Managing Risk in the Tail
There are many definitions of risk, with most coming pretty close to each other. Interestingly, most all of these definitions put “risk” well beyond the point of “expected losses” on the actuarial loss curve (see graph below).
Focusing only on the downside of risk for the moment, are expected losses and those that fall to the right of the “expected” loss point really “risks?” If risk is the effect of uncertainty on objectives, then by that definition, “expected losses” would not be materially “uncertain;” they would be “expected” (though not certain).
This dichotomy has perplexed many risk professionals — especially those who lean into the traditional insurable risk realm, as these sources of loss are the primary focus of most of their responsibilities.
All good then, as that is what they were hired to do; a very necessary function for the successful operation of organizations. And yet this may be the one thing that limits the influence and in some cases the upward mobility of many traditional risk managers. After all, senior managers are typically most concerned about the unexpected and uncertain potential for disruption to the organization, its strategy and its plans that defined success.
As one CEO I worked for would say: “tell me what I don’t know.” An understandable interest since the CEO is the ultimate accountable person for the successful achievement of the plan of the organization he or she leads.
It is unlikely that expected losses will prevent the successful execution of operational or strategic plans, assuming these losses have been accounted for in budgets or transferred to others through insurance or contract. Now, budget shortfalls do occur and some claims may not be paid under certain insurance or contract conditions, but these are typically one-off variances that should be well within risk appetite and thus usually wouldn’t prevent accomplishment of most objectives.
So the obvious questions are: 1] how does your organization define risk and is it the definition that all stakeholders understand, agree upon and can manage to; and 2] where on the loss curve do you want to manage risk to?
Other questions might be, for example, do you assign more importance to likelihood or impact? I would suggest they are not of equivalent import and get their relative importance from a well-defined risk strategy, appetite and the risk culture that undergirds it.
Another question that quickly becomes critical is: how far out on the likelihood axis may be relevant to your risk strategy? This is the ultimate question that will define where you focus along the x-axis (likelihood or frequency), where resource needs are, the level of sophistication of tools and techniques necessary to manage risk effectively etc.
I urge you to get your key risk stakeholders together and vet these issues to ensure you have the right priorities and focus for managing risk within your organization. Absent this, you’ll be flying blind along a curve that presents an infinite set of outcomes. Can you afford to fly blind in the face of the potential of catastrophic uncertainty?
Florida High Court Signals Demise of Controversial Ruling
To the extent a trial-court decision declaring the Florida Workers’ Compensation Act unconstitutional was the shot heard ‘round the workers’ compensation world, a new Florida Supreme Court ruling is a powerful salvo.
Florida Circuit Court Judge Jorge E. Cueto last summer declared the state’s Workers’ Compensation Act unconstitutional.
The case now known as Padgett drew national attention when Cueto ruled that the Workers Compensation Act no longer provides injured workers with an adequate remedy because of benefit cuts lawmakers implemented over the years.
While the Supreme Court of Florida did not directly rule on the constitutionality of the Florida Act — that question was not before the court — it is difficult to see how Padgett can stand in the wake of the high court’s decision in Leticia Morales v. Zenith Ins. Co., handed down Dec 4, 2014.
Responding to three questions certified to it by an appeals court, the high court held in Morales vs. Zenith that a provision in a landscape company’s employer liability policy that excluded from coverage “any obligation imposed by workers’ compensation … law” excludes coverage of an estate’s claim for a $9.525 million default judgment entered against the company in a state trial court.
Morales sustained fatal injuries in a landscaping accident. His widow entered into a settlement agreement with Zenith Insurance, which provided Morales’ employer with both a workers’ compensation policy and one for employer liability.
The agreement provided for a payment to Ms. Morales in exchange for a release from all liability regarding insurance coverage provided to the employer by Zenith.
At the time of the settlement agreement, Ms. Morales also had initiated a wrongful death action against the employer. She obtained a default judgment and then sued Zenith in state court, requesting that it be required to pay under the terms of the employer liability policy.
