The Risks of an Offshore Business Interruption claim: is there any hedging option?

Armando Goncalves, DSc/UFRJ Virgilio J.M. Ferreira Filho, DSc/UFRJ, SPE Guilherme Caloba, DSc/Petrobras
Paulo Couto, DSc/UFRJ
The offshore oil and gas industry is continuing
Abstract improving its oil offshore production, taking into account its
The purpose of this paper is to analyze the main risks sedimentary basin areas around the coast. After the severe
that can affect an offshore facility during Exploration and damage that occurred since 1988, the Energy Line insurance
Production activities, which could be a catastrophic event. underwriting tasks became more and more selective and
Besides reliability of design features, other measures should restrictive regarding E&P offshore activities.
be attempted in order to ensure the safety of operational In order to evaluate and to analyze the biggest claims
conditions. in this specific market, including offshore and onshore
Even if these measures are applied, the materialization explorations, we show above the main losses occurred until
of a severe and catastrophic claim could impact the Project 2001 around the world:
cash flow of an Offshore Facility, becoming unfeasible the
progress of its exploration activities.
Enterprise Claims Payment Nature of the peril
In this paper we discuss the role of insurance as an (1000 US Dollars)
alternative to guarantee the project continuity after a long Total France 1.200.000,00 Refinery
period of a Business Interruption generated by a big claim or Petrobras P36 500.000,00 Semi-submersible
the materialization of a natural catastrophe. In order to
Citgo USA 380.000,00 Refinery
simulate the financial impact of a possible in the Project cash
El Paso Aruba 350.000,00 Refinery
flow we use Monte Carlo simulation method. In the chapter 1
we explain the existence of a Business Interruption cover that Conoco Refinery 260.000.00 Refinery
UK
could be bought by Oil companies. Chapter 2 gives a figure of BASF 119.000,00
the main severe accident in upstream and downstream market.
SASOL 104.000,00 Refinery
Chapter 3 describes the main characteristics of a BI cover. In
G.D.M. 100.000,00
the chapter 4 we made a simulation exercise considering the
impact in the cash flow of the Oil company since it has Tosco USA 99.000,00 Refinery
occurred a big BI claim. Chapter 5 shows the results and Citgo USA 85.000,00 Refinery
chapter 6 describe a possible misunderstanding that could Tosco USA 51.000.00 Refinery
arise by the Insured (Oil Company) interpretation of the 2.937.000,00
Total
concept of losses due to business interruption. Table 1. Source: Smith, Terry (February 2002)
Recently, one of the Marsh’s Company Report (3),
1. Introduction presented a picture showing a relation between the majors
The main goal of this paper is to evaluate the decision claims and their timing relating the E&P activities. It represents
of buying an insurance cover for Business Interruption (BI) a total of a 91 severe claims in E&P offshore fields, from 1970
events that could arise from an offshore rig accident caused by to 1999 (categorizing the events by the nature of peril and the
a Material Damaged covered by Energy Policy wordings, equipment type):
during E&P (Exploration and Production) activities. In such Equipment criteria
case, these facilities maintain their production stopped for a
long time , generating extreme financial losses. In contracting of Average Loss1 Percentage
the insurance policy, another difficulty is determining the
Equipment Number
accidents (US$ 1000)
deductible level and the sum assured. The latter point is not an Transport 4 402000 29%
obvious thing because, generally in these accidents the physical
Jacket 10 100000 18%
reserves of oil remain almost in the same level, although the
Production 5 67400 6%
principal loss is the opportunity cost of selling the oil in the
FPSO2 3 53200 3%
present time against selling this production after the facility
replacement. This period could last more than a year and the Drilling 741 40400 30%
delay period could match the market in a hard cycle where the Others 28 28100 14%
Table 2. Claims by type/equipment. Source Marsh (2001)
prices are lower than in an accident time. Facing these features
could be a problematic question and the Contractors managers
should decide what is the sum assured and deductible for the
policy. Thus, after showing these points, they look for a
methodology that could express mathematically the managers’
decision making structure regarding the insurance purchasing By Event
option.

