The profitability of Energy Insurance for an Oil Company:

Why using self-insurance and how different Petroleum Contract impact profitability.

Table of contents
A.

Abstract .......................................................................................................................................2

B.

Introduction .................................................................................................................................2
B.1. Where this analysis comes from ....................................................................................... 3
B.2. What can be done with this analysis ................................................................................. 3

C.

Peculiarity of Petroleum Contracts .............................................................................................3

C.1. Concessions: Export Oil and Royalties ............................................................................. 4
C.2. Production Sharing Agreements: Cost Oil and Profit Oil ................................................... 4
C.3. Service Contracts: Cost Oil plus Service Fee ................................................................... 5

D.

Impact of insurance on costs of Petroleum Contracts ...............................................................5

D.1. Exploration insurance: criterias for recoverability .............................................................. 6
D.2. Construction Insurance: Fixed Costs ................................................................................ 6
D.3. Operational Insurance: Variable Costs.............................................................................. 6

E.

Insurance as a source of Profit for Oil Companies.....................................................................7

E.1
Insurance within recoverable costs ................................................................................... 7
E.2. Drivers of captive insurance profitability ............................................................................ 8
E.2.1.
Self-insurance thru the captive .................................................................................. 9
E.2.2.
Premium for volatility ............................................................................................... 10
E.2.3.
Rate differentials between market and captive pricing structure ............................. 11
E.2.4.
Asymmetric information ........................................................................................... 11
E.2.5.
Sources of capital at risk ......................................................................................... 11
E.2.6.
Shareholders vs. borrowed capital remuneration ................................................... 12
E.3. Dividends distribution vs. captive capitalization : striking a balance ............................... 12

F.

Final considerations ..................................................................................................................13

G.

Disclaimer .................................................................................................................................13

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A.

Abstract

There are a number of centralized services which large Integrated Oil Companies retain and
manage internally. Insurance is among those centralized services. Legislation in most Countries
largely allow to internalize those services as long as the cost structure is transparent within the
several companies which make up the large integrated Oil companies.
The choice among the options for internalization versus out-sourcing is driven by cost-saving
considerations, but insurance is different: proper management of insurance activities, together with
an adequate level of self-retention can generate a long-term profit.
Insurance centralized management provides not only a cost-saving mechanism, but, due to the
inherent nature of the risks themselves, the structure of the Petroleum Contracts, the time-lag
between premiums and claims payments, a benign fiscal treatment, and some other
considerations, including asymmetric information, volatility and capital remuneration, altogether
afford to the Oil Companies a profit generation which is normally sufficient to fund entirely the
insurance process itself, its own costs, to pay all the claims insured, and generate a non-negligible
long-term profitability.
Many Oil companies utilize the services provided by the insurance markets as a residual
instrument, because they have internalized these services, within a captive insurer, and the profit
generation associated with them.
Insurance market players should recognize the increasing role of captives and design new tailormade specialist services for those Oil Companies to explore this business niche.
B.

Introduction

There are a number of centralized services which large Integrated Oil Companies retain and
manage internally. Insurance is among those centralized services. Legislation in most Countries
largely allow to internalize those services as long as the cost structure is transparent within the
several companies which make up the large integrated Oil companies.
The choice among the options for internalization versus out-sourcing is driven by cost-saving
considerations, but insurance is different: proper management of insurance activities, together with
an adequate level of self-retention can generate a long-term profit.
Insurance centralized management provides not only a cost-saving mechanism, but, due to the
inherent nature of the risks themselves, the structure of the Petroleum Contracts, the time-lag
between premiums and claims payments, a benign fiscal treatment, and some other
considerations, including asymmetric information, volatility and capital remuneration, altogether
afford to the Oil Companies a profit generation which is normally sufficient to fund entirely the
insurance process itself, its own costs, to pay all the claims insured, and generate a non-negligible
long-term profitability.
Many Oil companies utilize the services provided by the insurance markets as a residual
instrument, because they have internalized these services, within a captive insurer, and the profit
generation associated with them.
Insurance market players should recognize the increasing role of captives and design new tailormade specialist services for those Oil Companies to explore this business niche.

m.n.c.

