create greater profit for the manufacturer.Where such voluntary exchanges prevail, risk management decisions are likelyto approach a mutually acceptable result.Where accidents affect third-parties, by definition, the harm caused tovictims is not internalized by the injurer. Three major regimes can internalizethe costs of accidents to third parties: tort law, statutory regulation, and usercharges [46; 64]. Activated subsequent to an accident, the tort processdetermines which party, if any, is at fault or liable for the ensuing costs.Statutory regulation establishes and enforces constraints upon behavior priorto the occurrence of an accident. Sometimes these constraints mandate orprohibit certain inputs, such as specifying the design of hazardous waste sitesor banning the production of an insecticide. Sometimes these constraintsregulate outputs, such as discharges of toxicants into waterways. Statutorysanctions include civil and criminal penalties, such as fines, injunctions, andimprisonment. User fees are imposed on behavior likely to result in externaldiseconomies, whether or not harm results. Taking the form of effluent feesor insurance payments, user charges are imposed as the risk-creatingbehavioroccurs, without consideration of fault.Public policy towards accidental external diseconomies like pollution-engendered injuries have two basic objectives: efficient deterrence and justcompensation or equity [11; 12]. Using the status quo as a baseline, theefficiency criterion weighs the expected marginal cost of pollution against the


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78 The Journal of Risk and Insurancemarginal cost of pollution control. Where these marginals are equal, the costof pollution-engendered accidents plus the cost of accident prevention isminimized. The equity criterion is expressed as "the polluter pays." While theefficiency and equity objectives are analytically distinct, the public finds leastacceptable those technologies where the injuring party does not compensatethe victims of its actions [67].Alternative regimes of controlling externalities differ in their efficiency,equity effects, and transactions costs [11; 12]. These latter include the costs ofmonitoring behavior, collecting and analyzing information, enforcingcontracts, and imposing sanctions. Under any regime, these costs are far fromtrivial.Under tort regimes, whether the cost of accidents is borne by the victim orthe injurer depends upon liability rules.2 Of the several available common lawtheories, negligence and strict liability best internalize risks from chemicalinjuries. Regardless of the theory employed, the plaintiff must provecausation.The burden of proof is not an insurmountable barrier to recovery fordamages from commonplace mechanical hazards. If a construction worker isstruck by a falling brick or a pedestrian struck by a car, the injury isimmediately apparent. When chemicals cause harm through their mechanicalor acute biological characteristics, such as the explosion of a natural gas plantin Mexico City, they can be treated in the same legal and insurance frameworkas mechanical accidents. The defendant and plaintiffs can be easily identified;the causal links between defendant's behavior, the accident, and the damagesare clear; and the injuries are immediately manifest. Usually, courts candetermine the cause of the accident and apportion blame in a reasonablemanner.Unusual Characteristics of Chemical Perils

Chemical injuries may possess several unusual characteristics thatundermine the applicability of conventional liability rules and insurabilityprinciples [8; 46; 55]. First, many toxic chemicals persist in the environment.An accidentally-releasedchemical may gradually seep into the groundwater ormay become concentrated as it is assimilated in the food chain. As a result,the time of a spill or release may precede the time of human exposure by manyyears.Second, for some toxic chemicals, particularly carcinogens, the time ofhuman exposure may precede the manifestation of injury by several decades.Chemical exposures to one generation may result in harm to their offspring.3

2Under the assumptions of the Coase theorem, liability rules are irrelevant in determiningoptimal risk management. Two critical assumptions are zero transactions costs and thereplaceability of losses by financial expenditure [11; 12; 16]. These conditions hardly hold forpollution damages.3Two mechanisms of intergenerational chemical injury exist. Chemicals may mutate male orfemale zygotes prior to conception, as has been alleged by Vietnam Veterans exposed to Agent


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Pollution Liability Insurance 79Under traditional tort law, a statute of limitations prevents the filing of a suitmore than three to five years after an accident. Because of the time lagsbetween chemical release and human response, conventional statutes oflimitations prove an insuperable barrier to recovery.Third, a given chemical may affect humans through multiple pathways.Furthermore, a given biological response, such as lung cancer, may resultfrom alternative sources, such as occupational exposure to asbestos orsmoking. The multiplicity of potential pathways causes two problems inestablishing liability: identification of the defendant and proof of causation.Under traditional tort law, the plaintiff must identify one or more specificdefendants. The source of exposure determines whether the victim can seek aremedy through the workers'compensation system, a product liability suit, orthrough appeal to environmental protection statutes.4 Even if the locale ofexposure were identified, it might be virtually impossible to identify thespecific defendant whose molecule caused the plaintiff's exposure. This isclearly the case with exposure to hazardous waste sites, where manycompanies discard identical chemicals.Proof of causation depends upon presenting sophisticated biomedicalevidence, most of which is indirect or analogous in nature. Epidemiologistshave difficulty in sorting out health effects of lifestyle (especially diet andintake of stimulants), occupational, and environmental exposures tochemicals. Toxicologists are uncertain about long-term human responses tolow, intermittent doses of chemicals, especially when they act in concert.The latency period between exposure and manifestation of illnessobfuscates the search for causality. The latency period increases opportunitiesfor further confounding causes to intrude. Furthermore, the quantity ofevidence (including eyewitnesses) decays over time. Not surprisingly, experttestimony about causality is rarely conclusive.

