&EPA
Protection
Off'C« of
Sond Wa«i«
DIRECTIVE NUMBER: 9>*77.oo-i
TITLEi Background Document - Financial Test for Liability
Coverage
APPROVAL DATE: 0^-09-82
EFFECTIVE DATE: 0*1-09-82
ORIGINATING OFFICE: Office of Solid waste
m FINAL
D DRAFT
STATUS:
REFERENCE (other documents):
[ ] A- Pending OMB approval
[ ] B- Pending AA-OSWER approval
[ ] C- For review &/or comment
[ ] D- In development or circulating
headquarters
DIRECTIVE DIRECTIVE L
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UnttedStttJsenvironmenu^rotectjofntoency^"""™™"^™"
Washington. DC 20460
QSWER Directive Initiation Request
1. Directive Number
9^77.00-1
2. Originator Information
Name of Contact Person
Carole Ansheles
Mail Code
N/A
Office
osw
3. Title
Background Document - Financial Test for Liability Coverage
Telephone Code
(202) 382-1*761
4. Summary of Directive (include brief statement of purpose)
This background document explains EPA's position on use of a financial test to
provide liability coverage to meet requirements of 261*. ll* 7 and 265.11*7.
5. Keywords
Liability/Insurance/Financial
oa. Does This Directive Supersede rrevious uirective(s)'.
b. Does It Supplement Previous Directive(s)?
No
No
Yes What directive (number, title)
Yes .What directive (number, title)
7. Draft Level
A - Signed by AA/DAA
6 - Signed by Office Director I C - For Review & Comment
D - In Development
8. Document to be distributed to States by Headquarters?
Yes
X
No
This Request Meets OSWER Directives System Format Standards.
9. Signature of Lead Office Directives Coordinator
1 0. Name and Title of Approving Official
N/A
Date
Date
EPA Form 1315-17 (Rev. 5-67) Previous editions are obsolete.
OSWER OSWER OSWER O
VE DIRECTIVE DIRECTIVE DIRECTIVE
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BACKGROUND DOCUMENT
RESOURCE CONSERVATION AND RECOVERY ACT
SUBTITLE C—HAZARDOUS HASTE MANAGEMENT
Section 3004 - Standard* Applicable to Owners and Operator*
of Hazardous Waste Treatment, Storage and Disposal Facilities
Parts 264 and 265, Subpart H
Financial Requirements
Financial Test for Liability Coverage
April 9, 1982
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I. introduction . •
Sectiu*»jlfD4(61 of the Resource Conservation and Recovery Act (RCRA)
•*&*. r~
of 1976, Pub*ti 94-580 (October 21, 1976), requires the Environmental
Protection Agency to promulgate financial responsibility standards applicable
to owners and operators of facilities for the treatment, storage, or disposal
of hazardous waste as may be necessary or desirable to protect human health
and the environment.
The Agency has concluded that liability coverage requirements constitute
a desirable part of the RCRA regulatory program, as explained in the preamble
to the revised interim'final regulations (40 CFR 264.147 and 265.147,
promulgated April 1982) which this background document accompanies.
The requirements are designed to assure that funds will be available
from which third parties can seek compensation for bodily injury and
property damage resulting from operations of the facility.
The regulations specify two means by which owners or operators can
satisfy the requirement for liability coverage: purchasing liability
insurance or passing a financial test. The financial test for liability
coverage was developed in conjunction with the financial test for closure
and post-closure care. The reader is referred to the preamble and background
document accompanying the financial test for assurance of closure and
post-closurewomxe (47 PR 15032-74, April 7, 1982) for a detailed description
-•?-.
of the rational* and analysis supporting these tests. The present background
document supplements the earlier document and is focused on the issues
specific to the test for liability coverage. It also includes responses
to comments from the public regarding such a mechanism.
A. Description of the Financial Test for Liability Coverage
The regulations require that owners or operators maintain liability
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coverage amounting to $1 million per sudden accidental occurrence with a
$2 milllai^^K*£*99r*9ate' and' in addition, for surface impoundments,
treatment facilities, coverage amounting to $3 million
per nonsudden accidental occurrence with an annual aggregate of $6 million.
The regulations allow owners or operators to satisfy the liability coverage
requirement by providing evidence of insurance or by passing a financial
test. The test may also be used to demonstrate part of the required
coverage. In such a case the remainder of the liability coverage requirement
must be met by insurance as described in the regulations.
An owner or operator may pass the financial test for liability coverage
by demonstrating that he meets either of two sets of criteria.
Alternative I:
(A) Tangible net worth of at least $10 million; and
(B) Net working capital and tangible net worth each at least six
. times the amount of liability coverage to be demonstrated by
this test; and
(C) Assets in the United States amounting to either: (1) at least 90
percent of total assets, or (2) at least six times the amount of
liability coverage to be demonstrated by this test.
Alternative II:
(A) A current rating for its most recent bond issuance of AAA, AA,
A, or BBB as issued by Standard and Poor's, or Aaa, Aa, A, or
Baa as issued by Moody's; and
Is net worth of at least $10 million; and
net worth at least six times the amount of liability
to be demonstrated by this test; and
(D) Assets in the United States amounting to either: (1) at least
90 percent of total assets, or (2) at least six times the amount
of liability coverage to be demonstrated by this test.
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financi
audlte^r
Ac evidence of satisfying the financial test, an owner or operator must
"
latter to the Regional Administrator signed by his chief financia
officer that includes the required data from the owner's or operator's
independently audited, year-end financial statements, a'nd
(2) A copy of the independent certified public accountant's report on~
examination of the owner's or operator's financial statements for the latest
completed fiscal year; and
(3) A special report from the owner's or operator's independent
certified public accountant to the owner or operator stating that the
accountant has compared the data which the letter from the chief financial
officer specifies as having been derived from the independently
year-end financial statements for the latest fiscal year with the- amounts
in such financial statements and/ in connection with this procedure/ no
matters came to his attention which caused him to believe that the
specified data should be adjusted.
As in the case of the financial test for closure and post-closure
care/ if the auditor's opinion that is included in his report on examination
*
of the owner's or operator's financial statements is an adverse opinion
or contains a disclaimer of opinion, the owner or operator may not use
the finafsfijt test to satisfy the financial requirements.
tal Administrator may disallow use of the financial test based
on other qualifications expressed in the auditor's opinion of the owner's or
operator's financial statements* For example, if the Regional Administrator
determines that the opinion raises questions as to whether th* owner or
operator will continue as a "going concern, * the financial test will be
disallowed. Other qualified opinions will be evaluated on a ease-by-case
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basis. -The o«m*g or operator must provide evidence of insurance for the
entire- rflflK&V** of coverage within 30 days after disallowance.
' submission of the letter froa the chief financial
officer and the accountant's reports, a new letter and new reports for
each subsequent fiscal year must be submitted to the Regional Administrator
within 90 days after the end of the firm's fiscal year. Alternatively, by
the end of this 90-day period the owner or operator oust provide evidence
of third-party liability insurance coverage to the Regional Administrator.
B. Development of the Financial Test for Liability Coverage
The development of- the financial test for liability coverage has
been influenced by public comments received on two sets of proposals.
of permitted facilities to establish liability coverage through evidence) of
insurance/ self-insurance for an amount not exceeding 10 percent of the owner's
or operator's equity, a combination of the two, or some other evidence of
financial responsibility acceptable to the Agency (43 FR 58995, 59007).
In a reproposal published May 19, 1980, on both liability coverage
and financial assurance for closure and post-closure care, the liability
coverage requirements for facilities in permitted status were not changed,
but because the Agency felt that resolution of the issues raised by the
proposed r*f^BBPnt> would benefit from further public comment the
comment perJJKtar reopened (45 FR 33260, 33264). In addition, the
Agency proposed liability requirements for coverage of sudden accidental
occurrences at interim status facilities, but did not permit self-insurance
as an alternative to liability insurance during interim status because
the Agency believed that owners or operators either already had or could
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obtain liability policies that covered sudden accidental occurrences (45 .*
PR 33273). * .