B.1.

Where this analysis comes from

The cumulated experience of the insurance function within an Integrated Oil Company shows
some interesting considerations with regard to profitability.
The above is remarkable when compared to the insurance market. Insurance market profitability in
the long-term is sometimes questioned in some high volatility sectors.
The same happens for the insurance arranged internally by the Oil Companies. However,
experience shows that some advantages brought by self-insurance and risk retention allow the Oil
Company to generate an extra profit margin compared to the traditional insurance market
participants.
This paper analyses the drivers of the profitability and the reasons for internalizing insurance
services in a corporate function.
B.2.

What can be done with this analysis

The Top Management in Integrated Oil Companies is normally well aware of the cost drivers and
profitability drivers in their companies. This paper highlights the interesting phenomenon by which
a Cost Driver becomes a Profit Driver, pushing towards centralization of the insurance service.
Insurance market players should be aware of this trend and fully understand the implication it has
on reinsurance pricing, choice of market Leaders, captives involvement, and rating considerations.
Lastly, transparency is of the utmost importance since a large number of professionals and
consultants are often used (brokers and loss adjusters, primarily) and their sources of
remuneration subject to increasing scrutiny from Clients and Regulators.
C.

Peculiarity of Petroleum Contracts

The contractual agreements struck by a Sovereign Authority to allow one or more foreign Oil
Companies to extract raw hydrocarbons from the underground reserves of one given Country, is
referred to as a Petroleum Agreement. Such contracts have a hybrid and strange nature, if one
considers carefully the nature, the roles, and the relative negotiating power of the Parties to these
contracts.
In spite of the peculiar contractual situation, in short, the sovereign authority, normally the local
Ministry of Oil or the local National Oil Company, enter into an agreement with one or more foreign
Oil Companies to allow such foreign Oil Company to bring in technology and expertise to extract
hydrocarbons and then apportion the production between the Ministry and the foreign Oil Company
in order to guarantee a source of revenue to the sovereign authority, and a taxable income to the
foreign Oil Company.
Insurance is one of the costs incurred by the foreign Oil Company and falls within the scope of the
Petroleum Contract. Claims are payable by the insurers subject to receipt of an annual insurance
premium payable by the foreign Oil Company, who is the Operator of the assets concerned in the
Petroleum Agreement. Noticeable, the Insured is the Operator, not the local public authority.

m.n.c.

Figure nr.1
Title:
Insurance cash flow
Explanation:
Payment patterns
over a number of
years.

$
+ Claims paid
to company
- Premiums
paid by
company

years

In the long term, over many years, total premiums paid by the Operator will equalize the sum of all
claims incurred and paid by the Insurers, plus the insurers remuneration , which also includes a
premium for volatility. In formal notation, at the end of the project life after many years,
(premiums) = (claims) +
Annual premium will be adjusted year-on-year to reflect the real claim experience and adjusted
upward or downward according to the real size and number of claims experienced in that risk. It is
a basic rule on insurance that each risk stands on its own merit.
The first interesting aspect is that since Petroleum Contract really last many years (15, 20 or even
30); insurance premiums and claims have a real chance to equalize over the long time-span (and
thus the premium for volatility reduces, and the only differential will ultimately be the insurers
remuneration . Rarely a shorter-lived non-energy project would ever come near this opportunity.
Because Petroleum Contracts are not all working in the same way, it is the case that different
Petroleum Contracts treat incurred project costs in different ways. Insurance costs behave under
different Petroleum Agreements in different ways. Noticeably, sometimes it is a recoverable cost.

C.1.

