The Gulf Oil Spill: A New Black Swan?

Almost two full weeks have passed since Hurricane Isaac ravaged the Gulf Coast of the United States. Although the new levees that were constructed as a response to the Hurricane Katrina disaster successfully protected New Orleans against devastation this year, the neighboring Plaquemines Parish and many other communities were devastated by Isaac’s destructive power.

Many meteorologists predicted that the hurricane’s devastating winds and lashing rains would destroy buildings, collapse electrical power lines, and flood entire communities. But few anticipated that the storm would also bring forth an unwelcome reminder of another recent catastrophe.

In the wake of Isaac’s path, massive globs of oil and tar washed up on Gulf Coast beaches and shorelines. And this past weekend, federal government investigators confirmed that the toxic material had been lurking in the water nearby since BP’s Deepwater Horizon oil spill in 2010.

Chemicals and Bacteria

One of most harmful effects of an oil spill is the damage that the spilled product itself inflicts on the natural environment. The 1989 Exxon Valdez oil spill in Alaska’s Prince William Sound, for instance, released 250,000 barrels of oil into the water, leading to the deaths of thousands of sea animals and well over 100,000 birds.

Just as worrisome, though, is the fact that much of the spilled Valdez oil was not recovered during clean-up activities. Instead, significant quantities remain on the floor of the Sound and under the topical sand and soil of the shoreline, where the toxicity of the material continues to damage the environment.

BP’s Deepwater Horizon disaster actually disgorged far more oil into the natural environment than did the Exxon Valdez event. Up to 4.9 million barrels of oil was spewed directly into the Gulf of Mexico in 2010; it entered an eco-system that was already under stress from industrial development and climate change.

Geologists have noted that chemical dispersants successfully dissipated much of the Gulf oil, and at the time, they hoped that warm water bacteria would devour the rest of it. Nevertheless, the sudden emergence of the oil and tar after Hurricane Isaac was a sober reminder that large quantities of BP’s spilled oil still remain in the water.

An Insurance Challenge

In most business sectors, the risk of industrial accidents can be managed through the purchase of property insurance. An automobile manufacturer in the American South, for instance, can purchase a hurricane damage rider on its insurance policy; its annual premium cost would be established by the meteorological probability that a hurricane would hit the factory, as well as by the estimated damage that would occur as a result of the weather event.

In the event of a loss, after the hurricane passes, the insurer would promptly inspect the wreckage and then issue a check to reimburse the automobile manufacturer. But in the case of the BP oil spill, the environmental damage is continuing to occur many years after the primary catastrophic event. And the substance that is causing the damage is not readily observable (and thus is not easily quantifiable) while it lurks on the ocean floor and under the shoreline soil.

Furthermore, there is no consensus about the method that should be utilized to define and then quantify the insurable loss itself. BP, for instance, has already invested billions of dollars in the Gulf Coast region to restore its seafood and tourism industries. If the emergence of additional pollutants sets back progress in these sectors, should BP’s “sunk cost” restoration investments be treated as insurable losses? Or should they simply be regarded as write-offs of failed expenditures?

The Black Swan

In the field of insurance, the phrase “black swan event” refers to a situation where an extremely improbable loss of great magnitude has struck an organization. Because of the improbability of the event, the organization is likely to be uninsured because its insurance company is likely unable to determine an appropriate premium cost for a coverage policy.

However, the oil related environmental damage from the Hurricane Isaac event was, in retrospect, not improbable at all. Small quantities of oil and tar having been washing ashore after every rain storm, and thus large quantities of such pollutants should have been expected to wash ashore after major hurricanes.

Indeed, although actuaries may be challenged to define the extent of the insurable loss of such events, they should not find it difficult to estimate the probabilities of occurrence. The National Weather Service of the United States has been studying the incidence rates of destructive weather events since it was first created in 1870.

Environmentalists may be disheartened by the emergence and increasing prevalence of post-oil spill pollution clauses in the property insurance policies of upstream industrial energy organizations. Nevertheless, such clauses may be appropriate in an era when deep sea drilling, hydro-fracking, and other risky methods of extraction must be utilized to produce energy resources for an increasingly restive world.