The Merits 1980, reproposal included a financial test for assurance of
closure and post-closure costs. To pass this test, an owner or operator had
to have the following: (1) at least $10 million in net worth in the United
States; (2) a ratio of total liabilities to net worth of not more than 3;
and (3) net working capital in the United States of at least twice the cost
estimates for closure and post-closure care. Several commenters suggested
that this test could also be used to qualify owners or operators for self-
insurance.
The interim final regulation of January 12, 1981 (46 FR 2802 -
2888), required insurance coverage. As the preamble stated, self-J
i.e., financial test provisions, were being considered for both interim si
and permit standards. The Agency intended to reach and publish its
decision prior to the effective date of the regulations.
Since testing the financial strength of an owner or operator with
reference to liability coverage is similar in purpose to testing with
reference to closure and post-closure costs, the Agency decided to seek
developme it of a test for liability coverage in conjunction with its
development of a test for financial assurance of closure and post-closure care.
Out of ,over 300 candidate sets of test criteria, two were selected for
the finandA test for closure and post-closure care. One set required
certain financial ratios; amounts of net working capital and tangible net
worth each at least six times the estimated costs of closure and post-
closure care; at least $10 million in tangible net worth; and U.S. assets
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totaling"either (1) at least 90 percent of total asset* or (2) at least si*"
tines the 9J£jjt*t*A closure and post-closxire costs. This set of criteria
is considet^£bvpropriate for testing owners or operators in manufacturing
industries likely to be involved in hazardous waste management. The second
set of criteria requires a bond rating in the highest four categories of
ratings by Moody's or Standard and Poor's; tangible net worth at least six
tines the estimated costs of closure and post-closure care; at least $10
million in tangible net worth; and U.S. assets totaling either (1) at least
90 percent of total assets or (2) at least six times the estimated closure
and post-closure costs. This set of criteria was developed for utilities
and other industry 'sectors structured differently from the manufacturing
»
sector for which the first set of criteria was developed* *
The Agency concluded from its evaluations that this financial test ;
should be allowed as a means of satisfying the financial requirements for
closure and post-closure care because it provides strong assurance of
availability of funds and minimizes regulatory costs.
As described in the following section, the results of evaluating
candidate tests for assurance of liability coverage were slightly different
than for assurance of closure and post-closure costs. A test that did not
include financial ratios was judged to be most appropriate (this test
was labeled "anility to Pay test" in the evaluations and is so referred to
in subseqaesKMCtions of this background document). The ratios add
stringency to the test, but analysis indicated that the same level of
stringency was not required for a test for liability coverage] as for a
test for coverage of closure and post-closure costs. Liability for
accidents at a hazardous waste management facility is a contingent event,
unlike the certain obligation for closure and post-closure care. The
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possibtlitvtbAt an owner or operator who passes a financial test for
cannot pay liability costs is dependent both upon
the oecaff'Of'* serious accident and the owner or operator becoming
financially unable to pay the required sums. A test minus the ratios was
found to provide adequate assurance for liability coverage.
Based on its analyses the Agency concluded that the 10-percent-of-
equity measure for self-insurance that was proposed in December 1978
was inappropriate for several reasons: the Agency's analysis found that
equity amounting to 6 times the amount of liability covered/ rather than
10 times, was sufficient as an indicator of adequacy of total assets; the
equity percentage by itself does not measure capability to fund near-ten
*
obligations; and this test does not take into account the significantly .:
higher failure rates of smaller firms.
The test proposed on May 19, 1980, was evaluated in comparison with the
other candidate tests for liability coverage. It was rejected, however,
because the costs associated with this test were higher, without significant
added assurance of liability coverage, than those of the Ability to Pay
test (Table 1).
Apart from the test criteria, there are four ways in which the
requirements for th« financial test for liability coverage differ from
the test £fj^|pssMat« for closure and post-closure care:
Agency decided to allow use of the financial test for
part of the amount of required liability coverage, with insurance
for the remainder. Under the insurance requirements of the
regulation* the insurer must provide "first-dollar11 coverage.
The insurer is responsible for payments within any deductible,
with right of reimbursement by the owner or operator.
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ing use of th« financial test for part of the required
age allows the owner or operator to have a deductible for
he takes full responsibility. This should mean savings
in insurance costs and additional flexibility in obtaining
insurance. For closure or post-closure care, the test oust be
used to cover the entire amount of one cost estimate. However,
the owner or operator may use other mechanisms to cover other
closure and post-closure estimates he is required to provide
assurance for; the Agency believes this allow* flexibility
without placing undue administrative burden on the Agency*
(Based on information presented in Appendix B of the) background
document for the financial test for closure and posrt-cloetire |r
r
care, the Agency concludes that most owners or operators usjiag
the financial test will have more than one facility. In the
financial test analysis, an average of four facilities is
assumed.)
— Owners or operators may use a parent corporation's guarantee
to satisfy the closure or post-closure financial assurance
requirements if the parent passes the financial test, but
use of a parent's guarantee to satisfy the liability require-
is not allowed. The Agency decided not to allow use
parent's guarantee for liability coverage because there
are major questions concerning the validity and enforceability
of such an arrangement, especially as it may be affected by
State insurance laws.
•- The financial test provisions for liability coverage) require an
owner or operator using the test to satisfy the requirements
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to establish insurance coverage within 90 days after the end bf
year for which the financial statements show that he
passes the test. In contrast, the financial test
provisions for closure and post-closure care require that
within the 90 days after the end of the fiscal year for which
he no longer passes the test the owner or operator most notify
EPA of his intent to establish alternate assurance and then,
within 120 days after the end of the fiscal year, establish
such assurance. Upon reviewing this matter, the Agency has
concluded that 90 days is adequate time for an owner or
operator to become aware of his failure to pass the test and
to establish an alternate financial mechanism for either li
coverage or assurance of closure or post-closure care* The
Agency therefore expects at a future date to propose changing
the closure and post-closure financial test requirements to
also state that the owner or operator must provide alternate
financial assurance within 90 days after the end of the fiscal
year for which he fails to pass the test.
— The Regional Administrator may require reports of financial
condition at any time from owners or operators using the
icial test for closure and post-closure care if the
Administrator has a reasonable belief that the
owner or operator no longer meets the test criteria. This
provision is not included in the requirements for the
financial test for liability coverage* The Agency believes
that a yearly report from users of the financial test for
liability coverage will be sufficient because of the small
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1 against a • ••ills 9"
_JE
i. The • bankrupt n i lasX
likelihood that an owner or operator passing the test will
following year experience business, failure while
a major liability resulting from an accidental occurrenc
In contrast, closure and postclosure care are certain
obligations, and the Agency expects that there will be
occasions when additional financial reports are justified
to verify the continuing ability of owners or operators to
satisfy these obligations.
II. ANALYSIS OF .2ST CRITERIA
From the comments~'on the proposed tests and from the research, result*
of previous bankruptcy forecasting, the Agency assembled a list of
300 candidate financial tests. These were evaluated
consisting of 178 viable firms and 66 bankrupt firms*
were identified from previous bankruptcy forecasting literature and an
independent search; all had filed for bankruptcy between 1966 and 1979.
The sample of nonbankrupt firms was designed to represent the expected
asset size range and mix of industries likely to seek to use a financial
test. Another sample of 26 nonbankrupt utilities was also studied.
For each test evaluated against the sample, the Agency computed two
primary measures of effectiveness. One was the number of firms per
10,000 that:]fould pass the test and later go bankrupt without providing
insurance os)pB*soe . This measure determines the effectiveness of a
test in eliminating owners or operators that would be major sources of
direct public costs. The other primary measure was the percentage of
viable firms that would be able to use the financial test* This
factor represents the test's potential for reducing private cost* by
allowing owners or operators to use the test. Where several t«
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attained-the same level of effectiveness in eliminating bankrupt
firms, th« £fejjjl* tnat simultaneously allowed the greatest number of
viable firasJ^SB «•• it was judged a "best test* (these are listed in
*•
Table 1 and their components are described in detail in Appendix A of the
background document for the closure/post-closure financial teat).
