Deepwater Horizon: Torrent of oil, flood of insurance issues

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By Derek A. Jones, Jason B. Kurtz | 23 July 2010

On July 15, 2010, BP finally stopped the oil that gushed for 86 days from its Deepwater Horizon well in the Gulf of Mexico, possibly putting an end to the largest oil spill in U.S. history. While one phase of the event may be coming to a close, its fallout is far from over. Insurance experts say the situation has the potential to be among the most tangled in history, with questions of liability, policy language, and renewal pricing looming large. Interested parties hope the formation of a $20 billion compensation fund and implementation of an independent claims process will alleviate the concerns of those economically impacted by the spill. How the fund will work, however, remains unclear. Tropical storms threaten to further complicate the situation in the short term, while the possibility of long-term health and environmental concerns will surely extend the tail of this event for decades.

The players

The Deepwater Horizon project is a joint venture between BP, which owns 65% of the well, and Anadarko Petroleum Corporation and Mitsui Oil Exploration Company of Japan, which split the remaining interest 25% and 10%, respectively. The oil rig, which is owned by Transocean Ltd., sank on April 22 after an explosion two days earlier, unleashing a torrent of oil. Other parties include Cameron International, the maker of the blowout preventer, and Halliburton, a drilling service provider that cemented the well. According to the Insurance Information Institute, initial reports indicate first-party participants in the Deepwater Horizon project are insured for losses totaling $1.4 billion, while total insured losses for all affected parties could top $3.5 billion.

The majority of the losses so far have been to BP which, along with Transocean, has been named a responsible party. BP has some insurance through Lloyd’s of London, as well as through its captive, Jupiter Insurance Ltd, which has already set loss reserves at its policy limit of $700 million. Losses above this amount return to BP. This sole fact—that BP is essentially self-insured—greatly reduces actual insured losses, which is some relief to energy insurers who have gained a renewed appreciation of the high loss potential of such an event.

A massive spill of claims

While some first-party claims, such as Transocean’s property damage claim for the sunken rig, are straightforward, many others are not. For example, downstream claimants such as restaurants or hotels are likely to test policy language for environmental exclusions and bring intense scrutiny to business interruption coverages. Can a Midwest restaurant that buys seafood from a closed Gulf Coast fishery collect under its business interruption coverage? Did a shoreline hotel suffer a loss if the pollution didn’t touch the shore? Or to what extent did occupancy by cleanup workers offset a drop in tourists? Do pollution exclusions bar coverage for cleanup expenses and third-party claims? For insurers, policy language should provide clear guidance, but public policy pressures could potentially redraw coverage lines into areas that insurers had not intended to enter—a growing concern among insurers. For example, how might business interruption coverage respond to a presidential moratorium on deepwater drilling being upheld?

Another complicated issue will be sorting through the rapidly growing number of lawsuits, which topped 300 in July. Lawsuits have been filed against BP and other parties involved in the Deepwater Horizon venture in state and federal courts. The claims include personal injury, bereavement, loss of earnings or enjoyment of property, destruction of vulnerable wetlands and other environmental damage, threats to human health, and breach of fiduciary responsibility. Plaintiffs include boat operators, fisheries, restaurants, tourism operators, landowners, families of deceased oil workers, pension funds, and individual shareholders, among others. Many suits will be addressed by the BP compensation fund, but not all.

Litigation will also be complicated by the choice of legal venue, which can greatly influence the outcome of a case. Alabama, Florida, Louisiana, Mississippi, and Texas state laws vary considerably, and courts in some states have interpreted coverage issues more broadly than others. As a result, there is considerable uncertainty surrounding the potential expansion of liability. Manufacturers, suppliers, and contractors that worked on or supplied equipment to the Deepwater Horizon project could be swept into litigation. In addition to claims of negligence and misrepresentation, plaintiffs’ multi-frontal legal attack could bring in exotic causes of action from public nuisance laws to civil racketeering charges—a tactic that would inflate defense costs. Meanwhile, storm surge from a hurricane could carry oil further onto the coastline and even inland, contaminating the land and debris left by the hurricane.

With so many parties involved in the venture and billions of dollars at stake, the finger pointing has already begun. Anadarko's CEO, James Hackett, in an effort to direct liability away from his company, has accused BP of recklessness. Halliburton has said it followed instructions from BP. Transocean believes its liability is limited to surface spills, not those from a blown out well. While BP is the public face of the spill, it is not assuming sole responsibility. According to a company statement, "Other parties besides BP may be responsible for cost and liabilities arising from the oil spill, and we expect those parties to live up to their obligations." Disputes between insurers also loom. BP has already petitioned a U.S. court in Houston to grant coverage for cleanup costs and damage claims under a Transocean excess policy, precipitating a dispute between BP and various Lloyd's syndicates.

Victims compensation fund—sound familiar?

