Pollution Liability Insurance and Catastrophic Environmental Risk

Author(s): Martin T. Katzman

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

Abstract
Public concern with catastrophic consequences of chemical releases into the
environment resulted in the passage of RCRA and Superfund legislation, which
establish financial responsibility requirements. These acts encourage the creation of a
market in pollution liability insurance for purposes of risk spreading, safety regulation,
and victim compensation. This article analyzes policy alternatives for regulating
catastrophic risks, the insurability of pollution liabilities, factors contributing to the
rise and fall of the market, and conditions under which markets could be resuscitated.

Introduction
Threats to human health from chemical releases into the environment are
reported with increasing frequency. While biomedical evidence casts some
doubt on the matter [6; 57], the public perceives chemicals in the environment
as a major cause of cancer and heart disease [80]. Regardless of the locus of
exposure, toxic chemicals may engender a low-probability of long-term injury
to large numbers of victims. In this respect chemicals in the environment are
indistinguishable from those in the workplace or in consumer products (such
as drugs or food additives), although they come under different regulatory
and legal frameworks.
In response to an apparent mass disaster, Love Canal, Congress passed two
acts which introduced insurance as an important instrument of environmental

*Professor of Economics and Environmental Sciences, University of Texas at Dallas and

Senior Economist in the Energy and Environmental Systems Division, Argonne National
Laboratory. He was awarded a doctorate in economics from Yale in 1966. This project was
supported with grants from the Huebner Foundation for Insurance Education, the CPCU-Harry
J. Loman Foundation, and Resources for the Future. The author benefited considerably from
discussions with J. David Cummins and Robert C. Witt, Jr. and from comments on earlier drafts
by Anthony M. Champagne, Howard Kunreuther, Murray Leaf, Michael Murray, Joe G. Moore,
Jr., Emilio Venezian, and two anonymous referees. Prof. Katzman held a Guggenheim
Fellowship in 1980 and won the 1985 research award from the Risk and Insurance Management
Society. He served on the advisory board of the GAO hazardous waste insurability
study.
76 The Journal of Risk and Insurance

policy. These acts rely more on market incentives and less on traditional
proscriptive or prescriptive strictures than any other regulatory statutes.
Under the Resource Conservation and Recovery Act (RCRA), owners and
operators of facilities that treat, store, and dispose of hazardous chemicals
must demonstrate financial responsibility for third-party damages. For
sudden accidents, the levels of responsibility are $1 million per occurrence and
$2 million annual aggregate, exclusive of defense costs. For nonsudden
occurrences, the corresponding levels are $3 million and $6 million. The
Comprehensive Environmental Response, Compensation, and Liability Act
(or "Superfund") extends these requirements to transporters (Sec. 108(a)) and
generators of hazardous chemicals (Sec. 108(b)). Several states have raised the
required financial responsibility beyond the federal level. Unless a firm can
meet a test for self-insurability, financial responsibility must be met by
insurance.'
Superfund anticipated a major role for the insurance industry in the
regulation of chemical hazards. Acknowledging the limited ability of
regulators to assess the risks from complex technologies, this act called upon
insurers to advise the President on the appropriate limits of financial
responsibility for generating facilities. These limits were to be established in
the 1985-1990 period.
When RCRA was passed in 1976, several London insurers had been
developing liability policies for nonsudden pollution accidents. By the time
Superfund was passed in 1980, a few American insurers began offering such
policies. Despite the misgivings of many underwriters [77], at least a dozen
primary insurers were offering pollution liability policies by 1983 [49]. In
addition, more than 40 insurers and reinsurers had established a pool [43, pp.
83-85]. It appeared that the Congressional initiative toward market-based
environmental 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 existing
and prospective insurers. The number of pollution insurers operating
worldwide was about eight, most of whom insured "light risks" like gas
stations and dry cleaning establishments. Only two insured the "heavy" risks,
from which catastrophes are most likely to result. By mid-1985, only one
insurer offered coverage for nonsudden occurrences [19]. Many waste-site
operators were unable to meet the financial tests, so Congress twice extended
the original deadline (January 1, 1985) for demonstrating responsibility [9;
23]. By the end of 1986, two-thirds of waste facilities had failed to obtain
insurance [30], and no progress has been made in establishing financial
responsibility requirements for generators. In response, Congress ordered the
General 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 financial
strength, such as having tangible net worth greater than $10 million and a current ratio exceeding
1.5 [76].
 Pollution Liability Insurance 77

Superfund Amendments and Reauthorization Act (SARA, Sec. 208), enacted

in December 1986.
What has gone wrong? To what extent does the collapse of the pollution
liability market reflect a general disequilibrium in the reinsurance market
rather than a specific problem with this line? These questions raise the
broader issues of: 1) public policy alternatives in the regulation of
catastrophic risks, 2) the insurability of pollution liability, 3) factors reducing
the viability of a pollution liability market, and 4) strategies for resuscitating
a competitive market. This analysis suggests that, after a difficult transition
period, a workable chemical risk management system is likely to emerge from
complementary developments in liability insurance, statutes, and tort law.