A requirement for $10 million in net worth was included in all these
candidate tests. As discussed in the previous background document, firms
with less than $10 million in net worth have a greater failure rate and
present a reduced possibility of recovery in bankruptcy. The Agency
believes that they may'also significantly increase the burden ot adminis-
tering the test because of their greater instability.
The tests identified with numerals in Table 1 are based on financial $,
it'
ratios which function as indicators of viability. To also measure capacity^
to pay the amounts of liability coverage to be demonstrated by the test*
the Agency decided to add to each of these tests, for purposes of the cost
analysis, the requirement that the owner or operator must have net working
capital and net worth six times the amount of liability coverage to be
demonstrated. The Ability to Pay test included only this requirement
and the requirement for $10 million in net worth.
The multiple of 6 was derived in the following manner: The Agency
conducted anjuialysis of firms which had experienced rapid deterioration
of their fiaiadal condition for 2 to 3 years prior to business failure.
% '
This analysis showed that net working capital of these firms fell by an
average of 66 percent in 2 years. The Agency believes that in order to
ensure that adequate liquid assets, as indicated by net working capital,
will be available for liability coverage, net working capital of at
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AMD
OWN9M
' TABLB .1
PUBLIC AND MIVATB COBTB or, ALTERNATIVE HNAMCIA(. TBBTS ron LIABILITI BBQUi«BNW*4
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least six tines.the estimated costs is an appropriate level. This figure-"
is 111 il • I iifj^pEbttltiplying the factor of 2 (safety factor to ensure current
ability totpMr tiass 3 (to ensure against a high rate of deterioration before
' •
payment can be brought about). With a multiple of 6, it is likely that even
a rapidly deteriorating firm will have net working capital amounting to
twice the amount of required coverage 2 years after failing the test.
While it is unusual for firms to have less net worth than net working
capital/ the possibility does exist, and such a firm would be very weak
financially. Therefore a requirement was added for net worth of at least
six times the amount of coverage to be demonstrated.
The relative costs to the public and the regulated community associated
with allowing use of the candidate tests were estimated. The costs
associated with allowing only use of private insurance to demonstrate
financial responsibility were also part of the comparison. The test which
minimizes the sum of direct public and private costs was identified (the
Ability to Pay test). This test provides the lowest sum of all costs to
the public because/ over the long run/ private costs to owners and operators
will be passed on to the public through increased costs of goods and services.
The cost results were then reviewed in light of the basic consideration
of reasonable assurance that funds will be available for compensating
third P*r*r injuries from hazardous waste facility operations;
equity (i.e./ owners or operators responsible for
damages should pay for them/ rather than the injured parties or the
general public)/ and minimization of costs to the regulated consnmlty.
The Appendix to this background document describes the Agency's determination
of costs and provides analytic support for the numerical results reported
in the following discussion.
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X. -Costa lacaiaiaed
In. •^^^Hn.'elw costs of varioua alternative financial testa, two
types of oqlptpure examined: direct public costs and private costs.
(1) Direct public costs ware defined aa the sum of coata which
ultimately muat be borne by the public becauae of the nonpaynent of relief
to harmed parties. Two typea of direct public coata were- analyzed:
(i) The direct public coata due to bankruptcy of owners or
operators uaing insurance. These include liability judgments up to the
limits of coverage required by the regulation which cannot be recovered
from owners or operators through legal action. Such costs could reault
from claims filed after the cancellation of an insurance policy*
(ii) The direct public coata due to bankruptcy of owners ox operators^
uaing the financial teat. These include liability judgmenta up to the
limits of coverage required by the regulation which cannot be recovered
from the firms through legal action.
Any costa of litigation by third parties associated with the recovery
of funds from bankrupt firms were not included in direct public coata*
Costs to the Agency of adminiatering the regulation were not included}
they are estimated to be comparable between insurance and the financial
test.
(2) vqtafcl* eoeta were defined by the Agency aa the coats to the
regulated oMBiEity of satisfying liabilitiea up to the required amount
of coverage and the additional cost of financial mechanism* to serve as
assurances) of financial responsibility. Certain costs that all financial
mechanisms' have in common, such as the costs to the owner or operator of
routine management associated with maintaining any financial mechanism.
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were not iAfftoded. Two types of private costs were considered in the
analysis r^tr- «"
(i) ^Ttf* private costs of insurance. These include the premiums for
insurance policies. Including coverage for legal defense. Costs of other
aspects of the insurance required by the regulation, such as submission
of the Hazardous Waste Facility Liability Endorsement or Certificate of
Insurance, were assumed to be minimal.
(ii) The private costs of liability coverage evidenced by the
financial test. These include the liability judgments, settlement*, and
legal defense costs incurred by owners or operators which use the tact
plus the cost of auditors' reports required for use of the financial
The model used to analyze the costs of the financial test for'liaM
coverage had a structure parallel to the model for the costs of the)
financial test for closure and post-closure care. Figure t presents the
structure used for the liability test. The Agency based its estimate of
the direct public costs associated with bankruptcies of owners or operators
that pass the test on the assumption that liabilities outstanding 2 1/2
years prior to bankruptcy will have to be recovered in bankruptcy
proceedirgs and that 30 percent of these funds can be recovered from
bankrupt owners or operators. For owners or operators that fail the
test and usjfeinaurance, the Agency assumed that all liability outstanding
6 months pJJBe^to bankruptcy will have to be recovered in bankruptcy
proceedings due to termination or cancellation of the policy prior to
filing of claims. (See section III of Appendix for further discussion
of afcemt assumptions about recovery in bankruptcy.)
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,-s-- -.--
OR OPERATORS POTENTIALLY ABLE TO USE
A FINANCIAL TEST
FOR LIABILITY COVERAGE
PASS TEST
(PAY PRIVATE COSTS
OF FINANCIAL TEST)
DOES NOT PASS TEST
(PAT INSURANCE PREMIUM)
BUSINESS
DOES NOT
FAIL
BUSINESS FAILURE
(DIRECT PUBLIC
COSTS: 70% OF
FUNDS NEEDED FOR
CLAIMS AWARDS
DURING 2 1/2 YEARS
PRIOR TO BANKRUPTCY
ARE NOT RECOVERED)
BUSINESS
DOES NOT
FAIL
BUSINESS FAILURE
(DIRECT PUBLIC
COSTS* 70% OF*
PUML6 MUDSD P00|
CLAIMS AWARDS *
DURXHG 6 MOWTH8
PRIOR TO BAMXRO
ARB ROT RECOVERED)
FIGURE 1
STRUCTURE OF THE COST MODEL
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The *t^^Hpf*? tne Agency's analysis of the costs associated with
candidate €*In are presented in Table 1. (It should be noted that the
cost data are only for owners or operators of over $10 million in net worth
and independently audited.)
The test found to minimize the sum of public and private costs was the
Ability to Pay Test. This test with modifications as described below,
was adopted in the regulations. It requires that an owner or operator
have net worth and net working capital at least six times greater than
the amount of liability coverage to be demonstrated and at least $10 mi 111 on
in net worth. Two versions of this test were evaluated: one requiring
the owner or operator to meet the criteria based on financial statements
only for the preceding fiscal year and the other requiring him to meet
the criteria for 3 years before being allowed to use the test to satisy
the requirements. The 1-year version, which minimized costs, was selected.
