Is captive utilisation an optimal strategy for National Oil Companies? A 2010 industry research report

Transcription

1 Is captive utilisation an optimal strategy for National Oil Companies? A 2010 industry research report

2 Contents Who uses a captive insurance company? Does the global position of NOCs influence captive utilisation? 1 What factors might be impacting captive utilisation? 2 What other market dynamics are relevant? Can a captive add value for NOCs? 4 What risks should a NOC captive participate in? 5 How should risk funding decisions be made by a NOC?..6 Conclusion 8 About the author 8 Marsh 9

3 Captive insurance companies have been in existence for over 100 years. Over 5,000 such companies exist globally and over 70 jurisdictions have some form of captive legislation. As perhaps the most widely accepted form of alternative risk financing, its utilisation by certain industries varies markedly. Who uses a captive insurance company? In general, the oil and gas industry are significant users of captives. Oil majors such as BP, Shell, Exxon, Chevron, Conoco, Repsol YPF, ENI, TOTAL and Woodside each operate at least one captive insurer. Equally in the support industry, captive utilisation is also significant with businesses such as John Wood Group, Schlumberger, Subsea 7 and Nabors Industries operating a captive. Much as oil majors are significant, NOCs clearly occupy a unique position within the market. The Economist reported on 23 January 2010, that 75% of crude oil reserves are owned by NOCs whilst conventional multinationals control just 3% of the world s reserves and produce 10% of its oil and gas. Does the global position of NOCs influence captive utilisation? Figure 1: Oil price per barrel It is easy to see how, with such control, captive utilisation might be different. Much as oil prices of near US$147 a barrel, as in July 2008, are not presently being repeated, they have been increasing (as can be seen from Figure 1). With very high levels of cash flow generated, setting aside funds for potential loss events might seem unnecessary. So how does captive utilisation in the NOC sector compare with the majors? Based on an estimated total of 113 NOCs globally, Figure 2 reflects the level of captive utilisation. 12% NOCs operating captives include Petroleos de Venezuela, Gazprom, Statoil, Petrobras, Petroleum Oil & Gas Corporation of South Africa and China National Offshore Oil Corporation. Whilst this is a comparatively low utilisation rate, it is clear that significant variations exist in both size and extent of operation within NOCs. In 2006, a Stanford University study identified a Universe of Significant NOCs. Based on those companies (a total of 36), captive utilisation is reflected in Figure 3. This reveals a much higher level of utilisation. Interestingly a significant proportion of those operating captives are not 100% state owned albeit they are in the majority. Potentially, this might have impacted utilisation simply to reflect, from a governance perspective, that property and liability interests were being protected. 88% NOCs without captive NOCs with captive Source: Marsh Figure 2: Captive utilisation Is captive utilisation an optimal strategy for National Oil Companies An industry research report 1

4 What factors might be impacting captive utilisation? In general, there are a number of factors that drive captive utilisation by oil majors. These include: 33% 67% Lack of capacity or depending on your perspective, lack of capacity at a justifiable premium Alignment of stakeholders interest with regard to funding insurable losses. Such stakeholders would include both the local operating business and local regulators as well as those responsible for the group overall NOCs without captive NOCs with captive Source: Marsh Figure 3: Captive utilisation Compliance with local insurance laws, accepted local operating practices and potentially local funding requirements To access OIL capacity which has historically only been achievable with a captive To act as a buffer against market volatility both in terms of price and capacity, particularly in certain risk areas Enhance market security by accessing reinsurers directly. The benefit is achieved through reducing credit risk, potentially reducing price and increasing the overall capacity available. From a NOC perspective, factors impacting captive utilisation include: A significantly less litigious environment than many of the countries in which majors are headquartered. With fewer losses and lower loss settlements, the need for different funding mechanisms is reduced; The level of insurance being purchased is much less or indeed, may not occur at all; Do government stakeholders require the purchase of insurance? This needs to exist before one might think about formalising the funding of any risk being retained; Many of the countries from which NOCs operate have a very competitive domestic insurance market but with little capacity for Energy Risks. Equally, the cross shareholdings that can exist create a very close relationship with little incentive for the NOC to retain risk; Very few countries from which NOCs operate have captive legislation. Therefore, the establishment of a captive in another country will lead to assets being deposited in a third country. As a government controlled company, this may not be acceptable. However, over recent years this has been changing with Bahrain, Qatar and Dubai all having established captive legislation. 2 Is captive utilisation an optimal strategy for National Oil Companies An industry research report