2. Offshore Oil and Gas Platform Industry background 1

Average Loss considering values above US$ 10 million
2.1 Introduction 2
Floating Production, Storage and Off-loading vessel
 Events Number of Average Loss3 Percentage 7. Hurricanes
Accidents (US$ 1000)
Explosion 7 266900 25%  Operational Risks:
Fire 10 37500 5% 1. Contact;
Vapor Cloud 1 113400 2% 2. Collision;
Mechanical 45 84300 3. Shipwreck;
defects 51% 4. Stranding;
Others 28 47600 18% 5. Speculation;
Table 3. Number of Claims by peril nature. Source Marsh (2001) 6. Negligence;
7. Fire;
2.3 Insurance/ Reinsurance Market for Offshore Rigs 8. Explosion;
This topic looks to give an overview of the main 9. Marine Soil/ Foundation Collapse;
markets that are operating in this insurance business, having 10. Blowout: this is an unwanted and uncontrolled fluid
this subject extensively developed by Sharp (1994). flow (oil, gas, water, etc) from the drilled formations
The London market is the biggest insurance subscriber to the wellbore. Occurs when the hydrostatic pressure
of E&P units – not only rigs, but also other facilities – developed by the drilling fluid that fills the wellbore is
including the Lloyd’s Marine Syndicates and limited liability inferior to the drilled formation pore pressure;
insurance companies. It is estimated that the London market 11. Cratering: is determined as a depression in basin form
supplies 60 to 65% of the world’s total market capacity for this in the soil’s surface around the well, caused by the oil,
kind of insurance (Sharp, 1994). gas or water’s erosive action without restriction. It is
However, other markets also developed specialization more difficult, but can occur, the gas instead of
in the selection and acceptance of this kind of risk. The ones leaving through the well, spreads through the surface.
that stand out more are: The soil’s surfaces tend to be unsupported beneath and
a crater is formed due to the surface’s settling.
a) Scandinavian Market, formed principally by
Norwegian insurers. It is worth pointing out that b) Consequent Damages and extraordinary expenses:
Norway is a great oil producer in the turbulent and • well control;
deep waters of the North Sea; • restraint;
b) New Yorker Market, that historically always • leaking;
subscribed cargo and marine hull risks; • pollution;
• fire prevention;
c) European Market, developed by German and Swiss
reinsures, that provide direct market elevation capacity • fishing (fallen or stuck objects recovery in a well,
through reinsurance contracts of Excess Loss (EL – obstructing the normal operation to proceed);
type of non-proportional reinsurance for catastrophic c) Production loss;
events); d) Damages caused to Third Party – Contracted and general
d) Bermudas Market: that according to Bidino (1995) is third party;
“an emerging market, attracting capital due to the e) Personal Damages, including death of employees and
offered fiscal advantages (i.e. Immunity of income and general third party;
capital taxes payments until the year of 2006), f) Removal of Wreckage;
represents an increase in the catastrophes coverage g) War, strikes and political perils;
capacity offer”.
It is worth to mention that the mobile E&P
3.4 Main Risks present in Offshore E&P Activities structures have distinct physical and operational
characteristics from the fixed structures. This influences in
With no desire of exhausting this subject, Bidino (1995) the particular policy writing for each kind of structure.
presents a risk cast of great importance in the E&P and oil and
gas transportation phases for offshore activities:
3.5 General vision of Policies used during Offshore rig
a) Material damages to the rigs, mobile units, support vessels construction phase
and other equipments, in consequence to: According to Sharp (1994), some key points for the
insured operator or constructor in the elaboration of this
 Acts of Nature kind of insurance contract is to guarantee the insured’s
1. Storms; needs in the adequacy of the policy. Below, we list the most
2. Current Flows; relevant points:
3. Bad Weather;
4. Thunders; a) Evaluation: it considers standards that will be used to
5. Gales; determine the risk value and the insured structure value.
6. Ground Swell; This point will be very important, once the insufficient of
3
Average Loss per accident

