The PRA QIS Exercise: What does it cover and what will it mean for firms?
While the PRA stresses QIS should not be viewed as policy proposals, firms should consider the impact the exercise could have on their balance sheets.
Rapid developments in the energy industry have focused public attention on the practice of hydraulic fracturing, more commonly known as fracking. Increased awareness, along with negative publicity of recent accidents, has raised concerns about both the risks inherent in the fracking process and the public’s increased exposure to the risks of energy extraction in general. In this article, we will address a number of risk management considerations and strategies, including the potential for strengthened insurance requirements to protect the public, particularly those who suffer injury or property damage, from ultimately bearing the cost of pollution.
Fracking boom and emerging risks
Shale gas production (the energy source impacted most by fracking) in the United States has increased exponentially in recent years and is expected to increase further in the years to come. According to the U.S. Energy Information Administration (EIA), domestic natural gas production from shale is expected to nearly triple over the 25-year period 2010-2035, as shown in Figure 1.1
Several recent air quality studies and surface spills in Texas and Wyoming have raised concerns about the impacts of natural gas drilling on air quality. Fracking operations can also lead to surface spills, as recent incidents in Pennsylvania’s Marcellus Shaleregion illustrate.
Fracking opponents have warned about the potential for aquifer contamination from fracking fluids, which could be released from surface spills or by operations below ground. The fluids involved can contain heavy metals, naturally occurring radioactive material, toxic minerals, chemical additives, and known carcinogens.-2-3
If groundwater contamination does occur, the cleanup process could take anywhere from several years to many decades. The size and complexity of underground aquifers, the difficulty of locating and localizing the contamination, the different behaviors of the contaminants, and the techniques used for the clean-up process all would impact the final cost.-4
The recent MTBE contamination in California, while not fracking-related, offers an example of the difficulties in cleaning up ground water contamination and the potential liabilities when public water supplies are compromised. A common additive to gasoline in the 1990s, MTBE was found to have contaminated Santa Monica’s water supply in 1996, forcing the city to find other sources for half of its water.-5That incident led to a $120 million settlement.-6Another high-profile case was settled for a $422 million payment upfront, with additional funds for cleanup costs over the following 30 years.-7There are differences between MTBE and the chemicals found in fracking fluids, but if fracking operations were to lead to such widespread water contamination, the liabilities could reach similar levels.
As fracking expands, in the short term we can expect to see more of the spills, blowouts, and other types of quickly manifesting incidents that have already materialized. As production ramps up further, in the absence of improved safety controls in the fracking process, the number of these types of incidents is likely to increase accordingly.
The biggest uncertainty surrounds the long-term impacts of fracking on public health (through water pollution and airborne effects) and whether it will result in a wave of latent injury allegations sometime down the road. The expected growth of fracking over the next several decades, both domestically and internationally, combined with the time that latent injuries could take to manifest and the time needed to clean up contaminated sites means these issues will be dealt with for many years to come.
Risk management considerations
For firms involved in the energy industry and other parties affected by the rapid growth of fracking, there are a variety of considerations and strategies for managing the risk of uncertain future pollution costs.
Because of the concerns discussed above, opponents of fracking are arguing for either a permanent or temporary ban on fracking to allow further research and safety improvements. These are variations of the basic risk avoidance strategy that has been adopted by regulators in France-8and Vermont.-9
Supporters of fracking feel that the benefits outweigh the potential risks, which they say can be mitigated through the use of best practices. There has been a broad effort within the energy industry, in conjunction with other interested parties, to develop, promote, and enforce best practices for safety in fracking operations. These include standards for well drilling, casing, and cementing, maintenance, pre- and post-drill testing, ongoing monitoring, site preparation and isolation, and handling of fracking-related fluids and wastewater.-10-11Energy industry scientists and engineers expect that these practices will reduce the frequency and severity of pollution events, but no one is suggesting that these events can be eradicated altogether.
As with any activity, accidents that are due to equipment malfunction or human error are inevitable. As a result, firms in the energy industry employ risk-transfer mechanisms such as pollution liability insurance to manage these risks. Depending on the size and the nature of operations, pollution liability insurance is purchased with limits that range from approximately $1 million to just over $100 million for the largest gas companies.-12These policies provide coverage for indemnification of pollution damage or injuries, as well as associated defense costs. Considering the large dollar amounts associated with claims on comparable historical pollution events, there could be several scenarios where the indemnity and defense costs for future fracking-related pollution claims amount to several multiples of the largest pollution liability limits that are currently being purchased.
For a company responsible for such an event, if insurance coverage is inadequate then investors are at risk of losing up to the full amount of their investment in the company. If the full net worth of the company (in addition to insurance coverage) is insufficient to cover the costs associated with an event, those costs will be borne by those who have suffered property damage or injuries. With the common practice of using site-specific LLC/LLP corporations that are dissolved after operations are completed, and the hundreds of small companies active in shale gas production with typically minimal pollution liability coverage, this outcome is a very real possibility.