Public Risk Management Policy

Advanced industrial economies both eliminate and create risks. The vaccine
that saves millions from infectious disease may cause brain damage to an
unlucky few. The insecticide that saves masses from starvation may explode
during its production, as in Bhopal. Commercial enterprises internalize many
of the benefits of these risk-reducing activities through higher profits. The
costs 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 demand
higher wages for more dangerous jobs, employers have an incentive to
undertake marginal safety expenditures that cost less than the marginal
compensating wage differential [78]. Similarly, consumers may be willing to
pay more for a safer tool, and create greater profit for the manufacturer.
Where such voluntary exchanges prevail, risk management decisions are likely
to approach a mutually acceptable result.
Where accidents affect third-parties, by definition, the harm caused to
victims is not internalized by the injurer. Three major regimes can internalize
the costs of accidents to third parties: tort law, statutory regulation, and user
charges [46; 64]. Activated subsequent to an accident, the tort process
determines which party, if any, is at fault or liable for the ensuing costs.
Statutory regulation establishes and enforces constraints upon behavior prior
to the occurrence of an accident. Sometimes these constraints mandate or
prohibit certain inputs, such as specifying the design of hazardous waste sites
or banning the production of an insecticide. Sometimes these constraints
regulate outputs, such as discharges of toxicants into waterways. Statutory
sanctions include civil and criminal penalties, such as fines, injunctions, and
imprisonment. User fees are imposed on behavior likely to result in external
diseconomies, whether or not harm results. Taking the form of effluent fees
or insurance payments, user charges are imposed as the risk-creating behavior
occurs, without consideration of fault.
Public policy towards accidental external diseconomies like pollution-
engendered injuries have two basic objectives: efficient deterrence and just
compensation or equity [11; 12]. Using the status quo as a baseline, the
efficiency criterion weighs the expected marginal cost of pollution against the
78 The Journal of Risk and Insurance

marginal cost of pollution control. Where these marginals are equal, the cost
of pollution-engendered accidents plus the cost of accident prevention is
minimized. The equity criterion is expressed as "the polluter pays." While the
efficiency and equity objectives are analytically distinct, the public finds least
acceptable those technologies where the injuring party does not compensate
the 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 of
monitoring behavior, collecting and analyzing information, enforcing
contracts, and imposing sanctions. Under any regime, these costs are far from
trivial.
Under tort regimes, whether the cost of accidents is borne by the victim or
the injurer depends upon liability rules.2 Of the several available common law
theories, negligence and strict liability best internalize risks from chemical
injuries. Regardless of the theory employed, the plaintiff must prove
causation.
The burden of proof is not an insurmountable barrier to recovery for
damages from commonplace mechanical hazards. If a construction worker is
struck by a falling brick or a pedestrian struck by a car, the injury is
immediately apparent. When chemicals cause harm through their mechanical
or acute biological characteristics, such as the explosion of a natural gas plant
in Mexico City, they can be treated in the same legal and insurance framework
as mechanical accidents. The defendant and plaintiffs can be easily identified;
the causal links between defendant's behavior, the accident, and the damages
are clear; and the injuries are immediately manifest. Usually, courts can
determine the cause of the accident and apportion blame in a reasonable
manner.

Unusual Characteristics of Chemical Perils

Chemical injuries may possess several unusual characteristics that
undermine the applicability of conventional liability rules and insurability
principles [8; 46; 55]. First, many toxic chemicals persist in the environment.
An accidentally-released chemical may gradually seep into the groundwater or
may 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 many
years.
Second, for some toxic chemicals, particularly carcinogens, the time of
human 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 determining
optimal risk management. Two critical assumptions are zero transactions costs and the
replaceability of losses by financial expenditure [11; 12; 16]. These conditions hardly hold for
pollution damages.
3Two mechanisms of intergenerational chemical injury exist. Chemicals may mutate male or
female zygotes prior to conception, as has been alleged by Vietnam Veterans exposed to Agent
 Pollution Liability Insurance 79

Under traditional tort law, a statute of limitations prevents the filing of a suit
more than three to five years after an accident. Because of the time lags
between chemical release and human response, conventional statutes of
limitations 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 result
from alternative sources, such as occupational exposure to asbestos or
smoking. The multiplicity of potential pathways causes two problems in
establishing liability: identification of the defendant and proof of causation.
Under traditional tort law, the plaintiff must identify one or more specific
defendants. The source of exposure determines whether the victim can seek a
remedy through the workers' compensation system, a product liability suit, or
through appeal to environmental protection statutes.4 Even if the locale of
exposure were identified, it might be virtually impossible to identify the
specific defendant whose molecule caused the plaintiff's exposure. This is
clearly the case with exposure to hazardous waste sites, where many
companies discard identical chemicals.
Proof of causation depends upon presenting sophisticated biomedical
evidence, most of which is indirect or analogous in nature. Epidemiologists
have difficulty in sorting out health effects of lifestyle (especially diet and
intake of stimulants), occupational, and environmental exposures to
chemicals. Toxicologists are uncertain about long-term human responses to
low, intermittent doses of chemicals, especially when they act in concert.
The latency period between exposure and manifestation of illness
obfuscates the search for causality. The latency period increases opportunities
for further confounding causes to intrude. Furthermore, the quantity of
evidence (including eyewitnesses) decays over time. Not surprisingly, expert
testimony about causality is rarely conclusive.
Advances in biomedical measurement may exacerbate rather than abate the
legal problem. As lower and lower concentrations of chemicals in the
environment become measurable, the number of chemical hazards for which
human exposure can be measured, and hence the number of alternative
explanations of an injury, increases. As techniques for diagnosing such vague
symptoms as malaise improve, the potential number of measurable adverse
health effects increases as well [41].