the sum assured will imply in the reduction of the
indemnity;
b) Insured: only the participants that have some insurable
interest in the insurance object (rig) can be considered the
insured;
c) Period: it must be clearly mentioned in the policy when it
coverage starts and when the same expires. It should be
noted that the date of loss must be precisely characterized.
If an eventual loss, some times notified well after its
effective date of occurrence or in some occasions after the
end of the contract, occurred or not within the valid period
of the policy;
d) Insured Object: it should detail which activities/
situations are included in the policy. Usually, the insured
activities are listed within the insured object and the
situations supported by insurance are foreseen in the
general, particular and special conditions of this contract;
e) Premium: as a rule, only the insurer has knowledgement
of the calculations made to determine the premium to
charge the insured. Generally, it is the insured’s
responsibility of granting the insured values that can be
confirmed or not by the insurer, which will establish their
opinions on information within the risk inspection report,
also called survey report. This report can contain a study of
damages per type of coverage requested by the insured,
where the surveyor – based on his own experience,
indicates values for a probable maximum Loss (PML) and
for a Maximum Possible Loss (MPL). Following the
concepts defined in IMIA (2002) we can state:
“The PML is an estimate of the maximum loss which could be
sustained by the insurers as a result of any occurrence
considered by the underwriter to be within the realms of
probability. This ignores such coincidence and catastrophes as
may be possibilities, but which remain higher improbable.”
“The MPL is the largest loss that may be expected
from a single fire (or other peril when another peril
may be the controlling factor) equal to any given risk
when the most unfavorable circumstances are more
or less exceptionally combined and when, as a
consequence, the fire is unsatisfactorily fought
against and therefore is only stopped by impassable
obstacles or lack of sustenance.”
f) Losses: in case of loss, the party’s responsibilities,
including the government authorities, should be given in
the contract. There are also situations when an insured sum
is insufficient when the proportional clause, is applied – a
similar form used in other patrimonial insurance
businesses;
g) Guarantees: this is in respect to the main obligations of
the insured. Any action that alters the insured object or
brings a bigger risk exposition of the object, should be
previously notified by the insurer/ reinsurer so he can give
his approval. If this is not fulfilled, a loss of coverage
might happen;
h) Solvency: when hiring an insurance policy, the Insured
must find out who the underwriters are to know their
technical capacity and their economical stability to pay for
eventual losses due to events covered by the policy.
3
3.5.1 Main conditions used in the insurance construction for
Offshore Rigs
Bidino (1995) specifies the main clauses to be used for
construction/ installation services of fixed rigs, mobile units
and other facilities and equipments, offered by the market. It is
observed that, for each insurance policy, the clause will suffer
alterations due to the cover’s scope requested by the Insured,
due to the project’s characteristics, party’s liability and/ or the
construction and other factors that might increase or lower the
risk exposition. In addition, these alterations may have either
restrictive character or be destined to increase the insured
object’s coverage.
When receiving the insured’s coverage requested, the
underwriter (the one who makes the risk analysis and selection
and prices them) will request, if necessary, plants and
calculations that compose the project to improve the risk’s
evaluation. In this particular, the underwriter can request an
engineer expert’s opinion to settle any doubts regarding the
project.
If the construction works have already started, the
subscriber can provide an inspection with the purpose of
collecting verified information regarding the considered risk.
Having all data, the underwriter should made the
following decisions:
a) To accept the coverage request according to the
conditions proposed by the insured;
b) To limit the insured object in its coverage or in its
value, by the application of a deductible or an insured
allowance reduction or additional clause reduction to
exclude certain risks;
c) To decline the whole requested cover.
The most usual clauses for construction and installation
services of fixed rigs, mobile units and other facilities and
equipments used in the insurances for Oil Risks are:
1) Institute Clauses for Builders Risks (01/12/1972)
2) Institute Clauses for Builders Risks (01/06/1988) –
which is an update of the previous clause). It is an
all risk policy regarding the work’s damages, where
the coverage’s exclusions are well mentioned in the
contract.
 Used material defects in the construction (left out of
the project’s technical specifications).
 Project error (caused by the company responsible
for the technical project, causing partial or total
damages to the construction unit)
 Expenses which are the insured’s responsibility for
disassembly, repairing or replacing , after putting
back in the damaged part’s place (the limit for these
expenses is the value of replacement of the replaced
part).
This policy has also a clause covering damages due
to third party liability, called Protection and Indemnity
(P&I), including the events of:
a) damages to third parties not guaranteed in the
coverage of the Collision Liability RDC clause –
rigger or operator’s liability due to collision (which
 are the risks of collision with another vessel or mobile
unit);
b) expenses or other excluded expenses from the
mentioned item (a), just as damages with the wreckage
removal.
This RDC cover is only offered in the case that a
physical damaged within the scope of the policy has
occurred. Having its value limited to the value equivalent to
the insured allowance for physical damages coverage.
1) London Offshore Construction and Installation
(LOCC – 85 – 2)
Besides covering events due to material damages, this
policy supports the legal liability and war risks;
2) Additional coverage for risks that came from
maintenance activities:
This only support work’s damages, which are the
contractor’s liability, contrary to the Builders Risks
coverage where accidents provoked by third parties are
insured. The coverage scope includes:
a) Inspection’s maintenance: are the damages caused by
the constructor when the same returns to works, after
the delivery to the operator, to fulfill the contract
obligations, noticing the repairs executions during the
maintenance period;
b) Constructor’s maintenance: includes the same
mentioned damages in item (a). However, such losses
are derived from the services execution in the
construction phase, which coverage will be excluded
from damages due to the inspection’s maintenance.
3.6 Insurance contracts for Offshore operations
(production phase)
The operations of offshore unit’s involving high
risks value began on the 70’s, in the North Sea in deep
waters and adverse environment conditions (according to
Sharp, 1994). Due to the lack of acknowledgement and
absence of information regarding experience (losses) for
such structures, the market maintained a conservative
position, granting reduced capacity for these types of
insurances.
The first decade of Exploration and Production
activities were a soft time for insurance business without
any big claim. The geographic area of E&P activities
concentrated mostly in the North Sea. In the sense of this
good experience the insurance market was stimulated in
increasing its capacity.,. The accumulated value for only
one event is the base of the calculation to determine the
granting of proportional reinsurance (part correspondent to
the risk’s censurer’s liability). The insurer will retain, as a
rule, as to the insurance proportional plans, the maximum
percentage of the relationship between his Technical Limit –
maximum limit of subscription for only one risk in one
given department – and the maximum value to the
indemnified (MVI). Summarizing, it can be written:
Retention = 100% - Cession
Retention = . Maximum Limit of Liability .
Total Value of Risk for the coverage
Whereas: Retention = insurer’s liability
Cession = reinsurer’s liability
It is worth to mention that this type of calculation
is used when it is treated as a proportional reinsurance plan
called Surplus.
The insurers, in a way of minimizing even more
his losses, can, also, transfer part of the risks due to possible
catastrophic events to a reinsurer through the acquisition
with the same of a non proportional reinsurance plan,
Excess of Loss. Such plan will limit the indemnity due to
the insurer, in case the loss is covered by the policy, in
multiple value of his capacity (quantity pre established in
the reinsurance contract).
Generally, the costs of these type of non
proportional plans is the percentile over the conceded
premium (due to the reinsurer), not including the insurer’s
profit margin, providing to the cedant an efficient hedge
against major extension events, which might compromise
his financial solvency.
After this parenthesis, we will go back to the
subject. The insurance market for offshore operations lived
a prosperous period for more than ten years, from mid 70’s
until 1988, year that occurred the total loss of the Piper
Alpha Rig, in the North Sea, occasioning losses in the value
of US$ 1,500,000,000.00. This loss completely modified
the market’s behavior, going from euphoria to total distrust
regarding these types of risks. The capacity and coverage
scopes were drastically reduced.
Underwriters started to sense the need of a
specialization for Oil Risks insurances subscription for
offshore rigs, and, also, the urgency for developing methods
to control the accumulated values in the same risk.
3.6.1 Revision of the main covers applicable to Offshore
structures
Essentially, there are two applicable covers
to offshore facilities, as to the operational phase (Sharp,
1994):
• For the fixed rigs (steel or concrete), for pipelines and
the production facilities located at the deep sea, the
market developed an all risks cover that comes from
the London Standard Platform form clause (LSPF);
• For the floating production systems (the FPSO –
Floating Production Storage and Offloading types) and
for auxiliary vessels to the production services (for
example the so called shuttle tankers or relief ships –
oil storage and transport), a tendency of holding them
exists according to the conditions stipulated by the
Institute Clauses Hull Ports Risks, or rather, these
risks are faced as similar to the affected risks of the
Transport and Marine Hull departments.

