Number 90 October 2012

Profitability of Energy Insurance for an Oil Company:

Self-Insurance and the Impact of the Petroleum
Contract
Michele Cibrario ACII, Chartered Insurer

Summary
• There are a number of centralised services which the large integrated oil companies retain and
manage internally. Insurance is one of these. Legislation in many countries allows these services
to be internalised as long as the cost structure is transparent.
• Insurance centralised management provides not only a cost-saving mechanism, but also a profit
that covers the entire insurance process including running costs and final claims process. This is
due to a number of factors including the inherent nature of the risks themselves, the structure of
petroleum contracts, and time-lag between premiums and claims.
• Many oil companies utilise insurance captives as a residual instrument, because they have
internalised these services within a captive insurer, and the profit generation associated with
them.
• The top management in these oil companies is normally well aware of the cost and profitability
drivers in their companies. This paper highlights the interesting phenomenon by which a cost
driver becomes a profit driver.
• Insurance market players should recognise the increasing role of captives and design new tailor-
made specialist solutions if they intend continuing servicing this business niche. They should be
aware of this trend and fully understand the implications on reinsurance pricing, choice of
market leaders, captives involvement, and rating considerations.

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CII Introduction: There are a number of centralised The peculiarity of petroleum contracts
services which large global oil and gas companies
retain and manage internally. Insurance is one of The agreement struck by a sovereign authority to allow
these. This has interesting implications on the a foreign IOGC to extract raw hydrocarbons is known as
corporate business model and is worth examining. In Petroleum Contract. Such contracts are hybrid in
this thinkpiece, Mr Michele Cibrario describes this nature, if one considers roles and relative negotiating
unique arrangement and explains why insurance
power of the parties. The sovereign authority which is
market players should recognise the increasing role
of captives and design new tailor-made specialist normally a host government energy ministry or local
services that could work within this business niche. National Oil Company (NOC) enters into a joint venture
with the IOGC to allow it to import technology and
Insurance is one centralised service within the large expertise to extract hydrocarbons and then apportion
international Integrated Oil & Gas Companies (IOGC). the production between NOC and IOGCs to guarantee
Legislation in most countries allows such services an oil revenue to NOC and a taxable income to
provided their cost structure is transparent. Strategic participating IOGCs.
choice between internalising versus out-sourcing is
driven by cost-saving considerations, but insurance is Energy Insurance costs fall under petroleum contracts.
different: proper management of insurance activities, The operating IOGCs insure their investments in assets
together with an adequate level of self-retention can under the petroleum contract. It is worth noting that
generate a long-term profit. the insured in the contract (carrying the “insurable
interest”) is the oil and gas company, not the host
Insurance centralised management provides not only a government department.
cost-saving mechanism, but also a profit that covers
the entire insurance process including running costs Figure 1: Insurance Cash Flow Year by Year
and the final claims process. This is due to:

 the inherent nature of the risks themselves

 the structure of petroleum contracts

 time-lags between premiums and claims

 benign fiscal treatment

 asymmetric information Author’s own diagram: every insured company pays an annual
premium and recovers funds when claims occur.
 volatility and
Over several years, total premiums paid by the oil and
 capital remuneration.
gas companies will equal the sum of insured claims,
Many IOGCs use insurance as a residual instrument. plus the insurer’s remuneration which includes a
They internalise these services within what is known as premium for volatility.
a “captive” insurer, or wholly-owned subsidiary, and
Figure 2: Insurance cash flow cumulated over project life
use any profit generation associated with them.
Commercial insurers see their participation in oil and
gas risks severely diminished and must devise
innovative products to service the company’s risk
portfolios. Commercial insurers recognise the role of
captives and design tailor-made insurance solutions to
tap into this business niche. This is the drive towards
innovation.
Author’s own diagram.