Concessions: Export Oil and Royalties

Concession Agreements, the first category of Petroleum Contracts, allow the Foreign Oil Company
to extract hydrocarbons at its own cost. Costs are paid by the project and are not recoverable. The
Sovereign Authority will charge a significant royalty on the production, and the profit of the foreign
Oil Company is determined as the difference between prices of sales minus costs of production,
minus royalties.
It emerges clearly that the insurance cost, just like any other cost, should be minimized to increase
Oil revenue, and proportionally increase profit from sales after royalties are deducted. Lastly,
insurance costs are tax deductible and thus reduce the taxable income.
C.2.

Production Sharing Agreements: Cost Oil and Profit Oil

The PSA is a complex agreement which allows the foreign Oil Company to invest in the technology
and in the production on the basis that incurred costs will be fully recoverable as Cost Oil, that is
to say, the Sovereign Authority will pay to the foreign Oil Company the equivalent in Hydrocarbons
of the cost incurred to extract the hydrocarbons themselves.
After accrued costs have been recovered, the residual extracted hydrocarbons are divided among
the Sovereign Authority and the foreign Oil Company in agreed parts.

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The so-called Profit Oil is divided in parts according to an apportionment factor which is a function
derived from the desired rate of recovery and is tailored to provide and incentive to the Foreign Oil
Company to extract the Oil at a specific speed.
If the policy objectives of the Sovereign Authority include immediate profitability, then the recovery
rate which maximizes profitability of the contract for the Oil Company will be higher.
Otherwise, when the policy objective of the Authority is sustainability and long-term economic
viability, then the recovery rate will be intended to be low, and the contractualised formula will
trigger only a low recovery rate, then, also profit oil will be low.
Under PSA, the insurance costs are fully recoverable; thus, minimization of the insurance cost is
not per-se an immediate priority, especially when recoverable costs are not capped at an overall
certain absolute amount. Quality of insurance and reinsurers security is normally the priority.
C.3.

Service Contracts: Cost Oil plus Service Fee

In this third and last main category of Petroleum Contracts, recoverable costs incurred by the
foreign Oil Company provide a mean by which the foreign Oil Company is reimbursed for the
capitals invested on CAPEX and OPEX, and recoverability of the Cost Oil, in the form of Oil or
Money, is very similar to that of the Production Sharing Agreements (PSA).
However, the residual production in excess of Cost Oil is not apportioned between the Sovereign
Authority and the foreign Oil Company. Instead, the Sovereign Authority generates revenue from
the sale of the entire residual production, and pays a fixed compensation for each additional barrel
of Oil extracted by the foreign oil Company.
In this third category of contracts, Technical Service Contracts or so-called TSC, administration
burden is kept to a minimum, the foreign Oil Company has effectively a remuneration that is
proportional to the hydrocarbons production, and therefore there is a clear and transparent
incentive to maximize production.
All recoverable costs that fall under the Cost Oil definition, thereby including insurance among
others, are all fully recoverable, and therefore, there is no explicit contractual incentive to minimize
insurance costs per-se. Here also, quality of insurance and reinsurers security is normally the
priority.
D.

Impact of insurance on costs of Petroleum Contracts

We have insofar observed than in two out of three categories of Petroleum Contracts, being PSAs
and TSCs, costs do not necessarily need to be minimized to increase profitability because they are
fully recoverable anyway. The quality of insurance and reinsurers security in term of claims paying
capabilities is paramount.
There is indeed a precise logic behind the structure of the PSA and the TSC. Sovereign Authorities
can control in a much better way the recovery rates and the total production, and can pay either in
barrels of hydrocarbon or in cash money the profit to the Foreign Oil Company, at a pre-set
favourable price.
This complex mechanism at the end of the day allows the Sovereign Authority to generate revenue
from the venture, which is what they want, and also controlling the profits accumulated by the Oil
Companies. Also, it allows the foreign Oil Companies to gain access to increased quantities of
hydrocarbons, which is what the Oil Company want, in turn.
The caveat of the equilibrium in the contract is the selling price of the hydrocarbons, not the
quantities produced alone. The selling price and the agreed prices set into the contractual formulas
drive the equilibrium among the Parties to the PSA.
m.n.c.

