Risk Insider: David Hershey

Maximize the Advantage of Finite Risk

By: | December 2, 2014

David S. Hershey is the Risk Manager for Sprague Operating Resources LLC / Lexa International. He is a 2014 Risk & Insurance Risk All-Star and a 2014 Liberty Mutual Responsibility Leader. He can be reached at [email protected]

The concept of finite risk is not new. Finite risk, in this context, is intended to maximize your tax deductibility for known losses. Currently, the practice is to deduct losses as they are incurred, typical GAAP policy. An insurer, on the other hand, has the benefit of statutory accounting rules which allow for the deductibility when the loss is incurred, allowing for accelerated deductions early in the project term.

The principle of determining the optimal method of risk financing for known losses has various tax implications often influencing the cost effectiveness of the project. Based on specific criteria, the IRS has allowed deductions for the entire finite risk payment when in conjunction with certain insurance related policies.

Consider the advantages of finite risk transactions and remediation cost containment – the latter being an insurance policy.

The Scenario

The basic application for finite risk coupled with remediation cost containment is designed for entities that have acknowledged environmental liabilities that will require funding for a period of time extending into the future (usually 4-plus years).

The Fix

The finite risk portion of the product is structured similar to an annuity generating payments for remediation expenses on a scheduled basis. Remediation cost containment coverage will provide financial security for the entity in the event the cost of the remediation project exceeds a previously determined level.

The Process

The remediation project is calculated on the basis of total cost, annual cost and projects duration. The total project is calculated at net present value factoring the time and frequency value of money. A lump sum payment is paid to a third-party fiduciary (the insurance company), and a commutation account is established in an off-shore or on-shore facility.

When remediation costs are incurred in conjunction with the previously determined payment schedule, payments are made from the commutation account on the behalf of the entity. If the cost of the cleanup exceeds the original estimates, even if for a change in law during the project period, the remediation cost containment insurance will pay the difference.

The Advantages

Depending on the fiduciary selected, the interest generated in the commutation account can be tax exempt. The lump sum payment or installments paid to the commutation account can be tax deductible in the year the payments are made. The insurance premium payments for the remediation cost containment coverage can also be tax deductible. In the event the project cost less than the original estimation and subsequent funding, any balance remaining in the account is returned to the entity.

In addition, risk-financing techniques such as this can result in substantial balance sheet adjustments, added financial security, increased credit ratings, and modifications in the accounting footnotes. Once the remediation phase is completed, any ongoing operation and maintenance that may be associated with the long-term monitoring may also be transferred to the third-party fiduciary.

To maximize the cost benefits of your risk management program, the underwriter must understand the specifics of the remediation project and the additional protection that can be extended under the Brownfields legislation.

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The R&I Editorial Team can be reached at [email protected]