CII Thinkpiece no.90 (October 2012) – The Role of Self-Insurance in the Energy Sector Page 1
Thus, at end of project life, the benefits become even latter pays a fixed compensation for each additional
more apparent. Annual premium are typically adjusted extracted barrel of oil (say US$2/barrel). In these
year-on-year to reflect the real claims experience and contracts, the company has a remuneration that is
insurance premiums and claims have a real chance to proportional to oil production, hence the incentive to
equalise over the long term (thus premium for volatility maximise the latter. Insurance cost recoverability
reduces, and the only differential will ultimately be the under these contracts implies that cost minimisation is
insurer’s remuneration). Rarely would a shorter-lived not a priority. Quality of insurance and security
non-energy project enjoy this opportunity. becomes the priority.

Insurance centralised management provides not only a Impact of insurance on costs of petroleum
cost-saving mechanism, but also a profit that covers contracts
the entire insurance process including running costs
and final claims process.
Insurance costs are sometimes recoverable so
Petroleum Contracts treat incurred project costs minimisation is not paramount. But consideration
differently, and insurance cost, sometimes, it is above must factor in the timing of cost-recoverability
recoverable. and related time value of money. Recoverability in
Petroleum Contracts depends on the phase of field
Concessions: Export Oil and Royalties activity: exploration, construction or production.

These allow the IOGC to extract hydrocarbons at its  Exploration insurance: criteria for recoverability: Costs
own (not recoverable) cost. The sovereign authority will incurred during exploration are not recoverable
charge a significant royalty on the production, and the until hydrocarbons are found. Out of many wells
company’s profit is determined as the difference drilled, the one where oil is found will pay for all,
between price of sales minus costs of production, but only once production starts some years
minus royalties. Thus costs, including insurance, afterward.
should be minimised to increase profits from sales.  Construction Insurance: Fixed Costs – CAPEX:
However, when insurance costs are tax deductible they Construction insurance and all investment costs
reduce the taxable income. fall under fixed costs. Insurance premiums paid
during construction phase are recoverable together
Production Sharing Agreements (PSA): Cost and Profit Oil with periodic instalments of initial capital
expenditure. There is a delay for cost recovery.
These allow the IOGC to invest and start production on
the basis that incurred costs are recoverable within  Operational Insurance: Variable Costs – OPEX: Costs
“cost oil”, i.e.: the sovereign authority will pay the incurred in day-to-day production are variable
IOGC the equivalent in hydrocarbons of the cost operating expenditure and recovered quarterly.
incurred to extract the hydrocarbons. After accrued Therefore, a neutral insurance cash flow to IOGC:
costs have been recovered, the residual hydrocarbon premiums paid are recovered and “transformed” in
“profit oil” is divided between the sovereign authority barrels of oil in three months.
and the oil company. Cost recoverability under PSAs
implies that minimisation of insurance cost is not Since operational insurance is the largest component,
utmost priority, but, bear in mind, will indeed reduce we can generalise and state that in both production
the “profit oil”. sharing agreements and technical service contracts,
the cost-impact of buying insurance cover is
Technical Service Contracts (TSC): Cost Oil plus Service Fee respectively low or practically neutral to the IOGC.
Instead, in concession agreements the company does
Here as with PSAs, costs incurred by IOGC are not recover the cost of insurance.
recoverable in oil or cash. But residual production in
excess of cost oil belongs to sovereign authority. The

CII Thinkpiece no.90 (October 2012) – The Role of Self-Insurance in the Energy Sector Page 2
What is the impact of claims? Claims are paid by those funds to earn interest income. It will pay its share
insurers to IOGCs when the losses occur to make good of claims in the future when claims arise.
the damages. Then the oil company records a money
inflow used in meeting the costs to repair damages. The captive effectively transforms insurance costs of
the IOGC in a risk portfolio producing a stream of
Figure 3: Insurance cash flow in PSAs and TSCs premiums in the captive as revenues, ultimately
rendering a profit. Noticeably, the captive takes the
premiums out of the petroleum contracts before the
profit–sharing or royalty/tax mechanisms can
intervene. Therefore it has extracted wealth from the
petroleum contracts to the IOGC benefit. This new
stream of revenue reduces the total cost of production
of the IOGC and improves its lifting costs. The captive
has inverted the equilibrium in the petroleum contracts
Author’s own diagram: Operator pays premiums but recovers those for insurance costs, and makes a profit out of it.
premiums in barrels of oil, or cash equivalent, and also receives
money from incurred claims to made good the damages. Drivers of captive insurance profitability