What indicated above referring to insurance cost recoverability must factor in the timing of
recoverability. Costs under PSA and TSC become recoverable under a set of conditions identified
in the Petroleum Contract depending on the phase of field prospect and development (exploration,
construction, or production).
D.1.

Exploration insurance: criterias for recoverability

The costs incurred in the pure exploration activities are not recoverable until hydrocarbons are
found and extracted. This is the general rule. Therefore, a single exploratory wildcat well, which
results in a dry well, is considered an exploration cost which results in a straight loss to the foreign
Oil Company. If several other wells are subsequently drilled in the same field, and at least one
contains hydrocarbons in a quantity sufficient for development and production, then cost
recoverability applies to the entire field, but only once production starts, maybe three years later.
Consequently, insurance premiums paid for exploration drilling are indeed recoverable, but
possibly many years after they were originally paid.
D.2.

Construction Insurance: Fixed Costs

There is a fixed amount of investments that each Sovereign Authority requires in the Petroleum
Contract. The foreign Oil Company must invest at least that amount of money. That is the minimum
price that the foreign Oil Company commits to the venture under the Contract. Such investment will
become cost recoverable only when production starts. This is effectively a barrier to entry for
smaller foreign Oil Companies.
Construction of facilities, development of fields including lying pipelines, storage tanks, and all
plants and equipments to be sources, procured, installed, and tested are paid by the foreign Oil
Companies and the costs are depreciated over time according to a timetable set and agreed in the
Petroleum Contract spanning over the entire life of the hydrocarbon production of that oil/gas field.
Lastly, a decommissioning fund must be allocated to ensure adequate end of project activities to
secure and decommission the installations under the International Best Practices commonly
applied by the Oil Industry.
Construction insurance and those investment costs fall under fixed costs as detailed above.
Insurance premiums paid at inception of the construction phase are recoverable in periodic
instalments together with the instalment of the initial investments. Again there is a significant time
delay from cost payment to cost recovery.
Financing for Energy Construction projects is the main funding need of the foreign Oil Companies.
Similarly, external funding for insurance capacity is a traditional way of purchasing peace of mind.
Given the historically low level of insurance capacity available in the energy commercial insurance
market, recently, insurance practitioners and risk managers have witnessed the entrance of
finance houses and banking vehicles into the construction insurance business, and, at the same
time, the success of the mutual insurers, made up of Oil Companies, who provide a all-inclusive
bulk capacity which includes construction risks.
D.3.

Operational Insurance: Variable Costs

Cost incurred in the day-to-day operations and depending on the production rate, such as
consumables, and operations and maintenance, operational insurance costs all fall under variable
costs and are recoverable immediately.
m.n.c.

Normally, Petroleum Contracts settle the incurred variable costs at the end of each quarter based
on the production rate of the previous quarter. Sometimes recoverability is on a half-year basis.
For example the TSC adopted in Iraq and the PSA in Angola settles incurred variable costs each
quarter, while PSA in Kazakhstan settles the equivalent incurred variable cost as soon as they are
paid.
Therefore, insurance premium purchased on a yearly basis for operational coverage are
recoverable immediately in the quarter following the payment, which normally take place at
inception of the coverage year.
Therefore, cost recovery happens even before the end of the same year. It is clear that operational
insurance brings about a neutral cash flow impact to the Foreign Oil Company. In fact, insurance
premiums paid in January are cost recovered within three months, and literally, they are magically
transformed in barrels of oil, or the equivalent sum of cash money, by the beginning of May.
Since operational insurance is by far the largest component when compared to exploration and
construction insurance, then it is possible to generalize and state that in PSA and TSC, the cost
impact of buying insurance cover is indeed practically neutral.
E.