Compared with allowing insurance only, allowing use of the Ability
to Pay test results in a saving of about $200 in private cost for every
dollar of added direct public cost (Table 1). Table 2 provides a detailed
comparison of private costs associated with allowing insurance only and
0
allowing use of the Ability to Pay Test for firms of ever $10 million in
net wort&* •JHRtttimtes of private costs are disaggregated according
to cost* tHe^pMUd be borne by the regulated community regardless of
the liability requirement (i.e., costs of liabilities and associated
litigation) and the costs specific to a regulation requiring liability
coverage (assuming all firm* of $10 million in net worth would self-insure
in the absence of a regulatory requirement). If all owners or operators
are required to use insurance, the costs of the regulation are the insurance
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TABLE 2
of Private Costs into Costs of Liabilities
of Regulatory Compliance, For Owners and Operators
of at Least $10 Million in Met Worth
(Thousands of 1980 Dollars)
Cost Component
Insurance Only
Ability to Pay Test
Total private cost
Expected value of
liabilities and
associated litigation
Cost attributed to the
regulatory requirement,
assuming all large firms
would self-insure in the
absence of a regulatory
requirement
23,945
16,761
16,952
7,184
191
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premiums minus the liabilities and associated litigation. The costs of
a fimss*o|^^^E^$i|»$BAe the costs of submitting an annual auditor's
report* ^BBImfPI iv the Table, the private costs of complying with an
•Insurance Only" requirement are 38 times greater than those, associated
with the Ability to Pay Test.
After the cost analysis was completed, the Agency decided that the
net worth used for this criterion and for the multiple of fr should be
"tangible* net worth, since good will, patent rights, and other nontangible
assets may be difficult to convert into-funds for satisfying liabilities.
The financial test criteria as promulgated therefore specifies tangible
net worth*
The Agency decided furthermore to add two additional criteria whose
effects were not incorporated into the cost analysis described above.
These two criteria are:
(1) Assets in the United States amounting to either* (1)
at least 90 percent of total assets or (2) at least six
times the amounts of liability coverage to be demonstrated
by the test; and
(2) Submission of an independent auditor's opinion of the owner'*
or operator's financial statements and footnotes, which must
be unqualified in order for use of the financial test to
be allowed without further review. Adverse) opinions,
disclaimers of opinion, and opinions which' raise "going
concern" questions will disqualify an owner or operator
using the financial test. Owners or operators which
Lva> other types of qualified opinions will be evaluated
avasse by case basis.
As in the test for closure and post-closure care, a measure of assets in the
United States is included to help ensure accessibility of funds. The Agency
considers the auditor's opinion of the financial statements to be an
important indicator of the adequacy of the financial data submitted. In-
dependent accountants are guided by standards set by the Securities and
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Exchange Commission for auditors within the scope of the Federal securities
laws and bjlpifede of Professional Ethics promulgated by the American '
Institute dss^BeVtified Public Accountants. In addition, the profession is
regulated, to differing extents, by State licensing boards and State
societies of certified public accountants.
The Ability to Pay test was rejected for assurance of closure and
post-closure care on the grounds that it did not meet the goals of protecting
human health and the environment, equity, and minimization of costs as
well as the test eventually chosen for assuring closure and post-closure
costs (Test 100), which included a requirement for financial ratios) that
made the test more stringent. The Agency examined the question of wJijether^.
the use of a financial test for liability requirements was sufficiently
different from the use of a financial test for closure and post-closure
care to justify adopting the Ability to Pay Test.
The Ability to Pay test was rejected for assurance of closure and post-
closure care largely because of the expected number of failure* each year
among owners or operators who would use the test. Each year, on average,
1.3 companies that use this test and that own or operate a total of about
five faci. ities would go bankrupt. However, unlike closure and post-closure
costs, which are certain liabilities, major liabilities in the form of
damage to ttflf*: parties caused by accidental occurrences would attach to
. ^i c"
M
only a porvBpi of. the facilities. Premium estimates used in this document
^^v
(see section III of the Appendix) would indicate that insurers could not
cover costs if major liability events exceeded a probability of about 1
percent a year. This would mean that, among owners or operator* using
the test and entering bankruptcy, one facility every 20 years would be
-19-
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involved in accidental occurrences resulting in liabilities. The Agency
concluded iBr*1!? •aaly«i' that the Ability to Pay test provided
reasonable- aSprance of owners' or operators' financial capability to
satisfy liabilities due to accidental occurrences at their facilities.
With respect to minimizing private costs, the Agency considered the
possibility that tests weaker than the Ability to Pay Test might be
suitable for liability coverage. This possibility was rejected* however,
on the grounds that any test significantly less stringent than the
test chosen would present the danger that a major liability event would
itself cause bankruptcy. As explained earlier, the requirement for nat
working capital and net worth amounting to at least 6 times tha amount
of coverage to be demonstrated is based on analysis of tha rata at which
working capital drops among failing companies in the years prior to their
bankruptcy. The requirement is designed to assure that funds are
available for satisfying liabilities, in the amount of coverage to be
demonstrated by the test, prior to bankruptcy. A weaker test would not
assure funds in the amount that may be necessary. Thus, with a weaker test,
in the event of a liability in the amount of coverage to be demonstrated
by the test, sufficient funds may not be available, and bankruptcy may
be precipitated. Such a situation would cause public costs associated
with usa af^£be test to rise enormously and thus counter potential savings
S: -
in private g0sJ€p>.
T*». -
As an alternative to the Ability to Pay test for industries such as
utilities that typically do not maintain high net working capital, the
Agency has decided to include a test based on investment-grade bond
ratings, coupled with two tangible net worth requirements (tangible
net worth of at least $10 million and at least 6 times the amount of
-20-
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liability to her. covered by the test) and a requirement that asset* in
the 3ait*4^Hp)p b* at least 8ix timcs 9*«»ter than the annual aggregate
liability fP|p covered or at 1«*«t 90 percent of total assets. This
test is exactly comparable to the bond rating test for closure and post-
closure financial assurance. Analysis of the available data on the
performance of the two major bond ratings services indicated that firms
receiving any of their four highest ratings (investment-grade bonds)
have compiled a record of viability at least equal to the Ability to Pay
test. The other criteria, requiring specific amounts of net worth and
U.S. assets, are included to help assure adequate financial capacity,
stability, and accessibility of funds. The measure of effectiveness
in terms of the number of firms that pass this bond rating test that
will go bankrupt without providing insurance coverage per 10,000 is at
least equal to the effectiveness of the Ability to Pay test, while the
percentage of viable firms that pass the bond rating test is slightly
lower. (The bond rating test is discussed in Section VII of Appendix A
to the background document for a financial test for closure and post-closure
care.)
C. Limits to the Analysis
An analysis of the type described in this document incorporates
** d*scribed below, many assumptions had to be made
about iamflNeoverage and about the technical and financial characteristics
of the hazardous waste management facilities which will be affected by
this regulation. However, the Agency examined the sensitivity of the
result that the test adopted in the regulation minimizes the sum of
direct public and private costs, and found that this result is highly
-21-
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insensitive to change* in the cost assumptions. (See Sensitivity
Analysis tflB|BMtlons. This analysis assumes that any firm that could use the
financial test for liability coverage would do so* The fact that soste
firms already have insurance and the possibility that others might choose to
purchase it voluntarily are not considered* The effect on presd.ua* of
owners' or operators' use of the financial test for coverage of the first
dollars of liability is not considered. The analysis assumes that, aoong
-22-
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by insurance, each facility will be covered by a
•ollcy. If policies cover more than one facility, the
facility would be smaller. Since the costs associated
with liability coverage demonstrated by a financial test are assumed to
represent a constant share of premiums, these costs would also fall
proportionally*
A number of uncertainties relating to a financial test for closure
and post-closure care are also relevant to costs of insurance and the
test for liability coverage. These uncertainties, however, also would not
affect the choice of a test. They include the estimation of the number
of owners and operators independently audited, the baseline failure*
rate, the size distribution of firms, and the absence of consideration
of certain possible economic efficiency benefits.
Comparable to the uncertainty in the financial test of the costs
of closure and post-closure care is the uncertainty of the expected
value of liability judgments. Because of the difficulties involved in
performing a formal risk analysis and the lack of adequate data to perform
a statistical analysis based on past experience of hazardous waste facilities,
the Agency felt that for purposes of this analysis, the best available
data on frequency and costs of liabilities were those implied by the
premiums. tfllHpVDera quoted for insuring these facilities. These are
analysed ijfjj^Rf*1* &X of the Appendix. It was assumed for this analysis
that approximately 70 percent of the value of insurance premiums would
be used for payment of liabilities (SO percent) and associated litigation
costs (20 percent). As explained in the Appendix, this percentage reflects
normal casualty and property insurance ratios with adjustment for the effect
of lack of actuarial data and relatively high underwriting costs for non-
-23-
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sudden accident*! coverage. The Agency assumes that the probability of
.*-" -
liability ju4|j|ltat« and of bankruptcy for firm* using the test are not
correlated events beeauae the criteria are designed to allow the test to
be used only by large companies with sufficient current assets to satisfy
liabilities in the amount covered by the test.
