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BP has always been in the news sometimes for the wrong reasons and sometimes for good reasons. Its size is the most fascinating feature. BP was the largest company in the UK in the 1980s and 1990s (Doherty & Smith 2003, 410). It was also the second largest in Europe and since then the situation has not changed. It still occupies its respective positions. It operates throughout the world and has stations in many countries. Most of its production licenses as well as facilities are in Alaska and the North Sea. Its equity capital was approximated at $35 billion. On the other hand, its debt was estimated to be about $15 billion. Its after-tax profit had averaged at around $1.9 billion between 1988 and 1992 (Doherty & Smith 2003, 410).
It consists of four operating companies. The first one is BP Exploration which is in charge of exploration as well as the development of gas plus new oil resources. The second one is the BP Oil which is responsible for refining, distribution as well as selling of petroleum products. The third is the BP Chemicals which deals with petrochemicals, nitrates as well as acetyl.
Finally, there is the BP Nutrition which operates the animal-feed business. Its assets include exploration as well as extraction licenses. It also includes technical as well as scientific capital particularly in the oil industry which is in the form of filling stations, refineries, rigs, road tankers, pipelines as well as ships. The concentration of value of its business and its limited range of activities means that it faces significantly undiversified business risk (Doherty & Smith 2003, 410).
BP’s risk exposure
According to Doherty and Smith (2003, 403), insurable events which include product liability suits as well as physical damage on the assets of the company; and toxic torts raises the cost of production for these industrial corporations. Most large companies usually buy insurance against their large potential losses as they practice self-insuring against smaller potential losses.
BP is exposed to a range of small routine losses to multi-billion-dollar potential losses. Its small scale potential losses include industrial injuries and even minor shipping or vehicle accidents. It also includes equipment failures as well as small fires. On a larger scale, there are refinery explosions and fires as well as oil spills that cause minor environmental damage.
There is also the possible loss of oil tankers. BP’S very large losses are likely to be caused by huge clean-up costs that result from major oil spills; defective fuel may also result into liability due to major disasters such as airline disaster, and may also result from tort claims arising from widespread injuries which result from the release of noxious gases. Loss of lives due to an offshore rig could also result in a major loss to the company. The worst of all to happen could be the cancellation of the operating license as a result of political backlash on claims of environmental damage. To the extent of such potential losses, BP has to buy insurance in exchange for loss settlements should the risks occur (Doherty & Smith 2003, 411).
To have the real statistics of its potential loss distribution for decision making, BP retained independent actuarial consultants. The actuarial consultants were presented with every industry as well as BP loss data. They estimated BP’S whole distribution of expected annual loss to be about $157 million. In the past, BP had insured its property as well as liability exposures. However, it was not very keen on ensuring its business-interruption exposures although insurance coverage for the same had been available. It had only insured it to a very limited extent.
Its liability insurance, as well as business-interruption insurance, was acquired through external insurers; however, some insurance was purchased through O.I.L. which was an oil-industrial mutual and where BP was a joint partner. It, therefore, purchased its upper tail insurance coverage from O.I.L. Some of its property had been insured directly through independent insurers while others had been insured by a captive insurer. All of this external coverage had covered the first two losses which were; those below $10 million; and $10-$500 million. Most of the insurance coverage had been in the range of $10-$500 million. However, there was no insurance coverage available for above $500 million potential risks and therefore it had self-insured this range. The cost-benefit framework that was presented by the actuarial consultants made BP undertake a comprehensive re-examination of its insurance coverage plan (Doherty &Smith 2003, 411).
Coverage for losses under $10 million
In its new approach, the managers of the local operating units were now in charge of losses under $10 million. In cases where there was a provable need for insurance, the local managers could purchase it from BP’s captive insurer. They were also allowed to look for competitive quotations in the local markets. The main reason was that uninsured losses in this category are minimal and therefore could only cause small changes in the firm value. According to Doherty and Smith (2003, 412), the standard deviation for BP’s after-tax earnings was above $1 billion. Thus, self-insuring of BP’s losses below $10 million could only raise the standard deviation of its after-tax earnings by about $12 million. This meant that the expected insurance benefits gained through controlling of financial-distress were insignificant at this level.
The resolution that now gave local managers the authority to ensure small losses were made after making other considerations. BP had seen that since markets for losses had become very competitive at this level, it meant that market forces would effectively eliminate the anticipated insurer rents. Market forces usually force insurance companies to hold only highly liquid as well as safe assets to eliminate the problem. Since such assets may have lower predictable returns, insurers may be forced to increase capital to reduce competition. According to Danielsson and Keating (2011) insurers have often been forced by the market forces to increase their illiquid asset holdings.
They also felt that insurers usually have a competitive advantage especially in terms of service-provision activities in areas like claims administration. Since losses that occur in this range are many and also routine, insurers usually provide informational advantage particularly in loss assessment as well as control. Besides, their contract enforcement is also reliable.
BP also felt that insurance coverage would satisfy their local financial-responsibility requirements. For example, the insurers set a minimum amount which they provide for injury liability in case of an employee gets in an accident within the company, they pay for property damage during accidents and they also pay for costs incurred during lawsuits. They would, therefore, be better placed to recover from costs of environmental clean-ups that occur as a result of spills, overfills as well as failures in the piping system; and third-party compensations.
According to the amendments that were made in the Federal Financial Responsibility Regulations in 1991, owners or operators of the underground storage tank, majorly oil industrial companies have to demonstrate financial responsibility that they can cater for the costs of carrying out corrective actions as well as third–party compensations that arise from discharge of petroleum from their underground storage tanks (United States Environmental Protection Agency 2000, 3).