Insurance as a source of Profit for Oil Companies

E.1

Insurance within recoverable costs

In the previous parts of the paper it has been argued and demonstrated that, by virtue of the
Petroleum Contracts under PSA or TSC structure, the net cost impact of insurance on Oil and Gas
Companies is neutral.
Under Concession Agreement it is not the case and the cost is supported by the Foreign Oil
Company.
The next logical step is to discuss the cost impact of claims.
Claims, by definition, must be equal to the sum of premiums paid in the previous years plus a
loading for volatility and insurers remuneration.
But since premiums paid are fully cost recoverable, then the amount payable by the insurers as
claims actually have a positive impact on the net economic position of the foreign oil Company.
Since the premium was recovered in oil, and the claim is paid when the loss occur, then, under the
PSA and TSC, the Oil Company has recorded a net profit. Under the strict condition of a long term
oil field development (typically at least 20 years) when premiums almost equalize claims, the PSA
gives a bottom line insurance profit.
Figure nr.2
Title:
Insurance cash flow in PSAs and TSCs
Explanation:
The Operator pays premiums but recovers
those premiums paid in barrels of Oil, or
the equivalent in Dollars, and also receives
money for the claims incurred.

p
Oil
c

We are implying that the PSA and the TSC shift the burden of insurance cost on the Sovereign
Authority, while the foreign Oil Company receives the benefit of insurance protection and avoids
m.n.c.

because a loss would have caused the original investment

to be destroyed and it would need to be re-built and paid for, again.
Under concession agreement, the situation changes when considering claims recovered. The Oil
Company suffers the cost impact of the premium, but recovers the claim, and therefore when
premiums equalize claim in the long-term, then the balance is again a neutral cost impact.
Figure nr.3
Title:
Insurance cash flow in Concessions

Explanation:
The Operator pays premiums and receives
money for the claims incurred.

At the end of the day, when it comes to insurance costs, PSA and TSC can result in an insurance
profit, and Concessions are cost neutral.
The purpose of the above mechanism is clear: to ensure that the Oil Company is protected against
the risk of paying for its investments twice, shall a total loss occur. The insurance premium is
ultimately paid by the local authority. With the self-insurance-by-captive mechanism, the Oil
Company receives the insurance premium with which it will pay its share of claims when they will
happen.
E.2.

Drivers of captive insurance profitability

An Integrated Foreign Oil Company with worldwide operations typically has a centralized insurance
function.
There are significant economies of scale and scope in doing this, including the build-up of firstclass expertise needed when it comes to negotiating complex risks vis--vis other global players,
such as global insurance companies, Lloyds brokers, other corporations, loss adjusters with
worldwide exposure, and others. Insurance is an highly globalized service, just like finance.
To optimize the use of its corporate financial strength, leveraging on a solid financial strength
rating, issued by a rating agency, Integrated Oil Companies carry a large insurance retention and
self-insure a significant share of the large industrial risks they carries. A centralized insurance
function serves the needs of managing such large group retention in a consistent manner.
Such large retention is usually structured in order to allow each subsidiary and affiliated company
in the corporation to withstand a pre-set level of financial burden, and no more. Indeed, losses in
excess of that pre-set level fall automatically under the corporation insurance protections at the
ultimate parent company - holding level, and do not impact the small operational subsidiaries,
which typically work in far-away countries under difficult conditions and are minimally capitalized.
A structure of insurance policies with suitable level of deductible and limits protect each subsidiary
and affiliate company, and it is a common practice to have a fully owned insurance company,
within the Oil Company itself, to issue all the insurance documentation.
Such fully owned insurance company (the captive) carries the risk portfolio of the entire
corporation, have an aggregate retention and, in excess of its aggregate retention, it purchases

m.n.c.

bulk reinsurance capacity on the energy insurance markets, such as Lloyds or Bermuda, or SwissRe or Munich-Re, and can negotiate substantial quantity discounts on reinsurance premiums.
Captives are a risk management tool of the Oil Companies, in fact they are an instrument used of
many large corporations also outside of the energy industry, but also are a profit center.
Because the risk portfolio of the captive is so well know by the captive manager and by the
centralized risk management function, the profitability of the captives, arising from the
management of its insurance portfolio, is often non-negligible.
Captive profitability is driven by a set of factors which we now analyze.
Then, afterward, we will see how this profitable captive fits into the consolidated financials
statements, and really represent a profit center for the Oil Company as a whole.