The analysis does not consider certain potential economic benefits
associated with financial responsibility requirements. To the extent
that the requirements result in owners or operators internalizing cost
externalities, in the form of insurance premiums, the price of waste
management will more accurately reflect its true costs* This higher
price will lead to reduced hazardous waste generation and increased
recycling.
One important consequence of the above limitations is that the
analysis presented here should not be used as a basis for a cost analysis
of the liability coverage requirements as a whole/ since the methodology
is directed toward identifying relative effects of the various test
alternatives rather than determining absolute costs.
III. Responses to Comments
Many o ' the comments pertaining to the use of a financial test for
closure and post-closure care were also relevant to the financial test
for liability ^coverage. The reader is referred to the background document
for a financial te»t for closure and post-closure care for an overview
of such comments.
Additional comments, directed specifically to the question of self-
insurance and a test for liability coverage, were also received by the
Agency in response to proposed rules, and the January 12, 1981, interim
final regulation/ which are described in Section IB above.
-24-
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inters said self-insurance should be allowed. Several
ranee was a standard practice followed by large
t£ unnecessary costs.
By adopting the financial test for liability coverage, the Agency
is allowing those owners or operators who can demonstrate financial
strength through the test to have the choice of self-insuring or purchasing
insurance. The Agency thus achieves the basic objective of demonstrated
financial responsibility while allowing the flexibility and cost saving*
in providing coverage that many commenters listed as valuable features
of self-insurance.
Responses to more specific comments are as follows:
1. Use of The Financial Test for Liability Coverage During Interim Status
The Hay 19, 1980, proposed rule (45 FR 33273) which would impose a
requirement for liability coverage for sudden accidental occurrences on
interim status facilities but would not allow use of self-insurance to
satisfy the requirement (on the basis that owners or operators already
had or could readily obtain such coverage as part of general liability
policies). Several comments were received recommending that self-insurance
be allowed during interim status. One commenter opposed allowing self-insurance
for interim status faciliities.
• •Us?~inaurance should be allowed during interim status.
• Mffi^inaurance should not be allowed during interim status
b&rase there will be little incentive for facilities
to be upgraded until Part B of the permit application has
been filed, and therefore, there will be a higher risk of
liability-creating occurrences during interim status.
The Agency has decided to allow use of the financial test dozing
interim status. The analysis of the financial test indicates) that it
provides reasonable assurance of financial responsibility and that
-25-
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allowing-~its use- would lead to a significant savings in the sum of
direct pdMflB^Fcirivate coats.
2. gylt^gJaBijf ^he Financial Test
Possible criteria for self-insurance were suggested by a number of
commenters. Some were included in the 300 combination* of criteria that:
the Agency evaluated in developing its financial tests.
• The financial test proposed on May 19, 1980, should be used
as criteria for self-insurance.
The May 19, 1980, test was among those that were evaluated in
developing a financial test for liability coverage. However, the
criteria that were finally selected was found more effective in minimizing'
costs (see Table 1).
• Self-insurance for liability during interim statue should bet
based on a criterion of working capital two times the liabil
requirement plus the non-working-capital requirements of the
financial test proposed on May 19, 1980.
' The level of self-insurance should not exceed 10 percent of
net worth for a single occurrence risk and should not exceed
50 percent of net worth with respect to aggregate loss*
As described in the analysis, a multiple of six for working capital
and net worth was judged to be most appropriate and was incorporated in
the financial test.
• The criteria for self-insurance should follow the industry
standards currently in use for conventional liability coverage,
as products liability, medical malpractice and other forms
Sessional liability.
many large firms are required by their existing
insurance contracts to self-insure up to specified limits, the
EPA should examine such provisions for guidance on allowable
levels of self-insurance.
The suggested criteria are designed for the guidance of firms In
determining insurance coverage that is affordable and otherwise appropriate
from the viewpoints of individual insureds and insurers. The EPA's
-26-
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purpose Ha the financial responsibility regulations is somewhat different.
The finaite^Bpift^ to* liability coverage was designed to oe a broadly
applicable ssfeVbre that will provide reasonable assurance) that Injured
parties will be compensated. Therefore/ the Agency chose to develop
criteria directed to this purpose.
• The programs of the Pension Benefit Guaranty Corporation
should be studied as possible self-insurance criteria.
The Pension Benefit Guaranty Corporation has not promulgated self-
insurance criteria as of this date (April 1982). The EPA did review
self-insurance criteria of several environmentally-related government
programs in the course of developing its financial tests (see Introduction
to background document for the financial test for assurance) of closure
and post-closure care).
3. Use of Financial Teat for Part of Required Coverage
• The criteria used to establish qualifications for self-
insurance should also apply in determining the use of
deductible s.
The Agency agrees with this comment. Since the deductible is a
form of self-retention, the amount of any deductible that is not covered
by the insurer must be covered by the financial test. This provision
is included in both the endorsement and certificate of insurance: required
as evidence of insurance.
[-insurers should be required if necessary to obtain
ixces* insurance contract over and above the acceptable
1 of self-insurance.
• Firms should be allowed to have a combination of purchased
insurance and self-insurance.
The Agency agrees with these comments. For reasons given in Section
IB, owners or operators are allowed to cover part of the required amount
through the financial test and the rest with insurance.
-27-
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4.
*^™™^^^•JJ^^^^BPEBHJ^^*
insurance is not an option that will be available to
1 businesses with insufficient equity to pass the teat/
and ahould not ba allowed.
The financial reaponaibility regulations have been designed to provide
assurance of financial responsibility while avoiding unnecessary costs.
One method of reducing such costs is to allow the use of a financial
test. The Agency recognizes that small owners or operators will be
unable to use the financial test because of the requirement for $10 million
in tangible net worth. For reasons noted in the analysis, the Agency
believes that the net worth requirement is necessary for adequate assurance of
coverage. However, the Agency will continue to look for other approaches!
that would allow small owners or operators who are financially strong to
self-insure.
• Owners and operators that self-insure should be required to
qualify under the insurance laws of the State of their
domicile.
The Agency is not aware of any State laws covering self-insurance for
accidental occurrences at hazardous waste facilities and therefore does
not find the suggestion relevant at this time.
• "Pre-funded" self-insurance generally provides more funds
than does "pay as you go" self-insurance. EPA might require
"pre-funded" self-insurance.
l-insurance backed by trust funds or letters of credit
d be allowed on an individual or group basis.
The Xgtrnby believes that its current test provides adequate assurance.
A requirement of pre-fvmding or backing by financial instruments would
significantly reduce the cost advantages of the financial test. Owners
or operators may submit petitions to the Agency proposing alternative
approaches, however. To enable adequate evaluation, the petitions should be
-28-
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accompanied by information demonstrating the need for the option ia the
description of how it would work, and information
on how it p^pMs* adequate assurance of availability of funds for
liability coverage as specified by the regulations.
• Uncertainty concerning the availability of liability insurance
for nonsudden occurrences compels SPA to allow the regulated
community wide flexibility in the form of self-insurance*
EPA has decided to allow a financial test for liability coverage
because it believes the test provides adequate assurance of coverage and
will lower the costs of the regulation. The considerable recent growth
of the pollution liability insurance market has diminished the signifl
of a possible insurance capacity shortfall as a factor in KPA's declaim
to allow this financial test.
-29-
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APPENDIX
COST ANALYSIS FOR A FINANCIAL TEST
FOR LIABILITY COVERAGE
-------
I. ,INTRODUCTION
Tnis Jljttjll$Lx~ provide* further detail on the cost analysis for a financial
test for IJ^Ppfekty coverage. The analysis employed the same methods and
many of the sane assumptions as those used to analyze the costs of a financial
test for closure and post-closure care. The reader Is referred to the back-
ground document for the financial test for closure and post-closure car*
(November 1981) for a fuller discussion of the methodology and assumptions.