We demonstrated that both sharing agreements and To optimise the use of its corporate financial strength,
service contracts shift cost of insurance to the IOGCs carry a large insurance retention. A centralised
sovereign authority (which ultimately pays premiums), insurance function serves the needs of consistently
while the company receives the benefit of insurance managing such group retention thru the captive.
protection and thus avoids risk of paying twice its
investments. Losses in excess of the pre-set level of burden fall
automatically under the insurance protections of the
ultimate parent company, and its captive, and do not
Under concession agreements, the IOGC bears itself impact the small operational subsidiaries
the cost-impact of the premium, but recovers claims;
therefore when premiums equalise claim in the long- The retention is structured to allow each subsidiary to
term, then the balance is again a neutral cost impact. withstand a pre-set level of financial burden. Losses in
excess of that level fall automatically under the
Figure 4: Insurance cash flow in Concessions insurance protections of the ultimate parent company,
and its captive and do not impact the small operational
subsidiaries.

Tailored insurance policies protect each subsidiary,

and the group uses the captive to carry the petroleum
company’s risk portfolio. It has an aggregate retention
and purchases excess of loss reinsurance capacity on
Author’s own diagram: the IOGC operating a concession agreement reinsurance markets negotiating substantial quantity
pays premiums and receives money from incurred claims.
discounts.

Insurance as a source of profit for oil companies Captives are a corporate risk management tool but also
are a profit centre. Because their risk portfolio is so
With the self-insurance-by-captive mechanism, the
well know by the captive manager and by the
IOGC receives the insurance premiums, instead of
centralised risk management function, profitability is
letting them flow to the insurance market. Thus the
often non-negligible. We analyse such profitability,
IOGC retains hard currency. Also, it immediately invests

CII Thinkpiece no.90 (October 2012) – The Role of Self-Insurance in the Energy Sector Page 3
then review how captives fit into consolidated financial IOGC Financial Rating Rating Captive
Size Agency
statements and really represent a profit centre. Category
Shell not avail AA S&P Solen
Total not avail AA- S&P Omnium
Self-insurance through Captive
ExxonMobil not avail A++ A.M. Best Ancon
BP XV: ≥$2bn A A.M. Best Jupiter
IOGC’s risk portfolio is usually entrusted to captive’s ConocoPhillips XIII: 1.25bn- A A.M. Best Sooner
$1.5bn
management. Captive retains a share of each risk net Chevron X: $500m- A A.M. Best Heddington
for its own account, as net retention, up to a certain $750m &
VII: $50m- A A.M. Best Iron Horse
occurrence limit. The captive charges a premium for the $100m

part of the risks it retains. The presence of excess Eni IX: $250m-
$500m
A A.M. Best Eni
Insurance
mutual reinsurers if any make the reinsurance rates Repsol --- not rated --- Gaviota

very competitive and the captive can pass such benefit Source: A.M. Best and Standard & Poor's websites.
to its insureds. This holds true also when reinsurers
Premium for volatility
offer quantity discounts. This is the first advantage
captive have against commercial insurers. Pricing self-insurance includes a premium for volatility.
The captive is the corporate instrument to absorb large
Captive net retention is priced based on technical
part of the volatility associated with claims. Volatility is
considerations, those primarily being:
just another word for profit: captives, as any risk-taking
 known cost of claims incurred/settled, based on enterprise, charge a premium including a cost item for
historical evidence (“burning cost”); volatility.
 “expected cost” of claims (the cost of claims
The written risk portfolios of a captive behaves better
arising from development of outstanding claim
or worst then the commercial market and, based on
reserves for incurred claims yet to be settled);
such observed volatility, the captive can offer a
 ultimate cost of claim (factoring-in claim not yet discount to its insureds, if its claim experience is
incurred, but statistically expectable); improving and volatility reducing. IOGC could
 known cost of reinsurance; experience lower volatility than the market, possibly
due to benign location of assets or superior asset
 loading for overheads; quality, and therefore lower volatility premium can be
 mark-up (in a typical cost-plus formula) for short- factored into the captive pricing based also on a
term volatility. superior knowledge of its portfolio risk profile, while
the market would not be able to recognise such lower
Setting the retention right becomes the main decisions volatility.
at start up to minimise probability of ruin. Energy
captives are usually large to retain risks and reinsure Rate differentials between market and captive pricing
structure
only peak exposures. The size of energy captives can
be inferred by “Financial Size Category” assigned by Captives base their pricing on technical analysis but
A.M. Best and defined as “…based on adjusted also can include some mutualisation of claims among
policyholders' surplus and is designed to provide a its insured business units. In addition, there is a strong
convenient indicator of the size of a company in terms standardisation of risks, because of similar policies,
of its statutory surplus and related accounts.” 1 such as health and safety, procurement, etc… all
contributing to portfolio homogeneity, thus a more
Table 1: Energy Captives
All major IOGCs have at least one captive predictable claim impact, and ultimately an element of
discount can be included, producing a lower technical
pricing.