It is important to point out that the insurance industry has
the basis for these types of covers, either for fixed structures
or for mobile units, the conditions foreseen in the London
Standard Platform Form clause. The quoted, in a last
analysis, is originated from the conditions foreseen by the
London Standard Drilling Barge Form, joining to these their
own characteristics of the operational activities of the
offshore rigs.
This form of coverage is not rigid, having to adjust to
each particular insured and the risk’s expositions by him
faced.
3.6.2 How the Offshore Production facilities are chosen
and how they affect the Insurance Policy
To have a very brief idea on the subject, which
interferes on the type of necessary cover for the offshore
production activities, a list of factors that can influence the
type of structure to be chosen is presented below:
a) environmental factors;
b) water scales;
c) reserve size and nature;
d) recovery factor (percentage of oil in place volume
that will be economically produced);
e) nature and quality of the oil and gas to be extracted;
f) oil and gas distribution options;
g) possibility of associating future developments to
operation fields;
h) economic factors (economic exploration viability of a
certain field.
It is worth to mention that the operational risks of the
offshore structures associated with drilling activities are
typical risks covered in the Marine Transport and Hull
departments (Sharp, 1994). Even if such risks are not
always covered, we listed the main risks that an offshore
facility is exposed to:
a) Environmental Factors
• Wind velocity
• Wave heights
• Tide velocity
• Equipment deterioration due to the sea variation;
b) Fire and explosion;
c) Blowout, cratering and fishing;
d) Vapor cloud explosion;
e) Collisions;
f) Maintenance and ongoing construction activities;
g) Construction defects and equipment failure;
h) Fatigue and corrosion;
i) Collapse of foundations;
j) Political risks;
3.7 Business Interruption coverage overview
3.7.1 Introduction
It is very important to state that a BI Claim payment is
due only if the peril that caused a production interruption is
5
covered under the wordings of Material Damage policy.
The Business Interruption risks which include Oil and
Gas Exploration and Production (E&P) activities are comprised
in the Energy line insurance. This Business Insurance Clause
(BIC) is very expensive, turning out its price prohibitive for the
Oil Companies. As can be certified in the insurance market, a
Material Damage (MD) coverage including a BIC could be
acquired for approximately 2,0 % or 2,5 %, which is a very
high and unusual ratio.
Another option in order to decrease the price is to
adopt higher deductibles. Notwithstanding this measure could
drive the oil company in bad situation since the coverage does
not include a big part of its damages.
As in the Delay in start Up Clause (DSUC) – which
means an unexpected delay in starting the commercial
operating phase of the platform that is being built - as was
predicted in the contracts, the BIC embraces the perils that
could cause a delay. However, BIC covers accidents that could
cause a loss of earnings after the initial commercial date due a
claim covered in the MD insurance policy.
Following the historic costs of this kind of policies
(MD including a BIC), the price becomes a big obstacle to
contract them. Nevertheless, after the big claims occurred in
1988 (Exxon Valdez accident that causes the production
interruption for a long time period, directed the Oil companies
to consider the possibility of buying a BIC. Without insurance,
who could support these economic losses including long-term
paralyzations? A loss like that could drive the oil company to
bankruptcy situation.
Studying the possibility of the acquisition of a BIC,
Sharp (1994) highlights most important things that have to be
observed:
a) The maximum period of time necessary to restart the
production. Commonly the Insurance Companies offer
indemnity periods between 12 or 18 months. This time
of cover could be insufficient to cover all the
paralyzation time in cases like Total Loss (TL) of the
structure;
b) The maximum deductible period, measured in days or
months, known as Waiting Period (WP), establishes
that the BIC will only begin to work after the WP;
c) The determination of the Insurance amount contracted
for BIC. This question does not has an elementary
answer once it is very difficult to set a correct amount
that will be sufficient to cover all the paralyzation
costs;
d) To verify if the causing circumstances of the MD
event costs are comprised in the covered perils of the
MD policy. If the MD event cause is excluded of the
covered perils, no payment is due for the financial loss
caused from the BIC.
3.7.2 Main Characteristics of the BI policy
(a) Indemnity basis
It is a hard task to determine the correct amount
sufficient to comprise the economical damages occurred.
However these calculus proceedings are based in the BIC for
the commercial insurance lines.
In the case that there is no pattern of wordings for
BIC, the cover scope will vary according to:
 e) Insured necessities;
f) Reinsures financial capacity and
g) Reinsurer and Insurers willingness to underwrite such
kind of risks. These risks comprised claims with a
high degree of severity but a small probability of
occurrence. This fact means that if there is a claim it
will impact in a bad way the reinsures and insurers
cash flow for this specific branch.
In the past, the basis of the indemnities allowed the
insured to get some financial benefit from the insurance once
the indemnity amount could overcame the real loss. In order to