Orange. Chemicals may also cause birth defects by upsetting fetal development, as was the case of
pregnant mothers who ingested thalidomide.
4Federal environmental statutes do not provide for victim compensation for personal injury or
private 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. An
increasing number state of environmental statutes extend the rights of individuals to recover for
personal damages. If the defendant violates a statute, it is negligent per se in a tort action [43, pp.
42-43].
80 The Journal of Risk and Insurance

Chemical Perils and the New Toxic Torts

The barriers of traditional tort law virtually prohibited the recovery of
damages from long-term chemical injuries. In the past decade, the courts have
outflanked these barriers through changes in environmental law, based upon
changes in products liability law. This revolution in toxic torts has proceeded
at 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 limitations
by adopting a discovery rule. Under such a statute, the time of accrual begins
not with the chemical release or the victim's exposure but with the
manifestation of injury. A few state legislatures, however, have reaffirmed the
traditional statute of limitations, which is triggered at the time of the alleged
exposure. In such states, recovery for latent environmental damages is
virtually impossible, with the exception of Agent Orange and asbestos
exposures [42; 74].
Identifying a defendant liable for a specific chemical exposure in the
environment is at least as difficult as identifying which company manufac-
tured the pharmaceutical that caused a birth defect, or which asbestos
manufacturer supplied a fiberboard installer with the hazardous raw material.
Landmark cases in the areas of pharmaceuticals and asbestos have resulted in
the adoption of rules of joint and several liability in most states.5 While there
are several alternative rules, in essence they hold a defendant that was
remotely connected with a hazardous chemical to be held liable for a share of
the damages. If other parties are unidentifiable, or bankrupt, then this
defendant may be held liable for all the damages. This rule of apportioning
blame among defendants increases the probability that someone pays for
environmental risks imposed upon third parties. While this rule serves the
victims well, it can be counterproductive by exacerbating moral hazard. By
making a firm "its brother's keeper," the costs of poor waste handling
practices are spread to other firms and incentives for deterrence are
attenuated. Clearly by viewing joint and several liability as a search for the
deepest pocket, the objectives of optimal deterrence and fair compensation
conflict.
Traditionally, plaintiffs have had to prove that defendants in tort actions
were negligent. By this is meant that the defendant failed to exercise due care,
as judged by reasonable societal standards. Where the plaintiff is unknowing
or unable to protect himself from a hazard and the defendant is better able to
control 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. Abbott
Laboratories, 26 Cal.3d 588; Cal. 607 P.2d 931; 163 Cal.Rptr. 132 (1980) plaintiff ingested
diethylstilbestrol (DES), a drug that was intended to suppress miscarriages. A large number of
daughters of these mothers developed cervical cancer during puberty. The courts apportioned
damages according to the pharmaceutical companies' market share of DES.
 PollutionLiabilityInsurance 81

additional basis that enterprises may be better able to spread the costs of
injuries than plaintiffs, the theory has become widely adopted in the areas of
workers' 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. Courts
have customarily phrased the question of causation in particular terms: " Did
Chemical X cause the specific injury of Plaintiff A, yes or no?" Because of the
statistical nature of epidemiological and toxicological evidence, this question
is generally unanswerable. In the face of scientific uncertainties and
conflicting expert testimony, the court may ignore the problems of isolating
the harm-causing substance, tracing the pathway from the polluter to the
plaintiff, and showing the etiology of the disease. Instead, it may simply ask
whether it is more likely than not that the plaintiff suffered a particular injury
as a result of presumed exposure to the defendant's chemical hazard.
Suppose, for example, one tumor normally occurs per 10,000 people, but
among the exposed plaintiffs, the incidence is three tumors per 10,000. The
court may reason that the chance that the plaintiffs' injury was caused by the
hazard exceeds 50 percent; i.e. the odds are two to one. Clearly, the court
cannot identify the one in 10,000 that would have incurred the tumor, but it
may spread two full awards over three plaintiffs. Obviously, the application of
such 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 any
way), the result is not necessarily unfair. In any case, the increasing
acceptance of such statistical evidence reduces the burdens of proof on the
plaintiff.
The Problem of Financial Responsibility
Winning in court does not guarantee recovery. The mortality of businesses
is often higher than the mortality of their victims. In several cases, the
polluting business had been dissolved before the injury was discovered, and
the plaintiff had no defendant to sue. Furthermore, losses to victims may
exceed a firm's ability to pay, and the victim cannot recover the award.6 As a
consequence of bankruptcy limits to liability, a business has no incentive to
reduce the probability of accidents for which losses greatly exceed its net
worth [46; 64]. Losses to third-parties from such accidents do not inevitably
translate into corporate losses, and thus there may be significant external costs
to private management of catastrophic risks.
Financial responsibility requirements permit successful plaintiffs to recover
from increasingly more severe accidents. While such requirements are central
to 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 an
industrial polluter can escape an order to clean up a toxic waste site under the umbrella of federal
bankruptcy.
82 The Journalof Risk and Insurance

recent for pollution hazards. The enactment of financial responsibility for

third-party damages was essential in gaining public acceptance of commercial
nuclear power in the 1950s [32]. In the early 1970s, financial responsibility
requirements for oil spills were imposed on transporters under the Clean
Water Act, Trans-Alaska Pipeline Act, Deep Water Port Act, and Outer
Continental Shelf Act [13]. Oil spills pose few special problems of insurability,
while radiation hazards pose many of the same problems as chemical perils.
Since chemical releases may have both acute and latent biological impacts,
dual financial responsibility requirements were established, for both sudden
and gradual damages.

Insurance as a Regulatory Tool

While the insurance industry views its primary purpose as that of spreading
losses, not reducing catastrophic risk [14], Superfund makes an implicit
argument that the insurance industry can serve a regulatory function. Under
the following assumptions, insurance encourages "acceptable" risk manage-
ment practices, with minimal statutory regulation [24; 26; 34]:
1. By the application of its skills in safety engineering and actuarial
science, the insurance industry can identify and assess the risks of
alternative chemical products and process [61];
2. Insurers set premiums on the basis of risks, which are sensitive to
loss-control measures taken by the chemical industry and can
recommend cost-effective measures to their clients;
3. Competitive pressures among insurers result in continual improve-
ments in the art of risk analysis. Unlike government bureaucrats,
insurers may lose business if they overestimate risks and set premiums
too high;
4. Insurers can help corporate risk managers assess the frequency-
severity distribution of losses resulting from alternative technologies;
5. Risk managers select cost-effective products and processes, which
minimize the expected payments to victims (net of insurance
coverage), insurance premiums, and accident prevention expenditures
[21]; and
6. Because the costs of accidents are internalized and polluters have the
financial means to pay victims, both efficient deterrence and just
compensation result from private decisions.
The idealized role of insurance as a regulatory tool is most closely fulfilled
in the property line. Here insurers have developed a tradition of research into
fire safety, an aggressive search for cost-effective risk-reduction practices,
inspections, and merit rating [18, pp. 82-85; 33, pp. 199-201]. While arson is
a costly moral hazard of property insurance, fire losses would undoubtedly
have been greater without the research and development sponsored by the
insurance industry.
 PollutionLiabilityInsurance 83