5 What other market dynamics are relevant? The Petroleum Economist reported in January 2010 that the doubling of petrol prices (in the US) and more in other countries over the past 10 years is forcing a rethink of driving habits and the vehicles used. Equally, a report published by Global Insight in the third quarter of 2008 titled Outlook for Light Vehicle Sales Under A High Oil Price Scenario reflected that a persistently high oil price would drive down usage. Whilst fuel efficiency is likely to increase (and not just in motor vehicles) the backlash over climate change also has an impact. This may be at government level (such as in the EU with the introduction of CO2 emissions limited to an average of 130g/km per vehicle across a motor manufacturer s entire vehicle range and due to be implemented between 2012 and 2015) or at a more personal level (simply choosing to use a vehicle less). Of course, reduced consumption due to higher prices results in the available supply of commodities, such as oil, lasting longer. This maintains a higher level of cash flow for those companies who control it. Therefore, in terms of funding for risk, this is largely neutral. Reflecting on this, it is perhaps worth considering the experiences of BP. In the Journal of Applied Corporate Finance in 1993, BP s decision to largely abandon the purchase of mid range and catastrophe insurance was examined. Whilst the rationale for not purchasing such insurance was largely acknowledged, the report identified that perhaps the real need for insurance related to risk-assessment, monitoring, and loss settlement services. In essence, the rigour of the process of placing insurance was as vital as any cover that was put in place. This was particularly the case for BP given that the level of indemnity limit available was often below BP s real needs. Other beneficial areas identified also included tax and regulatory considerations.... doubling of petrol prices (in the US) and more in other countries over the past 10 years is forcing a rethink of driving habits... Is captive utilisation an optimal strategy for National Oil Companies An industry research report 3

6 Can a captive add value for NOCs? For NOCs, many of whom are also in a similar situation with regard to coverage, can a captive add value? Whilst there are many generic reasons for captive utilisation (and earlier we looked at ones more focused on the oil and gas industry), the benefit to NOCs will often include the following:... Over recent years, rebuilding costs have increased substantially impacting both property damage values and business interruption costs... Rigour of process in identifying and valuing assets and managing losses. Over recent years, rebuilding costs have increased substantially impacting both property damage values and business interruption costs. Using the latest data, a project that would have cost US$100 million in 2000 would have cost US$172.5 million in Of late, inflationary building costs have levelled off as reflected in the IHS CERA Downstream Captive Costs Index (DCCI). The Index recently reflected that the last 6 months of 2009 had seen costs increase by 1.5%. Across a variety of industries, loss management can be an issue. Where the formalised process of purchasing insurance is not in place, many losses effectively disappear in the capital expenditure budget; Direct reinsurance market access. Accessing capital providers directly and increasing competition on the placement (or limits available) can help in managing costs and the breadth of coverage; Management of insurance relationships with joint venture partners. Many of the majors utilise a captive insurer to manage the retentions on major projects and/ or joint ventures, at least for their percentage interest. It is equally appropriate for the NOC to do the same. As a wider point, helping such local operations manage their exposure can provide some benefit; Management of risk within international business operations. Many NOCs have expanded internationally introducing them to a different regulatory environment, insurance market and risk profile. The manner in which the international operations are run (and potentially financed) will have a bearing on the level of risk that the NOC takes, whether by desire or default. Accordingly, it is likely that a captive will have more of a role in order to manage this from a group perspective versus leaving it to the overseas business. It must be recognised that all NOCs are different and that the extent or manner of expansion varies. However, the desire to acquire assets for the benefit of a given country s expanding population is clearly apparent. With many NOCs expanding in Africa, a market with fewer internationally experienced oil and gas insurers and limited capacity, the role will be more pronounced. 4 Is captive utilisation an optimal strategy for National Oil Companies An industry research report

