Insurance agreements, or contracting for disaster?

Jack Carnegie 

Last month, Transocean Ltd., the operator of the Deepwater Horizon, lost up to $750 million when a federal court of appeals held that BP Energy was entitled to the full coverage for the Gulf oil spill under Transocean’s entire insurance stack, potentially leaving Transocean with little or no coverage for its own liabilities. Most energy industry contracts contain provisions defining who is responsible for what if something goes wrong. These contractual “risk allocation” provisions appear in joint operating agreements, drilling contracts, service agreements and other contracts. Done right, they can allocate liabilities among the parties and their insurers so everyone knows what to expect if disaster strikes. Done wrong, they create new risks and can result in unanticipated losses. This is particularly true in the energy business where well blowouts, pipeline leaks or explosions or refinery accidents can result in liabilities big enough to bankrupt a company. How this happened, and how it can be prevented, lies in understanding these “risk allocation” provisions. Generally, they come in two flavors: The first is an “indemnity agreement,” under which one party agrees to accept the other party’s liability for certain risks. For example, each party may agree to indemnify the other for injuries to its own employees. The second is an “additional insured” agreement. This is when one party agrees that its insurance will cover the other party for certain losses. Unfortunately, some of these provisions are not well understood, even by many lawyers and insurance professionals. The rules governing them differ from state to state. Getting them wrong can destroy a business. So what happened to Transocean? The drilling contract between Transocean and BP had the typical extensive risk allocation provisions. Transocean agreed to indemnify BP, but only “for pollution … originating above the surface of the … water,” such as a leak from the Deepwater Horizon drilling vessel. For all other pollution risks, such as a well blowout, BP agreed to indemnify Transocean. Like many contracts, the drilling contract also contained an additional insured clause requiring Transocean to name BP as an additional insured “in each of [Transocean’s] policies, except Workers’ Compensation for liabilities assumed by [Transocean] under the terms of this Contract.” Transocean did not dispute that its insurance covered BP to some extent, but it argued that coverage was only for liabilities Transocean assumed anyway under its indemnity agreement – liability for pollution from the drilling vessel itself. It also argued that the parties would not spend several pages carefully providing that BP would indemnify Transocean for pollution from subsurface discharges, and then “undo” those provisions by requiring Transocean to provide insurance coverage to BP for those same enormous liabilities, with the consequent depletion of Transocean’s own coverage. Ultimately, the Fifth U.S. Circuit of Appeals found against Transocean because its insurance policies did not contain the same limitations as the drilling contract. It held that the insurance coverage provided to BP, or to any insured, was governed by the terms of the policies themselves. Because Transocean’s policies did not explicitly adopt limitations from the drilling contract, BP was entitled to full coverage. This kind of result is not uncommon. People often wrongly assume that their underlying contract will control the scope of any insurance provided to another party. Or sometimes those responsible for negotiating the contracts, and those responsible for maintaining a company’s insurance, fail to communicate so the contracts and insurance policies do not dovetail with each other. In either case, there may be bet-the-company consequences. To protect your business, make sure the individuals responsible for both indemnity and insurance understand how these provisions work, and that they communicate with each other. These provisions need to be carefully drafted. And most important, the insurance needs to be tailored to fit the underlying contract. It is dangerous to rely on standard boilerplate additional insured language in your policies.

Jack Carnegie is with the Texas-based law firm of Strasburger & Price LLP. He is a partner in the Energy, Oil and Gas practice group. He is also board certified in civil appellate law by the Texas Board of Legal Specialization.