E.2.1. Self-insurance thru the captive

The risk portfolio of the corporation is entrusted to the captive, which actively manages such
insurance portfolio. Specifically, the portfolio of risks insured by the captive is retained net for the
captives own insurance account, as net retention, up to a certain limit, any one event, any one
occurrence, and possibly with an annual aggregate under a stop of loss arrangement, at least on
some selected parts of the portfolio.
The captive charges a premium for the part of the risks it retains based on the rates quoted by its
own reinsurers.
Under certain circumstances, the presence of mutual reinsurers, such as Oil Insurance Ltd 1 (OIL),
make the reinsurance rates competitive and the captive can recharge to its own insureds a flat
premium rate at very convenient economic terms. This holds thru also when the traditional
reinsurance market can offer cheap reinsurance in bulk quantities.
This is the first advantage captive have against the commercial insurance market.
Captive net retention is priced based on technical considerations, those primarily being:
a)

the known cost of claims incurred and settled, based on historical evidence (so-called
burning cost);

b)

the expected cost of claims (the cost of claims arising from development of
outstanding claim reserves for incurred claims yet to be settled);

c)

the ultimate cost of claim (factoring-in claim not yet incurred, but statistically
expectable);

d)

the known cost of reinsurance;

e)

cost recovery for covering general overheads;

f)

a mark-up (in a typical cost-plus formula) to factor-in a small profit.

In short, a zero-sum formula for cost recovery (claims + reinsurance + overheads) with a small preset profit percentage target (including an adequate loading for volatility), this is the general rule for
the technical pricing of the captives.
Setting the retention level becomes one of the crucial decisions at start up, and its upward
revisions are subject to a substantial increase of capitalization.

1
Oil Insurance Ltd, the mutual instrument of the energy industry worldwide, please visit www.oil.bm for all official
information.

m.n.c.

Energy captives are usually large enough to retain risks fully. Alternatively, they reinsure only peak
exposures. The size of the Energy captives can be inferred by the Financial Size Category
assigned by A.M.Best and defined as
The FSC is based on adjusted policyholders' surplus (PHS) and is designed to provide a convenient
indicator of the size of a company in terms of its statutory surplus and related accounts. 2
Figure nr.4
Source:
A.M.Best and S&P
websites
Title:
Energy captives
Explanation:
All Oil Majors have
at least one captives

Captive
Solen
Omnium
Ancon
Jupiter
Sooner
Heddington +
Iron Horse
Eil
Gaviota

Rating
AA
AA
A++
A
A
A
A
n.r.
n.r.

Agenzia
S&P
S&P
A.M. Best
A.M. Best
A.M. Best
A.M. Best
A.M. Best

Financial Size Category

XV ($2 Billion or greater)

XIII ($1.25 Bln to $1.5 Bln)
X ($500 Mln to $750 Mln)
VII ($50 Mln to $100 Mln)

IOC
Shell
Total
ExxonMobil
BP
ConocoPhillips
Chevron
Eni
Repsol

Rating agencies assign the rating to a captive insurer, unless under special circumstances, exactly
with the same rating of its ultimate parent company. Lastly, not all captives are rated, this is a
strategic decision taken by each corporation.