The matter was removed to federal court, where the district court held the insurance policy’s exclusion provision barred any recovery. Ms. Morales appealed, contending the judgment was not the result of a workers’ compensation claim and that Zenith, therefore, should have to pay.
Following certification of the questions to the Supreme Court of Florida, that court said, in relevant part, that the employer liability insurance was a “gap-filler,” providing protection in those situations in which the employee had a right to bring a tort action despite the provisions of the workers’ compensation statute.
The high court continued that the estate did not have a right to proceed in tort against the employer; its exclusive remedy was under Florida’s Workers’ Compensation Law. The default judgment did not alter the fact that a wrongful death action was barred.
The court concluded that in as much as the workers’ compensation policy and the employer liability policy provided mutually exclusive benefits to the employer, the liability policy’s exclusion clause precluded any recovery by the estate.
While the court did not discuss either Padgett or the constitutionality of the Florida Act, it is difficult to see how Judge Cueto’s decision in Padgett can stand in the fact of the Morales decision.
If the state supreme court had any notion that the exclusive remedy provisions of the Act or the Act itself could not withstand the sort of onslaught represented by Padgett, the court likely would have given us some indication. It did not.
Padgett is currently before Florida’s Third District Court of Appeals. That court, armed now with an understanding that the Supreme Court likely has its back, should give Padgett an ignominious end.
Passion for the Prize
In his 1990 book, The Prize: The Epic Quest for Oil, Money and Power, Pulitzer Prize winning author Daniel Yergin documented the passion that drove oil exploration from the first oil well sunk in Titusville, Penn. by Col. Edwin Drake in 1859, to the multinational crusades that enriched Saudi Arabia 100 years later.
Even with the recent decline in crude oil prices, the quest for oil and its sister substance, natural gas, is as fevered now as it was in 1859.
While lower product prices are causing some upstream oil and gas companies to cut back on exploration and production, they create opportunities for others. In fact, for many midstream oil and gas companies, lower prices create an opportunity to buy low, store product, and then sell high when the crude and gas markets rebound.
The current record supply of domestic crude oil and gas largely results from horizontal drilling and hydraulic fracturing methods, which make it practical to extract product in formerly played-out or untapped formations, from the Panhandle to the Bakken.
But these technologies — and the current market they helped create — require underwriters that are as passionate, committed and knowledgeable about energy risk as the oil and gas explorers they insure.
Liability fears and incessant press coverage — from the Denton fracking ban to the Heckmann verdict — may cause some underwriters to regard fracking and horizontal drilling with a suppressed appetite. Other carriers, keen to generate premium revenue despite their limited industry knowledge, may try to buy their way into this high-stakes game with soft pricing.
For Matt Waters, the chief underwriting officer of Liberty Mutual Commercial Insurance Specialty – Energy, this is the time to employ a deep underwriting expertise to embrace the current energy market and extraction methods responsibly and profitably.
“In the oil and gas business right now, you have to have risk solutions for the new market, fracking and horizontal drilling, and it can’t be avoidance,” Waters said.
Matt Waters, chief underwriting officer of Liberty Mutual Commercial Insurance Specialty – Energy, reviews some risk management best practices for fracking and horizontal drilling.
Waters’ group underwrites upstream energy risks — those involved in all phases of onshore exploration and production of crude oil and natural gas from wells sunk into the earth — and midstream energy risks, those that involve the distribution or transportation of oil and gas to processing plants, refineries and consumers.
Risk in Motion
Seven to eight years ago, the technologies to horizontally drill and use fluids to fracture shale formations were barely in play. Now they are well established and have changed the domestic energy market, and consequently risk management for energy companies.
One of those changes is in the area of commercial auto and related coverages.
Fracking and horizontal drilling have dramatically altered oil and gas production, significantly increasing the number of vehicle trips to production and exploration sites. The new technologies require vehicles move water for drilling fluids and fracking, remove these fluids once they are used, bring hundreds of tons of chemicals and proppants, and transport all the specialty equipment required for these extraction methods.
