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BY DEREK JONES, FCAS, principal and consulting actuary; and JASON KURTZ, FCAS, consulting actuary, at Milliman

In the wake of the Deepwater Horizon disaster, U.S. lawmakers have proposed raising the $75 million liability cap for economic losses relating to oil spills. Initial proposals called for raising the cap to $10 billion, but the House of Representatives recently passed legislation that would remove the cap entirely. Passage in the Senate is less clear, but while Congress wrangles over the merits of changing the cap, energy risk managers must re-evaluate their current insurance programs in light of this new reality.

Or if sufficient coverage is no longer available at affordable prices in the commercial energy insurance market, risk managers could also contemplate increased levels of self-insurance or forming a captive.

To help evaluate the efficacy of the alternative risk transfer (ART) option for their company, energy risk managers should address these five questions.

1. What level of expected losses can we retain?

The initial step an energy company must take is to determine the expected losses associated with each coverage it might self-insure. An analysis of the company's historical losses, adjusted to the prospective coverage period's inflation level, is critical to identifying the amount of loss the company could reasonably expect in an average year. Reviewing expected losses in comparison with the company's desired aggregate retention will also help the company evaluate its need for additional protection from the commercial market.

For example, suppose the company's desired aggregate retention is $500 million, but the average historical loss is $600 million. The company would need to transfer its exposure to the $100 million layer in excess of $500 million in aggregate via either aggregate excess insurance (i.e., stop-loss protection that attaches at the desired retention) or specific excess insurance (e.g., a per-occurrence retention that reduces the expected aggregate losses to the desired aggregate retention).

2. How predictable are the losses?

With commercial insurance, an energy company pays a fixed premium to transfer the exposure to a third party. A self-insurer gives up the certainty of paying a fixed premium for the uncertainty of the actual losses, with the expectation that strong loss-control measures will keep actual losses below expected. As a result, self-insurance is most attractive for coverages with predictable frequency or severity.

Many coverages needed by energy companies, however, are subject to low claims frequency and high severity. This increases the difficulty in projecting future losses for coverages such as control-of-well (operator's extra expense when regaining control after a blowout) and environmental/pollution liability. Oil spill losses exhibit these characteristics, as companies can operate for many years with no incidents but then experience one year with catastrophic losses.

For these types of coverages, an energy company's risk manager must determine the maximum loss level the company is willing to retain, as well as its maximum foreseeable loss (MFL). To the extent that an energy company's MFL exceeds its maximum desired retention, the company should consider excess insurance (or reinsurance for a captive) to address the unwanted variability (i.e., risk) of the loss distribution.

3. How available is affordable excess insurance/reinsurance?

Insurers typically raise rates or write less coverage in the immediate aftermath of an industry-changing event. In turn, this lack of availability and affordability can be significant obstacles in the effort to reduce an energy company's exposure to catastrophic risk. Not only did primary insurance rates see large increases after the Deepwater Horizon disaster, reinsurance rates were also impacted, albeit to a lesser extent.

According to a report by Guy Carpenter, reinsurance rates for deep-water rigs increased by approximately 10 percent at the July 1 renewals. While rates may have increased, it also appears that there has been no noticeable reduction in reinsurance capacity for energy coverage. In fact, over time, reinsurers may begin to expand capacity if they perceive an increased profit opportunity. Greater availability of excess insurance and reinsurance would give the risk manager increased flexibility in tailoring a self-insurance/captive insurance program that best serves the needs of smaller energy companies.

4. What are the benefits of self-insurance?

With pure self-insurance, an energy company does not pay premiums that include commissions and other acquisition costs, as well as insurers' overhead and other expenses such as premium tax. This can result in significant savings to the energy company.

By forming a captive insurer, an energy company pays a premium that is tailored to reflect its specific exposures and historical claim experience, not those of its peers in the energy market. The captive may also facilitate cash-flow management and lead to investment income earnings prior to claims payment, while retaining underwriting profits when claim experience is better than expected.

Both alternatives to the commercial-insurance market can result in better claims experience as energy companies are incentivized to improve loss control and prevention. In addition, there are other tax benefits for captive insurance, as captives can deduct the sum of paid losses and discounted claims reserves. Captives also have direct access to the reinsurance market as needed.

5. What disadvantages exist?

The most significant risk of self-insurance mechanisms comes from the exposure to large, random losses. For small and midsize energy companies, the law of large numbers may not apply because of the low-frequency and high-severity nature of energy claims. As a result, one large claim could erode most of the self-insurer's equity or the captive's surplus.

In order to address the year-to-year volatility of the claims experience, the energy company must be prepared to make a long-term commitment. The self-insurer will also need to identify the confidence level at which it wants to fund its own losses. By leaving the commercial insurance market, there will likely be a change in the amount of capital an energy company commits to its insurance program. While the commercial market will likely demand a large fixed premium, the self-insured energy company may need to commit significant capital to support a risk margin for the uncertainty of its future claims experience. Self-insurers may incur additional expense because of the need for claims administration and defense costs. Cost-containment measures such as safety training are another possible cost.

For energy companies that choose to form a captive insurer, they can expect to incur these costs as well as others needed to establish the captive's infrastructure. Like all startup insurance companies, a captive would require a feasibility study, a management team, an auditor, an actuary and a legal department.

If the government-mandated liability limit is indeed increased or removed, the decision for energy companies may come down to evaluating the tradeoff of committing capital required to support a self-insurance program versus the stability of earnings afforded by having such a program in place. If the commercial-insurance market deteriorates to the point where energy companies face instability of earnings because of the costs of the commercial coverage, it may be necessary to commit capital to a self-insurance program.

Only through careful consideration of these issues can risk managers and senior management effectively evaluate their insurance options in the aftermath of the Deepwater Horizon disaster.

October 1, 2010

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