P&C the October 2012 issue

What Lies Beneath

Over-hyped or over-estimated? Fracking’s biggest challenge is to figure out the potential risk.
Posted on October 11, 2012

At this point, no one can really say for certain. Which is why fracking, for all its potential, is proving to be such a challenge to insure.

The basic technology is nothing new. As drillers are quick to point out, they’ve used fracking for decades. They pump high-pressure, chemical-laced water down a well to extract oil and gas from rock. But the current scale of fracking projects across the country is unprecedented.

Shale gas production has grown fast, more than tripling from 2007 to 2010 to over 5 trillion cubic feet, according to federal government data. And it’s expected to keep growing. The Energy Information Administration projects it will more than double again over the next two decades, generating 13.6 trillion cubic feet—enough natural gas to heat 200 million homes—by 2035. Energy companies have added tens of thousands of new wells in Texas, Appalachia and the Dakotas and are snatching up leases on new fields in places like western Iowa and southern Illinois. Following behind are scientists, authoring sometimes conflicting studies on the environmental impact of all of this drilling, and state regulators from New York to New Mexico, who are racing to keep up.

So what’s an insurance broker to do?

The picture around insurance for fracking these days is about as clear as the gray muddy water being pumped out of the ground. Unknown environmental risks below ground and ever-more-expensive equipment above it leave operators weighing how much coverage to buy, while underwriters take a close look at what kinds to write. But for such a fast-moving industry, it’s slow going.

“In a way, we’re struggling to establish a viable market here,” says Theresa Fadul, energy practice director at IMA in Denver. “There’s limited competition and a lot of uncertainty.”

Traditionally, oil and gas drillers have carried general casualty and liability policies to protect against accidents, such as a well blowout or explosion. But with fracking, the risks are often more subtle, buried deep underground. Pollutants can seep out over time. General casualty and liability policies typically don’t cover that sort of gradual pollution, and even many environmental insurers are waiting for the science to become clearer before taking on the risk if something goes wrong at a fracking site.

A handful of underwriters have stepped into the gap. Some actually see a lot of opportunity. Increased scrutiny of gradual pollution is helping to fuel a noticeable shift in the way energy companies approach environmental risk, says John O’Brien, president of Ironshore Environmental. So-called “upstream” operators, who focus on finding and drilling oil and gas, traditionally haven’t carried much environmental insurance beyond “sudden and accidental” for obvious one-time events. But in the wake of the BP Macondo blowout in the Gulf of Mexico and now the uncertainty around fracking, more upstream firms are buying environmental coverage. O’Brien estimates the market has grown from “virtually nothing” to close to $60 million in premiums in the last five years.

“They’re looking at it in a different light,” O’Brien says. “There’s more potential litigation. There’s more scrutiny. And there’s a lot more exploration. Just in the last few years in fracking, we’ve gone from the Barnett Shale in Texas to the Dakotas, Colorado, Ohio, western Pennsylvania. It’s just a much bigger business.”

“There’s more potential litigation. There’s more scrutiny. And there’s a lot more exploration.”

But pricing the risk associated with that business is still tricky. Much depends on the condition of the shale, on regulations that vary widely from state to state, and especially on the companies involved. Ironshore spends a lot of time vetting its clients, O’Brien says, visiting fracking sites and working through best practices.

“You can tell an awful lot about a company when you go visit them,” he says. “We don’t write too many companies that are operating out of a strip mall.”

That’s as it should be, says Bart Canon, a managing director at Wortham Insurance in Houston. Given how unsettled the sector is, he says, underwriters are smart to take a close look at individual operations before writing policies. Canon contends that operators and their brokers would be smart to explain what they’re up to deep down in the ground.

“This kind of risk is very carefully underwritten these days. There tend to be a lot of questions asked,” he says. “Companies that want coverage are probably going to have to spend some time really talking to underwriters and sharing with them what they’re doing, to be good risk partners.”

It’s still far from clear what the risks really are.

Environmental groups have been busy ringing alarm bells about fracking—blaming it for everything from well-water contamination to cancer spikes. And images of sink faucets on fire from methane leaks do tend to stick in the public’s mind. But research on the issue is decidedly mixed.

“The science seems to be lagging behind the sensationalism,” says Richard Baron, an environmental defense attorney with Foley, Baron and Metzger in Livonia, Mich.

What science there is has proven to be controversial. A major study released in May by the State University of New York at Buffalo found that new regulations in Pennsylvania’s Marcellus Shale had considerably improved well safety there. But critics immediately pointed out that the researchers who ran the study had received funding from the oil and gas industry.

When a draft EPA report came out in December suggesting fracking chemicals may have leaked into aquifers used for drinking water in Wyoming, industry groups quickly called that report into question, calling it premature. The full report is due later this year.