There are stark contrasts when we compare this situation to the solvency requirements for insurance companies. Insurers are generally required to have sufficient capital and reinsurance protection so that if they were to experience an extreme catastrophe loss event (typically much more severe than any historical loss), they would not run out of money and leave those who have suffered injuries or property damage to bear the costs.
Energy industry regulators can adopt a similar framework by considering the pollution catastrophe scenarios for their regions and requiring companies to have sufficient insurance or other financial resources to cover the costs of these types of events. In addition to requiring that sufficient insurance limits be in place, the policy terms need to be comprehensive and should respond to claims regardless of the lag between occurrence and discovery.
Besides reducing the risk to the public and individual energy companies by improving their financial strength, the increased use of insurance also offers the advantage of greater efficiency in the energy market.
Insurance industry competition and profit motive maintains a premium rate level that is based on the best current estimate of future pollution costs. One key benefit is that current energy prices will better reflect the true cost of energy production, including pollution events, when these premiums are charged back to energy producers.
Another benefit of insurance requirements is that energy producers will have additional incentive to employ best practices, because any reduction to their expected insurable losses will allow them to realize savings through premium rate reductions. In situations where there are disagreements or distrust between energy regulators and the energy producers, insurers could play a valuable role as an independent third party known to be focused solely on those safety practices that are most effective and cost-efficient. Insurers may also provide valuable advice based on experience in underwriting similar risks in other regions around the world.
Insurance capacity for fracking pollution risks
Some may express reservations about increasing insurance requirements for companies involved in fracking, citing lack of capacity available in the insurance market. Regulators that determine there is a need for increased limits but become aware of capacity constraints should seek to understand the underlying causes of the lack of capacity.
A current lack of insurance capacity may be due to a lack of historical demand. Fracking-related energy production will be around for a long time, with many thousands of wells expected to be drilled in the next several decades, but as this technology is just starting to become more widespread, there may be a temporary lack of capacity as insurers increase their familiarity with the unique aspects of fracking exposures in a particular location.
Insurers have a variety of ways to approach new types of exposures. To estimate expected losses when there is a lack of historical record, they relate the new exposure to something with which they are more familiar and seek the advice of engineers, scientists, claims handlers, and other experts to understand how the new risk compares in terms of expected frequency and severity of loss, as well as potential catastrophe scenario outcomes. For large risks that require coverage with limits in the hundreds of millions of dollars, many insurers participate in the risk via a tower structure, each taking their own slice—typically ten to fifty million—of the total limits. Each insurer also monitors their aggregate exposure to insureds in a particular region, and purchases reinsurance to further decrease the impact that a single adverse outcome could have on their bottom line. Thus, the increased risk associated with the new exposure is spread throughout the insurance industry.
Global insurance markets are competitive—increased demand driven by strengthened regulatory requirements should attract additional capacity over time, as long as there are no other factors limiting insurers entering the local market.
If insurers are too concerned about high pollution liability for fracking exposures, perhaps it’s worth evaluating the particular situation to see whether the pollution risk could somehow be further reduced or, at the extreme, avoided. A lack of insurance availability for certain energy companies in a region may be a signal that the likelihood of major pollution losses is too high, either because best practices are not being followed or because of the complexities associated with the use of fracking in that region.
There may be other issues at play, though, that limit capacity.
An example would be a situation where a number of small fracking companies operate in a particular area, any of which has the potential to cause very large losses. This could cause two potential problems. With many operators in a small area, it may be difficult to establish fault for some types of leak or seepage events. In addition, while potential catastrophe losses may be very high, expected losses for individual companies may be so low that it could become inefficient to administer the policies—the expense component of the premium could become too high in relation to the expected loss component from the insured’s perspective. In this situation, regulators may be able to help in the establishment of a pool to provide coverage for similar risks across an entire region, perhaps for all such companies operating within a particular shale formation. Management of the pool would need to be independent from its members to avoid the potential danger of charging inadequate premiums, which could result in the pool lacking the necessary capital or reinsurance protection needed to respond in the event of a major accident (i.e., back to square one). Ideally, the pool would access reinsurance markets for capacity up to the limits required for a catastrophe event, and the reinsurance premiums would be allocated back to the companies in a manner consistent with the risk exposure of each member’s operations.
A fracking cat bond?
Once regulators have taken a close look at all the possible pollution scenarios, if they determine that the catastrophe scenario outcomes require pollution liability limits so high that all insurers and reinsurers in the market would be at maximum capacity, then in addition to further investigating if there is an underlying cause for the lack of capacity, there may still be another option to provide some form of additional coverage for quickly manifesting, high severity incidents.
At the intersection of reinsurance and capital markets, insurance-linked securities (ILS) are financial instruments that are structured so that the risk of low-frequency and high-severity events can be transferred by accessing the trillions of dollars of capacity potentially available from capital market investors. So far, these instruments have been used primarily for property natural catastrophe risk, where the primary attraction for investors is the diversifying benefits of a risk that is uncorrelated with the financial markets.
