Domestic focus: New legislation and emphasis on energy-related risk are set to drive development of local content

A 2010 law mandating local content for insuring risks in the energy sector domestically aims to create growth from the current small base in the insurance sector. Enforcement is a potential challenge, if recent history and the current legal environment are any indication. Further, market studies indicate that profiting from providing coverage to this complex and capital-intensive activity requires careful risk management and a commitment to sufficient capital reserves and the incremental building of capacity.

CLOSE TO HOME: The Nigerian Oil and Gas Industry Content Development Act, passed into law in 2010, came about due to concerns about decades of capital flight in the energy sector. The goal is to insert Nigerians and local firms into the process wherever possible to keep more of the profits from the energy sector directly and from the indirect participants, such as insurers, at home, and to develop local capacity. Early successes for the law, commonly referred to as the “Local Content Act”, include the transference of ownership in some productive oil fields from international oil companies (IOCs) to local start-ups. Insurance is addressed specifically in the law; it states that risks incurred in Nigeria in the energy sector cannot be insured outside the country until local capacity is fully tapped. Placing risks with insurers outside the country requires permission from the insurance regulator, the National Insurance Commission (NAICOM).

SETTING GOALS: As with other laws in the sector, such as those that make six types of insurance mandatory in the country, implementation is understood to be a gradual process rather than an immediate and comprehensive change. For now, most risks continue to be covered by captive insurers established by the IOCs themselves or by syndicates typically operating in London. Eventually, however, the goal is to retain up to 70% of risk locally. “The regulation provides Nigerian insurers with an appreciable level of exposure to complex oil and gas risk underwriting deals that could rub off positively on human capital development and underwriting expertise in the industry,” according to a description of it in NAICOM’s most recent annual report from 2011.

The act covers all risks in the energy sector, and outlines specific definitions for what constitutes local actors and capacity. The latter is defined as an insurer’s net retention in addition to its reinsurance capacity, either through reinsurance treaties or facultative agreements. The captive insurers of IOCs can also serve as reinsurers. Furthermore, insurers can seek business in the energy sector either individually or as members of syndicates in which one party is designated the lead member. However, companies cannot bid on coverage provisions for the same risk as both an individual company and as part of a consortium. To qualify as a local insurer, a company must be licensed in Nigeria and is required to submit a copy of any of its reinsurance arrangements to NAICOM by the December in advance of the calendar year in which it intends to win contracts.

FOREIGN STAKE: While working towards having the bulk of risk insured domestically will support sector growth, some sector leaders also recognise the importance of maintaining the involvement of foreign players. “Under Nigerian local content legislation, up to 30% of energy insurance can be ceded overseas. This means that global underwriters impose their own conditions on the insurance cover and play a large role in driving risk management standards in Nigerian oil and gas,” Rosaline Ekeng, managing director of International Energy Insurance, told OBG. “In a sense, the insured must operate as if they were uninsured.”

The Local Content Act also provides specific targets within different areas of risk management for energy companies. For example, 100% of brokerage commissions must remain in Nigeria, but just 40% of risks must be retained for marine-related insurance. For general risks, the level is 70%, while a full 100% is required for relevant life insurance policies. Foreign loss adjusters are not permitted to participate in the sector without specific permission from NAICOM, which is to be granted on a case-by-case basis.

Enforcement is envisioned as the collaboration between NAICOM and the Nigerian Content Development and Monitoring Board (NCDMB), which was created by the Local Content Act and is headed by the executive secretary and CEO of the NCDMB, Ernest Nwapa. According to guidelines to the law published by NAICOM, penalties for non-compliance with the Local Content Act will take the form of fines, set at between five and 10 times the value of the premium paid to a foreign insurer.

MARKET LEADER: In the current market, Leadway Assurance, one of the country’s main non-life insurers, has been the most active domestic provider of coverage. However, most of Nigeria’s insurance firms are currently in the process of establishing oil-and-gas-specific desks. To start, most market participants are expected to retain minimal amounts of risk and remain highly reliant on reinsurance. The extent to which these companies can keep energy sector risks on their books calls into question whether the law’s goal of retaining 70% of relevant risks in country is realistic. According to a report from Leadway Assurance, oil-and-gas lines of business were worth about $324m in the insurance market as of 2010, a figure that includes upstream, midstream and downstream operations. Of that total, about 77.5% of the value goes to brokerages and to marine, general and life policies – the areas addressed by the Local Content Act. The implied figure of roughly $251.6m is within the capacity of the local insurance industry based on current capitalisation levels. However, this is before factoring in regulations to ensure prudent risk management, including the rule that no single type of insurance should surpass 5% of shareholders’ funds for operational risks or 2.5% for construction risks. Following NAICOM’s guidelines on risk diversity would mean that as of 2010 the industry had a total capacity of $98m it could allocate to oil and gas, according to Leadway Assurance’s calculations. That would mean local capacity would be exhausted at about 38.9% of market share – slightly more than half of the 70% goal stated in the law. The local capacity compares with about $6.9bn globally as of the time of calculations, the report found. With the domestic insurance industry in expansion, however, overall capacity is expected to grow to the extent that the 70% threshold could be reached soon, given the increase in gross premium income averaging 25% annually in recent years.

CAPACITY FOR RISK: With the added capacity to insure oil and gas comes additional risk, however. Even for less complex lines of business, risk-based underwriting is a challenge for the industry thanks to low levels of expertise. Energy sector risks come with additional challenges due to the highly technical nature of oil-and-gas exploration and production, in particular from deepwater reservoirs offshore. Another challenge is profitability; data from global coverage in recent years suggest that capturing market share would add to top-line revenue growth but not necessarily bottom-line profits. Leadway Assurance’s study charted energy sector claims and premiums from 1994 to 2010 and found that the global value of claims surpassed that of premiums in all but three years during the study period. In most years, both values were near $5bn. However, in 2005 and 2008, catastrophes sent claims totals to more than triple that of premium income. In 2005 Hurricanes Rita and Katrina made landfall in the US’s south-east region, where upstream installations offshore and mostly mid- and downstream operations onshore suffered losses. In 2008 Hurricane Ike hit the same region.

NATURAL ADVANTAGE: Although recent global history implies that insuring the energy sector is unlikely to be profitable, the country’s geography could emerge as the key variable that makes Nigeria’s market different. The country is not prone to hurricanes, cyclones or other potential natural disasters that pose the greatest threat to energy-sector assets, meaning more profit could be gained from insuring overall risks in the country than the global average. “It would appear against common sense to accept such a risk, but the argument is that losses have been better contained within West Africa, which, unlike other parts of the world, is not subject to severe weather hurricanes,” the Leadway Assurance report stated.

An additional potential benefit is that risks in Nigeria could increasingly be priced according to domestic factors rather than international ones, which may be driving up local costs on account of potential losses unlikely to be experienced in the country.

The insurer argued that a long-term view towards profits would be best to account for the possibility of years of major losses mixed with profitable ones. Insurers should conserve premium income in good years to have a financial cushion when losses happen. “It is with a careful organic growth and an appropriate risk management and underwriting acceptance strategy that the insurance industry will begin to reap the reward of local content,” the report concluded.