MADISON, Wis.—In order for environmental risk management to work effectively, organizations need to follow the five basic principles of risk management, and risk managers need to be part of the process, according to an environmental brokerage executive.

Most organizations today focus on controlling environmental losses while ignoring other efforts such as analyzing environmental risks and implementing appropriate risk financing techniques, said Kenneth E. Anderson, central team leader for Aon Environmental based in Chicago. Too often, environmental risk management "begins and ends with the lawyers," he said.

"The environmental risk management function is severely broken. I see it day in and day out," Mr. Anderson said during a session at "Advanced Environmental Risk Strategies," a recent Madison, Wis., seminar presented by the Environmental Risk Resources Assn. and the University of Wisconsin School of Business.

For environmental risk management to be effective, it must contain the same steps found in traditional risk management--and the first step is to identify the exposures within the organization, Mr. Anderson said. Some exposures are obvious, like a letter from the Environmental Protection Agency saying the company is a potentially responsible party to a Superfund cleanup site, while others are not so obvious.

"I would suggest to you that even if your organization may employ a 'don't ask, don't tell' policy when it comes to figuring out what liabilities may exist--and legally you may be OK in doing that--you still have the liability until the law changes," Mr. Anderson said, referring to numerous different federal and state environmental laws. "The liability will still be yours when the pollution is found out. Whether it's because of a transaction or third-party injury occurs, it will still be yours, and pollution doesn't usually get better in time."

Once exposures are identified, their frequency and severity need to be analyzed, Mr. Anderson said, referring to the second step in the risk management process. This can be accomplished in a variety of ways with third parties such as environmental consultants and insurers.

While organizations generally "don't do a very good job" with the second step, they usually do an "excellent job" in step No. 3--controlling the loss, Mr. Anderson said.

With all the environmental laws that have been passed, from The Resource Conservation and Recovery Act to the Comprehensive Environmental Response, Compensation and Liability Act, regulations have ensued, Mr. Anderson said. Underground storage tanks, which are governed by RCRA, must be properly contained, he said in citing an example. These are control issues, and companies do a good job of avoiding losses and in their crisis response once a loss does occur.

Mr. Anderson said that if $1 is spent on all five risk management steps, 98 cents of the total is spent on the third step.

"Where we fail miserably...is implementing the appropriate risk financing alternatives," he said, referring to the fourth step of the risk management function.

"The environmental insurance business is at best a $2 billion (premium) industry," he said. Half of that comes from environmental companies, such as waste haulers, he said.

As a whole, about $400 billion in premiums is spent annually in the U.S. property/casualty insurance market, said Mr. Anderson, who estimates that the exposure to insurable environmental liabilities in the United States for all organizations is at least 5% if not 10% of their total exposure to risk.

"So if we're using insurance for $400 billion, we should be using environmental insurance to the tune of $20 billion on the low end and $40 billion on the high end," Mr. Anderson said.

While environmental insurance is an underutilized financial mechanism for environmental risks, it can effectively mitigate many financial consequences related to environmental losses, he said.

Environmental site liability, also known as pollution legal liability, for example, is one of the most flexible insurance policies available, Mr. Anderson said. It covers broad environmental liabilities, including sudden and gradual forms of pollution, for a single site or a group of specific sites. Environmental site liability insurance provides coverage for pre-existing and new conditions, cleanup, third-party liability and changes in environmental laws, he said.

Remediation stop loss coverage, also known as cost cap coverage, is a separate policy that pays for cost overruns above an attachment point, which is based on the expected cleanup cost, Mr. Anderson said. Such cost overruns might include discovery of additional, higher concentrations of materials requiring cleanup or a greater spread of pollution.

Unlike pollution legal liability coverage, remediation stop loss coverage is expensive, Mr. Anderson noted. The cleanup cost needs to be at least $1 million and the premium is about 8% to 15% of the limits purchased, he said. So a $10 million policy above a $10 million cleanup would cost between $800,000 and $1.5 million.

The fifth step in the risk management function is to evaluate the process and implement improvements. This means figuring out what works and what doesn't work and starting the process all over again, Mr. Anderson said.

When it comes to environmental risk management, there needs to be coordination of expertise within the organization including legal, real estate, finance, environmental management, operations and facilities, and risk management, he said.

Environmental liabilities exist, whether an organization knows them or not, and a risk manager's job is fairly straightforward, he said. "His or her job definition is to reduce the overall cost of risk to the organization and environmental liabilities are risks to the organization."

Risk managers can play a "very strong part" in the environmental risk management process, Mr. Anderson said.