Circular /97: Limit on Cover
LIMIT ON COVER
Why 4 billion dollars?
In 1996 the P&I clubs in the International Group accepted the principle of a limit on P&I cover. The limit agreed was a compromise - the so-called "20 per cent compromise" - reflecting the fact that the Boards of some clubs were reluctant to abandon the concept of unlimited cover, whereas others including the UK Club wanted a much lower limit than "20 per cent".
Apart from introducing the limit principle (although cover for one important P&I risk - oil pollution - has been limited since 1970) the compromise has focused shipowners' minds on the financial implications of funding a catastrophic claim. The UK Club Board made it clear that it considered the 20 per cent figure to be far too high, but it supported the change because it was the best that could be achieved at the time if the International Group's beneficial pooling and reinsurance arrangements were to be preserved intact. However, the UK Club Board emphasised its reservations by asking the UK Club Members by way of a questionnaire whether they supported the Board's ultimate aim of a realistically collectible limit. The result from 98 per cent of those who responded (about half the membership) was overwhelming support for a realistically collectible limit. Those other clubs who have similarly polled their memberships have received similar responses.
A realistic and balanced approach
In seeking to progress this issue, the Board and the Managers have tried to achieve an acceptable balance between the need to provide adequate insurance cover for a shipowner on the one hand, and the need to set a realistic limit on his obligation to contribute to the funding of a catastrophic claim on the other. In late 1996 Members were advised that, after careful thought, the Board was of the view that a cover limit of US $4 billion represented the best balance, based on optimum use of reinsurance cover as well as overspill calls. What follows is a fuller explanation of the UK Club Board's thinking on the limit on cover issue generally, and on the suggested US $4 billion limit figure in particular.
The current position
Before 1996 a shipowner's cover with his P&I club had no financial limit (other than for oil pollution). Superficially this appeared attractive. However, there was a price: unlimited cover meant that the shipowner himself would have unlimited exposure to any additional catastrophe, or 'overspill' calls. These are the calls which would be needed to fund that part of any shipowner's claim that exceeded the limit of the International Group's reinsurance programme (US $1.5 billion at that time).
In 1996 a limit was imposed on each shipowner's liability to contribute to overspill calls, this limit being equivalent to 20 per cent of the property damage limitation fund for each of his ships under the 1976 Limitation Convention.
A limit was also imposed on the overspill cover made available to the shipowner in respect of each claim, equivalent to the amount of the overspill contributions which his club could collect from its own shipowner members and from the other clubs in the International Group Pool.
Examples of the 20 per cent limit for various ship sizes are shown in the following table:
|Ship size||100% Convention||20% Limit $|
|gross tons||limit $|
A shipowner with a fleet of five 25,000 gross ton ships, three 70,000 gross ton ships, and two 130,000 gross ton ships would have an aggregate fleet limit of $22,635,920.
Under the 1976 Limitation Convention, the shipowner's limitation fund is calculated according to a tonnage based sliding scale: up to 500 gross tons there is fixed minimum of 167,000 SDRs (Special Drawing Rights); the next 29,500 gross tons is calculated at 167 SDRs per gross ton; the next 40,000 gross tons at 125 SDRs per gross ton; and any excess of 70,000 gross tons at 83 SDRs per gross ton. Converted into US dollars at a rate of 1 SDR = $1.385.
It is estimated that if every shipowner member of all the International Group clubs were to pay his full 20 per cent limit, the funds available would total approximately US $18 billion (the precise number is not known).
However, it is quite unrealistic to suppose that every shipowner would be able or willing to fund his maximum 20 per cent limit. US $18 billion is more than ten times the average annual mutual premium of all the International Group clubs combined.
A recipe for chaos
A report recently commissioned by boards in favour of continuing with the 'status quo' - (ie the 20 per cent compromise figure) suggests that overspill calls at this level would be economically supportable by the shipping industry, particularly if collected over a long period such as five or ten years.
In the view of the UK Club Board this assumption is flawed. Even if the overspill call were $10 billion there would be chaos, for a number of reasons:
There would be huge problems collecting the call
Many owners would consult their lawyers to see if they could avoid paying; many would be financially unable to pay.
The shortfall in collection would have to be funded by the financially strong
Further calls would have to be made on the financially strong to fund the shortfall (although each owner's call liability would be limited to the equivalent of his 20 per cent Convention limit). This would merely worsen the legal and financial problems, and would place a much increased (and, therefore, resented) burden on those shipowners able and willing to pay.