Advances in biomedical measurement may exacerbate rather than abate thelegal problem. As lower and lower concentrations of chemicals in theenvironment become measurable, the number of chemical hazards for whichhuman exposure can be measured, and hence the number of alternativeexplanations of an injury, increases. As techniques for diagnosing such vaguesymptoms as malaise improve, the potential number of measurable adversehealth effects increases as well [41].

Orange. Chemicals may also cause birth defects by upsetting fetal development, as was the case ofpregnant mothers who ingested thalidomide.4Federal environmental statutes do not provide for victim compensation for personal injury orprivate property damage. The statutes, however, allow private individuals to initiate "citizen suits"against polluters that violate these statutes. The remedy can be an injunction or a payment. Anincreasing number state of environmental statutes extend the rights of individuals to recover forpersonal damages. If the defendant violates a statute, it is negligent per se in a tort action [43, pp.42-43].


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80 The Journal of Risk and InsuranceChemical Perils and the New Toxic Torts

The barriers of traditional tort law virtually prohibited the recovery ofdamages from long-term chemical injuries. In the past decade, the courts haveoutflanked these barriers through changes in environmental law, based uponchanges in products liability law. This revolution in toxic torts has proceededat an uneven pace from state to state, sometimes at the initiative of the courts,sometimes at the initiative of legislatures [74].Forty-five states have overcome the barriers posed by statutes of limitationsby adopting a discovery rule. Under such a statute, the time of accrual beginsnot with the chemical release or the victim's exposure but with themanifestation of injury. A few state legislatures, however, have reaffirmed thetraditional statute of limitations, which is triggered at the time of the allegedexposure. In such states, recovery for latent environmental damages isvirtually impossible, with the exception of Agent Orange and asbestosexposures [42; 74].Identifying a defendant liable for a specific chemical exposure in theenvironment is at least as difficult as identifying which company manufac-tured the pharmaceutical that caused a birth defect, or which asbestosmanufacturer supplied a fiberboard installer with the hazardous raw material.Landmark cases in the areas of pharmaceuticals and asbestos have resulted inthe adoption of rules of joint and several liability in most states.5 While thereare several alternative rules, in essence they hold a defendant that wasremotely connected with a hazardous chemical to be held liable for a share ofthe damages. If other parties are unidentifiable, or bankrupt, then thisdefendant may be held liable for all the damages. This rule of apportioningblame among defendants increases the probability that someone pays forenvironmental risks imposed upon third parties. While this rule serves thevictims well, it can be counterproductive by exacerbating moral hazard. Bymaking a firm "its brother's keeper," the costs of poor waste handlingpractices are spread to other firms and incentives for deterrence areattenuated. Clearly by viewing joint and several liability as a search for thedeepest pocket, the objectives of optimal deterrence and fair compensationconflict.Traditionally, plaintiffs have had to prove that defendants in tort actionswere negligent. By this is meant that the defendant failed to exercise due care,as judged by reasonable societal standards. Where the plaintiff is unknowingor unable to protect himself from a hazard and the defendant is better able tocontrol the risk, the courts easily accepted the theory of strict liability. On the

5Borel v. Fibreboard Paper Products Corp., 493 F.2d 1076 (5th Cir. 1974) has been called a"bill of rights" of asbestos workers. It permitted workers to sue suppliers to their employers,without identifying one specific defendant whose asbestos caused disease. In Sindell v. AbbottLaboratories, 26 Cal.3d 588; Cal. 607 P.2d 931; 163 Cal.Rptr. 132 (1980) plaintiff ingesteddiethylstilbestrol (DES), a drug that was intended to suppress miscarriages. A large number ofdaughters of these mothers developed cervical cancer during puberty. The courts apportioneddamages according to the pharmaceutical companies' market share of DES.


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PollutionLiabilityInsurance 81additional basis that enterprises may be better able to spread the costs ofinjuries than plaintiffs, the theory has become widely adopted in the areas ofworkers' compensation, product liability, and hazardous chemicals [31; 46;59; 74].While the plaintiff no longer has to identify specific acts of negligence,recovery still depends upon a formidable proof of scientific causation. Courtshave customarily phrased the question of causation in particular terms: " DidChemical X cause the specific injury of Plaintiff A, yes or no?" Because of thestatistical nature of epidemiological and toxicological evidence, this questionis generally unanswerable. In the face of scientific uncertainties andconflicting expert testimony, the court may ignore the problems of isolatingthe harm-causing substance, tracing the pathway from the polluter to theplaintiff, and showing the etiology of the disease. Instead, it may simply askwhether it is more likely than not that the plaintiff suffered a particular injuryas a result of presumed exposure to the defendant's chemical hazard.Suppose, for example, one tumor normally occurs per 10,000 people, butamong the exposed plaintiffs, the incidence is three tumors per 10,000. Thecourt may reason that the chance that the plaintiffs' injury was caused by thehazard exceeds 50 percent; i.e. the odds are two to one. Clearly, the courtcannot identify the one in 10,000 that would have incurred the tumor, but itmay spread two full awards over three plaintiffs. Obviously, the application ofsuch an insurance principle overcompensates one plaintiff and undercompens-ates two. If one accepts the Rawlsian veil of ignorance as a reasonable premise(no victim knows whether or not he or she would have had the tumor anyway), the result is not necessarily unfair. In any case, the increasingacceptance of such statistical evidence reduces the burdens of proof on theplaintiff.The Problem of Financial Responsibility

