Ensuring Mitigation by Insuring Banks

Mitigation bankers are on the hook financially for projects that fail to deliver the promised environmental benefits, but the systems that cover financial assurance not only tie up cash but fail to generate payments that benefit the environment.   A new insurance mechanism may prove both more cost-effective and greener.

4 January 2012 | When working on risk management for a construction project, Bob Spoth encountered a question he’d never heard before – namely: how can mitigation bankers best provide financial assurance in case a Section 404b Clean Water project fails to deliver the promised mitigation credits.   Because a portion of a project’s mitigation credits are typically released before the physical work is complete, this is a required component for mitigation bank project proposals.

“Honestly, at the time, I looked at them and said ‘You have got to be kidding me.   No, I don’t do that.   We issue workers compensation, car insurance, general liability, things like that,” says Spoth, now the President of Ecosystem Insurance Associates.   “But they took the time to teach me their business and introduce me to people at the (United States Army) Corps of Engineers (USACE).”

With help from the USACE’s Institute of Water Resources to understand the regulatory system governing mitigation banking, Spoth was sold.   Just over two years ago, his firm began developing an insurance product that could function as financial assurance.     His firm has now been selling this insurance product to mitigation bankers for six months—and trying to gain approval for it as a form of financial assurance in individual districts across the country.

According to the Final Rule issued by the United States Environmental Protection Agency (EPA) in March, 2008, insurance is one of the many options for financial assurance.   But until now, there has been no source for it.

“I am the first insurance company to do it,” says Spoth.

Why it Matters

His insurance product will be addressing what he considers to be a gap in the financial assurance options for mitigation bankers.   Currently, the other options require substantial cash collateral. In addition, if failure becomes a reality, the USACE would receive a payment rather than a solution.   Spoth sees insurance addressing both of these issues.

However, for mitigation bankers to actually purchase his insurance product, the individual districts of the USACE needed to approve it as a legitimate form of financial assurance.   So far, Spoth has gained approval for his product in four of the 38 Corps Districts, and is working through the process in 11 more.   Though this has been a difficult process, Spoth expects it to go much smoother in the near future as the USACE headquarters just released guidance for the district level, focusing on the financial assurance requirement.

The headquarters developed this guidance to make specific recommendations around the issue of financial assurance.   Though it is an internal document, Spoth was given a copy because the guidance specifically mentioned casualty insurance and made certain recommendations around it.   And he thinks it will prompt more districts to approve it.

“While we have been getting approved and are providing insurance on offset credits for mitigation bankers in several districts, we hope that this guidance from Chief Counsel will crack the bureaucracy in most or all districts,” says Spoth

However, in order to gain anything beyond verbal approval from individual districts, Spoth needs to work with mitigation bankers to connect his product with their mitigation banking instrument.

Why Insurance?

Before a mitigation banking project can even be submitted for approval, the mitigation banking instrument has to be defined in a prospectus.

“That instrument identifies a host of things – including the credit yield, when credits are released and, in addition, the financial assurance obligations,” says George Kelly, the Director of Environmental Banc and Exchange.

The financial assurance amount is based on the credit release schedule, which is developed using performance and implementation criteria.   While the release schedule varies, according to Kelly, most districts release 15% of the project’s total credit yield before the physical work is complete.   When one of these credits is sold, the mitigation bank has an obligation to fulfill the terms of that credit.   In other words, it transfers the compensatory mitigation obligation of that project over to that bank.

All forms of financial assurance ensure that this obligation will be followed through on once the responsibility has been transferred to the bank.
 
There is always a possibility that the physical work will never be completed.   A USACE Institute of Water Resources’ (IWR) white paper, “Implementing Financial Assurance for Mitigation Project Success,”,says, “Mitigation projects are generally complex and the final outcomes are uncertain even when mitigation providers fully implement approved mitigation plans and diligently apply adaptive management and corrective measures as problems are encountered.”  

The report identifies a number of different financial assurance alternatives in the Final Rule, including performance, bonds, escrow accounts, casualty insurance and letters of credit.   All these alternatives need approval from the district engineer.

Existing Alternatives

The three most common forms of financial assurances are a letter of credit, cash escrow and a surety bond, with the latter being the most popular. “All three of those things are credit instruments, so all three are a bit like going down to the bank and saying ‘Can I have a loan?’” says Spoth. And that means collateral and building interest—which means they are not ideal alternatives for mitigation bankers.

“What we want to do is find the optimum product to meet the needs of both ourselves and the Corps,” says Kelly.   “There have been some questions historically about the best approach for providing assurances.”

“Honestly, bonding doesn’t really work,” says Dave Urban, the Director of Operations for Ecosystem Investment Partners and President of the National Mitigation Bankers Association. “The Corps thought it would, but it doesn’t.   Putting escrows up is basically causing us to put our money down twice…and this really makes huge barriers to entry.   Letters of credit are expensive also.”

On the other hand, insurance does not require this type of cash collateral.   Though, as the IWR report points out, mitigation providers need to assure the insurer they have the capacity to complete the project, this qualification process is much simpler than applying for a performance bond.