7 What risks should a NOC captive participate in? In many ways, the typical risk areas are similar to that of the majors. Such risks would include: Property Damage and Business Interruption Liability 13% 13% Marine 37% 24% Aviation 13% Construction Environmental Terrorism Control of Well. Less than $10m $10m - $50m $50m - $100m $100m - $1bn Over $1bn Source: Marsh Figure 4: Captive capitalisation of benchmarked oil majors From analysis recently undertaken by Marsh on a sample of majors, the level of capitalisation also helps set some context as to the level of risk being assumed. However, given the unique nature of each NOC or indeed each company generally, it is perhaps more useful to consider the appropriate process that should be adopted in determining the value of a captive and the decision to finance risk using one mechanism versus another. Is captive utilisation an optimal strategy for National Oil Companies An industry research report 5

8 How should risk funding decisions be made by a NOC? Taking the right risks at the right time ensures optimal captive deployment and it is in this area that the right process is vital. Successful captive optimisation and the recognition of when not to use the captive are necessary to enhance its long term effectiveness. How is such captive optimisation achieved and what is best practice? Three fundamental principles govern the process of evaluation. These are: Realising and positioning the purchase of insurance as only one of a number of tactics that can be deployed, as part of a broader, long-term risk management and financing strategy; Focus on delivering a higher return of capital or simply delivering the lowest ultimate cost (but with the correct assessment of all the costs involved). This involves moving away from looking at the direct cost of insurance to the lost return to the business had it been deployed differently;... taking the right risks at the right time ensures optimal captive deployment and it is in this area that the right process is vital... Matching the buying needs of the NOC with its appetite to take risk, the losses it is likely to sustain and the capital cost associated with its various financing options. Clearly for government sponsored companies, the cost of allocating capital might be considered minimal. Having established the principles, three broad best practice steps are involved in pursuing an optimal programme that ensures capital is well allocated. These are: Understanding the strategy and current position of the business This is wide-ranging, covering areas such as historic losses, business continuity, corporate governance, board level attitudes toward risk, identification of information gaps and a snapshot of the business. This part of the process contains many qualitative aspects and is vital in the engagement process of senior management. As highlighted earlier, there are numerous factors needing consideration many of which are external; Analysis and model data Creating decision-making tools from raw data is a critical stage in the process. Different aspects within this include stress testing the adequacy of current risk financing arrangements, defining an appropriate risk tolerance calculation for the business, analysing the current structure and retention levels, creating theoretical and market based pricing models and the evaluation of alternative risk financing tools; 6 Is captive utilisation an optimal strategy for National Oil Companies An industry research report

9 Design and place risk financing solutions This is the critical point at which it is possible to demonstrate that capital has been allocated as efficiently as possible. Having established which risk financing structure is most appropriate in terms of type, limits and retentions the placement must be finalised. A final decision can be made around carriers, a risk in itself, but with the underwriting submission having been enhanced through this process, more market interest should have been created. As was highlighted in the review of BP decisions, value is created as much in the process as in the final result. In looking at this process and the way the business interacts with the risk transfer markets, how is captive involvement optimised in this process? In Marsh s view, there have been three distinct phases of captive development. The first involved captives established over 100 years ago in the same country as the parent and which often developed into a separate insurer in its own right. The second stage involved captive development during the 1960s where the concept gained ground and provided the underlying basis for development over the next 40 years. This stage of captive development was focused on managing costs associated with deductibles or excesses and for a period, largely for tax reasons, included underwriting some third party business, albeit generally unsuccessfully. The third stage involved what we term optimised captives, being those captives pursuing a clear, documented strategy but adjusting tactics to make best use of its capital given the actions of the external risk transfer market. In our mind, NOCs that have been operating a captive for a number of years will be progressing towards the latter stage. Based on this, the following general characteristics apply to an optimised captive: A clearly documented strategy exists which addresses how the captive supports the business and identifies ways to increase that support. For a NOC, the value a captive brings needs to be reinforced on a regular basis. This is particularly the case given the issues previously identified;... the capital (and retained earnings) held in the captive reflects both the current and reasonably foreseeable needs of the captive... A clear evaluation approach exists for the alteration of existing risk levels or the acceptance of new risks; The capital (and retained earnings) held in the captive reflects both the current and reasonably foreseeable needs of the captive. With the high level of cash flow enjoyed by some NOCs, the benefit of this may be muted; That the return on the capital employed by the captive is at least equal to that within the core business; The investment strategy is reflective both of the underlying nature of the risks within the captive e.g. frequency, volatility and timing of payments and reflects the need to limit the cash flow impact of the captive on its owner; The tactics involved in implementing the strategy need to be reviewed at a regular date, at least annually, in order to ensure that the strategy is achieved; Recognition that a captive programme that changes from one renewal to the next may actually provide best value. Is captive utilisation an optimal strategy for National Oil Companies An industry research report 7