Whether the insurance mechanism would perform as hypothesized for

gradual pollution exposures is doubtful. Insurers may question whether the
demand 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 horizon
than the firm. Current decisionmakers may reap no reward within the
organization for reducing remote risks and may even be penalized for
expending current funds for doing so.
Agency theory, however, suggests that the stockholders' long-term interests
may be protected by requiring risk managers to utilize formal processes in
justifying their decisions, as when applying for insurance [25; 45].7
Preliminary experiments with corporate risk managers suggest that they
indeed pay attention to the low-probability, high-consequence contingencies
as suggested by normative insurance theory [42]. Furthermore, Federal
financial responsibility requirements focus the attention of risk managers on
remote contingencies from chemical hazards. These considerations suggest
that demand should not be a limiting factor in the development of a pollution
liability insurance market. The question is one of supply.

Insurability of Chemical Risks

Conventional Standards of Insurability

The passage of statutes establishing financial responsibility requirements
for nonsudden liabilities does not automatically create a market in pollution
liability insurance. All risks are not necessarily insurable. Exposures that are
readily insurable approximate several ideal attributes [18, pp. 154-156; 52, pp.
29-35]: 1) exposures must be numerous, homogeneous, and uncorrelated
enough to allow risk pooling; 2) the fact of the loss must be clearly
determinable; 3) the loss must occur within a well-defined time period; 4) the
loss must be frequent enough to calculate pure premiums; and 5) the insured
must have no incentive to bring about the loss. Of course, many insured
exposures do not partake fully in all of these ideal characteristics [48]. Do
chemical perils come workably close to these ideals?
Number, Homogeneity, and Correlation of Exposures
The number of potential exposures is relatively large. In the United States
there are 115,000 chemical plants, of which 67,000 are large enough to be
included in the RCRA "manifest system," which records shipments of more
than 100 kilograms per month. There are 5 thousand transporters and at least

7In correspondence, Emilio Venezian suggests that mobile risk managers can be induced to
consider long-term losses by making retirement compensation contingent upon future accident
losses. For example, suppose losses in 1995 result from an event in 1985. The individual managing
the risks in 1985 will suffer a reduction in pension payments.
84 The Journalof Risk and Insurance

100,000 industrial waste disposal sites, of which at least 30,000 contain

hazardous wastes [74, pp. 6-19; 43, p. 77].
Most firms that meet the RCRA financial test self-insure. Of those which
purchase insurance, few obtain more than the statutory minimum [43, p. 93].
Nevertheless, demand is likely to grow swiftly in the 1986-1990 period, as
generators come under the financial responsibility requirements of Superfund.
With the diffusion of RCRA standards of care, hazardous waste sites
should become more homogeous. These factors should result in a sufficient
number of exposures to achieve adequate risk pooling, as well as sufficient
loss experience to develop actuarial tables. The number of exposures would be
even larger if the right of business to self-insure were abolished, as has
occurred in several states [42].
A major source of correlation of losses is the commonality of processes and
products in the chemical industry. If Chemical X is discovered to cause latent
environmental harm, all manufacturers might become liable through the
joinder of defendants. If an insurer concentrated its portfolio only upon
generators or handlers of that chemical, it would face the same correlated risk
as an insurer whose portfolio consisted of hurricane insurance on the Gulf
Coast. An insurer could avoid this eventuality by insuring across many
products and processes.

Definiteness of Loss
Losses which cannot be publicly verified lend themselves to counterfeit
claims. Property damage caused by chemical hazards, including contamina-
tion of ecosystems, can be publicly validated. So can personal injuries, like
tumors or birth defects. Until recently, public policy toward hazardous
chemicals has focused exclusively upon such injuries.
Recent biomedical evidence, however, opens the possibility that human
exposure to chemicals in the environment results in increased sensitization;
i.e. a lowered threshold of morbidity response. Moreover, morbidity may also
take the form of a diffuse malaise, analogous to the debilitation associated
with lead poisoning. In Ayers v. Jackson Township,8 plaintiffs argued that a
contaminated municipal water supply was responsible for malaise, rashes, and
general anxiety. Although the trial court rejected malaise and rashes as
evidence of injury, it awarded the plaintiffs $2 million for emotional stress
and $8.2 million for lifetime medical monitoring. These portions of the award
were overturned on appeal, but there is no guarantee that future courts will
not recognize malaise or anxiety as compensable. Indeed, in Jackson v.
Johns-Manville, a Federal Court of Appeals upheld an award for anxiety over
probable 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).
 PollutionLiabilityInsurance 85

Temporal Demarcation of Losses

As noted, there may be significant time lags between the time of a chemical
release, human exposure, and manifest injury. The difficulty of defining the
time of nonsudden chemical occurrence obfuscates the activation of
conventional occurrence-based insurance policies. The insured may have been
covered by several underwriters during the relevant period. The losses cannot
easily be allocated among a sequence of insurers, who can never be sure that
the 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 of
a release, at the time of commencement of illness, and at the time of
manifestation of illness. The insurance industry's solution to this problem is
the creation of a claims-made policy for nonsudden or gradual pollution, to
be discussed below.