In response to growing complaints regarding the speed of claim payments and increased pressure from the White House, BP has agreed to set aside $20 billion in an escrow account for paying claims for damages from individuals and businesses impacted by the spill. While it is unclear whether $20 billion will be sufficient, other questions remain regarding what types of claims will be paid, claimants’ burden of proof, and interactions with existing insurance coverage.

Mention of an account designed to compensate disaster victims brings to mind the $7 billion September 11th Victim Compensation Fund. While the escrow account will be administered by the same Kenneth Feinberg who administered the September 11th fund, that is largely where the similarities between the two compensation mechanisms end. The BP oil spill compensation fund wasn’t created by an act of Congress or executive order, but by an agreement between BP and the federal government. The vast majority of the oil spill claims will not be for personal injury, but instead for claims of economic losses, which are more prone to fraud. The sheer volume of potential claims and the multitude of jurisdictions are additional complicating factors. Nevertheless, Mr. Feinberg will draw on his experiences with the September 11th fund to craft the inner workings of this new fund.

Below the radar

What has been a relatively small issue in the Deepwater Horizon spill are the potential claims from cleanup workers whose numbers have ballooned to more than 35,000, many of whom have minimal training related to oil spill cleanups. The primary concern is that cleanup workers could develop serious health problems by inhaling vapors containing volatile organic compounds released from the oil or by exposure to dispersants, chemicals used to speed up the breakdown of crude into oil droplets that can then be absorbed by naturally occurring bacteria.

Cleanup crews have responded to this spill by using far more dispersant than what was used in Alaska’s Prince William Sound following the 1989 Exxon Valdez spill. Because of their record level of use—and their potential for toxicity—many warn of the serious damage dispersants can cause to the environment and to humans, especially cleanup workers. In May, the Environmental Protection Agency asked BP to find an alternative to the dispersant Corexit, which is approved for use in the United States but is banned in other countries.

After the Exxon Valdez spill, thousands of cleanup workers fell seriously ill after inhaling the oil fumes and handling dispersants, according to Merle Savage, a general foreman of cleanup crews for the Exxon Valdez oil spill. Research on the toxic effects of oil spills is surprisingly limited, however. In the case of the Exxon Valdez, researchers couldn’t protect the confidentiality of detailed medical histories once lawsuits were filed, discouraging workers from reporting additional information. Exxon never revealed its own internal reports documenting reported illnesses. Some are worried the same will happen along the Gulf. There are also questions as to whether health problems would be reported due to the inherent conflict of interest since the cleanup workers are hired by BP and may no longer have another source of income. These issues add another layer of uncertainty to the true cost of the spill.

Markets rattled

Energy insurers have responded to the disaster like other insurers struck by a catastrophe—by hiking premiums, in some cases as much as 50% for deepwater rigs. This is a sharp turnaround from the decrease in rates that was expected for many accounts renewing in May or June.

Rates, which on offshore accounts had largely been driven by windstorm exposure, had been falling, following a relatively calm 2009 hurricane season. But insurers have begun to recast their underwriting guidelines with a sharper eye on the operational risks such as fire and explosions. This shift—some would say a "wake-up call"—in underwriting is a departure from earlier practices when operational risks were viewed as reatively low.

Impact of changing the liability cap

Another significant wildcard in the mix is possible legislation that would raise the liability limit of the Oil Pollution Act of 1990. The measure requires responsible parties to pay for all cleanup costs, plus liability damages up to a limit of $75 million. The cap can be lifted if gross negligence or willful misconduct were found to have caused the spill or if a federal safety construction or operating regulation were violated.

Some members of Congress have proposed raising the limit to $10 billion or even removing it completely, an action that could upend energy markets. One of the chief reasons against either increasing or removing the limit is that most energy insurers do not have the capacity to accommodate a sudden surge in demand for coverage that would be triggered by an increase in liability requirements.

Large multi-national energy companies typically rely on self-insurance to manage their exposures, and they are expected to continue this practice because of cost considerations. But smaller players, which tend to obtain coverage through more traditional channels, could seek to increase coverage at a time when energy insurers have become more cautious about writing these high-severity, low-frequency risks. Higher liability limits, combined with the potential lack of insurance availability at affordable levels, could force those companies that are too small to self-insure to leave the business.

Stay tuned

Who would have predicted at the time of the Exxon Valdez spill that nearly 20 years after the event, courts would still be considering Valdez-related cases? Yet in 2008, the U.S. Supreme Court ruled to reduce a $5 billion punitive damage award against ExxonMobil to $500 million, effectively ending litigation on the incident. It goes to show that, whatever the exact outcome, the Deepwater Horizon disaster will likely be a source of claims activity and litigation for decades to come.

Derek Jones is a principal and consulting actuary with the New York office of Milliman and can be contacted at derek.jones@milliman.com. Jason Kurtz is a consulting actuary with the New York office of Milliman and can be contacted at jason.kurtz@milliman.com.