Winning in court does not guarantee recovery. The mortality of businessesis often higher than the mortality of their victims. In several cases, thepolluting business had been dissolved before the injury was discovered, andthe plaintiff had no defendant to sue. Furthermore, losses to victims mayexceed a firm's ability to pay, and the victim cannot recover the award.6 As aconsequence of bankruptcy limits to liability, a business has no incentive toreduce the probability of accidents for which losses greatly exceed its networth [46; 64]. Losses to third-parties from such accidents do not inevitablytranslate into corporate losses, and thus there may be significant external coststo private management of catastrophic risks.Financial responsibility requirements permit successful plaintiffs to recoverfrom increasingly more severe accidents. While such requirements are centralto worker compensation and automobile liability systems, they are relatively

6In Ohio v. Kovacs (U.S.S.C 83-1020), the U.S. Supreme Court unanimously ruled that anindustrial polluter can escape an order to clean up a toxic waste site under the umbrella of federalbankruptcy.


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Pollution LiabilityInsurance 83Whether the insurance mechanism would perform as hypothesized forgradual pollution exposures is doubtful. Insurers may question whether thedemand is sufficient to justify the creation of a product. Given a "finite

reservoir of concern," risk managers may pay little attention to low-probability risks, no matter how severe the potential consequences [65; 66].Because of turnover, risk managers may have a much shorter time horizonthan the firm. Current decisionmakers may reap no reward within theorganization for reducing remote risks and may even be penalized forexpending current funds for doing so.Agency theory, however, suggests that the stockholders' long-term interestsmay be protected by requiring risk managers to utilize formal processes injustifying their decisions, as when applying for insurance [25; 45].7Preliminary experiments with corporate risk managers suggest that theyindeed pay attention to the low-probability, high-consequence contingenciesas suggested by normative insurance theory [42]. Furthermore, Federalfinancial responsibility requirements focus the attention of risk managers onremote contingencies from chemical hazards. These considerations suggestthat demand should not be a limiting factor in the development of a pollutionliability insurance market. The question is one of supply.

Insurability of Chemical RisksConventional Standards of Insurability

The passage of statutes establishing financial responsibility requirementsfor nonsudden liabilities does not automatically create a market in pollutionliability insurance. All risks are not necessarily insurable. Exposures that arereadily insurable approximate severalideal attributes [18, pp. 154-156; 52, pp.29-35]: 1) exposures must be numerous, homogeneous, and uncorrelatedenough to allow risk pooling; 2) the fact of the loss must be clearlydeterminable; 3) the loss must occur within a well-defined time period; 4) theloss must be frequent enough to calculate pure premiums; and 5) the insuredmust have no incentive to bring about the loss. Of course, many insuredexposures do not partake fully in all of these ideal characteristics [48]. Dochemical perils come workably close to these ideals?Number, Homogeneity, and Correlation of Exposures

The number of potential exposures is relatively large. In the United Statesthere are 115,000 chemical plants, of which 67,000 are large enough to beincluded in the RCRA "manifest system," which records shipments of morethan 100 kilograms per month. There are 5 thousand transportersand at least7In correspondence, Emilio Venezian suggests that mobile risk managers can be induced toconsider long-term losses by making retirement compensation contingent upon future accidentlosses. For example, suppose losses in 1995 result from an event in 1985. The individual managingthe risks in 1985 will suffer a reduction in pension payments.


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84 The Journalof Risk andInsurance100,000 industrial waste disposal sites, of which at least 30,000 containhazardous wastes [74, pp. 6-19; 43, p. 77].Most firms that meet the RCRA financial test self-insure. Of those whichpurchase insurance, few obtain more than the statutory minimum [43, p. 93].Nevertheless, demand is likely to grow swiftly in the 1986-1990 period, asgenerators come under the financial responsibility requirementsof Superfund.With the diffusion of RCRA standards of care, hazardous waste sitesshould become more homogeous. These factors should result in a sufficientnumber of exposures to achieve adequate risk pooling, as well as sufficientloss experience to develop actuarial tables. The number of exposures would beeven larger if the right of business to self-insure were abolished, as hasoccurred in several states [42].A major source of correlation of losses is the commonality of processes andproducts in the chemical industry. If Chemical X is discovered to cause latentenvironmental harm, all manufacturers might become liable through thejoinder of defendants. If an insurer concentrated its portfolio only upongenerators or handlers of that chemical, it would face the same correlated riskas an insurer whose portfolio consisted of hurricane insurance on the GulfCoast. An insurer could avoid this eventuality by insuring across manyproducts and processes.Definiteness of Loss

Losses which cannot be publicly verified lend themselves to counterfeitclaims. Property damage caused by chemical hazards, including contamina-tion of ecosystems, can be publicly validated. So can personal injuries, liketumors or birth defects. Until recently, public policy toward hazardouschemicals has focused exclusively upon such injuries.Recent biomedical evidence, however, opens the possibility that humanexposure to chemicals in the environment results in increased sensitization;i.e. a lowered threshold of morbidity response. Moreover, morbidity may alsotake the form of a diffuse malaise, analogous to the debilitation associatedwith lead poisoning. In Ayers v. Jackson Township,8plaintiffs argued that acontaminated municipal water supply was responsible for malaise, rashes, andgeneral anxiety. Although the trial court rejected malaise and rashes asevidence of injury, it awarded the plaintiffs $2 million for emotional stressand $8.2 million for lifetime medical monitoring. These portions of the awardwere overturned on appeal, but there is no guarantee that future courts willnot recognize malaise or anxiety as compensable. Indeed, in Jackson v.Johns-Manville, a Federal Court of Appeals upheld an award for anxiety overprobable future illness.9

8N. J. Super. L., 461 A.2d 184, 189 N.J. Super. 561 (1983).954 U.S.L.W. 3100 (5th Cir. 1986).


