NYT: No Environmental Study, but the Loan Still Clears

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November 13, 2002

No Environmental Study, but the Loan Still Clears

By MICHAEL BRICK

nvestors and developers who want to secure loans quickly are buying insurance policies instead of going through the more time-consuming process of having buildings and land parcels examined for environmental contamination.

The policies cover only the bank's exposure to loss on the loan; they do nothing to protect the investors who purchase the loans, and they do not cover any costs of actually cleaning up contamination.

Still, commercial real estate investors are buying the policies at a rapidly escalating pace, motivated by eagerness to lock in loans while interest rates are low and sometimes by the desire to persuade banks to underwrite loans they might otherwise reject.

Billions of dollars in commercial real estate loans have been secured using these policies in the last few years, and now the first claims are beginning to trickle in. The moment presents a significant test for the insurance companies that have set up divisions to write these policies, the banks making the loans, the real estate investors and developers and the buyers of commercial mortgage-backed securities that ultimately invest in pools of loans.

The policies are still relatively new and untested, and they are to a large extent filled with exclusions for problems like asbestos, lead-based paint and mold. In recent years, though, insurance companies have set up separate divisions to sell the policies as an alternative to environmental inspections.

J. , the president of Environmental Warranty, an underwriter based in West Hartford, Conn., promotes the policies as a substitute for inspection, likening them to title insurance. "If I could transfer risk, as opposed to understanding it, for about the same money and a lot less heartache, why not do it?" Mr. said.

Francis W. Coughlin, the president of the British American Development Corporation of Latham, N.Y., bought such a policy this summer for the mortgage on a 40,000-square-foot office building in his 350-acre Airport Park development near Albany. The reason, he said, was speed.

"Interest rates were buzzing around, and looked like they were going to go up," Mr. Coughlin said. "I wanted to get it locked in. The rates can vary a whole point, and they don't go down as fast as they go up."

Mr. Coughlin bought an environmental insurance policy for about $1,800, and his $2.6 million mortgage loan was processed by Legacy Banks of Pittsfield, Mass., within a day. Because Mr. Coughlin already owned the land and had completed construction, his use of the policy, specialists say, was among the safest ways to omit an environmental study and substitute an insurance policy.

The study he chose to forgo is called a Phase 1 environmental survey. These cost from $750 to $1,500 and take about a month. In performing them, environmental engineering consultants typically do visual site inspections, interviews, studies of the chain of ownership, Freedom of Information Act requests from state agencies and reviews of aerial photographs. They include pages of documentation of kinds of contamination that were not found, as well as problems that were found.

Critics of the reliance on insurance as an alternative to an environmental survey say that skipping the study can leave a buyer uninformed of and unprotected from the risk and liability of contamination.

"I just don't think it's a prudent thing when representing a buyer or a developer," said A. Moerdler, a member of the environmental group at the law firm of Mintz, Levin, Cohn, Ferris, Glovsky & Popeo in New York. "Environmental insurance is really designed to work hand in hand with a buyer's due diligence. It's an add-on. It's a credit enhancement."

The insurance policies do not cover the buyer, they cover the lender, typically for the principal of the loan. And the policies typically require two conditions for payment of claims: Contamination must be found, and the loan must be in default. In effect, the insurance company is betting against the lender's willingness to foreclose and take control of a property with environmental liabilities.

Three major insurance companies — the Chubb Group of Insurance Companies, the Zurich Financial Services Group and the American International Group — dominate the market for these policies. Officials with A.I.G. Environmental, a division of American International, estimated that $60 million to $70 million in premiums a year, covering at least $500 million in commercial real estate loans, are being written by the three companies and some smaller competitors.

The first claims are starting to arrive from lenders to insurance companies that wrote policies for the acquisition of gas stations and convenience stores, said H. Hespe, chief underwriting officer for A.I.G. Environmental.

Lenders have shown varying degrees of comfort with the practice. The Wachovia Corporation has $3 billion in real estate assets protected by environmental insurance policies, while Washington Mutual has only $200 million in loans issued that way, out of a $30 billion commercial real estate portfolio.

"The key here is to be able to be flexible with our customers," said Malcolm D. Griggs, the director of corporate risk policy for Wachovia, stressing that the policies are much more appropriate for refinancing arrangements than for acquisitions.

D. , corporate environmental risk manager for Washington Mutual, said the bank was still proceeding cautiously into the market, partly because "we don't have a lot of experience knowing whether or how claims are going to be paid."

"I'm not real sure it works by itself as a due diligence replacement," Mr. said.

An environmental risk official with a major national bank, speaking on the condition of anonymity, said that the policies were sometimes used to secure loans that banks would not otherwise approve. In a few cases where the banks know that the property involved has a high risk of being contaminated — and would usually be disqualified from a loan — the loans are still sometimes written when insurance coverage can be obtained, the bank official said. "We might want to make the loan from a customer-relationship policy."

ph L. Boren, president of A.I.G. Environmental, cautioned that the policies do nothing to protect the borrower and emphasized that A.I.G. did not encourage borrowers or lenders to use its policies as a substitute for environmental studies.

But J. Jung, vice president in charge of the environmental group at Zurich North America, said his firm promotes the policies directly to lenders as a substitute for inspections.

"The product is a much better alternative to a Phase 1, because when you do a Phase 1, there's a time element," Mr. Jung said.

Debt rating agencies have put up significant resistance to the use of these insurance policies, and banks have been forced to listen because their loans usually become truly profitable only if they can be resold to investors as packages of commercial mortgage-backed securities.

"The issue of concern of substitution is something we've focused very intensely on," said E. O'Rourke, a senior director of the commercial-mortgage-backed securities group at Fitch Ratings. Her agency has demanded that the policies cover the full balance of the loan plus 25 percent of expenses, like property taxes and unpaid interest, for the loan to receive a favorable rating for inclusion in a security.

No amount of insurance for lenders will protect the ultimate investors, the buyers of securities, from legal claims, said Abby L. Cohen, a partner in Philadelphia with the law firm of Dechert who specializes in real estate closings.

"If you're going to rely upon environmental insurance, you're not going to have information about the properties," said Ms. Cohen, who, along with Mr. , leads a committee of the Mortgage Bankers Association that was established to study the use of these policies. "You're going to have a pool that will have more environmental issues and costs that the trust is going to absorb."

Mark H. Fackler, business development manager for ESA 1, a national environmental consulting firm based in Louisville, Ky., said that his firm had lost business to insurers, prompting it to develop yet another product, a hybrid of insurance and a stripped-down Phase 1 survey.

"There is a place for insurance, because there are limitations to due diligence," Mr. Fackler said. "To acquire a portfolio of gas stations with just insurance is foolish, but I've seen it happen. It has its place, just not on every deal."

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