The increase in vehicle use comes at a time when professional drivers, especially those with energy skills, are in short supply. The unfortunate result is more accidents.
“In the oil and gas business right now, you have to have risk solutions for the new market, fracking and horizontal drilling, and it can’t be avoidance.”
— Matt Waters, chief underwriting officer, Liberty Mutual Commercial Insurance Specialty – Energy
For example, in Pennsylvania, home to the gas-rich Marcellus Shale formation, overall traffic fatalities across the state are down 19 percent, according to a recent analysis by the Associated Press. But in those Pennsylvania counties where natural gas and oil is being sought, the frequency of traffic fatalities is up 4 percent.
Increasing traffic volume and accidents is also driving frequency trends in workers compensation and general liability.
In the assessment and transfer of upstream and midstream energy risks, however, there simply isn’t enough claims history in the Marcellus formation in Pennsylvania or the Bakken formation in North Dakota for underwriters to rely on data to price environmental, general and third-party liability risks.
That’s where Liberty Mutual’s commitment, experience and ability to innovate come in. Liberty Mutual was the first carrier to put together a hydraulic fracking risk assessment that gives companies using this extraction method a blueprint to help protect against litigation down the road.
Liberty Mutual insures both lease operators and the contractors essential to extracting hydrocarbons. As in many underwriting areas, the name of the game is clarity around what the risk is, and who owns it.
When considering fracking contractors, Waters and his team work to make sure that any “down hole” risks, be that potential seismic activity, or the migration of methane into water tables, is born by the lease holder.
For the lease holders, Waters and his team of specialty underwriters recommend their clients hold both “sudden and accidental” pollution coverage — to protect against quick and clear accidental spills — and a stand-alone pollution policy, which covers more gradual exposure that unfolds over a much longer period of time, such as methane leaking into drinking water supplies.
Those are two different distinct coverages, both of which a lease holder needs.
Matt Waters discusses the need for stand-alone environmental coverage.
The Energy Cycle
Domestic oil and gas production has expanded so drastically in the past five years that the United States could now become a significant energy exporter. Billions of dollars are being invested to build pipelines, liquid natural gas processing plants and export terminals along our coasts.
While managing risk for energy companies requires deep expertise, developing insurance programs for pipeline and other energy-related construction projects demands even more experience. Such programs must manage and mitigate both construction and operation risks.
Matt Waters discusses future growth for midstream oil and gas companies.
In the short-term, domestic gas and oil production is being curtailed some as fuel prices have recently plummeted due to oversupply. In the long-term, those domestic prices are likely to go back up again, particularly if legislation allows the fuel harvested in the United States to be exported to energy deficient Europe.
Waters and his underwriting team are in this energy game for the long haul — with some customers being with the operation for more than 25 years — and have industry-leading tools to play in it.
Beyond Liberty Mutual’s hydraulic fracturing risk assessment sheet, Waters’ area created a commercial driver scorecard to help its midstream and upstream clients select and manage drivers, which are in such great demand in the industry. The safety and skill of those drivers play a big part in preventing commercial auto claims, Waters said.
Liberty Mutual’s commitment to the energy market is also seen in Waters sending every member of his underwriting team to the petroleum engineering program at the University of Texas and hiring underwriters that are passionate about this industry.
Matt Waters explains how his area can add value to oil and gas companies and their insurance brokers and agents.
For Waters, politics and the trends of the moment have little place in his long-term thinking.
“We’re committed to this business and to deeply understanding how to best manage its risks, and we have been for a long time,” Waters said.
And that holds true for the latest extraction technologies.
“We’ve had success writing fracking contractors and horizontal drillers, helping them better manage the total cost of risk,” Waters said.
To learn more about how Liberty Mutual Insurance can meet your upstream and midstream energy coverage needs, contact your broker, or Matt Waters at firstname.lastname@example.org.
This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Liberty Mutual Insurance. The editorial staff of Risk & Insurance had no role in its preparation.