As a growing number of lenders in the CMBS market use environmental insurance as a substitute for Phase I Environmental Site Assessments (due diligence) - a procedure that has been traditionally required by the rating agencies as part of the underwriting process - insurers are starting to offer new products that would inevitably push the increased use of environmental insurance for CMBS collateral, experts say.

A prime example of this is the development of a hybrid product that would combine environmental insurance with due diligence, thus allowing lenders to enjoy the best of both worlds and decrease costs.

The introduction of this product would likely trigger the wider use of environmental insurance in CMBS, industry participants said.

According to Malcolm Griggs, senior vice president and director of risk policy at Wachovia Corp., one of the reasons why environmental insurance has had limited use in the CMBS market so far is that investors have mixed feelings about the product - some CMBS buysiders actually like environmental insurance while others would rather have the detailed due diligence report on each property, and it is not usually feasible for these investors to require that both processes be done.

However, with leading insurance companies now coming out with a hybrid product (the cost of which is within the range of a traditional Phase I site assessment), it is possible that "the hybrid product would be used more often in the CMBS market than just pure insurance," said Griggs.

Zurich North America, a major environmental insurance provider which is said to be ahead of the game in the development of this hybrid product, is currently working with a national Phase I provider to combine environmental insurance with an "environmental screen." The "environmental screen" is the minimum amount of due diligence that many banks are required to perform. By combining together environmental insurance with an environmental screening report, this would satisfy the lender's due diligence requirement and would still allow them to qualify for the innocent landowner defense.

Aside from the development of the hybrid product, more insurers are now trying to get approval from the rating agencies to use environmental insurance for CMBS. Industry experts said that this would improve the product by promoting competition and would also spread the word regarding the benefits of using this type of insurance.

Until recently, only AIG Environmental offered the type of environmental insurance known as the full-balance loan policy (which protects the lender and not the borrower) that was recognized by all of the three rating agencies for the use in CMBS. However, other companies have now entered the playing field. Standard and Poor's just completed its review of Chubb Environmental Solutions' policy. Chubb is also finalizing the process with Moody's Investors Service and Fitch Ratings. The agencies are also reviewing Zurich North America's policy.

Use in CMBS

The use of environmental insurance in CMBS varies. Credit Suisse First Boston, for instance, uses environmental insurance to address B-piece buyers' specific issues. The firm also applies it to small, seasoned loans where it does not make economic sense to conduct due diligence (see ASR 4/15/02, p.15).

Wachovia, on the other hand, has not used this product much for CMBS at this point. Basically, the firm has mainly applied the lender liability product on loans that it has kept on its own portfolio.

Wachovia's Griggs said that the use of environmental insurance has been very effective for them because the cost of this type of insurance tends to be less than a traditional site assessment. He added that unlike using a Phase I, having this type of insurance allows his firm to transfer the risk to the insurance companies.

Other banks that are using environmental insurance include Lehman Brothers, Morgan Stanley, Deutsche Bank, Goldman Sachs, Banc of America, Bear Stearns and JPMorgan.

Popularity of the product

Perhaps there is no better evidence of the increasing popularity of environmental insurance than the fact that rating agencies - despite their preference for Phase I site assessments as a requirement for underwriting CMBS collateral - have become willing to accept the use of the loan balance insurance policy in lieu of the due diligence requirement on loans below $20 million dollars (specific to S&P) or for loans that are $3 million and under (which Fitch said is the acceptable amount if Phase Is were to be used in lieu of due diligence).

The rating agencies had to look into developing criteria for this type of insurance because a growing number of lenders have started using environmental insurance as an alternative. This is, after all, the less expensive route.

Lenders have used it in various ways, according to David Krause, director in the environmental insurance group at B.G. Balmer and Company, Inc. Some have used it in lieu of or in conjunction with a Phase I site assessment. Others have also used it instead of getting an updated due diligence report in cases where there might be seasoned loans that don't have current Phase Is.

Sometimes there are loans where a Phase I assessment was conducted but because the lender needed to gain a greater degree of comfort about a recognized environmental condition that may be present on the property, instead of conducting a Phase II site assessment, the parties may opt to get environmental insurance instead.

The pros

People in the industry have said that this type of insurance is good because it protects the lender from liabilities even after the Phase I report is done.

"A Phase I report is like a snapshot," said Helen Eichmann, product line manager at Chubb. "You capture one instance in time and that provides a lot of information but it is no protection against what may happen in the future or potential inaccuracies in the report. Back in the day, lenders, rating agencies and investors only had Phase I reports to rely on and because the loans we are dealing with quite often have been warehoused, the Phase I reports were 18 months old or even older, so conditions could have changed."

According to Charles Perry, president at Environmental Warranty Inc., due diligence consists of an engineer's report giving a summary of the history on the use of a property. However, that report would not be able to contemplate future events that might affect a particular property.

"The way I see it is a Phase I does not have eyes: it cannot look forward, it can only look backward," said Perry. "Due diligence on securitizations is not required to be ongoing, whereas the insurance is protection over the life of the loan."

The cons

However, there are also some disadvantages which were stated in a Standard & Poor's write-up on environmental insurance that was released two years ago, at the time when all the rating agencies released their criteria on the product.

"The most significant disadvantage in using environmental insurance as a substitute for traditional due diligence is the loss of the adverse selection process that naturally occurs as a result of the use of traditional due diligence," said the rating agency.

S&P added that the limited due diligence that is done by most insurers may not look at significant issues that would have been identified during the due diligence process.

"The process of removing loans secured by environmentally impacted collateral properties that normally occurs through the use of Phase I reports will not exist," said S&P. "Therefore, there is an increased likelihood of loans secured by properties with environmental conditions being included to a greater extent in CMBS transactions with environmental insurance policies where due diligence was not performed."

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