Calculability of loss distributions

Because chemical disasters are such rare events, the computation of
premiums on the basis of loss experience is virtually impossible. Even if
historical loss data were available, they would reflect outmoded safety
technologies. This problem is characteristic of any complex, innovative
technological system, like satellites and offshore oil rigs.
Instead, risk analysis methods, like fault- and event-tree analysis, might be
used. Developed for weapons systems and nuclear power plants, these
methods trace the chain of events that could unlease a catastrophe, such as a
nuclear meltdown [51]. Bayesian methods might be used to combine
fragmentary evidence about the probabilities at branches of the fault- and
event-trees [50].
The chain of events that could result in a chemical catastrophe, however, is
far more complex than virtually anything that is conventionally insured. Only
nuclear catastrophes come close. Radioactive isotopes, however, are far fewer
in number than toxic organic chemicals. There appear to be fewer pathways
for human exposure to these isotopes, and far more is known about the effects
of human exposure to radioactivity than to chemicals. Consequently, risk
analysis 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 assess
low probabilities and tend to demonstrate upward biases in their estimates of
the reliability of complex systems [29]. The near-meltdown at Three Mile
Island is far more likely under the Bayesian priors of the insurance industry
than 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 by
nuclear engineer, Norman Rasmussen, then the probability of 1 meltdown in 500 hundred-reactor
years is only 0.015. If one's prior probability is 1/1060, as revealed in premiums of the nuclear
liability pool, then the probability of one meltdown in 500 reactor-years is .27 [79]. While
Three-Mile Island was not a meltdown, it came close and makes the insurers' prior appear more
plausible than that of nuclear engineers.
86 The Journal of Risk and Insurance

Insurers have little knowledge of the loss-prevention or loss-protection

technologies available to the insured chemical handlers. Interviews with
underwriters reveal little interest in developing their own knowledge base
about either technologies or losses [14]. Nevertheless, simple screening
techniques are coming into increasing use by environmental consultants
employed by pollution liability insurers [4; 35; 75]. These techniques score
facilities on the basis of risk factors, like nature of chemicals handled and
proximity to populations. Risk managers often employ these same consultants
to provide advice on loss-prevention [27].
Despite advances in the art of risk analysis, premium-setting has proven
difficult. One underwriter told the author:
We have no data, no actuarial table, no cookbook policy. Insurers are supposed to be
professionals selling products of substance and integrity, not just guesswork. Prices for
risks are by gosh and by darn, and what the market will bear.

The inherent difficulties of chemical risk analysis has been amplified by

difficulties in anticipating the behavior of the courts. Despite its caution, the
insurance industry has suffered severe losses in pollution coverage. Premiums
collected in 1983 were about one-third of the losses expected after eventual
claims settlement [40]. In 1984, London reinsurers had to pay five times as
much as they collected in world-wide pollution liability premiums in the past
four years.11
Why do not insurers simply increase their premiums by a factor of five or
more until they surpass the breakeven point? Possible explanations include
adverse selection and differential response to ambiguity. Insurers may be less
capable of discrimination among risk classes than the insured, an example of
the lemon problem [5]. Furthermore, low probability losses are poorly
calibrated. In other words, the degree of uncertainty is high. Hogarth and
Kunreuther [37] have performed some interesting experiments on the impact
of ambiguity about loss frequencies on willingness to pay to insure or to offer
insurance. They found that for very low-probability losses, insurers demand a
risk premium that made the rates exceed the expected losses by a substantial
margin. The insureds were willing to pay less than the expected loss, a
common result [36; 62; 66]. The more ambiguous the estimate of the
frequency, the greater the divergence between required premium and
willingness to pay. This finding suggests that a voluntary insurance market for
low-probability events might not come into being. The only solution to these
two problems may be compulsory insurance.

"According to Dick Drain, of Alexander Howden Ltd., the London reinsurers of pollution
liability collected $10 million in premiums worldwide, and indemnified one insured for $50
million over the past five years. Source: personal communication at annual seminar of
Dallas/Fort Worth Chapter of RIMS, Oct. 1984.
 Pollution Liability Insurance 87

Perverse Incentives to Bring about the Loss

The modern literature on law and economics views all accident-engendering
behavior as subject to the control of the insured [21; 46; 63]. Accidental
chemical 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. The
decision to undertake a risky activity, however, is not the same as the choice to
bring about an accident. In this respect, chemical exposures are no different
from common mechanical exposures.
Joinder of defendants, however, is more common in toxic torts than in
mechanical torts. Joinder may attenuate incentives for care, but several
approaches to creating countervailing incentives are discussed below.

Development of the EIL Policy

Several major environmental incidents, like oil spills, in the 1960s made the
public aware of a whole class of accidents that could have long-term
consequences. In response, Comprehensive General Liability (CGL) policies
written after 1966 included an exclusionary clause for any pollution
occurrence, that was defined as "an accident, including continuous or
repeated exposure to conditions, which result in bodily injury or property
damage neither expected nor intended from the standpoint of the insured"
[73]. The exclusion did not apply to sudden accidents, which were similar in
temporal demarcation to mechanical accidents.
This exclusion created a gap in coverage. In response, Environmental
Impairment Liability (EIL) policies were developed by 1973 on the London
market. As they have evolved, EIL or pollution liability policies have been
tailored 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 on
a claims-made basis while CGL policies are issued on an occurrence basis.
Under a claims-made policy the insured is covered for claims initiated during
the policy period arising out of occurrences that take place after a retroactive
date. As a result, the occurrence might take place long before the policy date.
For example, one chemical company sought coverage against claims filed in
1985 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 or
before January 1, 1910 even though the policy date was January 1, 1985.
Nonetheless, the retroactive date may be meaningless because the timing of
gradual 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 gradual
releases, they differ from CGL policies by covering specified sites only.
Generally CGL policies cover all locations. EIL policies cover specified sites
because a major element of the protection is the underwriting audit performed
by the insurance company. At each listed site, an inspection is made prior to
88 The Journal of Risk and Insurance