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Pollution LiabilityInsurance 85Temporal Demarcation of Losses

As noted, there may be significant time lags between the time of a chemicalrelease, human exposure, and manifest injury. The difficulty of defining thetime of nonsudden chemical occurrence obfuscates the activation ofconventional occurrence-based insurance policies. The insured may have beencovered by several underwriters during the relevant period. The losses cannoteasily be allocated among a sequence of insurers, who can never be sure thatthe books are closed on any given policy year. Indeed, a court may adopt a"triple trigger theory" that requires indemnification by insurers at the time ofa release, at the time of commencement of illness, and at the time ofmanifestation of illness. The insurance industry's solution to this problem isthe creation of a claims-made policy for nonsudden or gradual pollution, tobe discussed below.Calculability of loss distributions

Because chemical disasters are such rare events, the computation ofpremiums on the basis of loss experience is virtually impossible. Even ifhistorical loss data were available, they would reflect outmoded safetytechnologies. This problem is characteristic of any complex, innovativetechnological system, like satellites and offshore oil rigs.Instead, risk analysis methods, like fault- and event-tree analysis, might beused. Developed for weapons systems and nuclear power plants, thesemethods trace the chain of events that could unlease a catastrophe, such as anuclear meltdown [51]. Bayesian methods might be used to combinefragmentary evidence about the probabilities at branches of the fault- andevent-trees [50].The chain of events that could result in a chemical catastrophe, however, isfar more complex than virtually anything that is conventionally insured. Onlynuclear catastrophes come close. Radioactive isotopes, however, are far fewerin number than toxic organic chemicals. There appear to be fewer pathwaysfor human exposure to these isotopes, and far more is known about the effectsof human exposure to radioactivity than to chemicals. Consequently, riskanalysis is more difficult to implement in the chemical cycle.Even if such analysis were implemented, the results would be suspect.Technological risk analysts tend to be overconfident of their ability to assesslow probabilities and tend to demonstrate upward biases in their estimates ofthe reliability of complex systems [29]. The near-meltdown at Three Mile

Island is far more likely under the Bayesian priors of the insurance industrythan under those of the technological risk analysts [56, chaps. 1-2].10'"If one's prior probability of a meltdown is 1/30,000, as taken from the well-known study bynuclear engineer, Norman Rasmussen, then the probability of 1 meltdown in 500 hundred-reactoryears is only 0.015. If one's prior probability is 1/1060, as revealed in premiums of the nuclearliability pool, then the probability of one meltdown in 500 reactor-years is .27 [79]. WhileThree-Mile Island was not a meltdown, it came close and makes the insurers' prior appear moreplausible than that of nuclear engineers.


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86 The Journal of Risk and InsuranceInsurers have little knowledge of the loss-prevention or loss-protectiontechnologies available to the insured chemical handlers. Interviews withunderwriters reveal little interest in developing their own knowledge base

about either technologies or losses [14]. Nevertheless, simple screeningtechniques are coming into increasing use by environmental consultantsemployed by pollution liability insurers [4; 35; 75]. These techniques scorefacilities on the basis of risk factors, like nature of chemicals handled andproximity to populations. Risk managers often employ these same consultantsto provide advice on loss-prevention [27].Despite advances in the art of risk analysis, premium-setting has provendifficult. One underwriter told the author:We have no data, no actuarial table, no cookbook policy. Insurers are supposed to beprofessionals selling products of substance and integrity, not just guesswork. Prices forrisks are by gosh and by darn, and what the market will bear.

The inherent difficulties of chemical risk analysis has been amplified bydifficulties in anticipating the behavior of the courts. Despite its caution, theinsurance industry has suffered severe losses in pollution coverage. Premiumscollected in 1983 were about one-third of the losses expected after eventualclaims settlement [40]. In 1984, London reinsurers had to pay five times asmuch as they collected in world-wide pollution liability premiums in the pastfour years.11Why do not insurers simply increase their premiums by a factor of five ormore until they surpass the breakeven point? Possible explanations includeadverse selection and differential response to ambiguity. Insurers may be lesscapable of discrimination among risk classes than the insured, an example ofthe lemon problem [5]. Furthermore, low probability losses are poorlycalibrated. In other words, the degree of uncertainty is high. Hogarth andKunreuther [37] have performed some interesting experiments on the impactof ambiguity about loss frequencies on willingness to pay to insure or to offerinsurance. They found that for very low-probability losses, insurers demand arisk premium that made the rates exceed the expected losses by a substantialmargin. The insureds were willing to pay less than the expected loss, acommon result [36; 62; 66]. The more ambiguous the estimate of thefrequency, the greater the divergence between required premium andwillingness to pay. This finding suggests that a voluntary insurance market forlow-probability events might not come into being. The only solution to thesetwo problems may be compulsory insurance.