Whatever the potential impact, Baron says, it helps to know what’s under the ground before you start digging fracking wells, in case a plaintiff files a lawsuit later. Contaminants can enter the drinking supply if a fracking well isn’t built right. Of course, a fracking operator could get sued even if the contaminants were already in the water prior to digging.

“Be proactive,” Baron says. “You need to obtain baseline environmental data ahead of time. A lot of private water supplies could have cross-contamination that has nothing to do with fracking.”

That sounds all well and good in a risk management office or insurance brokerage. But that kind of study takes time, and fracking fields are developing fast. More than one expert described the climate around the industry these days as “the Wild West.” When there’s gas to be pumped, it’s easy to drill first and study later. That’s a mistake, says Tom Segalla, a partner at Buffalo-based environmental defense law firm Goldberg Segalla.

“From the insured’s standpoint, you have to have good risk management,” he says. “Unfortunately, as many companies have proceeded in this, the business part of the company is the side that’s pushing it. The risk managers, if there are risk managers on staff, aren’t assessing the overall risk.”

There’s a lot of risk above ground to be sorted out, too. A fracking site is a capital-intensive place, with drills and pumps and compressors lined up cheek by jowl, blasting away around the clock. As technology has improved and demand has grown, operators are drilling multiple wells off the same pad, piling even more equipment onto a relatively small site.

Throw in a web of suppliers and subcontractors, and trucking companies hauling tanks of sand and water, and there’s a lot of potential for an accident. If one happens, who’s responsible?

That, says Fadul, depends on the master service agreement, the contract that dictates who does what on a job site. Typically, these agreements carry so-called “knock for knock” indemnity clauses, in which operators and contractors take responsibility for their own equipment, without regard to fault. But in some cases, there’s a carve-out for catastrophic loss—think a well blowout or explosion—that can put most, if not all, of the fault on the site operator—not the contractors—for personal injury, equipment damage, or loss of use.

And that can get very expensive. As fracking has boomed, so has the cost of equipment. A pad with multiple wells can hold $50 million worth of hardware, owned by several different entities.

“We don’t know whether somebody would claim, or if a court would uphold, that because the frack equipment is under lease that it’s the responsibility of the operator,” Fadul says. “But it’s a big enough dollar amount, who wants to risk having a claim denied?”
So Fadul tells her operator clients to consider buying extra protection— operators’ extra expense or well-control insurance—and a fair bit of it.

“These are big-dollar items,” she says.

The market is beginning to respond. Earlier this year, for instance, Travelers broadened its care, custody and control coverage in energy policies to protect operators from claims made by service providers whose equipment they’re leasing. And it sharply increased coverage limits—to $30 million from $5 million.

Indeed, for all the uncertainties both below and above ground, fracking is big business. And there are signs that underwriters are becoming more comfortable and more willing to cover it.

In April, Willis devoted about one third of its annual Energy Market Review to exploring the many questions around fracking. The review found that “the market is still keen to underwrite” shale gas drilling risk as long as the drillers are following best safety practices. At Wortham, which represents a growing number of frackers, managing director Mike Ruehman says he sees a lot of energy companies trying to do just that.

“The more sophisticated companies really care about their long-term reputation,” he says. “They’re going to take a very careful, deliberate approach to this and not knowingly do things that are going to harm the environment.”

With fracking in the political cross hairs right now, no one—big or small, established or newcomer—wants to see any accidents, O’Brien says. A couple of high-profile accidents could bring regulators and trial lawyers. Such a scenario is prompting some natural self-policing, says O’Brien, who compared the situation to the construction industry in the 1990s, which found itself defending a wave of lawsuits alleging building defects.

“From a loss mitigation standpoint, the industry is in a similar state,” he says. “You had this cottage industry that sprang up to promote best practices. The same thing is happening today in fracking.”

Gradually, O’Brien says, efforts aimed at self-policing will push the industry toward clearer standards, helping to settle the insurance market, too. Meanwhile, experts say, a spate of lawsuits is moving slowly through the legal system. When they’re resolved, they’ll offer a clearer picture of the potential costs when something goes wrong. Lawsuits claiming well-water contamination from fracking have been filed in at least seven states, while some property damage claims tied to earthquakes may have links to fracking activity. Most of the lawsuits are in the early stages of litigation, but how they get resolved will give underwriters a sense of the scope of their potential losses.

“In these types of exposure cases, you really don’t know until the litigation gets started,” Segalla says. “And you don’t know the significance of any litigation until some courts start to rule. These things move very slowly.”

“And you don’t know the significance of any litigation until some courts start to rule.”

But they are moving, along with the science, the regulation, and the knowledge of how best to case wells in cement deep below the earth and what to do with all the leftover water. And as the industry and the litigators figure out the best way to handle this controversial and booming business, the insurers will figure it out, too—with brokers having a seat right in the middle.

Fadul sees it happening more all the time, bringing experts and insurers together so they all feel more comfortable with the risk.

“There’s still a lot of educating that has to be done,” she says.

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