The types of public and private costs analyzed and the cost model used
were presented In the body of this background document.
All costs In this background document are presented as annual costs In
real 1980 dollars before taxes.The convention used in measuring private
costs is the change in revenue necessary to leave the profits of a firm
unchanged, which is the convention usually employed in EPA regulatory
analysis. The most commonly used alternative convention is that of decline
in profits to the firm if it cannot increase revenues. The disadvantage; to
this approach is that it would then require a third category of costs to be
calculated—costs to States and the Federal government due to losses in
corporate profits tax.
1-1
-------
II. Sn0tffe£tt9?VMXABLZS — THE COST ESTIMATING MODEL
i ..-
'iSCludes a discussion of the equation* used to estimate
public and private costs of insurance, the definitions of the variables
employed, and the values of the variables used in the estimates. It is
divided into two parts t Part A presents the suomary equations for computing
the costs of any given financial test and Part B presents the values of
variables employed in the equations and provides brief discussions of why
these values were assumed. (Section III presents more detailed support for
the values of many of the more important variables used in the analysis
of the financial test for liability coverage.)
Many of the assumptions are the same as those used in the financial
test for closure and poet-closure care analysis (e.g., the supporting
equations used to compute the value of certain variables used in .Part A
below). Only assumptions and variables which differ for the analysis of a
test for liability coverage are included in this Appendix.
A. Summary Equations for Computing Total Annualizcd Costs of Alternative
Financial Tests for Liability Coverage
Table II-1 presents the formulae used in calculating total annualized
direct public and private costs associated with alternative financial
tests for liability coverage for firms of greater than $10 million in
net worth ••^independently audited. The constant terms represent the
costs assweflK^&at all firms of over $10 million in net worth that are
independently audited use either the financial test for liability coverage
or private insurance and go bankrupt at the failure rate, P. Ac with the
*
costs of closure and post-closure financial responsibility, to determine
the actual costs associated with any given test, the constants were adjusted
-------
to reflect the percentage of viable firm* that pas* a given te«t
and the aaijjir-ct ~tLrm» per 10,000 that pass a given test that will go
bankrupt witS»»t providing insurance coverage (E).
»
B. Value* of Variables Used in the Model
Table* II-2 and and II-3 present the value* of variable* used in esti-
mating the cost* discussed in this model. Table IX-2 describe* the variables
that remain constant regardless of the type of hazardous waste facility con-
sidered/ and Table II-3 shows the variables that do change according to the
type of facility.
It is assumed that 30 percent of the funds needed for liability clais*
can be recovered from bankrupt firm*. This mean* that 70 percent will not
be recovered and thus will be left a* direct costs to the public. This)
factor is applied to bankrupt firms that use the test a* evidence of financial
assurance for liability coverage. The basis for this estimate is given in
Section III.
II-2
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TABLE I1-1
FORMULAE FOR CALCULATING TOTAL ANNUALIZED COSTS OF ALTERNATIVE FINANCIAL
MECHANISMS FOR LIABILITY REQUIREMENTS FOR ALL FIRMS WITH GREATER THAN
$10 MILLION IN NET WORTH AND INDEPENDENTLY AUDITED
Type of Cost
Formula
Value of Constant Term
Public Costs due to
Failure of Firms
Using Insurance
Public Costs due to
Failure of Firms
Using Financial Test
Private Costs of
Liability Coverage
with, Financial Test
Private Costs of
Insurance
>,ooo /F-AI
\F
F-ANBE \
Ni F
1 10,000
45,000
10,000
16,952,000
2
1
C)
23,945,000
Sum of Public Costs If all
facilities use Insurance
Sum of Public Costs If all
facilities were self-Insured
Sum of Private Costs If all
firms self-Insure
Sum of Insurance Premiums If
all firms use Insurance
Notat See next pa90 for definitions of variables
II-!
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DEFINITIONS OP VARIABLES USED IN TAB^E. II-1
g* of viable firms that pass a given financial te*t
C, * Private costs of auditor's special report/facility/year
E » Number of firms per 10,000 that pass a given financial test
that will go bankrupt without providing insurance coverage
F • Failure rate for all firms to which analysis ia applied,
measured in number of firms per 10,000
i « Subscript for facility class (storage, surface impoundment,
land disposal, incinerator)
I - Private costs of insurance (premiums)/facility/year
N * Number of facilities owned by firms with $10 million in net
worth and independently audited
Rj * Share of liability judgments not recovered from bankruptcy
proceedings
Sj - Private costs of liability coverage, with financial test/
facility/year
Wj * Liability judgments to be recovered from bankruptcy if a
firm fails using insurance/facility
WSI * Liability judgments to be recovered from bankruptcy if a
firm fails using financial test/facility
II-4
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TABLE II-2
FOR VARIABLES THKT DO NOT VARY BY FACILITY TYPE
Private costs (thousands of dollars) of auditor's special
report/facility/year (C^)1 » .075
Failure rate for all firms to Whidi analysis is applied (F)2 * .0022
Share of liability judgments not recovered from
bankruptcy proceedings (Rj)3
.7
a nor* detailed discussion of this variable, see Section III of
Appendix Bjjgfcthe Background Document for a financial test for closure
and ost-dn* car*.
2For a nor* ^Mailed discussion of this variable, see Appendix A, of the
Background Document for a financial test for closure and post-closure care.
3For a itore detailed discussion of this variable, see Section in of this
Appendix.
II-5
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TABLE II-3
EONS WHICH VARY ACOOIOINS TO TYPE OF FACILITY*
red in thousands of 1980 dollars per year)
'
Assumptions
1) Number of facilities (N)
(17% of total
facilities)
2) Private costs of insurance
(premiums ) /facility /year
(I)
3) Private costs, with
financial test/facility/
year (SI)
4) Liability judgments to be
recovered from bankruptcy
if a firm fails using
financial teat/facility
5) Liability judgments to be
recovered from bankruptcy
if a firm fails using
insurance/facility (Wj)
Storage
1,292
1.5
1.05
1.875
.375
FacilJ
Incinerators
153
3.0
2.1
3.75
.75
* ^^^^^^^^^^H^^^
Lty Type
Surface
Impoundments
680
19.5
13.65
24.375
•
4.875
•^^^^••^^^^^•^•w
Land
Disposal
425
19.5
13.65
9
24.375 |
;
*
4.875
*More detailed discussions on the valui
in Section III of this Appendix.
of these variables may be found
II-6
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.The'failure rate for firms of over $10 million in tangible net worth •
is estiaat«4|f» be 22 p«r 10,000 (see Appendix A of the background document
for the finsjpsial test for closure and post-closure care). The total
number of bankruptcies among this group of firms is assumed to be constant
regardless of the financial test used, thus if the failure rate for firms
passing a given financial test falls below 22 per 10,000, the failure rate
for firms which fail the test will become higher to maintain the same
overall result.
i
The average cost of an auditors special report (required annually for
firms using the financial test) is estimated at $300 per year. AssoscLng
that the average firm has four facilities the par-facility annual cost is
$75. (See Appendix B of previous background document for further diecussi4$
r
of these estimates.)
It has been conservatively estimated that firms of greater than $10
million in net worth own 50 percent of all hazardous waste facilities.
Of the 50 percent of all facilities owned by firms of greater than $10
million in net worth, 34 percent are independently audited. The total
population of facilities evaluated in this cost analysis is assumed to be
2,550, composed of 1,292 storage facilities, 153 incinerators, 680 surface
impoundments, and 425 landfills. The basis for these estimates is dis-
cussed in Affjsadix B of the previous background document.
-~h
Cost* 4Br each type of facility were developed separately for costs of
premiums, costs of liability coverage among users of the financial test, and
value of judgments to be recovered froa owners or operators in bankruptcy.
These estimates are discussed in the next section.