"According to Dick Drain, of Alexander Howden Ltd., the London reinsurers of pollutionliability collected $10 million in premiums worldwide, and indemnified one insured for $50million over the past five years. Source: personal communication at annual seminar ofDallas/Fort Worth Chapter of RIMS, Oct. 1984.


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Pollution Liability Insurance 87Perverse Incentives to Bring about the Loss

The modern literature on law and economics views all accident-engenderingbehavior as subject to the control of the insured [21; 46; 63]. Accidentalchemical pollution can be viewed as a result of conscious business decisions.By choosing to produce a particular commodity with a particular technology,the insured accepts a given mix of risk and risk-reduction expenditures. Thedecision to undertake a risky activity, however, is not the same as the choice tobring about an accident. In this respect, chemical exposures are no differentfrom common mechanical exposures.Joinder of defendants, however, is more common in toxic torts than inmechanical torts. Joinder may attenuate incentives for care, but severalapproaches to creating countervailing incentives are discussed below.

Development of the EIL PolicySeveralmajor environmental incidents, like oil spills, in the 1960s made thepublic aware of a whole class of accidents that could have long-termconsequences. In response, Comprehensive General Liability (CGL) policieswritten after 1966 included an exclusionary clause for any pollutionoccurrence, that was defined as "an accident, including continuous orrepeated exposure to conditions, which result in bodily injury or propertydamage neither expected nor intended from the standpoint of the insured"[73]. The exclusion did not apply to sudden accidents, which were similar intemporal demarcation to mechanical accidents.This exclusion created a gap in coverage. In response, EnvironmentalImpairment Liability (EIL) policies were developed by 1973 on the Londonmarket. As they have evolved, EIL or pollution liability policies have beentailored to the unique characteristics of chemical hazards.EIL policies differ from CGL policies in several significant ways [43, pp.

73-86]. Most important of these differences is that EIL policies are issued ona claims-made basis while CGL policies are issued on an occurrence basis.Under a claims-made policy the insured is covered for claims initiated duringthe policy period arising out of occurrences that take place after a retroactivedate. As a result, the occurrence might take place long before the policy date.For example, one chemical company sought coverage against claims filed in1985 for loss-causing events that might have originated as far back as 1910,when the company was founded. The retroactive date needed to be on orbefore January 1, 1910 even though the policy date was January 1, 1985.Nonetheless, the retroactive date may be meaningless because the timing ofgradual releases is hard to pinpoint (and EIL policies cover gradual releases)and because the courts have employed various definitions of occurrence.In addition to the fact that EIL policies are claims-made and cover gradualreleases, they differ from CGL policies by covering specified sites only.Generally CGL policies cover all locations. EIL policies cover specified sitesbecause a major element of the protection is the underwriting audit performedby the insurance company. At each listed site, an inspection is made prior to


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88 The Journal of Risk and Insurancethe issuance of the policy. The inspection is funded outside of the premiumand paid for even if the policy is not issued. This report can be used to satisfygovernment regulations of the site's safety.

In the period 1980-1984, when insurers began competing in this line, theirpolicies differed in severalrespects. All covered liabilities for bodily injury andproperty damage to third parties, the cost of legal defense of a claim, and off-premises cleanup of a preventive nature. Some policies covered on-premisescleanup of a preventive nature, where there was an imminent off-premiseshazard. All policies excluded injuries to employees (who are covered underworkers' compensation), first party damage, damages resulting from willfulviolation of government regulations, and costs of routine cleanup.

The CGL and EIL policies are quite different in their regulatoryimplications. The CGL policy is forward-looking, because incidents thatoccur in the future as a result of behavior in a given policy year are covered bythat year's policy. The risk analyst and underwriter thus look at the futurestream of losses resulting from this year's actions. Risk-based premiums thushave a deterrent effect on current loss-prevention and -protection decisions.The EIL policy is backward-looking, because it is activated by claims madein the policy year resulting from past actions. For firms which were heavilyengaged in handling chemicals (or which shared facilities with such firms),current premiums are not easily affected by current risk managementpractices. Chemicals released into the environment several decades ago mayalready have initiated latent diseases. While the past cannot be undone, someof the consequences can be. If firms are capable of remedial action, such ascleaning up older waste sites or purifying damaged aquifers, current bahaviorcan affect current liability.Claims-made pollution liability policies are less risky for insurers thanoccurrence-based ones. In underwriting a claims-made policy, the insurer isnot making a commitment into the indefinite future, when liability rules,medical detection technology, and jury awards may differ from today's.Furthermore, under a claims-made format, even if an insured switchesinsurers from year to year, which insurer must indemnify the insured isunequivocal.The claims-made format also imposes risks upon the insured. Suppose aninsured undertakes a hazardous operation for a single year only. An insuredmay secure an EIL policy for hazardous operations this year, without anyguarantee that coverage would be available in the future when damages maybecome manifest. While an EIL policy may be written with a tail, the insuredcannot be sure that the tail is sufficiently long.These considerations suggest that there may be great mutual advantages tolong-term, monogamous contracts between insureds and insurers. If the termof the contract is long enough, say more than 10 years, the distinction between