the issuance of the policy. The inspection is funded outside of the premium
and paid for even if the policy is not issued. This report can be used to satisfy
government regulations of the site's safety.
In the period 1980-1984, when insurers began competing in this line, their
policies differed in several respects. All covered liabilities for bodily injury and
property damage to third parties, the cost of legal defense of a claim, and off-
premises cleanup of a preventive nature. Some policies covered on-premises
cleanup of a preventive nature, where there was an imminent off-premises
hazard. All policies excluded injuries to employees (who are covered under
workers' compensation), first party damage, damages resulting from willful
violation of government regulations, and costs of routine cleanup.
The CGL and EIL policies are quite different in their regulatory
implications. The CGL policy is forward-looking, because incidents that
occur in the future as a result of behavior in a given policy year are covered by
that year's policy. The risk analyst and underwriter thus look at the future
stream of losses resulting from this year's actions. Risk-based premiums thus
have a deterrent effect on current loss-prevention and -protection decisions.
The EIL policy is backward-looking, because it is activated by claims made
in the policy year resulting from past actions. For firms which were heavily
engaged in handling chemicals (or which shared facilities with such firms),
current premiums are not easily affected by current risk management
practices. Chemicals released into the environment several decades ago may
already have initiated latent diseases. While the past cannot be undone, some
of the consequences can be. If firms are capable of remedial action, such as
cleaning up older waste sites or purifying damaged aquifers, current bahavior
can affect current liability.
Claims-made pollution liability policies are less risky for insurers than
occurrence-based ones. In underwriting a claims-made policy, the insurer is
not 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 switches
insurers from year to year, which insurer must indemnify the insured is
unequivocal.
The claims-made format also imposes risks upon the insured. Suppose an
insured undertakes a hazardous operation for a single year only. An insured
may secure an EIL policy for hazardous operations this year, without any
guarantee that coverage would be available in the future when damages may
become manifest. While an EIL policy may be written with a tail, the insured
cannot be sure that the tail is sufficiently long.
These considerations suggest that there may be great mutual advantages to
long-term, monogamous contracts between insureds and insurers. If the term
of the contract is long enough, say more than 10 years, the distinction between
 Pollution Liability Insurance 89

claims-made and occurrence policies blurs.12

Microeconomic efficiency requires that the discounted value of future
damages resulting from current production be reflected in prices paid by
current consumers. When added to production costs, the premiums on
forward-looking, occurrence-based insurance policies are compatible with
efficient pricing. Premiums on claims-made policies, in contrast, reflect risks
from the past and are less compatible with efficient pricing. For firms which
handled hazardous chemicals in the past, claims-made premiums will reflect
these risks, and current consumers will be overpaying. For new firms without
a history of prior chemical hazards, claims-made premiums will not reflect
future claims, and consumers in the early years of a firm's operation will be
underpaying [2].
Lacking toxic skeletons in the closet, new firms may be able to purchase
EIL insurance for lower premiums than established companies, especially if
they use new waste facilities. The insurance cost differential might encourage
the creation of new chemical and waste management enterprises, which drive
the older companies out of business. This outcome may harm the insurers,
who would be held jointly liable for harm from such abandoned facilities. The
corresponding regulatory consequences are also perverse.

Judicial Revisions of Insurance

Contracts and Their Implications
An unwritten criterion for insurability is the predictability of the tort
process and the sanctity of insurance contracts. From the viewpoint of the
insurer, these expectations are termed the "reliance interest" [44, p. 42]. While
an insurer can expect the tort law to evolve and contracts to be reinterpreted in
unanticipated ways, judicial decisions have virtually undermined the
predictability of the interpretation of insurance contracts when pollution is at
issue [60]. The insurability of pollution liability has been diminished by the
adoption of theories of joint and several liability, by the adoption of the
discovery rule in statutes of limitations, and the activation of liability policies
for first-party damages.
Joinder of Defendants
The adoption of theories of joint and several liability raises the likelihood
of insurers indemnifying clients for claims that resulted from damages caused
by other firms. The insurer can reduce the probability of accidents from some
careless behavior on the part of the insured by demanding certain verifiable
actions as a condition of insurance. Although insurers may have inspected and
analyzed their clients' facilities, they have little knowledge of or ability to
reduce their risks from their clients' joinder to careless parties with whom the

'2A long-term monogamous contract on a specific facility might include annual adjustments
for loss experience or for changes in interest rates. It might be voided if a facility were
downgraded below regulatory standards or if were expanded.
90 The Journalof Risk and Insurance

insured may have shared a waste facility or who releases a similar product into
the environment.
Several solutions to the problem of joinder from future actions on the part
of the insured are emerging. First, many hazardous-chemical handlers now
favor the establishment of standards of care through regulation [20; 471. Even
though adherence to statutory standards is no defense under strict liability,
tough regulations can reduce the frequency and severity of future damages
resulting from the behavior of chemical handlers as a group [64]. Both
insureds and insurers have an incentive to monitor adherence to such
regulations: the insured in order to prevent a "free-rider"from creating a peril
whose cost can be spread to deeper pockets; the insurer, because coverage
lapses in the event of willful violation.
Second, the larger chemical manufacturers are leading the voluntary
clean-up of abandoned sites [15; 22; 54; 72]. A voluntary clean-up is a rational
risk management strategy if the cost to these firms is less than the present
value of their future damage.
Third, a waste-management industry has developed, which is specialized in
transporting, storing, and disposing of waste. Many manufacturers are
excavating chemicals buried on their own sites for relocation to these
specialized sites. The spinoff of hazardous waste provides the generator with a
dual buffer against joint and several liability. The waste management firm and
its insurer bear the first two tiers of liability. Offsetting this advantage is the
possibility of liability for damages cuased by another party. The advantages
appear to offset the disadvantages, for the waste-management industry is
growing 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 to
segment the market between liabilities from occurrences which were sudden
and those which were gradual. The former segment, which includes
conventional, mechanical accidents, would continue to receive coverage under
the traditional CGL policy, with its pollution exclusion. The latter segment,
which includes latent pollutant damages, would be covered under the new EIL
policy.
The abandonment of traditional statutes of limitation for the discovery rule
means that insurers cannot close their books on CGL policies written without
the 1971 pollution exclusion. An insured that was issued an occurrence policy
with the pollution exclusion can always claim that the leaking may have
occurred prior to 1971. Moreover, courts have tended to ignore the pollution
exclusion by redefining gradual pollution as "sudden" from the point of view
of the insured's knowledge of the damages. Indeed, several insurers have been
ordered to indemnify insureds whose policies contained the exclusion [7]. This
has been justified on the "reasonable expectations of the insured" principle
[1].
In essence, the courts have transformed the CGL policy into a pollution
liability policy with unlimited coverage. Because of the gradual nature of
 PollutionLiabilityInsurance 91