E.2.2. Premium for volatility

The mechanism of pricing self-insurance, in the form of captive net-retention, also includes a
premium for volatility. Energy business is a particularly volatile business, and loss frequency and
severity are subject to strong volatility.
The captive is the corporate instrument to absorb the large part of the volatility associated with the
claims of the Oil Company and is normally heavily capitalized to absorb significant financial shocks
brought by severe claims. At the worst, a captive can go burst, if and when the parent company
decides to let it go alone, without the proper parent company guarantees in place.
Volatility is just another word for profit. In fact, the captive, just like any other risk taking enterprise,
will charge a higher price to include an element of cost associated with higher volatility. Thus, there
is a premium increase in the technical pricing phase.
The written risk portfolio can behave better or worst than the general average portfolio written by
the commercial market and, based on such observed volatility, the captive can, and usually do,
offer a discount to its insureds when the claim experience is improving and volatility reducing.
A typical example is CAT NAT exposures, where volatility can be very high, however, one single
Oil Company can experience lower volatility than the market, possibly due to benign location of
assets or superior asset quality, and therefore lower volatility premium can be factored into the
captive pricing, which is extremely well informed about the risk itself, while the market would not be
prepared to recognize such lower volatility.

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

m.n.c.

10

E.2.3. Rate differentials between market and captive pricing structure

Captives base their pricing on technical analysis, such as expected cost and burning cost
methodologies, but also have other instruments, including an element of mutualisation of the cost
of claims that can be sustained by the several companies being insured (bear in mind, it is mostly if
not all, intercompany transactions within the same Oil Company).
In addition to a level of mutualisation, a number of element of standardization of the risk, because
of similar policies in the several companies, same risk policy, same human resource management
policy, same health and safety measures, standardization of procurement policies, etc.., all provide
a good level of risk homogeneity, thus a claim pattern more forecast-able, and ultimately an
element of discount can be included, producing a somewhat lower technical pricing compared to
the commercial insurance market. This portfolio optimization activity is one of the sources of the
competitive advantage of captives over the commercial market.

E.2.4. Asymmetric information

Captives have, here, a distinct advantage compared to the commercial insurance market: they are
themselves part of the Oil Company they insure at the same time as being the insurer, and their
knowledge of the risk is superior, they own the risk, literally.
Captives benefit from the entire risk management process carried out by the centralized risk
management function of the Oil Company, to which they normally belong 100%. This ultimately
provides a good level of information and a significant timing advantage.
Lastly, a captive could perform a significant level of cherry-picking, leaving the worst risks on the
commercial market. It is not a widespread practice, but it is there as a possibly available tool.

E.2.5. Sources of capital at risk

This is where the capital structure of the captive becomes an advantage for the benefit of reduced
pricing to its insured. Captives normally do not borrow money, they are funded by parent company
capital and their shareholder normally is a quiet man who does not interfere in management.
Not so the insurance companies in the commercial insurance market, which are judged by a large
panel of differentiated investors, including institutional investors and speculative investors, seeking
a higher yield from their investments and who will easily switch to a different investment, should
capital remuneration be below average or simply below their expectations.
Therefore, commercial insurers have to remunerate a distinctively greedier and larger panel of
shareholder, while the captive can afford to focus more on the business, instead of having some
resources and part of its staff dedicated to investor relations.
Ultimately, this also implies that captives employ a lesser number of staff, and have commonly a
smaller number of personnel with minimal structure.
As an example for comparison, some of the intermediate-sized Oil Companies employ a dozen
people maximum in their captives, or even entrust the captive to insurance brokers who have
establish a Captive Management Service and run the captive on behalf of the Oil Companys risk
management function, simply as an administrative tool.

m.n.c.