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Pollution Liability Insurance 89claims-made and occurrence policies blurs.12Microeconomic efficiency requires that the discounted value of futuredamages resulting from current production be reflected in prices paid bycurrent consumers. When added to production costs, the premiums onforward-looking, occurrence-based insurance policies are compatible withefficient pricing. Premiums on claims-made policies, in contrast, reflect risksfrom the past and are less compatible with efficient pricing. For firms whichhandled hazardous chemicals in the past, claims-made premiums will reflectthese risks, and current consumers will be overpaying. For new firms withouta history of prior chemical hazards, claims-made premiums will not reflectfuture claims, and consumers in the early years of a firm's operation will beunderpaying [2].Lacking toxic skeletons in the closet, new firms may be able to purchaseEIL insurance for lower premiums than established companies, especially ifthey use new waste facilities. The insurance cost differential might encouragethe creation of new chemical and waste management enterprises, which drivethe older companies out of business. This outcome may harm the insurers,who would be held jointly liable for harm from such abandoned facilities. Thecorresponding regulatory consequences are also perverse.

Judicial Revisions of InsuranceContracts and Their ImplicationsAn unwritten criterion for insurability is the predictability of the tortprocess and the sanctity of insurance contracts. From the viewpoint of theinsurer, these expectations are termed the "reliance interest" [44, p. 42]. Whilean insurer can expect the tort law to evolve and contracts to be reinterpretedinunanticipated ways, judicial decisions have virtually undermined thepredictability of the interpretation of insurance contracts when pollution is at

issue [60]. The insurability of pollution liability has been diminished by theadoption of theories of joint and several liability, by the adoption of thediscovery rule in statutes of limitations, and the activation of liability policiesfor first-party damages.Joinder of Defendants

The adoption of theories of joint and several liability raises the likelihoodof insurers indemnifying clients for claims that resulted from damages causedby other firms. The insurer can reduce the probability of accidents from somecareless behavior on the part of the insured by demanding certain verifiableactions as a condition of insurance. Although insurers may have inspected andanalyzed their clients' facilities, they have little knowledge of or ability toreduce their risks from their clients' joinder to careless parties with whom the'2A long-term monogamous contract on a specific facility might include annual adjustmentsfor loss experience or for changes in interest rates. It might be voided if a facility weredowngraded below regulatory standards or if were expanded.


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90 The Journalof Risk and Insuranceinsured may have shared a waste facility or who releases a similar product intothe environment.Several solutions to the problem of joinder from future actions on the partof the insured are emerging. First, many hazardous-chemical handlers nowfavor the establishment of standards of care through regulation [20; 471. Eventhough adherence to statutory standards is no defense under strict liability,tough regulations can reduce the frequency and severity of future damagesresulting from the behavior of chemical handlers as a group [64]. Bothinsureds and insurers have an incentive to monitor adherence to suchregulations: the insured in order to prevent a "free-rider"from creating a perilwhose cost can be spread to deeper pockets; the insurer, because coveragelapses in the event of willful violation.

Second, the larger chemical manufacturers are leading the voluntaryclean-up of abandoned sites [15; 22; 54; 72]. A voluntary clean-up is a rationalrisk management strategy if the cost to these firms is less than the presentvalue of their future damage.Third, a waste-management industry has developed, which is specialized intransporting, storing, and disposing of waste. Many manufacturers areexcavating chemicals buried on their own sites for relocation to thesespecialized sites. The spinoff of hazardous waste provides the generator with adual buffer against joint and several liability. The waste management firm andits insurer bear the first two tiers of liability. Offsetting this advantage is thepossibility of liability for damages cuased by another party. The advantagesappear to offset the disadvantages, for the waste-management industry isgrowing faster than the amount of waste generated [43, p. 16].Statutes of Limitations

In developing the EIL policy, the intent of the insurance industry was tosegment the market between liabilities from occurrences which were suddenand those which were gradual. The former segment, which includesconventional, mechanical accidents, would continue to receive coverage underthe traditional CGL policy, with its pollution exclusion. The latter segment,which includes latent pollutant damages, would be covered under the new EILpolicy.The abandonment of traditional statutes of limitation for the discovery rulemeans that insurers cannot close their books on CGL policies written withoutthe 1971 pollution exclusion. An insured that was issued an occurrence policywith the pollution exclusion can always claim that the leaking may haveoccurred prior to 1971. Moreover, courts have tended to ignore the pollutionexclusion by redefining gradual pollution as "sudden" from the point of viewof the insured's knowledge of the damages. Indeed, several insurers have beenordered to indemnify insureds whose policies contained the exclusion [7]. Thishas been justified on the "reasonable expectations of the insured" principle[1].In essence, the courts have transformed the CGL policy into a pollutionliability policy with unlimited coverage. Because of the gradual nature of


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Pollution LiabilityInsurance 91pollution, the limits of previous years can be activated ad infinitum once thecoverage of one year has been exhausted.To obviate further confusion, the Insurance Services Office has tightenedthe pollution liability exclusion in the CGL policy. For policies written after1986, sudden and accidental pollution are not covered under CGL, althoughan insured may be given the option to buy this exclusion back. This exclusioncannot overcome the unpredictability of policies written before 1986. On aprospective basis, however, this exclusion neatly separates the market forpollution-related accidents from other risks. Contractual confusion aboutwhether a particular incident is sudden or nonsudden should be renderedirrelevant in a consolidated, claims-made EIL policy.Nevertheless, in the event that harm results from the actions of a defunctpolluter, the courts may require its past EIL or CGL insurers to indemnify thevictims. Courts may justify the conversion of claims-made EIL and new CGLpolicies into retroactive pollution liability policies by the legislative intent ofRCRA and Superfund; i.e. that the insurance industry provide adequatecoverage for third-party damages. This specter decreases the insurability ofpollution liabilities.Indemnity for First-Party Cleanup