For casualty risks, the use of these instruments has been uncommon, but one notable example was Avalon Re,-13which was set up in 2005 and provided coverage for energy companies over a three-year period for loss amounts in excess of $300 million and up to $750 million. Low-frequency, high-severity casualty losses have some diversification benefits similar to property risks, but one of the major hurdles has been the “long tail” nature of casualty risks, where individual claims may not be settled until many years after the original accident occurred. Investors so far have been wary of taking on these longer-term risks, for a variety of reasons. The reinsurers, brokers, consultants, and investment banks at the forefront of the ILS market continue-14-15-16to research the types of structures that could provide the coverage needed by insureds for catastrophic casualty losses while also appealing to investors.
One approach that could be effective for shortening the tail for a pollution ILS is the use of innovative parametric tools (similar to those being developed by CatVest) to model loss amounts based on pollution levels, in conjunction with robust monitoring systems to quickly detect air and water pollution events. The result would be similar to what has commonly been done for property catastrophe risks with cat bonds that use a modeled loss or index trigger. For those bonds, once an event occurs the loss amounts are calculated using a previously agreed model (RMS, AIR, or EQECAT for storms) and the parameters (windspeed, landfall, etc.) of the actual event—if the calculated amounts are high enough, coverage is triggered and the funds can be dispersed immediately.
There are many uncertainties associated with fracking—we have highlighted a number of risk management considerations and strategies that energy industry participants, regulators, insurers, and other affected parties have available. Strengthened insurance requirements could be an effective way to alleviate concerns that potential victims or the public will be left holding the bag if something were to go wrong.
There is still much work to be done in figuring out how best to provide protection for those exposed to damage or injury and in determining the coverage structures that would best enable fracking-related pollution risk to be transferred to insurers or investors who are better positioned to bear the risks. Actuaries, who are called on to estimate uncertain future costs in a variety of contexts, have a unique skill set to assist in this work.
Considering the history of pollution costs associated with energy production, the potential risks of fracking, and the expected expansion over the next several decades, there are compelling reasons for all parties involved to come together, consider all possibilities, and invest the time and effort in order to make sure we have the most effective systems in place to cover the pollution costs now, rather than later.
1 U.S. Energy Information Administration (2012). Annual Energy Outlook 2012 Early Release Overview. Retrieved June 14, 2012 from http://www.eia.gov/forecasts/aeo/er/pdf/0383er(2012).pdf.
2 To examine shale gas production and water resources in the Eastern United States: Hearings before the Water and Power Subcommittee. 112th Congress (2011) (testimony of Cynthia C. Dougherty). Available from http://www.epa.gov/ocir/hearings/testimony/112_2011_2012/2011_1020_ccd.pdf.
3 (September 2011). Should fracking stop? Nature. Retrieved June 14, 2012 from http://www.bu.edu/energy/files/2011/07/Fracking-article-Sept-14-2011.pdf.
4 U.S. Environmental Protection Agency. (December 1996). Ground Water Cleanup at Superfund Sites. Retrieved June 14, 2012, from http://www.epa.gov/superfund/health/conmedia/gwdocs/brochure.htm.
5 Drinking water. (N.D.). Retrieved June 14, 2011 from http://www.epa.gov/mtbe/water.htm#occurrence/.
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10 U.S. Department of Energy. (November 18, 2011). Shale Gas Subcommittee Ninety Day Report. Retrieved from http://www.shalegas.energy.gov/resources/111811_final_report.pdf.
14 (March 19, 2011). ISO Casualty Index launches; could result in casualty insurance-linked securities. Retrieved June 14, 2012 from http://www.artemis.bm/blog/2011/03/29/iso-casualty-index-launches-could-result-in-casualty-insurance-linked-securities/.
15 (March 21, 2011). RMS and RAND Corporation launch Praedicat, aim to facilitate liability catastrophe bonds. Retrieved June 14, 2012 from http://www.artemis.bm/blog/2012/03/21/rms-and-rand-corporation-launch-praedicat-aim-to-facilitate-liability-catastrophe-bonds/.
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17 IHS Global Insight (USA) Inc. (December 2011). The Economic and Employment Contributions of Shale Gas in the United States. Retrieved June 14, 2012 from http://www.energyindepth.org/wp-content/uploads/2011/12/Shale-Gas-Economic-Impact-Dec-2011_EMB1.pdf.
18 Urbina, I. (February 26, 2011). Regulation lax as gas wells' tainted water hits rivers. New York Times. Retrieved June 14, 2012, from http://www.nytimes.com/2011/02/27/us/27gas.html?pagewanted=all.
19 Bateman, C. (June 21, 2010). A colossal fracking mess. Vanity Fair. Retrieved June 14, 2012, from http://www.vanityfair.com/business/features/2010/06/fracking-in-pennsylvania-201006.
22 Maykuth, A. (July 14, 2010). $400,000 fine for Marcellus Shale blowout. Philadelphia Inquirer. Retrieved June 14, 2012, from http://articles.philly.com/2010-07-14/news/24968455_1_eog-resources-blowout-dep-employee.
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25 Texas Oil and Gas Accountability Project (April 2011). Natural Gas Flowback: How the Texas Natural Gas Boom Affects Health and Safety. Earthworks. Retrieved June 14, 2012, from http://www.shalegas.energy.gov/resources/060211_earthworks_natural_gas_flowback.pdf.