No. 3, 2004

Andrey Yelokhin,
Dr. Sc. (Techn.), Head of the Department of Property Insurance of JSC LUKOIL


The LUKOIL experience of insurance protection from industrial risks

Throughout the world, oil companies facilities are rated as highly hazardous. The risks involved in the production and transportation of oil, operation of refineries and petroleum product tank farms may result in major accidents and even catastrophes. For this reason, insurance occupies an exceptionally important place as an element of risk management in the oil and gas industry.

An excurse into the history

The problems of safety, risk assessment and protection against dangers have accompanied mankind since ancient times. Even in Ancient Rome, agreements were concluded to distribute the risk of possible loss of ships and cargoes carried by sea among the interested parties. In the Middle Ages, as cities grew up, the first organizations emerged to take action to avert the danger of loss of or damage to property from fire or natural disasters and to eliminate their consequences, including by economic means. For instance, in 1310, in the Flemish town of Brugge, a Chamber of Insurance was established to perform operations to protect the property interests of the merchants and the craft guilds.

In Russia, the insurance business developed extremely slowly right up until the second half of the 19th century. In 1786, by manifesto of Empress Catherine the Great, the State Loan Bank was founded. This included an Insurance Department, which insured houses mortgaged to the bank.

In 1827, the First Russian Fire Insurance Company was founded and the government granted it quite a few major benefits and privileges, in particular, the exclusive right to insure buildings in certain parts of the country for a period of 20 years and relief from all taxes for the same period. The company's business began developing quite successfully right from the start.

The successes scored by the First Russian Fire Insurance Company clearly demonstrated the importance and promising nature of this new business for Russia, so, in 1835, a Second Fire Insurance Company and in 1846, the Salamander Insurance Company emerged.

In the second half of the 19th century, societies offering different specialized insurance services for businessmen and industrialists appeared: Russian Lloyd (1870), Volga (1871), Yakor (1872) and others, providing insurance against fire, for marine, river and road transport, and of valuables sent by post.

In 1909, the All-Russia Union of Mutual Insurance Companies, uniting 83 insurance companies, was founded. The advance of the insurance business in Russia was halted by the events of World War I, the October Revolution in 1917 and the Civil War.

The new government took the insurance business under their vigilant control. In 1921, by decree of the Council of People's Commissars of the RSFSR, a system of state insurance was set up. Within the People's Commissariat of Finance, a Chief Department of State Insurance (Gosstrakh) was created. The state monopoly over insurance was secured by a resolution on State Insurance of the USSR, approved by the Central Executive Committee and the Council of People's Commissars of the USSR on September 18, 1925, and continued until 1988, when a law was passed on cooperation, envisaging the creation of cooperative insurance institutions.

In new realia

During Soviet times, there was no insurance instrument for managing the risks associated with accidents at Russian production facilities. In the early 1990s, however, managers of private companies had to think about the ways to effectively protect their assets and about insurance and the insurance market in connection with their business. Owing to the specific nature of the energy sector, the managers of energy companies (oil and gas companies in particular) were the first to study and use this instrument. They had to interact with the international insurance market, which operates according to long-established rules.

The production of oil and gas, refining and production of petroleum products are high risk operations, constantly requiring major financial injections. The extent to which a company's assets are protected influences the possibility of attracting investors. Any investor needs to know, apart from the standard information about an enterprise: how safe the enterprise is and how much the satisfaction of claims by third parties resulting from a possible accident might cost.

Insurance is traditionally, in a market economy, an integral part of industrial risks management. Insurance greatly reduces the dependence of the economic and financial status of the company on these risks. At the same time, outlays on insurance must be economically justified and profitable to both the company (the insured) and the insurance company (the insurer). In addition to commercial interests, the requirements of the federal legislation have to be considered, primarily the Federal Law On Protection of the Population and Territories against Natural and Technogenic Emergency Situations in the part relating to compensation for losses incurred from emergency situations and the restoration of production.

As practice has shown, shareholders in the leading, vertically integrated, oil companies, such as Royal Dutch/Shell, British Petroleum, ExxonMobil, Chevron Corp. and others, take, at a certain stage in their development, targeted efforts to ensure the stable development of the company by pursuing an industrial risk management policy.

As practice has shown, the leading vertically integrated, oil companies take, at a certain stage in their development, targeted efforts to ensure the stable development of the company by pursuing an industrial risk management policy. An essential element of it is economically efficient insurance protection against any risks which have a negative effect on business, staff's health as well as financial interests of shareholders and investors.

Any Russian oil company faces similar problems. The situation in Russia is exacerbated by the high degree of wear and tear on the fixed productive assets and the limited investment opportunities for modernization of companies.

One of the most promising and economically justified scenarios for resolving the problem for an oil company is to create an Industrial Risk Management System, which would ensure rational use of the limited material and financial resources for achieving industrial and environmental safety and would provide an economic incentive to the development and introduction of safe technologies.