The claim would not be paid in full
It is likely that in these circumstances the shortfall would not be funded in full, and that the shipowner's claim would not be fully paid. His cover would be shown to be illusory; his business might well be lost, as might the businesses of many other shipowners called upon to fund the catastrophe calls.
Insurance regulatory requirements could well arise
Increasingly strict regulatory requirements now governing P&I clubs' financial affairs could well raise serious solvency issues if clubs endeavoured to cover this huge overspill liability in their accounts with calls due to be collected over a long period.
A realistic way forward
It is quite possible that the scenario described above would mean the end of mutual shipowner-controlled clubs. At best it would lead the clubs to introduce a realistic limit on cover to avoid a recurrence in the future. The UK Club and the other clubs favouring a limit believe that a realistic limit should be introduced now before it is too late.
One view is that P&I cover should be limited simply to the extent of the International Group's reinsurance contract (US $2 billion for 1997); in other words, that there should be no overspill liability at all. There are two main drawbacks to this, however. First, a limit of US $2 billion is perhaps too low when set against a shipowner's cover requirements. Second, it would still not rule out altogether the possibility of additional calls. For example, a series of large claims might lead to failure of the reinsurance cover, and the resulting shortfall would then have to be made up by calls on the shipowners.
The view of the Board of the UK Club is that a realistic balance has to be found, and that shipowners have to accept some exposure to additional, unbudgeted calls in return for an adequate but secure insurance cover. There are many problems in trying to estimate precisely the likely cost of catastrophic scenarios, particularly those resulting from explosion with resulting loss of life, property and consequential loss of use of damaged facilities. However, the UK Club's Board found it difficult (though not impossible) to envisage the total liabilities arising out of an incident exceeding US $3 to 4 billion.
Such a claim could be funded. Currently, a $4 billion limit would require a $2 billion overspill call, with reinsurance and normal International Group club pooling arrangements covering the remaining $2 billion. Ideally, the reinsurance contract limit should be raised to say $2.5 billion, leaving a $1.5 billion overspill call, or the equivalent of one year's premium for the International Group. This should be collectible. In the even more unlikely event of a second catastrophic claim in the same year, or a reinsurance failure, some collection problems would start to arise, but at this level of limit the collection problems would be less severe.
The Board therefore puts forward $4 billion as being a realistic balance between shipowners' cover requirements on the one hand, and an acceptable financial obligation on the P&I system and its members on the other. A higher limit would simply increase the likelihood of a collection shortfall. The Board believes this would be unacceptable to the Club's Members. A lower limit would be less likely to provide a realistic level of protection for the Club's Members.
Why do some club boards oppose a limit reduction?
Over the past year, at least one club has changed its view and joined those who, like the UK Club and its membership, desire a realistic limit. However, the Boards of six of the thirteen clubs in the International Group continue to oppose any reduction in the current 20 per cent figure. Some of their reasons for doing so are summarised below, with the UK Club's comments in italics, based on the proposed $4 billion limit.
- The limit would be a target for claimants.
- The experience of the fixed oil pollution limit, which has been in place for more than 25 years, does not support this. During that time a number of oil pollution claims have been higher than the cover limit, and many have been lower, but there has been no particular cluster around the limit.
- The limit might encourage a secondary market in excess P&I insurance.
- In the oil pollution context, there has been pressure from oil company charterers for tanker owners to purchase the $200 million oil pollution cover offered by the commercial insurance market in excess of the club limit (currently $500 million). It seems extremely unlikely that a similar pattern would arise in the context of a general limit.
- The limit could create problems with legislators, particularly in respect of limitation rights.
- The proper position to adopt with legislation is to stress that limitation rights should be set at levels of sustainable insurance. Such levels should always be far lower than the total of available cover, since the availability of reinsurance would in all likelihood be reduced following a catastrophic claim.
- A much higher limit could be funded if calls were spread over a number of years.
- This point has been dealt with in detail above. Not only would shipowners endeavour to avoid meeting their call payment obligations and seek alternative insurance solutions going forward; but also increasingly stringent insurance regulatory requirements might well cause serious solvency difficulties for clubs. The future of the mutual P&I system would be imperilled.
Where to now?
The UK Club's Board and Managers would like to hear from any Members who wish to express a view or seek clarification. Meanwhile, in conjunction with other like-minded clubs, renewed efforts are being made to convince shipowners in the six clubs whose boards continue to favour the status quo that change is in the best interests of all shipowners and their clubs.
Thomas Miller P & I Ltd.