pollution, the limits of previous years can be activated ad infinitum once the
coverage of one year has been exhausted.
To obviate further confusion, the Insurance Services Office has tightened
the pollution liability exclusion in the CGL policy. For policies written after
1986, sudden and accidental pollution are not covered under CGL, although
an insured may be given the option to buy this exclusion back. This exclusion
cannot overcome the unpredictability of policies written before 1986. On a
prospective basis, however, this exclusion neatly separates the market for
pollution-related accidents from other risks. Contractual confusion about
whether a particular incident is sudden or nonsudden should be rendered
irrelevant in a consolidated, claims-made EIL policy.
Nevertheless, in the event that harm results from the actions of a defunct
polluter, the courts may require its past EIL or CGL insurers to indemnify the
victims. Courts may justify the conversion of claims-made EIL and new CGL
policies into retroactive pollution liability policies by the legislative intent of
RCRA and Superfund; i.e. that the insurance industry provide adequate
coverage for third-party damages. This specter decreases the insurability of
pollution liabilities.
Indemnity for First-Party Cleanup
Liability insurance policies are intended to be activated by damage to third
parties, not to the insured. Nevertheless, the courts increasingly require CGL
insurers to indemnify polluters for cleaning up their own property on the
grounds of preventing an imminent hazard to third parties [4].
Insurers argue that such rulings rewrite contracts in an arbitrary way, and
that the deep pocket of the insurance industry is being used to finance a social
program rather than to spread risks. Insurers note that this pocket is not as
deep as perceived. The $100-$200 billion estimated cost of cleanup exceeds the
surplus and approaches the annual premiums collected by the United States
insurers, 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, the
position of the courts may be justified by the same efficiency rationale as the
voluntary clean-up. The insurer might have had to pay even more if the cost of
on-site cleanup were less than the expected cost of off-site damage. In
principle, there is no reason why insurers cannot in the future underwrite
policies that explicitly cover cleanup costs. Insurers do offer retroactive
liability insurance for accidents that already happened, such as the MGM
Grand Hotel fire. Indeed, some EIL insurers explicitly covered on-site cleanup
costs in their contracts [43, p. 86].
In summary, the emergence of chemicals in the environment as a major
hazard has placed strains on the tort process and insurance contracts [Table
1]. The toxic tort law has evolved in response to the inability of plaintiffs to
collect under traditional rules. Conventional CGL policies are unadministr-
able under the new tort rules.
92 The Journal of Risk and Insurance

table 1
Strains on Tort and Insurance Systems from Chemical Catastrophes

Characteristics of Injuries
Mechanical injuries Chemical injuries
Individual victims Mass victims
Defined injurer Multiple injurers?
Definite loss "Fuzzy" loss
Clear causality Multicollinearity
Sudden Latent
Common/uncorrelated Infrequent/correlated?

Characteristics of Tort System

Conventional torts Toxic torts
Statute of limitation triggered by Statute of limitation triggered by
exposure discovery of injury
Negligence Strict liability
Individual liability Joint & several liability

Characteristics of Insurance
CGL EIL
Exclude gradual pollution Covers gradual pollution
Occurrence Claims-made
Actuarial science Risk analysis
Prospective/deterrent Retrospective/poor deterrent

Resuscitating the Market

The retraction in the supply of pollution liability insurance is occurring at

the same time statutory financial responsibility requirements are being
increased. As risk managers are becoming more aware of their liabilities, the
supply side of the insurance market appears to be contracting. How can this
disequilibrium be resolved?
One possibility is that the collapse of the pollution liability insurance
market in 1984 resulted from cyclical readjustments in reinsurance markets.
Cash-flow underwriting on the assumption of a continuation of high-interest
earnings may have undermined the solvency of the reinsurers [53].
Unexpectedly high losses resulting from large, mechanical accidents (like
satellite losses or oil rig collapses) as well as large indemnity payments for
toxic torts (mainly pharmaceutical and asbestos litigation) contributed to the
loss of underwriting capacity [13]. The steep rise in pollution liability
premiums and reduction in availability of coverage may simply have been an
overreaction.
If the collapse of the pollution liability market were merely a cyclical or
learning-curve effect, then the market would revive spontaneously. In this
case, the proper public policy is to do nothing. So long as premiums are
 Pollution Liability Insurance 93

