Corporate Insurance Strategy The Case Of British...

Journal of Applied Corporate Finance
F A L L

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Corporate Insurance Strategy: The Case of British Petroleum by Neil A. Doherty,
University of Pennsylvania, and
Clifford W. Smith, Jr.,
University of Rochester

V O L U M E

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CORPORATE INSURANCE
STRATEGY: THE CASE OF
BRITISH PETROLEUM

by Neil A. Doherty,
University of Pennsylvania, and
Clifford W. Smith, Jr.,
University of Rochester*

nsurable events such as product liability suits, toxic torts, and physical damage to corporate assets represent major production costs for industrial corporations. For large public companies, conventional practice is to buy insurance to hedge against large potential losses while self-insuring against smaller ones. The underlying logic of this strategy, which is reflected in insurance textbooks,1 is essentially this: For large and medium-sized corporations, small losses—the kind that stem from localized fires, employee injuries, vehicle crashes, and so forth—occur with such regularity that their total cost is predictable. To the extent such losses are predictable in the aggregate, buying insurance amounts simply to exchanging known dollars of premium for roughly equivalent and relatively known dollars of loss settlements (a practice called “trading dollars” in the profession). Larger losses, by contrast, are rare and much less predictable. Because such losses are borne by the company’s owners (mainly by its stockholders but also, if the losses are large enough, by its bondholders), they should be hedged with insurance.
Recently, however, British Petroleum, one of the largest industrial companies in the world, decided upon a major change in its insurance strategy that turns the conventional wisdom on its head. In this article, we analyze why BP now insures against most smaller losses while self-insuring against the larger ones.
Our analysis focuses on factors affecting the market supply of insurance as well as the corporate demand for it. On the demand side, we demonstrate that the primary source of demand for insurance by widely held public companies is not, as standard insurance textbooks assume, to transfer risk from the corporation’s owners, but rather to take advantage of insurance companies’ efficiencies in providing risk-assessment, monitoring, and loss-settlement services. On the supply side, we explain why the capacity of insurance markets to underwrite very large (or highly specialized) exposures is quite limited. Given BP’s size, when losses become large enough to be of concern, they exceed the capacity of the industry. In essence, BP has a comparative advantage relative to the insurance industry in bearing large losses.

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*The authors wish to thank Judith Hanratty and Rodney Insall of British Petroleum for many discussions and insightful comments. 1. See, for example, G. E. Rejda, Principles of Insurance (Glenview, Ill.: Scott Foresman, 1989), pp. 52-53; and C. A.
Williams, Risk Management and Insurance (New York: McGraw Hill, 1989), Chapter 13.

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Let’s begin with the simplest case: the purchase of insurance by individuals. Insurance allows individuals to transfer risks to insurance companies, thus reducing uncertainty about their net worth and standard of living. In return for accepting the risk of losses, the insurance company charges a premium. The expected cost of the insurance, known as the “premium loading,” is the difference between the premium and the present value of expected losses.
The decision to purchase insurance can be justified if the insurance company has a comparative advantage over the policyholder in bearing the risks in question. Such an advantage can derive from two sources: the reduction of risk accomplished by pooling a large portfolio of similar risks and better access to capital markets.
It is not hard to see that, relative to the riskbearing capacity of insurance companies, the ability of most individuals to self-insure

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