II-7
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III". VALUES OF MAJOR VODSL VARIABLES _ ; •
This action discusses major model variables specific to the financial
*£•
test for liaMlity coverage
A. Value f or RT (Share of Liability Judgments not Recovered from Bankruptcy
Proceedings)
The Agency reviewed legal steps involved in the two major bankruptcy
procedures — liquidation and reorganization. This section provides an
estimate of the rate of recovery likely for claims in bankruptcy proceed-
ings against an owner or operator using the financial test for liability.
(For further detail see Appendix B of the background document for the financial
test for closure and post-closure care.)
If judgment against an owner or operator is obtained but not satisfied?
prior to the bankruptcy of the owner or operator/ the judgment would represent
a claim in the bankruptcy case. Such a claim could be a low-priority unsecured
claim, or it could be secured by a lien against property of the owner or
operator. The Agency estimates that recovery in liquidation or reorganization
proceedings would range from 20 to 50 percent.
However/ securing a judgment of liability against an owner or operator
who resisted could easily take several years (see paragraph B3 below). It
is very likely that if the bankruptcy proceeding were initiated before
judgment was obtained, the effort to secure a judgment would be stayed by the
bankruptcy court. An attempt to obtain a lien to secure a judgment would
also be stayed. In these cases recovery in bankruptcy would be reduced in
priority. Although a liability claim/ if stayed, could survive the discharge
in bankruptcy/ it is unlikely that assets would be available at a later date
-------
to satisfy it* The Agency believes a reasonable estimate of the percentage*
of recoverjfi^pxally on liabilities of owners or operators using the
I
financial tfMFVho enter bankruptcy is approximately 30 percent. Therefore,
*
the value for Rj (the share of liability judgments not recovered from bankruptcy
proceedings) is equal to .7.
B. LiabilityRelated Costs
1. Value for I (Private costs of insurance premiums/facility/year)
Insurance premiums will vary depending on the type of facility in
question, the type and quantity of wastes managed, the design and construction
of the facility, the geology of the site, its location (e.g., proximity to
aquifers, surface waters, residences), management practices, past operating
experience, and amount of the deductible. The Agency developed estimated
premium costs for required coverages as shown in Table III-1. To check on
the current adequacy of the estimates, the Agency reviewed them with several
insurance industry representatives in April 1982. All agreed they were
adequate as representative premium costs, although, as noted above, numerous
factors affect the level of any specific premium. (These reviewers, were:
Kenneth Goldstein of Swett and Crawford, Peter Gerken of Johnson and Biggins
(brokers), and James Macdonald of Munich American Reinsurance Company.)
Typically insurance for sudden accidental occurrences is part of genera]
liability IflHKajtce and its cost is not identified separately. To estimate
the cost of fpjjnrance specifically for sudden accidental occurrences at
hazardous waste facilities, the estimated premium cost of adding such
coverage to gradual pollution coverage was used.
III-2
-------
For * fftfP with several facilities, per-facility- premium costs would be
less if a sSspfct policy covered all facilities. Because of the difficulty
of determining'to what extent separate facilities owned by the same firm
will be included on one policy, estimates of premiums are based on the
assumption that separate policies would be used for each facility.
2. Value for Sr (Private costs of the financial test for liability
coverage
The coats of satisfying the liability requirements through the
financial test are dependent upon what portion of the costs of insurance
premiums would be spent by the firm whether or not it purchased insurance*
The basic elements in premium costs and the estimated percentages) of pretaiusi
costs for each of these elements are shown in Table III-2. ^
f
These estimates are extremely uncertain due to the almost complete eteence
of actuarial data or claims history for pollution insurance policies. Fox
normal property and liability insurance, payment of claims represents from
60 to 70 percent of premium costs (A.M. Best Company data, 1974*80). The
percentage of premium costs used for the payment of claims arising from
accidents at hazardous waste facilities was estimated by EPA at 50 percent
because pollution insurance has unusually high underwriting costs, and in
the absence of data is perceived as risky. About 20 percent of premiums is
estimated fcq£ 1*9*1 defense and claims adjustment and another 30 percent for
profit and administrative costs.
III-3
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TABLE III-1 • - - '
PREMIUMS FOR MEETING LIABILITY REQUIREMENTS
(thousands of 1980 dollars per year)
Facility Type
Storage
Surface Impoundment
Landfill
Incinerator
Sudden
Accidental
Coverage
1.5
3.0
3.0
3.0
'
Nonsudden
Accidental
Coverage
0'
16.5
16.7
0'
Total Premium*
Required by
Regulation
1.5
19.5
19.5
3.0
1The regulations do not require storage and incinerator facilities to carry
nonsudden accidental coverage.
III-4
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-»*.
TABLE III-2 ~
ELEMENTS OF INSURANCE OOSTS
Element*
Estimated
Percentage
of
Claim* Paid
Legal Defense and Claim* Adjustment
Underwriting and Inspections I
Other Administration Sales |
Profit >
Risk Premiums I
50%
20%
30%
III-5
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• A firm that- chose to use the financial test would have to bear the
.± ™ ' . - ' •
cost* assoo&fCM with paying liability claims and with legal defense and
•r^~
claims adjusAseinit* It would not have to bear the costs associated with the
remainder of the cost elements. Thus, the cost of satisfying liabilities)
among users of the financial test would be 70 percent of insurance premiums.
Table II1-3 provides estimates of the costs of the financial test based on
the estimates of premiums shown in Table III-1 and the assumption that 70
percent of these costs must be borne by the firm if it use* the financial
test for liability coverage.
3. Values for Wej (Liability judgments to be recovered fron bankruptcy
proceedings if a firm fails using financial test/facility/year) and
WT (Liability judgments to be recovered from bankruptcy proceedings
if a firm fails using insurance/facility/year)
In order to quantify potential public costs, it was assumed that,
for firms using the financial test, all liabilities over a period of
2 1/2 years prior to bankruptcy would be dealt with in bankruptcy proceedings.
The Agency believes 2 1/2 years is a reasonable estimate of the average
time elapsed before liabilities are satisfied. The average tine from
initiation of a case to judgment in U.S. district courts is about 20 months
for cases that go to trial (e.g., data for year ending June 1981). Two and
a half years allows a further margin of 10 months for collection and possible
appeals and tag- variation in State courts. Since amounts of liabilities
are assumed tfO> be one-half of premium values, the liabilities to be covered
are calculated as 2.5 multiplied by one-half of annual premium values. Tn«
results of this calculation are shown in Table III-4.
III-6
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TABLE III-3
COSTS OP LIABILITY COVERAGE WITH FINANCIAL TEST
(ia thousands of 1980 dollars per year)
Type of Facility
Per-Facility Costs
for $1M/2M in Sudden Accidental Coverage
and $3M/6M for Nonsudden Accidental Coverac
Storage
Surface Impoundment
Land Disposal
Incinerator
1.05
13.65
13.65
2.10
III-7
-------
For aMttj&or operators using conventional insurance, it was assumed
that all frrijKpfe* outstanding up to 6 months of bankruptcy would be paid.
Coverage all the way up to bankruptcy was not assumed for the following
reasons. As bankruptcy becomes imminent, the quality of operation and
maintenance of facilities may deteriorate. Insurance may be cancelled
or not renewed because of such deterioration or in anticipation of it.
The owner or operator himself may not continue insurance coverage) due to
lack of funds as he nears bankruptcy. Assuming again that judgments are
one-half of premiums, the estimates of public costs with insurance are .5
multiplied by one-half of the yearly premium values. This result is also
shown in Table III-4.
IXX-8
-------
TABLE III-J
.T5T JUDGMENTS TO BE RECOVERED IF A FIRM FAILS'
(In thousand* of 1980 dollars per year)
Type of Facility
If Firm Fails
Uaing Financial Test
If Firm Fails
Using Insurance
Storage
Surface Impoundment
Land Disposal
Incinerator
1.875
24.375
24.375
3.750
.375
4.875
4.875
.750
-------
IV. RESUUfl* OK THE COST MODEL FOR LIABILITY KEQUIPEMENTS
A. DinHAc and Private Costa
lists the annual public and private costs associated with
selected financial tests derived by applying the values of the variables
to the cost model described in Sections II and III. The tests either have
a one-year or a three-year eligibility requirement as indicated in the Table.
