From the start, the concept of environmental insurance created significant challenges for underwriters, not least of all the moral hazard the idea that potential polluters would have little incentive to adopt preventive measures, thereby increasing the likelihood of losses. In overcoming that obstacle,

Three decades later, the environmental insurance market faces new challenges. For environmental insurance to remain a viable product, it must reach a broader market. Many Main Street businesses have a need for environmental insurance, but few local brokers and risk managers recognize the extent of this exposure and, until recently, few underwriters have tailored environmental products to meet the needs of smaller businesses. The maturing of environmental insurance into a mainstream product for local manufacturers and other small to mid-size businesses is a necessary step in its evolution--and a critical one for its ultimate sustainability.

Unless the environmental insurance market can broaden its base beyond today's typical buyer, it risks stagnating as a limited specialty market that appeals most to those at highest risk for losses--a recipe for destruction by adverse selection.

A PRODUCT EVOLVES

U.S. environmental laws have yielded some positive results, but they also have created a liability nightmare for businesses. Laws like the Superfund and the Resource Conservation and Recovery Act hold businesses responsible for the cost of cleaning up polluted sites. The need for environmental insurance became more apparent when insurers incorporated absolute pollution exclusions into commercial general liability policies in the mid-'80s.

Beginning in the 1970s, the insurance industry responded to pollution exposure in the only way it could. Given the general lack of information about the frequency and severity of expected losses, a handful of insurers offered expensive, narrowly tailored policies that required extensive environmental engineering inspections for each site.

Insurers today are better able to quantify and manage pollution risks. Over time, they have overcome the moral hazard and pricing challenges of environmental insurance policies by applying technical engineering practices, analyzing the accumulation of loss data, emphasizing loss control and improving the management of claims. Another key element was the use of claims-made or loss-discovery triggers of coverage, which limit an insurer's liability to claims made in a single policy period.

As a result, prices for environmental coverage have dropped, terms have broadened and demand has grown, driven by environmental legislation and the exclusion of pollution from general liability policies. Of course, in the wake of Sept. 11, the market for environmental coverages hardened as a result of the reduction in reinsurance capacity and loss development from the era of broad terms and low rates.

DISTRIBUTION STILL LIMITED

The market for environmental insurance has grown from $500 million in 1993 to an estimated $2 billion in 2003. With some exceptions, the spectacular top-line growth in the environmental insurance business over the past five to 10 years has resulted from the focus on larger limits and multiyear policies intended to address latent existing contamination, or undiscovered "sins of the past."

Despite the growth of environmental insurance over the last three decades, it largely remains a specialty product with limited distribution to a sophisticated clientele of high-risk businesses, real-estate developers and mortgage lenders. Environmental insurance plays an important role in commercial real-estate transactions and mergers and acquisitions by reducing uncertainty for buyers, sellers, lenders and investors.

The development of appropriate rates and terms on these policies has been a trial-and-error process for some underwriters, but it is clear that with solid engineering, these programs can be successfully underwritten. However, an overreliance on large, multiyear programs for top-line growth leads to anemic earned premium and a minimal renewal base. The evolution of environmental insurance as a sophisticated product with a highly technical underwriting process has lead to a very distinct distribution channel. Specialists within environmental practices in large brokerages interact with the chief financial officers and attorneys responsible for crafting the real estate deals that typically drive the purchase of an environmental insurance product. Thus, the environmental insurance product too often is viewed as an esoteric, deal-specific technical or financial instrument for difficult sites.

That view, however, does not reflect today's reality of environmental risk. The local manufacturer or small commercial insured may not have a complete understanding of coverage needs and may be unaware of cost-effective solutions to avoid the potentially catastrophic financial consequences of uninsured environmental risks. Risk managers for small and mid-size businesses should be aware of the following points:

* The limited time-element cover in casualty programs does not cover a host of environmental exposures.

* Environmental coverages to bridge this gap are affordable and flexible, and they should be part of the overall risk-management budget.

* Environmental coverages can be tailored to seamlessly match existing program structures. This broader view of environmental risk will take some time to catch on. One reason is that when it comes to environmental insurance, there exists a wide knowledge gap between the specialty practice environmental broker and the typical insurance agent addressing the casualty risks of small and mid-size businesses. Local agents may occasionally need to write coverage for underground storage tanks or a contractor's pollution policy, but typically they do not know enough about environmental exposures and the variety of environmental insurance products to comfortably sell them to their commercial clients. On the other hand, specialty environmental brokers may have excellent knowledge of environmental products and extensive experience applying them, but they have very. little access to the typical Main Street insured. Indeed, many brokers in this specialty are more likely to say they work in the environmental field than in the insurance business.

Viewing pollution coverage as a stand-alone coverage presents other challenges for risk managers, brokers and insurers. Marketing environmental programs, arranging loss control and purchasing stand-alone limits introduce inefficiencies that make the product--regardless of its benefits--less attractive.

Of course, given the nature of the exposure, environmental risks merit a specialized underwriting approach. Some high-risk businesses will always require a great deal of comprehensive technical evaluation. However, insurers do themselves and the business community a disservice by treating all potential environmental risks equally and segregating the distribution of environmental products. Many classes of businesses could benefit greatly from scaled-down, more affordable pollution products. By providing these products, insurers increase the likelihood of reaching a large enough portion of the potential market to gain an adequate spread of risk.

Some insurers are now beginning to offer pollution products that focus on the needs of small- and mid-size businesses, including products that combine pollution with other casualty coverages. By adding simplified environmental coverages to commercial general liability and umbrella policies--both for premises and services risk--insurers can broaden the appeal of environmental insurance.

At that point, when environmental products are in lock-step with traditional casualty offerings, we will see environmental insurance come of age. Broader distribution will ensure the viability of this product line so that it can continue to fulfill a critical need for businesses with a variety of previously uninsured environmental exposures.

KARL RUSSEK is vice president of ACE Environmental Risk, an environmental underwriting unit. He has more than 13 years experience in the insurance industry and environmental liability arena as well as the environmental engineering and regulatory community.