Liability insurance policies are intended to be activated by damage to thirdparties, not to the insured. Nevertheless, the courts increasingly require CGLinsurers to indemnify polluters for cleaning up their own property on thegrounds of preventing an imminent hazard to third parties [4].Insurers argue that such rulings rewrite contracts in an arbitrary way, andthat the deep pocket of the insurance industry is being used to finance a socialprogram rather than to spread risks. Insurers note that this pocket is not asdeep as perceived. The $100-$200 billion estimated cost of cleanup exceeds thesurplus and approaches the annual premiums collected by the United Statesinsurers, which were $75.5 billion and about $300 billion, respectively in 1985[3; 13; 39, pp. 16-18].While the insurance industry has suffered unexpected losses as a result, theposition of the courts may be justified by the same efficiency rationale as thevoluntary clean-up. The insurer might have had to pay even more if the cost ofon-site cleanup were less than the expected cost of off-site damage. Inprinciple, there is no reason why insurers cannot in the future underwritepolicies that explicitly cover cleanup costs. Insurers do offer retroactiveliability insurance for accidents that already happened, such as the MGMGrand Hotel fire. Indeed, some EIL insurers explicitly covered on-site cleanupcosts in their contracts [43, p. 86].In summary, the emergence of chemicals in the environment as a majorhazard has placed strains on the tort process and insurance contracts [Table1]. The toxic tort law has evolved in response to the inability of plaintiffs tocollect under traditional rules. Conventional CGL policies are unadministr-able under the new tort rules.


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92 The Journal of Risk and Insurancetable1

Strains on Tort and Insurance Systems from Chemical CatastrophesCharacteristicsof InjuriesMechanical injuries Chemical injuriesIndividual victims Mass victimsDefined injurer Multiple injurers?Definite loss "Fuzzy"lossClear causality MulticollinearitySudden LatentCommon/uncorrelated Infrequent/correlated?Characteristics of Tort SystemConventional torts Toxic tortsStatute of limitation triggered by Statute of limitation triggered byexposure discovery of injuryNegligence Strict liabilityIndividual liability Joint & several liabilityCharacteristicsof InsuranceCGL EILExclude gradual pollution Covers gradual pollutionOccurrence Claims-madeActuarial science Risk analysisProspective/deterrent Retrospective/poor deterrent

Resuscitating the MarketThe retraction in the supply of pollution liability insurance is occurring at

the same time statutory financial responsibility requirements are beingincreased. As risk managers are becoming more aware of their liabilities, thesupply side of the insurance market appears to be contracting. How can thisdisequilibrium be resolved?

One possibility is that the collapse of the pollution liability insurancemarket in 1984 resulted from cyclical readjustments in reinsurance markets.Cash-flow underwriting on the assumption of a continuation of high-interestearnings may have undermined the solvency of the reinsurers [53].Unexpectedly high losses resulting from large, mechanical accidents (likesatellite losses or oil rig collapses) as well as large indemnity payments fortoxic torts (mainly pharmaceutical and asbestos litigation) contributed to theloss of underwriting capacity [13]. The steep rise in pollution liabilitypremiums and reduction in availability of coverage may simply have been anoverreaction.

If the collapse of the pollution liability market were merely a cyclical orlearning-curve effect, then the market would revive spontaneously. In thiscase, the proper public policy is to do nothing. So long as premiums are


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Pollution Liability Insurance 93unregulated, the supply of insurance should be forthcoming. Indeed, by themiddle of 1986, three underwriting groups entered the market [28].There remain fundamental problems of insurability which result from legalrisks. The most important step in resuscitating the insurance market isincreasing the predictability of losses and liability rules. Uncertainty ofjudicial interpretations of past insurance contracts does not insuperablyrender future environmental liabilities uninsurable. If underwriters refuse toinsure a single exposure henceforth, they still will face the problems ofliabilities under old CGL policies. The tighter pollution exclusion in the newCGL policies should remove some ambiguities for new contracts.Interstate variations in statutes and common law regarding the appropriatestatutes of limitations and joinder of defendants are a minor source ofconfusion. While toxic tort law is converging to a new equilibrium, throughjudicial and legislative action, the enactment of a federal environmental tortstatute can accelerate the process [60].The calculability of risks is a second-order insurability problem. Becausethe chemical industry is in a better position to calculate its own risks than theinsurers, industry-owned mutual insurance pools might have a comparativeadvantage over traditional insurers. Since joint and several liability can beviewed as reciprocal liability insurance de facto, the chemical industry mightbe amenable to more formal arrangements. The rudiments of such a supplyresponse are indicated by the establishment of risk-retention groups bychemical manufacturers, chemical waste handlers, and asbestos-removal firms[10; 28; 37; 71]. A condition of insurance is adherence to industry standardsof care.If the pollution liability market fails to revive spontaneously, then theremay be considerable political pressure to create artificial markets. Forexample, states may create assigned risk pools. Companies that wished towrite CGL policies in a state may be required to write EIL policies in addition.A particular insurer might refuse to do business in a state with such anassigned risk pool. For such pools to function, they would have to beestablished in the major underwriting jurisdictions. Alternatively, states or thefederal government might establish its own insurance program [69].Assigned risk pools or government insurance would function in a regulatorycapacity only if premiums freely. If premiums were regulated on grounds ofequity or affordability, then insurance would serve no deterrent function.State automobile liability pools provide poor examples of flexible premiumsetting. Federal crop [52, p. 257] and flood insurance programs have sufferedconsiderable pressures to subsidize the premiums [58]. These function asincome-redistribution rather than insurance schemes. Since the polluter paysprinciple is firmly entrenched and the public is anxious about toxicants,chemical industry pressures to make premiums affordable through subsidiesare likely to be ineffective.If a voluntary insurance market fails to recover, then a remaining approachis to unlink the problems of deterrence and victim compensation.Bureaucratic regulation of standards of care would aim to achieve efficient