“This is just pure insurance.   You buy the insurance policy and then put it on the table and you are done,” says Spoth.   “The last thing in the world a business wants to do is put cash in the bank non-productively, for any reason.   If they can avoid that, they will.”

So when Spoth approached Urban about this insurance alternative, he jumped on board. “Bob Spoth contacted me early on and I said ‘This makes a lot of sense to have an insurance product.   Let’s see if we can make it happen,’” says Urban.

Urban sees two immediate benefits to the insurance alternative.   “One is the risk factor.   They are covering me by saying if I fail, they will take care of the problem,” he says.   “Second of all, it should be a lot cheaper for me to get insurance than for me to get an escrow amount covered.”

For Kelly, the positives come when comparing the coverage to a surety bond.   A surety bond, in this case, would promise to pay the USACE a specific amount if the mitigation provider fails to complete the mitigation obligations.  

“I think it is a better product for what it is trying to do than surety.   Surety only ensures the performance of the activity,” says Kelly.   “This is insurance for the compensatory mitigation obligation.   That is very different meaning you have got somebody standing by that mitigation obligation for the amount they are saying they are going to do.”

This is a benefit for the USACE as well.   While these other forms of financial assurance will provide a check to compensate for the loss, there is still the problem of the loss.   In addition, as the regulator, the USACE cannot possess or direct the money intended for mitigation.   However, since Spoth’s product functions as any other form of insurance, it will instead look for a solution to the problem.

What Can go Wrong?

There are, though, some risks to consider with casualty insurance.   For one, currently there is only one underwriter.

“We would like to see more competition within the numbers of underwriters that would be interested in this,” says Kelly.   “If you are limited to one underwriter, it could be expensive and selective.   The hope is that it opens up to more underwriters over time.”

In addition, this product has yet to be tested, which means there is little data to support the effectiveness of the insurance.   However, since the company has committed to the details in writing, there is a strong indication that it will follow-through.

Gaining Approval

To gain approval for Spoth’s insurance product at these various stages, it was necessary for proven mitigation bankers to become, in essence, its champions.

“The only way to get a product like this through all the way through finalization is to attach it to a mitigation banking instrument,” says Spoth.   “Somebody has to decide that this is a worthwhile product and be willing to take the extraordinary step trying to go out and help me get it approved.”

This is where Urban and Kelly come in.   Kelly’s firm, Environmental Banc and Exchange, has a long history of being early adopters—and this situation is no different.

“We have felt like this is an area of innovation that would improve the assurances for everyone.   It’s something that should be adopted,” says Kelly.   “We are willing to go out on a limb and support it even though we could have presented other alternatives.”

Regulatory Roadblocks

While some districts are open to the possibility, mitigation bankers have run into some road blocks.   Urban, for example, discussed Spoth’s earlier products with some Corps districts and had one Corps lawyer even tell him he was researching how to stop the use of this insurance.

Both Urban and Kelly have integrated casualty insurance into their mitigation banking instrument.   The mitigation banking instruments includes the credit yield, the credit release schedule and the financial assurance obligations.

“When we typically have negotiated the instrument, we then get to the financial assurance provision,” says Kelly.   “At that point, we present the financial assurance to the Corps as the lead agency as part of the inner agency review team.   They then typically vet it with their legal counsel.”

Since this insurance product is a relatively new alternative, the vetting process has slowed approval significantly as regulators and their legal counsel try to decide if they are going to accept the insurance product.

Urban says he has submitted proposals in both the New Orleans and Philadelphia districts, waiting months for a response.   “I have had endless discussions and I have submitted things and he doesn’t act on it,” he says.   “I am waiting on them right now in both districts.”  

And even if legal counsels seem open to the idea of insurance, the vetting process might lead to some changes being made to the insurance product.   Making it even more difficult, legal reviews are usually one of the last steps in the process.

Do it Early

“What everybody has to do is get their mitigation banking instrument written in such a way that the casualty insurance is presented to the regulator at an early enough stage in the process that it doesn’t delay it as it goes through the approval,” says Spoth. “That is easier said than done because the legal review of a mitigation banking instrument is usually the last thing that happens.     A mitigation banker does not want to delay his approval ever, but particularly if he has a credit sale hanging out there.   If it’s going to delay his approval, he will not buy my product.”

This was almost the case in one of Kelly’s mitigation projects.     In the review, the legal counsel said the insurance product would be accepted if some provisions were changed.   But as Kelly points out, legal counsels do not typically get involved until late in the process.   “We think this is somewhat problematic,” he says.   “A way to address this would be to have counsel involved at an earlier stage before the (mitigation banking instrument) is approved.”

Since that didn’t happen in this instance, the entire process was slowed down.

“Bob had to go to the underwriter and get their approval (for the changes),” says Kelly.   “That required some time and then they came back and there were questions again…it was to the point where we said, ‘This is taking so long.   We’ll just provide you with a surety bond.”   Ultimately, though, Environmental Exchange saw the process through.