unregulated, the supply of insurance should be forthcoming. Indeed, by the

middle of 1986, three underwriting groups entered the market [28].
There remain fundamental problems of insurability which result from legal
risks. The most important step in resuscitating the insurance market is
increasing the predictability of losses and liability rules. Uncertainty of
judicial interpretations of past insurance contracts does not insuperably
render future environmental liabilities uninsurable. If underwriters refuse to
insure a single exposure henceforth, they still will face the problems of
liabilities under old CGL policies. The tighter pollution exclusion in the new
CGL policies should remove some ambiguities for new contracts.
Interstate variations in statutes and common law regarding the appropriate
statutes of limitations and joinder of defendants are a minor source of
confusion. While toxic tort law is converging to a new equilibrium, through
judicial and legislative action, the enactment of a federal environmental tort
statute can accelerate the process [60].
The calculability of risks is a second-order insurability problem. Because
the chemical industry is in a better position to calculate its own risks than the
insurers, industry-owned mutual insurance pools might have a comparative
advantage over traditional insurers. Since joint and several liability can be
viewed as reciprocal liability insurance de facto, the chemical industry might
be amenable to more formal arrangements. The rudiments of such a supply
response are indicated by the establishment of risk-retention groups by
chemical manufacturers, chemical waste handlers, and asbestos-removal firms
[10; 28; 37; 71]. A condition of insurance is adherence to industry standards
of care.
If the pollution liability market fails to revive spontaneously, then there
may be considerable political pressure to create artificial markets. For
example, states may create assigned risk pools. Companies that wished to
write 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 an
assigned risk pool. For such pools to function, they would have to be
established in the major underwriting jurisdictions. Alternatively, states or the
federal government might establish its own insurance program [69].
Assigned risk pools or government insurance would function in a regulatory
capacity only if premiums freely. If premiums were regulated on grounds of
equity or affordability, then insurance would serve no deterrent function.
State automobile liability pools provide poor examples of flexible premium
setting. Federal crop [52, p. 257] and flood insurance programs have suffered
considerable pressures to subsidize the premiums [58]. These function as
income-redistribution rather than insurance schemes. Since the polluter pays
principle is firmly entrenched and the public is anxious about toxicants,
chemical industry pressures to make premiums affordable through subsidies
are likely to be ineffective.
If a voluntary insurance market fails to recover, then a remaining approach
is to unlink the problems of deterrence and victim compensation.
Bureaucratic regulation of standards of care would aim to achieve efficient
94 The Journal of Risk and Insurance

deterrence [64]. Either first-party medical and disability insurance or a public

indemnification fund, like workers' compensation, would address the
compensation issue.
First-party insurance for medical expenses and property damage has some
appeal in spreading the costs of chemical injuries [17]. Insurers would not
have to distinguish between environmental, occupational, or other causes. A
disadvantage is that harms like pain and suffering, emotional distress, and
birth defects are not insurable on a first-party basis. Also, requiring the victim
to pay for his or her own insurance against pollution-engendered damages is
unlikely to be perceived as fair or acceptable [67].
A Congressionally-mandated study suggested the creation of a two-tier
compensation mechanism for toxic injuries. Tier One consists of an
administrative system, like workers' compensation, for reimbursing medical
payments and lost wages [31]. The compensation fund would be financed by a
tax on the production of chemicals, just like the clean-up activities of
Superfund [2; 68; 74]. Tier Two consists of the new toxic tort law, with the
formidable barriers to recovery balanced against the potential for large awards
for 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 One
were defeated. Opponents saw the attenuated burden of proof as offering an
open-ended entitlement. Citing the experience of the Black Lung Fund for
miners, opponents saw no grounds for excluding anyone with the remotest
claim of injury from exposures to chemicals in the environment [60].
In states that have established victim compensation funds, the fears of the
opponents have yet to be realized. California, for example, has limited funds
for out-of-pocket medical expenses and property damage. Because the burden
of proof is formidable, only 21 claims have been filed since 1981, resulting in
only one award of $11,000.13 If the federal government followed the
California example, the creation of a victim compensation fund need not open
a Pandora's box.

Conclusions
The modern chemical industry poses risks to the environment through the
entire chemical life cycle. Toxicants may be inadvertently released suddenly or
gradually in the stages of production, transportation, consumer use, or waste
disposal. The passage of RCRA and Superfund reflects federal efforts to
employ pollution liability insurance as a market-oriented tool for controlling
the release of toxicants into the environment. The collapse of this initiative
raises fundamental questions about the insurability of chemical technologies.

13Mr. Jerry Jones, Program Manager, State Board of Control, California Hazardous
Substance Account, personal communication, May 21, 1987.
 Pollution Liability Insurance 95

Undoubtedly the changing tort rules have undermined the conventional

CGL policy as the basis for insuring pollution. The widespread assignment of
joint and several liability surely has created moral hazard and premium-setting
problems. The response has been the birth of reciprocals and risk-retention
groups, 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 the
insurance industry. Whether this burden continues to be borne by insurers or
whether it is eventually assumed by the Federal government has little bearing
on the insurability of future exposures. The total pollution exclusion in the
new CGL policy clarifies expectations in future contracts. If the possibility of
future clean-up levies is anticipated, the costs can be factored into new
contracts [Table 2].
table 2
Innovations Induced by the New Toxic Torts

Phenomenon Problem Response

Joint & severalliability Moral hazard Voluntarystandards

Compulsorystandards
Voluntarycleanup
Spinoff waste management
Premiumsetting Reciprocalinsurance
Risk-RetentionGroups
Ignoringpollutionexclusion Financiallosses Federalassumptionof
clean-up?
DepressEIL market Total exclusionin CGL
First-partycleanup Financiallosses Discountin futurerating

The most fruitful approach to chemical risk management is to develop

statutory regulation, tort law, and insurance as a mutually reinforcing tripod.
Statutory action can make both the tort process and insurance more effective
as regulatory mechanisms. Statutory standards of care reduces the moral
hazard from joint and several liability. Statutory financial responsibility
requirements help guarantee that the successful plaintiff will not face a
bankrupt defendant. The standardization of toxic tort laws, through either
natural convergence or federal statute, can render the legal process more
predictable and hence pollution risks more insurable. Under these conditions,
insurance premiums may become a powerful economic incentive for achieving
cost-effective environmental risk management.
96 TheJournalof Risk and Insurance

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