11

E.2.6. Shareholders vs. borrowed capital remuneration

Captives are not funded with debt, only with equity. When financing is not composed at all of debt,
and only equity is represented in the capital structure of the captive, then management is very
much simplified, and the policy for capital remuneration also is simplified.
Capital remuneration for one single corporate shareholders benefit is normally minimized, since
the captive is endowed with the funds strictly necessary to the risk management function it
performs, and the shareholder is aware that earned interests on shareholders capital are needed
for funding the working capital of the captive.
The investment policy of the captive is subject to the same rules and constrains of the commercial
market insurance companies, namely Prudential Regulations issued by the relevant national
central bank where the captive is incorporated.
Also, usually, captives are incorporated in fiscal residences where taxation is favourable to
corporations and investments, to maximize the investment returns to the benefit of the captive
capitalization.
In other words, investments must be extremely prudent as per the instructions of the local
regulatory authorities. But at the same time, a friendlier tax environment allows those small returns
on prudent investments to be used almost entirely for the captives own financial benefit and bring
about an extra buffer of funds as an additional guarantee against claims severity.
E.3.

Dividends distribution vs. captive capitalization : striking a balance

Captives in the early years of operations need to heavily capitalize, to face the potentially
significant volatility. Therefore, during any benign year with lesser cost for incurred claims, captives
tend not to distribute dividends, but to retain those earnings and carry them forward and then
incorporate them into additional shareholders capital.
Captives tend to grow over time because of retained earnings and almost zero dividends paid to
the shareholder. This until a string of major claims occurs.
Regulatory authorities sometimes question the capital accumulation happening within the captives
arguing that the original risk management tool becomes nothing more than a safe box. While this
could be the case at any given point in time, such situation is by-definition, only transitional.
A simply reality-check example clarifies this point and shows how it is really misleading: a couple of
single large claim to the captive could destroy the retained earnings accumulated in many years.
Volatility means that a true Energy loss, a loss of control of an oil well, for example offshore in
deep water, can easily incur a USD 600 millions bill made out of the entire loss of the oil rig plus
the costs of bringing the well under control, drilling relief wells, removal of wreck, removal of debris,
etc.. When in a single underwriting year more than two events as such happen, then the captives
ultimate net retention has easily burned a significant part of the retained earning previously
accumulated.
This is why the shareholder of the Oil Companys captive usually allows the captive to capitalize
and does not advocate dividends every year.
Lastly, recent Solvency II regulations impact captives as well as the commercial insurance
companies and the entire insurance industry at large. Many captives meet those new increased
solvency requirements only thanks to the retained earnings not distributed in previous years.

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F.

Final considerations

We have analysed the drivers of the profitability of Energy Insurance and how different Petroleum
Agreements differently impact profitability for the Oil Company.
We have demonstrated why Oil companies use self-insurance to retain some risk and the sources
of the arising profit, within their consolidated financial statements, thru the use of a specific tool: a
captive insurance company.
It is now clear why a centralized risk management insurance office represents not only a cost
saving mechanism (to recover, mainly in oil barrels, the cost incurred under the petroleum
agreements for purchasing insurance) but also a profit centre when it comes to managing the
captive risk portfolio, its volatility, its capital structure, its reinsurance arrangements, its net
retention, and its retained earnings.
All the steps described above allow the Oil Company to accumulate a small amount of readily
available capital (in the form of retained earnings in the captive) to be used to face emergencies
(which is the ultimate scope of self-funded insurance). But, at the same time, under normal
operational conditions and in the absence of critical emergencies, these readily available funds are
typically borrowed to operational business units (thru intercompany loans) to self-finance new
projects and new ventures, thus representing an additional source of equity capital to fund new
projects of the Oil Company.
It has been estimated by the author that, for every good year with benign loss experience, such
complex management of the insurance activities of the Oil Company can provide fresh funds to
finance a small number of new drilling oil wells, indeed providing a self-funding mechanism of
significant added value, contributing to the endogenous growth of the Oil Company.
G.

Disclaimer

The content of this paper does not contain analytic information, nor any confidential information
and, therefore, some quantitative analyses are necessarily simplified and rendered in qualitative
terms. The views expressed in the paper are the authors own or already available in the public
domain.
The author
Michele Cibrario is an ACII Chartered Insurer, holds a degree in Economics and attended the
Master MEDEA in 2005/2006. He works in the Insurance Activities Management within eni spa on
Upstream Risks and Construction Projects.

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