Though the delay will be too much for some mitigation bankers, Kelly and Urban see the approval time diminishing in the future.   First, they and Spoth have brought the issue to the attention of the Corps headquarters, leading to the development of guidance to reassure districts that this is a legitimate option.

“They are imminently away from putting a memo out to the field saying, ‘it is in the rules and it should generally look like this.   You don’t have to be scared to be the first one to accept it,’” says Urban.

“I think with the new guidance and with the fact and recognition that other districts have approved it, you are going to have see increased acceptance,” says Kelly.   “For districts that haven’t heretofore approved it…it’s probably not going to be a fast process because they are going to need to be educated about what it is.”
     

So, What is it?

Basically, the insurance product policy stipulations can say that for up to 10 years, it will provide coverage for the non-performance of the ecosystem, offering policy limits as high as $10 million.

“Now that sounds like a ridiculous thing to insure, but it’s a very managed process,” says Spoth.   “There is a baseline set of conditions and there is a restoration objective and there is a defined process of reaching that.”

 The Corps’ report outlines how the product actually works, in the event of a failure: “the insurer agrees to fulfill the mitigation obligation of the insured, up to a specified dollar limit within a specified period of time, if the Corps determines that the mitigation provider has failed to meet its mitigation obligation…A claim can be filed only by the Corps. The policy specifies that the insurer will satisfy a claim (up to the dollar limit of liability) by remediating the failed mitigation project or providing replacement mitigation, or by making payment to a Corps designee, as directed by the Corps.”

However, Urban says that before the Corps makes a claim against the insurance policy, it will call upon the mitigation banker to fix the problem.   Then if the banker is unable or refuses to meet the obligation, then the Corps will make an insurance claim to compensate for the loss.

When a claim is filed, the Corps would direct the insurance provider to make a direct payment to the Corps for an amount up to the insurance limit or pay a Corps designee the amount necessary to purchase mitigation bank or ILF credits.

Since the insurance company is at risk in terms of the size of the obligation, they take measures to lower risk, such as only selling insurance to mitigation bankers with experience.

“This policy isn’t going to apply to everyone because you are going to have to be a banker with a good track record,” says Kelly.   “That is an important thing for the underwriter.”

As the Corps report says, “To obtain a policy, mitigation providers must show the insurer that they have the capacity and financing to complete their obligations, although this qualification process is less detailed and time‐consuming than that required of applicants for performance bonds.”
In addition, as mentioned before, the product will only serve the compensatory mitigation aspect of the mitigation bank.   Therefore, it will only be responsible for the credits that the mitigation bank has sold.

Finally, like other forms of insurance, the insured party will also be required to pay a 2 to 4% deductible on a claim made by the Corps.

Spreading the Wealth

This is not the only frustration for mitigation bankers around the Corps’ districts handling of financial assurances.   While the Final Rule outlines the need for financial assurances for all credit types, it ultimately allows districts to make the final decision—and in most cases, financial assurances are not required.
     
“For many permittee-responsible mitigation projects, it is not practical to require financial assurances, so alternative mechanisms are often used instead, such as taking enforcement action to compel compliance with permit conditions relating to compensatory mitigation,” says the USACE IWR report.   “For in-lieu fee programs, contingency funding is commonly built into credit prices charged as an alternative…”

In addition, credit release schedules are not typical for other forms of mitigation.   Instead, both permittee-responsible and ILF forms of mitigation receive benefits before work is completed:   Permittee-responsible’s credits are all released before work begins and ILFs are paid fees before work is completed.

Mitigation bankers are frustrated by this seemingly double standard, as the multiple protections increase costs and decrease demand for these high-quality credits.

“You have got the credit release schedule… scenarios where, in addition to financial assurances, you have escrow provisions built in for every credit sale,” says Kelly.   “Right now, to me it is way overkill what is required in banks for protecting the credit release and the credits in the marketplace.   But for sure, it’s the highest integrity credit that you will see.   I only wish that the other types of credits are allowed under the law would have the same protections.”

“It seems to me it’s crazy because you know what the Corps across the board has failed to realize is financial assurances are to ensure performance,” says Urban.   “But credit release schedules are also for banks to ensure performance.   So why are they double penalizing us and not penalizing anybody else?”

Looking to the future

Though other ecosystem services are not currently regulated, there is a potential for this insurance to spread to other contexts.

“I think this is very intriguing for any offset in the environmental market spectrum,” says Kelly.   “There is no reason why this product can’t be adopted for other purposes.”

Spoth thinks it would also transfer easily to other forms of mitigation—as long as the regulatory framework was in place.   In fact, he says that he is already working with state regulators on state nutrient trading.

While it would take some work for everyone to understand the different financial obligations, this possibility provides a path for expansion.   But for now, Spoth and his team will focus on gaining approval for mitigation casualty insurance in districts around the nation, increasing the number of banks utilizing his product.

Though Spoth and the mitigation bankers have run into some challenges, they aren’t discouraged.   As Spoth says “Even a willing bureaucracy is difficult to crack.”