avoid such situation, insures started to contract external
financial auditors to criticize the indemnity values.
There are many factors that influence the final calculus of the
agreed amount due. Therefore, there are many ways to focus
this problem if an oil company wishes to protect its net
financial capacity to generate earnings (the gross value minus
taxes, tariffs and royalties). However it seems to us that the
most proper solution is to make a financial damage agreement
that should avoid court litigations, although this is not the way
to eliminate indemnities distortions. Nevertheless, we consider
besides the distortions cited above, which is inherent to
insurance matters, the agreement proceeding is the best way to
finish this question once is very difficult to calculate the actual
damage value.
Another way to solve this question is to set a Net
Operational Loss (NOL) that would be reimbursed to the
insured, since the claim is comprised in the cover scope, limited
to a maximum indemnity value fixed in the policy. This type of
indemnity should take in account costs and expenses that
should be excluded in a long run stoppage, such as royalties,
tariffs, another taxes, transport, oil processing in the rig topside
in the onshore terminals, Petroleum Tax Revenue, additional
costs and maintenance. This is not an exhaustive list but is very
complete.
Another form of indemnity evaluation is to set a Net
Profit lost per barrel (NPLB) in production activities. Taking
into account that it is not a hard task for the oil company to set
the NPLB, this method is the most preferred for the majority of
the firms.
Another possible solution could be to set the loss
based in the Annual Value of Contract (AVC). This method is
appropriated when there is a Contract Supply of Oil or Gas
with annual fixed prices.
Although there are various methods inserted in the
policies to evaluate the offshore platform BI losses, some
policies simplify this process assuming a maximum limited for
extraordinary expenses known in the insurance market as Oil
Extra Expenses (OEE). This expression means that the cost
incurred with the loss mitigation objective or with the purpose
to decrease Sue and Labor (SL) costs are considered
minimization measures. Generally such measures are
comprised in the policy as obligations.
(b) Indemnity period
The Indemnity Period is the time period in days that
the BIC is valid. After this fixed time, even if the BIC damages
still continuing the insurer or the reinsurer has no liability for
such monetary values.
The Indemnity Period will take in account the earnings
and expenses incurred in the previously years at the same time
considered avoiding possible distortions.
As in the DSUC, Sharp (1994) affirms that the biggest
BI time periods results from the big MD claims which include
total loss events. The average time to build a new facility is
around 3 or 4 years.
Nevertheless, in general the insurers and reinsures do
not wish to offer an Indemnity period of 3 or 4 years. In the
most common situations the adopted period will be 12 or 18
months.
Adversary of the DSUC ordinary works where the
occurrence probability of a big claim increases as the
construction time pass the probability of a MD severe claim
decreases as the time pass. This figure is justified because the
oil and gas reserves fall down during the production period.
(c) Scope of cover
Sharp (1994) says that the perils against which the
market is able to offer an insurance cover are similar to those
embraced in the DSUC:
“The coverage is similarly geared to perils insured under
specific policy forms, in particular the physical damage and
control of well policies effected on the facility. Insures are
rarely prepared to include other risks, but may be prepared to
include others facilities on which throughput from the insured
platform are dependant. The market term for such coverage is
Contingent Business Interruption which has come under much
sharper focus in recent years following Piper Alpha loss.
(d) General exclusions in the BIC
According to the previous item, most of the general
exclusions are comprised in the DSUC. We can list:
1. Insolvency of any part
2. Confiscation or expropriation of land equipment or supplies
3. The withdrawal of, or no issuance of, the license or permit to
commence commercial production works
4. Political risks are excluded to the policies for the majority of
insurers and/or reinsures. However there are some
specialized reinsures that can offer this cover
It is worth to mention that a specific insurance policy
may contain a particular exclusion applied in a particular facility
or in a particular offshore field venture.
3.8 What happened in the Market after big Katrina Losses?
It is important to note that progressively the oil and
gas production is migrating to offshore new discoveries areas.
In Brazil we have the big Campos Basin that represents more
than 80 % of the Brazilian oil production. At the time, some big
gas reserves have been discovered in Santos Basin. Taking a
look in the oil and gas worldwide market some recent
discoveries in Angola, Nigeria and other offshore basis confirm
this trend.
Keeping these areas productive, in the third world,
implies a fully access to foreign capital in order to make these
offshore zones economic viable. Since each year the E&P water
line increases and consequently the technical background
increases, it will be necessary more and more capital to make
these projects possible.
Having in mind that nowadays we have around 9,000
platforms around world (Infield, 2005), it is worth to mention
that more than 3,500 rigs are located in Gulf of Mexico (GoM).
Regarding this particular offshore area of the USA, let’s
 7