10 Conclusion NOCs are unique in the position they hold within the global economy. Many of the operational risks that they have to deal with every day are similar to those of private companies in the oil and gas industry. The financial pressures are different for many of the NOCs particularly given the cash flows that have been enjoyed over recent times. However, as was reviewed by the Journal of Applied Corporate Finance, the value of insurance is as much in the process of placement and administration as in the cover provided. Reflecting this, a captive has a role to play for NOCs generally, particularly for those with joint venture arrangements or who have operations in third party countries. The latter point regarding international expansion is a foreseeable result of both expanding populations and the finite level of such resource being available. NOCs with a strong cash flow are clearly seeking to manage this issue. As they do so, covering insurable risks in those countries will be important as will the utilisation of a captive vehicle. With the increase in countries that have captive legislation which are much closer to home for NOCs, this has also become a more relevant factor. For NOCs, it is now possible to establish a captive within their own, or very local, jurisdiction. It is difficult to foresee an environment where captives effectively replace the general insurance market, whether domestic or international, but an increasing role is possible. Ensuring that the role of the captive is optimal and that the process is best practice will continue to remain a challenge in a rapidly changing economic environment. About the author Jonathan is currently a Senior Vice President and responsible for Marsh s captive consulting services within the EMEA region. Jonathan is part of Marsh s Risk Finance Group. Jonathan has significant risk financing experience and most recently led Marsh s UK Captive Consulting Group. He previously worked for ACE European Group where he had responsibility for developing ACE s fronting business in Europe. Jonathan has spent more than 15 years working with multinational clients across Jonathan Groves, Senior Vice President a variety of risk financing areas including spending time in Europe as well as 3½ years in Bermuda. He is an Associate of the Chartered Insurance Institute (ACII), an Associate of the Institute of Risk Management (AIRM) and has a Masters in Business Administration (MBA). 8 Is captive utilisation an optimal strategy for National Oil Companies An industry research report

11 Marsh Marsh is the leading global captive manager and captive advisor. Marsh manages captives in over 25 jurisdictions including Barbados, Bermuda, Cayman, Canada, Dubai, Guernsey, Ireland, Isle of Man, Luxembourg, Malta, New Zealand, Singapore, Sweden and the US. EMEA London Jonathan Groves Telephone: Luxembourg Fred Gabriel Telephone: North America New York Art Koritzinsky, New York Telephone: Bermuda Scott Gemmell, Bermuda Telephone: Asia Singapore Vic Pannuzzo Telephone: Is captive utilisation an optimal strategy for National Oil Companies An industry research report 9

12 The information contained herein is based on sources we believe reliable and should be understood to be general risk management and insurance information only. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such. Statements concerning legal, tax or accounting matters should be understood to be general observations based solely on our experience as insurance brokers and risk consultants and should not be relied upon as legal, tax or accounting advice, which we are not authorised to provide. Marsh Ltd Registered Number: England Registered Office: 1 Tower Place West, Tower Place, London, EC3R 5BU Marsh Ltd. is authorised and regulated by the Financial Services Authority for insurance mediation activities only. Copyright 2010 Marsh Ltd All rights reserved