The LUKOIL experience

Upstream and downstream activities of JSC LUKOIL and its subsidiaries are associated with a wide range of financial, legal, social and humanitarian risks. Existence and possibility of these risks must not prevent LUKOIL from achieving its strategic goal to become one of the world leading oil companies.

For this reason the Company has developed the document under the title Fundamentals on the Insurance Strategy and Policy of JSC LUKOIL and its subsidiaries which determines the purpose and principles of the System of maintenance of insurance protection of the Company.

The basis of the LUKOIL System of maintenance of insurance protection is a set of specially worked out and economically verified procedures designed as corporate norms and standards, obligatory for all controlling bodies and subsidiaries of the Company.

Integrity of maintenance of insurance protection of LUKOIL Group, the System independence from the current state and methods of work of the subsidiaries can be achieved on condition that the certain mission is put in a basis of this System, called to express its purpose, necessity and utility for a society as a whole and for LUKOIL and its subsidiaries in particular.

The mission can be defined as ensuring stable operation and development of LUKOIL and its subsidiaries by economically efficient insurance coverage against risks which have a negative effect on the business of the Company, staff's health and shareholders' and investors' interests.

The LUKOIL System of insurance protection should combine: the management bodies of LUKOIL and its subsidiaries; divisions of LUKOIL and its subsidiaries which are entrusted with ensuring risk control and management; the division which implements control (calculation) of operational and environmental risks; insurance companies, protecting LUKOIL and its subsidiaries, personnel, as well as property interests of the shareholders and investors.

These participants should act and cooperate on a single specially created information, procedural and regulatory basis. Strategy of maintenance of insurance protection of LUKOIL and its subsidiaries is to be reviewed and approved by the LUKOIL Management Board; changes are brought in the Strategy as required and also are subject to the obligatory approval by the Board of the Company.

The mission is completed through Reaching the following objectives: Identification of all risks which might present a threat to Company's business; complete and timely compensation of all financial losses (including damage resulting from loss of crude oil, intermediate or end products; costs of localization of accidents and liquidation of their consequences, as well as associated mandatory costs, etc.) resulting from emergencies. Compensation shall be effected by transfer of unplanned costs (time-wise and volume-wise) for the coverage of probable losses to the category of planned and economically feasible insurance payments; recovery of property to the pre-accident condition; full compensation of legal liability for inflicting damage to the life, health and property of other persons and the environment; full compliance with the requirements of LUKOIL's Social Code with respect to insurance of the staff of the Company.

The LUKOIL Management Board shall review in compliance with the established procedure the current insurance policy every year for the coming year. This review shall result in taking the insurance program for LUKOIL as a base by Company's Management Board for the coming year.

The list of potential external insurers (re-insurers) of the risks of LUKOIL and its subsidiaries shall be defined on the basis of assessment of their reliability, financial stability, rating etc.

The purchase of insurance policies from commercial international insurance companies shall be performed in case of their compliance with the current rating of Standard&Poor's.

Re-insurance of risks, insured by the authorized companies, shall become an obligation of the authorized companies. The international insurers shall comply with similar reliability requirements, used in the course of direct purchase of such companies' insurances.

First steps

The corporate document, Fundamentals on the Insurance Strategy and Policy of JSC LUKOIL and its subsidiaries, includes a requirement to transfer risks to the external insurance markets in exchange for an insurance premium on a tender basis. To do so, the Company has released the Resolution on Tender Commission for providing insurance protection to the JSC LUKOIL and its subsidiaries. In 2003 work has been organized for conducting a relevant tender for the first time.

Based on the recommendations of the Expert Rating Agency, the largest Russian insurance companies were invited to participate in this tender. Those included ROSNO, Ingosstrakh, Kapital Strakhovaniye, Neftepolis, Progress-Garant, and Energogarant.

JSC Kapital Strakhovaniye was announced as the successful bid. Its tender offers underlied the Program of providing insurance protection for the property interests of LUKOIL and its subsidiaries for 2004 which has a number of advantages in comparison with the 2003 Program:

- Principles and methods of the Program have become more transparent and coherent for shareholders and investors.

- New types of insurance (mandatory civil liability insurance for transportation vehicle owners) are included in the 2004 Program.

- The Program of insurance protection of refineries and petrochemical plants covers the newly launched units at the Ukhta refinery and the Perm refinery and other facilities (Petrotel-LUKOIL in Romania).

- New facilities have been included in the 2004 Program (for example, new petroleum products transshipment complex LUKOIL-II and D-222 oilfield); and the scope of insurance for previously insured facilities has been expanded (e.g. the first phase of export oil terminal in the Astrakhan Region).

- The 2004 Program is more than 6% cost-effective.

The Program was reviewed by the LUKOIL Management Board and it was taken as the basis for organization of the insurance protection of the Company and its subsidiariesХ property interests for 2004.

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Oil of Russia, No. 3, 2004
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