suppose that the average value of each platform is US$ damaged

300,000,000 and its average daily production is 30,000 bbl and Rigs (adrift) 5 6 13
Rigs severely 4 9 10
the price of the barrel of oil is US$ 60, we could draw the damaged
following picture: Rigs destroyed 1 4 4
(a) Material Damage (MD) exposure in GoM Table 4. Damages on GoM platforms and rigs due to Hurricanes in 2005
Source: MMS
Value at Risk (VaR)MD = 3,500 x 300,000,000 =
= US$ 1,050 Billions OIL Limited is a mutualism society formed by the
proper Oil companies to guarantee the reinsurance capacity not
Defining the Maximum Probable Loss (MPL) as the available in the Reinsurance market. OIL Limited is one of the
worst situation when 10 % (or 350 units) of the platforms were possible options to get the available Energy reinsurance market
destroyed for a natural Catastrophe event, we could determinate capacity. Taking into account only the OIL payment to diverse
MPL in the GoM zone: Oil Companies (Insureds) working in the GoM until September
MPLMD = 10 % VaR = 105 Billions 30th we arrive at following amounts:

(b) Business Interruption (BI) exposure, considering an indem- (a) Hurricane Katrina: US$ 2,1 Billions
nity period of six months: (b) Hurricane Rita: US$ 1,3 Billions

VaR BI daily = 350 x 30,000 x 60 = US$ 630 Millions One of the biggest Reinsurance Brokerage Company
called Willis release a report that state a good figure payments
VaR BI 6 Months = VaR daily x 180 = US$ 113.4 Billions made by reinsures due to Katrina and Rita hurricanes:

Assuming a MPL loss scenario of 30 %, we could obtain:

KATRINA Material Operator’s Business Total
MPL BI 6 Months = 30 % x VaR BI 6 Months = US$ 34 Damages Extra Interruptio
Billions (approximately) (US$ 1000) Expenses n (US$ 1000)
(US$ 1000) (US$ 1000)
(c) Total risk Exposure (MD + BI): Upstream but 4,137,312 1,228,125 831,686 6,197,123
rigs
VaRTotal = US$ 1.163 Billions (approximately) Rigs 474,100 -x- 58,285 532,385
Downstream 1,791,205 -x- 628,500 2,419,705
MPL Total = US$ 139 Billions
Subtotal 6,402,617 1,228,125 1,518,471 9,149,213
Taking into account the calculus above, the worst Katrina
RITA Material Operator’s Business Total
scenario indicate a maximum total loss of US$ 139 Billions Damages Extra Interruptio (US$ 1000)
excluding another lines of insurance like Pollution Liability, (US$ Expenses n
Marine Insurance Cargo Clauses, etc., that could be used to 1000) (US$ 1000) (US$ 1000)
recover other nature of claims. Upstream but 2,762,756 870,478 853,260 4,486,494
rigs
It is important to remind that there will be only a BI
Rigs 497,750 49,995 547,745
payment due whenever the claim was caused by an event Downstream 481,635 364,565 846,200
covered by the MD policy. Subtotal Rita 3,742,141 870,478 1,267,820 5,880,439
The numbers shown above give us a big picture of a
big claim that could impact severely the cash flow of many Oil Table 5. Reinsurance Payments Estimative until May, 2006. Source: Willis
Energy Market Review, May, 2006
Companies working inside the GoM area. However a big
financial damage like that must be transfer to other financial Keeping in mind the calculus made in the item 2.2, we
players – the transfer risk mechanism. These agents are the can confirm the severity of our previously suppositions,
Reinsurance Companies that could be defined as the insurance although the severity of the actual aggregate claim (Katrina
for the Insurance Companies. Reinsures will only take a small plus Rita and Ivan) represents only a MPL of 2 % (66 platforms
share of some risk. Consequently, considering the transfer of destroyed and 6 rigs destroyed considering a total of 3,500
the risk will imply sharing the risks with many Reinsurance and offshore structures) comparing to the MPL of 10 % of the
Insurance Companies in order to elude a possible financial offshore structures predicted in the item 2.2..
bankruptcy of some of them.
In fact, claims like that requires a financial capacity 4. Case Study Simulating the Cash Flow Impact after a
not always available in the Insurance and Reinsurance market. Natural Catastrophic event
So the oil companies must be prepared to assume some small Before presenting the assumptions of a Natural
part of the damages. catastrophic claim, we should look the Oil Company Cash Flow
However the upset of Insurance and Reinsurance considered in our simulation. Instead of exhaustively describe
transfer mechanism would result in the Oil Company the accounts, we simplify the cash flow as follows
insolvency in the short term. This statement may be confirmed
by getting a look in the following tables that resume the Ivan, Production (bbl)
Katrina and Rita hurricanes losses ( x ) Oil Price (US$ per bbl)
( = ) Gross Revenues (GR)
Ivan Katrina Rita
Platforms destroyed 7 47 66
( - ) Revenues Taxes (% GR)
Platforms extensively 20 20 32 ( - ) Cost of Selling Goods
 ( = ) Gross Profit (GP) outputs.
( - ) Depreciation (5% GP - fixed value)
( - ) Overheads (%GP) Factor Analyzed MD Insurance MD Insurance
( - ) Insurance with BIC (US$ without BIC (US$
( - ) Cost of Material Damage Millions) Millions)
( - ) Cost of Business Interruption
( = ) Earnings before Taxes (EBT) Probability of NPV 1,06 1,07
( - ) Taxes (% EBT) negative (%)
( = ) Net Profit (NP) Average NPV (US$ 318.1 327.5
Millions)
This cash flow structure will be repeated in the
simulation for the 30 years life cycle of the platform (first NPV minimum (US$ (530.7) (809)
assumption). Bellow we show other suppositions, which will be Millions)
use in the Monte Carlo simulation utilizing the software @Risk NPV maximum (US$ 595.7 589
(Palisade Company): Millions)
1. Claim probability of Occurrence = 0, 2 % using the average Standard Deviation 87.8 91.1
of the Poisson Probability Distribution; (US$ Millions)
2. Platform Life cycle = 30 years;
3. Insurance ratio will be represented by a Triangular Table 6. Main Monte Carlo Simulation Results realized by @Risk
Probability Distribution considering an average of 1.0 % and a
6. Simulation Conclusions
minimum = 0.7% and a Maximum = 1.5 %;
4. Waiting Period will be represented by a Triangular Looking into the simulation results we could have a
Probability Distribution considering an average of 60 days and false idea of buying or not buying the BIC. At a first glance, it
a minimum = 30 days and a Maximum = 90 days; would seem that, without a BIC, NPV expected and the
5. Production will be represented by a Triangular Probability maximum NPV will drive the choice of a cover without BIC.
Distribution considering an average of 30,000 bbl per day and Nevertheless, the minimum NPV case implies in a much higher
minimum = 27,000 bbl per day and Maximum = 33,000 bbl per loss without BIC. Since the majority of Oil financial manager
day; firms are risk averse and the severity of a possible big BI claim
6. Overheads will be represented by a Triangular Probability would explode the Oil Company cash flow, it is better to think
Distribution considering an average of 18 % of the Production about slowly and in a prudence way in order to guarantee the
Revenues and minimum = 12 % and Maximum = 24 %; firms financial health.
7. The interest rate in order to discount the -Net Present Value
(NPV) will be represented by a Triangular Probability
Distribution considering an average of 16 % and minimum = 7. A final note regarding time value of money that could
12 % and Maximum = 20 %; cause an Insured misunderstanding
8. Barrel Price will be represented by a Normal Probability
Distribution considering an average of US$ 55 per bbl and Besides simulation analysis, we should consider the
standard deviation of US$ 1 per bbl; loss coming from the opportunity cost of selling. Although this
9. Production Costs per bbl will be represented by a Normal is not a simple task to calculate this loss. Exemplifying and
Probability Distribution considering an average of US$ 10 and simplifying a possible situation, let’s suppose the price of the
a standard deviation of US$ 1; Petroleum barrel immediately before the claim is US$ 45. The
10. Taxes under revenues will a fixed amount of 25% from the platform has stopped for one year. The date of loss (DOL) was
Gross Revenue; 01/1/2005 and taking into account the supposition that the well
11. The Insured Amount will vary from US$ 450,000,000 to remains with the same physical characteristics without the
US$ 750,000,000. necessity of any repair or reconstruction. The interest rate of
the financial market in the calendar year 2005 was 10 % per
After the Monte Carlo simulation generated with month. The monthly production is constant and equivalent a
@Risk, we will get the main results in terms of NPV and IRR 30,000 bbl/day. The rig restarting production date was
(Internal Rate of Return) and we will compare two basic 12/31/2005. At this last date, the oil barrel price was US$ 32. It
alternatives: could be also useful for these calculi to arbitrate the interest
ratio during 2006 equivalent to 8% per month.
(a) Cash Flow considering only the MD Insurance; and
It is worth to mention again that the calculus bellow is
(b) Cash Flow considering MD Insurance including a BIC
only a crude simplification of the actual cost opportunity of the
loss. So, we can make the following mathematical procedures:
5. Main Results of the Monte Carlo Simulation
The software @Risk offers various options of outputs. Estimative of the annual selling if there is no claim
As we have mentioned earlier, we will focus the possible from 01/01/2005 to 12/31/2006 is:
solutions to our simulation in terms of NPV for the two
scenarios cited above. In the sequence we resume the main Monthly Revenues = 30,000 x 30 x 45 = US$ 40,500,000 = A
 9

