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Tuesday, July 20, 2010

Deepwater Horizon Oil Spill Disaster: Risk, Recovery and Insurance Implications

Rawle O. King
Analyst in Financial Economics and Risk Assessment

The April 2010 Deepwater Horizon oil spill disaster in the Gulf of Mexico is now being characterized as the largest spill to have occurred in U.S. waters. As efforts to contain the current spill proceed, the likely scale of clean-up costs and third-party damages has prompted congressional review of clean-up and damage compensation mechanisms, as well as of ways to facilitate future oil spill prevention, response, and recovery. A key element is the role of insurance in ensuring that costs of spills can be financed, while at the same time enabling the continued effective and responsible functioning of offshore energy exploration and production, as well as protecting related economic interests.

The United States has an explicit oil spill liability and insurance mechanism to address the Deepwater Horizon incident. In 1990, Congress enacted the Oil Pollution Act (OPA) to strengthen the safety and environmental practices in the offshore energy exploration and production business, to create a system of so-called "financial responsibility laws" and compulsory liability insurance combined with strict liability standards, and to place limitations on liability. Although liable for all removal costs, current law limits an offshore facility's liability for economic and natural resources damages to $75 million per incident. Damages in excess of the cap could be paid by the Oil Spill Liability Trust Fund, which is financed primarily through a fee on domestic and imported crude oil.

Lease holders of a covered offshore facility (COF) must demonstrate a minimum amount of oil spill financial responsibility (OSFR) of $35 million per 35,000 barrels of "worst case oil-spill discharge" up to a maximum of $150 million for COF located in the Outer Continental Shelf (OCS) and $10 million in state waters. OSFR can be demonstrated in various ways including surety bonds, guarantees, letters of credit, and in some cases self insurance, but the most common method is by means of an insurance certificate.

Legislative measures (S. 3305, H.R. 5214, H.R. 5629) currently seek to raise the limit of environmental liability on responsible parties from an oil spill from the current $75 million, in some cases abolishing the limit altogether. Concerns have been expressed that higher limits of liability will deter many smaller operators (in terms of net worth) and their investors, as they may not be able to meet significantly higher financial responsibility requirements because of limited offshore energy insurance capacity.

The offshore energy insurance market currently has a finite amount of liability insurance capacity, including coverage for offshore oil pollution spills in U.S. waters, somewhere in the range of $1.25 billion to $1.5 billion. Working capacity for OSFR certification is currently no more than $200 million—an amount that is likely to be far less than what the market will demand should Congress choose to increase the limit of liability on responsible parties to unlimited from the current $75 million. Members of Congress might consider ways to assist the development of alternative sources of insurance capacity for spreading oil spill financial risks. Some of the alternative risk transfer mechanisms include "reinsurance sidecars," catastrophe bonds, and derivative financial instruments that securitize insurance risk. These alternative risk transfer mechanisms turn an insurance policy or reinsurance contract into a financial security that is then transferred to investors in the capital markets. These risk financing options could in theory provide the added capital needed in the insurance marketplace to cover the higher liability and associated OSFR limits.

Date of Report: July 12, 2010
Number of Pages: 24
Order Number: R41320
Price: $29.95

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