According to BP’s management, insurance coverage was seen to minimize the noise in the performance benchmarks that are put in place for the local managers. This, in turn, would provide stronger incentives for local managers to perform. According to Schnedler (2006, 1-4) when crafting incentives for a manager, identification of trade-off in insurance as well as the excellent allocation of effort in a variety of tasks need to be done concerning trade-off involving the responsiveness such as signal-noise ratio, precision and many more; of the performance benchmarks as well as similarity in terms of congruence to the benefit of the organization.
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Insurance coverage takes into account the difficulty of the task thereby making responsiveness and similarity informative on trade-offs involving insurance and allocations. This, in turn, provides information on best performance measures that the employer could use and how well each measure reflects the employer’s benefit from the particular activity. Insurance coverage is therefore used to provide cover for downside risks of employees’ subjective pay. According to Gibbs, Merchant, Van der Stede and Vargus (2003, 2), subjective bonuses are paid to employees to complement perceived weaknesses realized during quantitative performance measurements.
Subjective bonuses are highly related to the extent to which achieving the bonus target could be difficult and besides, could lead to considerable consequences should the organization fail to meet the target. They are also positively related to an operating loss. Subjective bonuses also contribute positively towards productivity, profitability as well as pay satisfaction. Its benefits are greater than the manager’s tenure since it improves incentive contracting. This implies that insurance coverage would help improve the performance of managers within the company.
The localized nature of certain BP’s tax liabilities has some potential tax-related benefits that come from insurance. According to Andrews (2006) insurance coverage may cause royalty relief meant to motivate the production of more oil and gas. Tax-related benefits are usually determined by laws and regulations. Captive insurance firms also offer tax planning via captive tax-planning tools.
By using these instruments they shift the profits from high-tax areas to low-tax. This profit Shift to a high-tax jurisdiction could as well be as a consequence of tax advantages. In the high-tax jurisdiction, deductibility is not allowed since payments are not considered as expenses for tax. The expense is considered extremely high while transfer pricing becomes paramount. Tax authorities usually reason that insurance premiums normally paid to insurance companies are per nondeductible since inter-company transfers are not included in expenses in a fiscal sense.
Coverage for $10-$500 million losses
The new approach required that losses which are over $10 million be insured through external markets only in specific circumstances such as in situations where the needed insurance is under joint-venture provisions or in cases where the insurance coverage is under current bond indentures. According to the new insurance policy, this range would no longer be insured through external insurance markets. This had reflected a major policy change as most of BP’s losses ranging from $10 million to $500 million had been previously insured. In making these changes, BP had made several considerations.
First, they acknowledged that in this range, there is limited effective competition within insurance markets. Doherty & Smith (2003, 409) agreed that there were few markets for pollution as well as other non-familiar lines of insurance, especially for high-risk lines. It meant that it was even more difficult to find insurance coverage for potential losses of more than $500 million. According to Mayers (1981, 391), effective competition in the insurance industry helps limit the divergence involving premium as well as the capital market’s valuation of company assets. Insurance contracts, therefore, create a separation between asset control and risk-bearing.
In this case, payoffs dependent on designated events are paid. Limits in effective competition in the insurance markets affect the pricing and variety insurance policy available. The markets for large losses of this level particularly in certain specialized risks had less competition, therefore providing services such as environmental audits as well as risk assessment for BP’s case; alone, would require large investments since there were only few insurance companies that offered coverage for extremely large exposures. BP would therefore only purchase insurance coverage in this level in certain situations where insurance contracts can contain complex provisions while stipulating exclusions as well as insurability requirements. It also stipulates settlement procedures for handling the problems.
Secondly, the costs of implementing insurance contracts at this level were seen to be high. There are usually taxes levied on insurance companies by the government which makes insurance companies increase their pricing. It meant that BP would have been forced to pay premiums which exceed the expected specified amount to cover for the tax levied on the insurance companies. The threshold of insurance premiums would now range between certain amounts. It also meant that BP would also have to pay for increases that arise due to inflation. According to Doherty and Smith (2003, 407), the charges of enforcing contracts at this level usually include legal costs of actions often with huge insurance policies which were normally much higher than the same costs. Since contracts have to be self-enforcing as the enforcement costs are too high, the employers have to pay for the costs to avoid a repeat of the same (Thomas 1988, 541-542).
Thirdly, the company also felt that in this level of losses, insurance companies do not have relative advantages for delivering safety as well as other services which have been left with financial indemnification. According to Doherty and Smith (2003, 412), BP paid a premium of up to $1.15 billion and only managed to recover $250 million through claims. Insurers do not provide distribution systems which have a comparative advantage especially in predicting risks. They also do not provide adequate customer information on coverage since they do not evaluate potential risks to make the customer more informed of the potential risks and the estimated costs of potential risks.
Finally, BP’s management concluded that the impacts of losses within this range have limited effect on the corporate value. According to the results the actuarial consultants that BP had retained, self-insuring losses which are in this range increases the standard deviation of the company’s annual earnings by just $98 million (Doherty & Smith 2003, 412).
BP which is one of the largest industrial companies in Europe and the world had applied various strategies for its insurance coverage. However, due to the increasing potential exposure to business risks as well as the impacts of insurance coverage costs on operating costs, it reviewed its insurance strategy. The policies that were adopted by the company are logical and have greater cost-benefits. The insurance strategies that were adopted by BP depended significantly on supply considerations within a range of sizes of possible claims.
After undertaking a supply-sided study of the insurance industry and other distinct features of business demand for insurance, BP concluded that it had a significant comparative advantage over insurers in terms of bearing the risks of the company’s largest exposures. Thus, it now purchased insurance for coverage below $10 million while undertaking most self-insuring to losses which are in the range of $10-$500 million as well as self-insuring coverage to losses above $500 million. This was a wise decision considering that the company used to pay more premiums and recovered less from claims.
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