1
A.M.Best Rating Center, http://www.ambest.com/ratings/guide.asp

CII Thinkpiece no.90 (October 2012) – The Role of Self-Insurance in the Energy Sector Page 4
Asymmetric information own financial benefit and bring about an extra buffer of
funds as additional guarantee against claims.
Captives are part of the IOGC they insure and their
knowledge of the risk is superior since benefitting from Dividends distribution vs. captive capitalisation: striking a
the entire risk management process of the centralised balance
functions. This provides excellent information and a
New-born captives need to heavily capitalise to face
timing advantage.
volatility of the energy industry. Captives tend not to
Sources of capital at risk distribute dividends in good years, but build additional
shareholder’s funds. Captives grow from retained
Peculiar capital structure of captives becomes an earnings and zero dividends, until major claims occur.
advantage towards reduced pricing to its insureds.
Captives do not borrow money, they are funded by Final considerations
parent company capital. Not so for commercial insurers
being judged by institutional investors seeking a We reviewed drivers of profitability of energy insurance
higher yield or switch investments according to and how different Petroleum Contracts apply. We have
expected profitability. Therefore, commercial insurers demonstrated why IOGC use self-insurance to retain
must remunerate a distinctively greedier panel of risk and the sources of arising profit, within
shareholders, while captives can focus on the consolidated financial statements, using a captive
business, instead of dedicating resources and staff to insurer. It is now clear why a centralised risk &
investor relations. Ultimately, they have lighter insurance management represents not only a cost
structure and less staff (10-20 people) or even fully saving mechanism but also a profit centre.
managed by insurance brokers.
All the steps described above allow the IOGC to
Shareholders’ versus borrowed capital remuneration accumulate a small amount of readily available capital
in the captive dedicated to meet claims. But, in the
Captives are not funded with debt, only equity. Capital absence of critical emergencies, these readily available
remuneration for one single corporate shareholder’s funds are borrowed to operational business units (as
benefit is minimised, since captive is endowed with intercompany loans) as internal financing, thus
funds strictly needed to its risk management function, representing an additional source of equity capital to
and the shareholder is aware that earned interests on fund new projects of the IOGC, all the while decreasing
premiums and equity are needed for funding the the debt to equity ratio of the IOGC.
working capital.
It has been estimated by the author that, for every good
Investments must be extremely prudent since local year with benign loss experience, such complex
regulatory bodies so require, but a friendlier taxation
management of the insurance activities of the oil
allows those returns on prudent investments to be used
almost entirely for the captive’s own financial benefit company can provide fresh funds to finance a small
number of new drilling Oil & Gas wells, indeed
Investment policy of captives is subject to same rules providing a self-funding mechanism of significant
and constrains of market insurers, namely Prudential added value, contributing to the endogenous growth of
Regulations issued by the central bank where the the IOGC.
captive is incorporated. Also, usually, captives are
domiciled where taxation is favourable, to maximise Such internalised insurance management reduces
investment return benefitting captive capitalisation. In companies’ need for the commercial market. Insurers
other words, investments must be extremely prudent see their participation to energy risks diminished and
since local regulatory bodies so require, but a friendlier are pushed towards designing innovative products to
taxation allows those small returns on prudent service the IOGCs risk portfolios.
investments to be used almost entirely for the captive’s