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94 The Journal of Risk and Insurancedeterrence [64]. Either first-party medical and disability insurance or a publicindemnification fund, like workers' compensation, would address thecompensation issue.

First-party insurance for medical expenses and property damage has someappeal in spreading the costs of chemical injuries [17]. Insurers would nothave to distinguish between environmental, occupational, or other causes. Adisadvantage is that harms like pain and suffering, emotional distress, andbirth defects are not insurable on a first-party basis. Also, requiringthe victimto pay for his or her own insurance against pollution-engendered damages isunlikely to be perceived as fair or acceptable [67].A Congressionally-mandated study suggested the creation of a two-tiercompensation mechanism for toxic injuries. Tier One consists of anadministrative system, like workers' compensation, for reimbursing medicalpayments and lost wages [31]. The compensation fund would be financed by atax on the production of chemicals, just like the clean-up activities ofSuperfund [2; 68; 74]. Tier Two consists of the new toxic tort law, with theformidable barriers to recoverybalanced against the potential for large awardsfor pain, suffering, and other damages. Because of the lesser burden of proof,Tier One would offer recovery to a larger number of victims than Tier Two,but at a considerably lower level of compensation.When Superfund was passed, victim compensation schemes like Tier Onewere defeated. Opponents saw the attenuated burden of proof as offering anopen-ended entitlement. Citing the experience of the Black Lung Fund forminers, opponents saw no grounds for excluding anyone with the remotestclaim of injury from exposures to chemicals in the environment [60].In states that have established victim compensation funds, the fears of theopponents have yet to be realized. California, for example, has limited fundsfor out-of-pocket medical expenses and property damage. Because the burdenof proof is formidable, only 21 claims have been filed since 1981, resulting inonly one award of $11,000.13 If the federal government followed theCalifornia example, the creation of a victim compensation fund need not opena Pandora's box.

ConclusionsThe modern chemical industry poses risks to the environment through theentire chemical life cycle. Toxicants may be inadvertentlyreleased suddenly or

gradually in the stages of production, transportation, consumer use, or wastedisposal. The passage of RCRA and Superfund reflects federal efforts toemploy pollution liability insurance as a market-oriented tool for controllingthe release of toxicants into the environment. The collapse of this initiativeraises fundamental questions about the insurability of chemical technologies.13Mr. Jerry Jones, Program Manager, State Board of Control, California HazardousSubstance Account, personal communication, May 21, 1987.


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Pollution Liability Insurance 95Undoubtedly the changing tort rules have undermined the conventionalCGL policy as the basis for insuring pollution. The widespread assignment ofjoint and several liability surely has created moral hazard and premium-setting

problems. The response has been the birth of reciprocals and risk-retentiongroups, with adherence to industry safety standards as a condition of entry.The courts disregard of the gradual pollution exclusion in old CGL policies,mainly for first-party clean-up, has caused severe financial distress for theinsurance industry. Whether this burden continues to be borne by insurers orwhether it is eventually assumed by the Federal government has little bearingon the insurability of future exposures. The total pollution exclusion in thenew CGL policy clarifies expectations in future contracts. If the possibility offuture clean-up levies is anticipated, the costs can be factored into newcontracts [Table 2].table 2

Innovations Induced by the New Toxic TortsPhenomenon Problem ResponseJoint& several iability Moral hazard Voluntary tandardsCompulsory tandardsVoluntarycleanup

Spinoffwaste managementPremium etting ReciprocalnsuranceRisk-RetentionGroupsIgnoringpollutionexclusion Financial osses Federalassumptionofclean-up?

DepressEIL market Total exclusion n CGLFirst-party leanup Financial osses Discount n futurerating

The most fruitful approach to chemical risk management is to developstatutory regulation, tort law, and insurance as a mutually reinforcing tripod.Statutory action can make both the tort process and insurance more effectiveas regulatory mechanisms. Statutory standards of care reduces the moralhazard from joint and several liability. Statutory financial responsibilityrequirements help guarantee that the successful plaintiff will not face abankrupt defendant. The standardization of toxic tort laws, through eithernatural convergence or federal statute, can render the legal process morepredictable and hence pollution risks more insurable. Under these conditions,insurance premiums may become a powerful economic incentive for achievingcost-effective environmental risk management.


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96 The Journalof Riskand InsuranceReferences

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