No. 1, 2006

Andrey Yelokhin
Head of Asset Insurance Section of JSC LUKOIL, Yury Tskhoverbov, Chairman of the Board of Directors of JSC Capital-Insurance ,
Yury Tskhovrebov
Chairman of the Board of Directors of JSC Capital-Insurance


LUKOIL exemplifies effective insurance practices

Major industrial companies' operations involve a variety of risks which have to be minimized or neutralized so they do not affect the Company's performance and stability. In a market environment, insurance is an integral part of industrial risk management; it significantly reduces the influence of risks on companies' economic and financial condition. Therefore, any major industrial company needs to develop an efficient insurance protection system.

Sustainable development through insurance

In April 2003, the Managing Board of LUKOIL voted to adopt corporate Fundamentals of the Strategy and Policy of Insurance Protection of JSC LUKOIL and its Subsidiaries. The document formulates the mission of the Corporate Insurance Protection System (hereinafter, the System) as supporting sustainable functioning of LUKOIL through implementing economical insurance protection from risks that may endanger its operations, personnel's health, and property interests of its shareholders and investors.

At present, the System is a set of customized economically sound procedures embodied in corporate rules and standards, featuring some unique methodologies and processes, which are mandatory for all the management bodies and subsidiaries of LUKOIL.

First of all, it is necessary to identify industrial risks that may jeopardize the operations, and hence, the stability, of the Company and its subsidiaries.

To identify such risks, industrial safety declarations and surveys of the largest and hazardous enterprises are used.

The industrial safety declaration procedure is implemented (and the declaration submission frequency is set) in accordance with the Russian Federation Federal Law On the Industrial Safety of Hazardous Production Facilities. Experience shows, however, that, for declaration results to be used for industrial facility insurance purposes, risk assessments should contain not only an assessment of the scale of potential accidents, but also the likelihood thereof.

Therefore, for industrial safety declaration results to be applied in practice (for insurance and other purposes), LUKOIL has set stricter requirements (compared to those in the Federal Law On Industrial Safety) regarding criteria for facilities that must undergo the industrial safety declaration and quantitative risk assessment procedures and report the results.

Surveys of larger and hazardous enterprises are conducted (in accordance with existing procedures) by independent surveyors and/or engineering divisions of international brokers and major international reinsurance companies. LUKOIL has regulations setting the frequency of surveyor's reports that must be prepared for larger and hazardous facilities (e.g., every two years for refineries and petrochemical plants).

Quantitative risk assessments of LUKOIL operations are performed by JSC Industrial Risk, a leading Russian industrial safety assessment agency.

Quantitative risk assessment of petroleum industry facilities is a sophisticated engineering task, involving the use of specialized methodologies and processes. For insurance purposes, risk analysis results are presented as an accident size/probability matrix, with accident sizes and likelihood assessed for all potential accident scenarios.

An adequate assessment of potential accident sizes can be provided through objective assessment of the replacement values of the assets insured. As per LUKOIL's procedures, asset appraisal for insurance purposes shall be performed by independent valuators recognized in international and domestic valuation services markets.

Quantitative risk analysis methodologies and processes are invariant to facility type and can be used in providing any type of insurance against risks pertaining to operation of industrial facilities.

From risk identification to risk management

Quantitative risk assessment methodologies and processes are also used in risk management.

A matter of major practical importance is the choice of engineering and organizational risk-mitigating measures, i.e. risk management interventions. There are a great number of measures to reduce probability of risks and/or resulting damage.

These processes and methodologies are used to make quantitative assessments of risks after implementing risk-mitigating measures. Risk mitigation reduces a company's expected annual unscheduled losses. This means that every preventive measure may be viewed as an investment project, whose efficiency can be calculated for each preventive measure.

The resulting reduction of expected unscheduled losses can be viewed as expected investment income. Comparing the losses prevented and the cost of each prevention intervention makes it possible to calculate payback periods for that intervention. Obviously, each facility has a certain level of reasonable investment, beyond which the facility will become a loss-making operation.

Work to support specific recommendations of preventive interventions to mitigate risks at LUKOIL facilities is performed through the above-mentioned industrial safety declaration procedure.

Implementation of the external surveyor's recommendations is a major factor of reducing risks (which entails reductions in insurance premiums). Implementing surveyors' recommendations requires extra spending by insured facilities, so in practice implementation of surveyors' recommendations at the rate of 60-70% is generally acceptable.

LUKOIL has a special procedure for monitoring the implementation of external surveyors' recommendations, which includes twice-a-year reporting.

Optimistic results

Measures to implement the Insurance Protection System are formalized every year (from 2003 on) in a dedicated corporate document an Annual Corporate Insurance Protection Program. Insurance protection is organized through bidding processes. In 2003-2005, the insurance bidding was won by JSC Capital Insurance, which performed all the obligations stated in its bids to provide insurance protection for LUKOIL and its subsidiaries.

Quantitative risk assessment is performed by JSC Industrial Risk, as part of the industrial safety declaration procedure. In 2003-2005, it prepared more than 150 declarations which were approved by Russia's leading expert review organization the State Project Review Authority of the RF Ministry for Emergency Management.

In 2004-2005, LUKOIL subsidiaries' assets were appraised for insurance purposes (in particular, the assets of refineries and petrochemical plants were appraised by American Appraisal Company).

In 2003-2005, routine surveys of large and hazardous facilities were performed, by Suregrove Ltd., an independent British surveyors, as well as by the engineering services of the international brokers March and Willis and of major international reinsurance companies, such as AIG, Swiss RE, and some others.

In 2003-2005, LUKOIL worked hard to implement independent surveyors' recommendations. Refineries and petrochemical companies made positive progress in implementing those recommendations (even despite of the fact that they grew in number).

To illustrate implementation of the System, here below follows information about the insurance protection of LUKOIL refineries and petrochemical plants in 2005.

In 2005, the Capital Insurance Group arranged insurance protection of LUKOIL's seven refineries and three petrochemical plants in Russia, Ukraine, Bulgaria, and Romania. The reinsurance program was arranged through the international brokers Willis. Insurance was provided against all risks. The terms of the insurance coverage were standard for all companies. The policy limit per insurance event was U.S.$400 million the largest policy limit of any Russian petroleum company. The Capital Insurance Group arranged a unique long-term insurance program, with 60% of the risk insured against for 18 months and 40% of the risk insured against for 36 months, with the international insurance company AIG as the lead re-insurer.

In October 2005, LUKOIL's project entitled Arrangement of Effective Insurance Protection as Part of Industrial Risk Management: LUKOIL's Practical Experience was named the Best Insurance Protection Project in the competition for the Best Risk Management Project of Industrial Enterprises and Financial Institutions, organized by Expert RA, a major Russian rating agency.

LUKOIL's risk identification procedures and risk management methodologies developed and implemented in 2003-2005 provided economically sound insurance protection against risks potentially threatening its operations and personnel, as well as the property interests of its shareholders and investors. The results achieved provide for a bright outlook for the year 2006.

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Oil of Russia, No. 1, 2006
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