Table IV-1 shows that not allowing a financial test for liability coverage
or choosing the most stringent test, Test 139 (one-year), will minimize
direct public costs. These two options result in direct public costs of
$9,000 as compared with $25,000 in direct public coats for Test 100 (an*-ys*r)
and $40,000 and $43,000 for the Ability to Pay Test with a three-y«*rr«nd
one-year eligibility requirement, respectively. .
However, direct public costs are dwarfed by the private costs associated'
with the various alternatives. The Ability to Pay Test minimizes the sum of
direct public and private costs, whether a one or three-year eligibility
requirement is imposed. The Ability to Pay Test with a one-year requirement
is somewhat less costly than the Ability to Pay Test with the three-year
eligibility requirement (a difference of $66,000).
The Ability to Pay Test (one-year) is significantly less costly than
any other test in .terras of. the sum of direct public and private costs,
saving $1JlfriO annually over the May 19, 1980 Test (one-year) and
$6,959,OOrapWr ths Insurance Only option. If Test 100 (one-year) .is
adopted rather than the Ability to Pay Test (one-year), $18,000 per year
La annual direct public costs will be saved At a cost to the regulated
i-ommunity of $279,000.
IV-1
-------
TABLE IV-1
PERFORMANCE AND DIRECT PUBLIC AMD PRIVATE COST! OP ALTERNATIVE FINANCIAL TESTS POM LIABILITY REQUIREMENTS rOR
OWNERS OR OPERATORS WITH AT LEMT $10 Million IN NET WORTH AMD PUBLICLT AUDITED
{In thousand* of IfSO dollar* par yaar)
Taat
Description
~
I naur «nc«
Only
139
125
138
127
138
151
134
136
.135
149
136
137
ft .
146 fc
iifcj^i**
•llMHDb
IsBMBiHrw^
•fflnt to
Paf Taat
May 19.
1900_Taat
|Tha Nuaibar of |
JFiraa Par j
Eligibility
Raqulraaant
(ona-yaar or
hthraa-yaar)
1
NA
3
1
I1
10,000 that |Tha Par-
Paaa tha Taat jcantaga of
and go Bank- (Non-bank-
rupt without |rupt PI ma
Providing (that can
Inauranca
Covaraga (E)
1
NA
0
1.
1.
1.
2.
3 .
4.
5.
5.
6.
7.
9.
Q
9.
10. 1
18.4
20.2
15.7
paaa tha
Taat
0
49
56
64
67
76
77
79
82
S3
87
89
92
93
95
96
99
100
90
Dlract
••bile Coata
Daa to Pall-
•ra of Plraa
Ualng Finan-
cial Taat
0
10
11
IS
IS
IS
20
20
38
42
L 32
i i
Dlract
1
Privata
Public (Coat of (Prlvata
Coeta Daa (Liability (Coat of
to rallaraJTotal (Covaraga (Liability
of Plraia (Dlractj with jcovaraga
Ualng
Inanranca
9
5
5
"
2
1
3
Public
Coat
9
9
11
11
11
12
14
16
16
17
IS
21
24
23
25
25
40
43
35
Financial
Taat'
0
8,306
9,491
10,849
11,158
12,884
13,053
13,392
13,901
14,070
14,740
15,087
15,596
15,765
16,184
with In-
aaranca
21.945
12,212
10.516
•
,310
.902
.747
,507
.028
,310
.071
.11)
,6)4
.916
.676
.197
16,171 1 958
'*M>W- v:
10. VfRfflMlf*' 2)9
\ T"^"*'
16, Ml 1 0
1
16,612 | 478
1 1
1
1
(•«• of
JDlract
(Public
Total 1 and
Prlvataj Privataj
Coat (Coata
T~ 1
23.945) 23,954)
1 1
20.518) 20,5271
20.029) 20.0191
19,489) 19,4801
19,260) 19,2711
18.631) 18.6431
18,560) t8,674|
18,420) 18.4361
18.211) 18,227|
18,141) 18,1581
17,861) 17.S79|
17,721) 17.7421
17.512) 17.5161
17,441) 17.467|
17,101) 17,1261
17,231) 17,256|
1
17,021) 17.061)
1 1
16.9S2| 16,995)
1
17,092) 17,127)
1 Tha Nay 19, 19SO propoaad taat had a ona-yaar allglblllty raqulraaant.
2 Coat Includaa liability Judojranta, aattlananta, lagal defanaa and accountanta* raporta.
3 Coat refar* to pra>lu«a which covar liability judqaianta, aattlaaianta and lagal dafanaa.
IV-2
-------
B. '
A WBjBBBBBsVir analysis was performed to determine how sensitive the
""^'•'
results fis^VsPfcft&lity to Pay Test (one-year) were to the assumptions of
the Model. The result* of this analysis are shown in Table XV-2. Like
the sensitivity analyses in Section IV.B. and IV.C. of the Background
Document for a financial test for closure and post-closure care, the Table
records for each major cost eleaent and for total direct public and private
costs of various tests, the percentage change in costs required to make a
given test dominant over the Ability to Pay Test (one-year), that is, to
make it the test that minimizes the sum of direct public and private costs.
The three alternative tests examined are "Insurance Only,* Test 100 (one-year)
r
with a $10 million net worth requirement, and the Ability to Pay Test T\
* -
•k.
fc.
(three-year).
These results show that the finding that the Ability to Pay Test (one-year),
is the test which minimizes the sum of public and private costs, is remarkably
insensitive to changes in most cost assumptions. Only a marked increase in
the private costs associated with the use of the financial test or a decrease
in the private costs of insurance could seriously affect this result. How-
ever, the magnitude of the changes required makes such an effect .
unlikely.
IV-3
-------
TABLE IV-2
SENSITIVITY OP THE ABILITY TO PAY TEST (ONE-YEAR) AS THE TEST
THAT MINIMIZES THE SUM OP DIRECT PUBLIC AND PRIVATE COSTS OF
LIABILITY REQUIREMENTS TO ASSUMPTIONS OP THE COST MODEL
1
(Percentage Change1 (Percentage Change
1
1
Percentage Change!
' (Required in Direct (Required in Direct | (Required in (Percentage (Percentage
(Public Coeta Due (Public Coats Due (Percentage Change (Private Coats of (Change Re- ' (Change Re-
jto Failure of (to Failure of (Required in Total (Liability Cover- (quired in (quired in
Test (Pins Using Finan-j Fins Using (Direct Public
Description
Insurance Only
Test 100 ($10
«Lllion in net
worth; one-
year)
Ability to P,ay
Test (three-
year)
icial Test
16,569
1,186
1,650
Insurance
Completely
Insensitive
.
Completely
Insensitive
Completely
Insensitive
|Costs
20,467
1,450
2,200
age with Pi nan- (Private Costs (Total Pri-
Icial Test
41
38
39
|of Insurance
-29
•
-27
. -28
vate Costs
-99
-94
-96
percentage change required for any given cost e levant represent* the percentage change in costs required for
all tests to change the choice of test which sd.niad.zes the sue) of direct public and private costs.
-------
do not take into account the effect of the required
capital and net worth in reducing the number of
firms greater than $10 million in tangible net worth and independently audited
that could pass a given financial test. (The effect of the multiples) is also
not considered in the analysis of the test for closure and post-clcemre care.)..
These multiples can be expected to reduce significantly the number of firms
which can pass a test for the entire amount of required coverage. However,
the relative positions of the tests with respect to reducing cost* would not
be affected since the multiples are incorporated in all the tests*
The analysis of this section has been conducted on the Mmwfeii
firms will always choose the least expensive alternative. However*
firms that could use the financial test may choose to buy insurance) for
w
advantages of avoiding risks and uneven cash flow*. Such choices might
greatly change the estimates of costs associated with using the test. Like
the multiples requirements* however, they would not affect the relative
standing of the tests in minimizing costs.
IV-5
------- |