Total Annual Revenues (at 12/31/2005) = F = A x (F/A, i, n),
where
A = Monthly payment (Present Principal sum) (US$)
F = Future sum (US$)
i = Interest rate (%)
n = period
(F/A, i, n) = Equal-payment-series compound-amount
factor
We can get (F/A, i, n) from a specific mathematical
table. So (F/A, 10 %, 12) = 22.060. Therefore:
F2005 = 40,500,000 x 22.060
F2005 = US$ 893,430,000 (B)
Reminding the assumptions, considering the scenarios
with loss or without, it is important to note that the physical
reserves of oil remain the same. The problem is the delay of
production caused by a severe MD which stopped the oil flow.
Nevertheless, we do not have an oil reserves physical loss
because its reserves will generated the same oil production in a
future moment. The life cycle of the petroleum well do not
altered. Since the DOL until the restart date of production,
there is a gap of production, which could induce the Insured to
request all Future sum calculate previously. However it is not a
fully right reasoning to consider the BI total claim payment as
the future sum (B). The actual total BI claim amount,
considering all suppositions previously stated, would be the
difference among the Future sum (B) minus Future sum of the
year 2006 that is:
Monthly Revenues = 30,000 x 30 x 32 = US$ 28,800,000 = A
Total Annual Revenues (at 12/31/2006) = F = A x (F/A, i, n),
Where
(F/A, 8 %, 12) = 19.351.
Therefore:
amount buying the insurance and will avoid eternal discussions
with the Insurance Company during loss adjusting process.
Sometimes, financial managers are faced with hard
market threats and in order to keep the Oil company operating
the better option is to buy BIC than the risky option of not buy
a BIC and gets a false higher profit.
References
1. BIDINO, M.H. Curso de Risco de Petróleo (Brochure),
Funenseg, Rio de Janeiro,1995.
2. DE LUCCA, M. & LE BLANC, L. ‘Forecast to 2005’ in
http://www.infield.com/article_offshore.htm
3. MARSH COMPANY. ‘Largest Property Damages Losses in
the Hydrocarbon-Chemical Industries- A Thirty year Review’.
2001, accessed in 2006 at www.marsh.com
4. IMIA Working Group Paper. Possible Maximum Loss
Assessment of Civil Engineering Projects accessed in the site
www.imia.org in 01/20/2007
5. Oil Limited Report 2006 in http://www.oil.bm/ accessed in
09/10/2006
6. sEnergy Report 2005 accessed in
http://www.oil.bm/senergy/financials accessed in 20/09/2006
7. SHARP, DAVID W.: Offshore Oil and Gas Insurance.
Whiterby, London, 1994
8. SMITH, TERRY B. Presentation in 2002 New Zealand
Petroleum Conference, 24-27 February 2002, accessed in
10/12/2006
9. Willis Energy Market Review, May 2006 accessed in
www.willis.com

F2006 = 28,800,000 x 19.351

F2006 = US$ 557,308,800 (C)
So we have:
Total BI Claim amount = (B) – (C) = US$ 336,121,200 (D)

Considering all these assumptions, the actual BI claim

would be the amount (D) very inferior to the (B) sum. But if for
an example, the barrel oil price was US$ 55 in 2006 and the
interest rate remains 8 %, it will be very dangerous to adopt the
same logic. Having in mind these last suppositions, we could
be driven to a zero claim. This picture would conduct to Future
sum in the 2006 (C) higher than amount (B), which could mean
a profit for the Insured which is not the purpose of the
insurance contract.
Tracing these various scenarios, we are trying to make
the Oil Company financial manager thinking about these
questions of buy or not to buy a BIC in a deeper way. We could
stress the risk assuming a higher quotation for the oil price and
a big annual interest rate. Another option would be consider all
these calculus with inflation rates in both periods. Therefore
there is no trivial solution to this problem.
In our opinion, the best way to deal with this question
is to contract an external financial auditor to set the Insured
sum as appropriate as possible. These will save premium