October 17, 2013

Preventing another Macondo – the role of Insurance. Part 2

By Leigh Williams.

In my previous article I considered the role that insurance has to play in preventing another Macondo.

If one accepts the premise that insurance is a good thing because of the opportunity for additional third party monitoring of offshore operations, the following questions arise:

  • First, how much pollution liability insurance actually needs to be made available?
  • Second, how will it be provided?
  • Third, how much should it cost?

First, the question of how much pollution liability insurance is it necessary for an operator to purchase.

If no operator actually needs to purchase insurance to absorb the cost of a pollution incident because it has a sufficiently large balance sheet (as most do), one answer is that no pollution liability insurance needs to be made available. On the other hand, if an operator needs to purchase insurance to meets its liabilities the obvious answer is the difference between the value of its net assets and the worst case scenario liabilities to which its operations expose it. That obviously depends on a detailed analysis and risk assessment of each of its operations.

Macondo has generated ‘costs’ of between $40-$60bn (although a large proportion of that will be penalties which are designed to punish BP not compensate third parties for damage). That is just one company and one well. As matters stand, world-wide commercial insurance capacity for absorbing all energy risks stands at about $3-$4 billion. About $1-$1.5 billion of that capacity is for meeting liability risks including pollution, in other words a fraction of the cost of Macondo. However, as concerns deepwater exploration and production activities (as opposed to shallow water activities) it is presently unclear to what extent any operator is exposed to worst case scenario pollution liabilities which are greater than its net assets. Most deepwater operators have a market capitalisation in excess of $100 bn and most are capable of self-insuring the bulk of the pollution risk. They may choose to purchase insurance if it is more cost-efficient than using their own capital. However, in those circumstances there is no obvious answer to the question of how much insurance needs to be made available by the commercial insurance market. The question is really more “how willing are insurers to participate in the pollution liability risk and at what price?“

Turning to the question of how significant additional pollution liability cover would be provided, in the wake of Macondo, there were calls to increase oil spill financial responsibility requirements to up to $10 billion and for that to be backed by commercial or mutual insurance. In June 2010 Robert Hartwig of the Insurance Information Institute testified before Congress that it would impossible for energy insurers and reinsurers to provide that level of pollution liability insurance coverage because (a) there simply not the capacity to provide that additional cover and (b) rating such a risk was fraught with difficulty. Most informed commentators would not disagree with what Mr Hartwig had to say, but just three months later Munich Re said that it was developing a product that would provide liability cover of $10-$20 billion on a rig-by-rig basis.

An increase in capacity to the sorts of levels that have been suggested would require a major influx of capital into the insurance industry. It has been suggested that this could be achieved by a combination of:

(a) pollution liability insurance being provided on a per facility (rather than per company) basis in order to diversify risk for the risk carriers;
(b) making commercial insurance compulsory in order to generate the amount of premium income that would be needed for such risks to be commercially insurable; and
(c) utilising alternative risk transfer vehicles which would be capitalised by the securities market rather than conventional equity.

As concerns alternative risk transfer vehicles, such as ‘sidecars’ and catastrophe bonds, the thinking behind them is that they take advantage of the capital that can be made available by the by the global securities market which is hundreds of times larger than the market for equity capital to be invested in insurers and reinsurers. But however sophisticated may be the risk bearing structure, there is no ‘free lunch’. The legal structure of these vehicles does not, of itself, generate value that does not exist in more conventional insurance or reinsurance vehicles. One of the reasons such vehicles are created is that they are less burdened by regulation than conventional vehicles. However, that may be wholly inappropriate in this context. Furthermore, the return on capital that is likely to be demanded by investors in such instruments and vehicles is likely to be very significant, particularly in the wake of Macondo. In other words, ‘insurance’ capital, however it is packaged, is likely to be expensive and one can expect the oil majors to make a strong case that they should not have to pay others to bear a risk they are perfectly capable of bearing themselves a lot more cost efficiently.

Furthermore, what is arguably the principal benefit of insurance in the context of offshore exploration and production, namely the opportunity for high quality third party monitoring of operations, may not happen at all where the capital providers are investors in a commoditised and tradable debt instrument rather than shareholders in a ‘living and breathing’ insurance company.

It is not without good reason that the industry is wary of pollution liability risks generally. No one predicted Macondo would happen and it did. Exploration projects are becoming increasingly challenging leaving aside what is happening in the Arctic. It is naïve to believe that Macondo represents the worst that could happen. The assumption by the insurance industry of significant pollution liability risk could create a game of Russian roulette very similar to the ones the insurance market has played in the past and essentially lost.

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