CII Thinkpiece no.90 (October 2012) – The Role of Self-Insurance in the Energy Sector Page 5
Such internalised insurance management reduces causing changes in this way insurers provide service,
companies’ need for the commercial market. Insurers and driving the market leaders towards further
see their participation to energy risks diminished and
are pushed towards designing innovative products to specialisation.
service the IOGCs risk portfolios
The direct involvement of IOGCs as dedicated capital
When captives participate heavily in any one risk, the providers for self-insurance purposes change
market is often still requested to provide a quotation substantially the equilibriums in the marketplace and
and strong leadership, typically by a Lloyds’ syndicate push a number of insurers towards product innovation.
or one continental reinsurer with a specialist expertise. This is welcome news in the views of the author,
At the end of the day, recognised market leaders are because it pushes competition in the traditional market
favoured, whist market followers see their lines in favour of clients’ needs.
reduced or cut altogether to leave room for the
captives. In short, IOGCs self-insurance mechanism If you have any questions or comments about this Thinkpiece,
and/or would like to be added to a mailing list to receive new
undermines large sections of the traditional insurance articles by email, please contact us: thinkpiece@cii.co.uk or
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market while strengthening only a small part of it, by telephone: +44 (0)20 7417 4783.

Michele Cibrario ACII Chartered Insurer joined Eni in 2006 and is currently working in the
Insurance Activities Management on Upstream Risks and Construction Projects. He was
previously Insurance Manager at the Eni captive insurance company in Dublin for four years. He
holds a Master Degree in Economics and Business Administration of Energy and Environment
from Scuola Enrico Mattei of Eni Corporate University and has a Degree in International
Economics at Bocconi University.

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The CII Thinkpiece Series

The CII Thinkpiece series consists of short 1,500–2,500-word articles on subjects of interest to the insurance and
financial services profession and stakeholders, and are written by a range of contributors. Recent articles include:

 No.89: “Ties that Bind: The Importance of Science and Technology to the Insurance Profession,” Rt. Hon. David
Willetts MP, UK Minister of State for Universities and Science (12 October 2012).

 No.88: “Non-Life Insurance in India: Managing Disaster Risk Exposures – An Opportunity for Better Risk
Management and Growth,” by Vankayalapati Padmavathi (30 September).

 No.87: “Social Investment: All Together Now?” by Gavin Francis (17 September)

 No.86: “The Power of Networking in the New Economy,” by Sue Carette (10 August).

 No.85: “Road to the White House: what’s at stake in the US election,” by Ana Catalano Weeks (29 July).

CII Thinkpiece no.90 (October 2012) – The Role of Self-Insurance in the Energy Sector Page 6
CPD Reflective Questions
Reading this Thinkpiece with respect to the learning outcomes below can count towards Structured CPD
under the CII CPD Scheme. The questions are designed to help you reflect on the issues raised in the
article in relation to these learning outcomes. Please note that the answers to the questions are not meant
for CPD records purposes.

Learning Outcomes
• To understand the centralised services that large integrated oil and gas companies retain and manage
internally, and the role of insurance among these.

• To understand how these petroleum companies use insurance within their business model, particularly
how insurance presents a cost-saving mechanism, but also a profit that covers the entire insurance process
including running costs and final claims process. This is due to the inherent nature of the risks themselves
as well as other factors.

• To appreciate how insurance market players could recognise the increasing role of captives and design new
tailor-made specialist solutions if they intend continuing servicing this business niche.

1. Why large integrated oil companies decide to internalise insurance services?

2. What are the drivers of self-insurance-by-captive profitability and how do Petroleum Contracts impact it?

3. Why should insurance market players recognise the increasing role of captives and design new tailor-made
specialist services for those oil companies?

4. How would the increased use of self-insurance and captives drive innovation into the commercial insurance
market. What are the implication for the traditional insurance market and its leaders?

CII Thinkpiece no. 90 (October 2012) – The Role of Self-Insurance in the Energy Sector