Recent experiences need to be translated into quality underwriting standards for the future
Underwriting energy risks is not for the faint-hearted, even during the best of times. The nature of these risks (with high concentration of values, highly flammable substances, harsh operating conditions, often in hostile environments, with complex business inter-dependencies) makes them far more hazardous than other industrial risks. When U.S. Gulf windstorm is factored in as a further hazard to contend with one might be forgiven for thinking that insurers willing to expose their capital to these risks are either extremely brave or rather foolhardy. In the past two years, losses from physical damage and the associated business interruption from the major U.S. windstorms have cost many billions of dollars, the large majority of which have been borne by insurance (and reinsurance) underwriters.
The effect on a worldwide insurance market of either too little or too much capacity being available is well recognized. Much has been written about the source of capacity and the influential role played by reinsurers who bolster the capital exposed by direct insurers and the very substantial part of the hurricane losses that falls into their laps. The U.S. hurricanes of 2004 and 2005 hit the market during a softer phase in the business cycle, which followed the recovery made since the comparatively lean years before 9/11. Not surprisingly the pendulum now swings sharply the opposite way but for how far and for how long are the big questions.
Offshore energy underwriters in particular will have been quizzed as to whether the premiums they receive for assuming these heavy (and often difficult to evaluate) risks are adequate, taking into account “normal” losses plus “shock” losses. The profitability of energy business is best judged over a long period of time, say 10 years, but there has to be a commensurate balance between risk and reward, otherwise why bother with such high risks?
For those underwriters who continue in the business in the aftermath of the 2005 hurricanes it is vital that some basic lessons are learned and enhanced underwriting principles and policy applied. Naturally, the huge cost of hurricane losses (in addition to other losses) cannot be recuperated overnight and the long-term answer will not be found in higher premiums alone, even if substantial.
Hurricane Ivan produced unexpectedly high accumulated business interruption losses arising from mudslides that caused damage to the vital sub sea pipelines. The age and condition of platforms and rigs were key determining factors for the extent of damage suffered in the 2004 hurricane.
Similarly, Hurricanes Katrina and Rita serve as costly reminders of how oil and gas businesses can be interrupted by direct damage to owned assets or more significantly by problems stemming from customers or suppliers being affected. The need for unambiguous policy wordings drafted by experts, especially for business interruption, is apparent. Otherwise settlement of claims is very challenging and can lead to disappointment, remembering that policy ambiguity normally turns against the drafting party.
Setting standards for the future
With major claims comes fresh experience and this needs to be translated into future underwriting policy. A heightened appreciation of the technical characteristics of each risk is necessary. The temptation to focus too much on the latest natural catastrophe and ignore the important operational risks such as fire, explosion and machinery breakdown must be avoided. Quality of management and maintenance standards has a direct bearing on loss experience and allows a differentiation between two seemingly similar risks.
Satisfactory details of hurricane preparedness plans that go beyond the priority for protecting health and safety of human life are a key part of the risk assessment. Orderly and timely shutdown of plants, platforms, etc., securing unfixed materials and safe start up procedures are all important points to be examined.
Better appreciation of extensions to the basic cover is required. How extensions might increase the indemnity being offered, setting realistic sub limits and how to price the additional cover being granted are essential parts of the underwriter’s thinking, e.g., removal of debris, making wells safe, contingent business interruption.
Price spiking as a consequence of a major interference in the supply chain and its spiraling effect on an individual operator’s profits is something familiar to power generation underwriters, whose policies refer to actual loss sustained and maximum daily values. Otherwise, the indemnity afforded by loss limit policies is exhausted more rapidly than expected, and ultimately the policy becomes a first loss cover.
Regarding CBI, the remoteness of risk, the absence of direct controls and difficulties in recognizing risk accumulation have led underwriters to be very cautious, some withdrawing altogether in regions of natural catastrophe. CBI lower limits and restricting cover to named (or 1st tier) parties only has been introduced.
The general application of policy limits for windstorm (and flood for onshore risks) aggregated for the policy period is essential if accumulated losses are to be managed effectively, with deductibles applicable to each and every occurrence forming part of the risk sharing/transfer mechanism. Equally, realistic time deductibles should apply to business interruption losses recognizing unavoidable delays in mobilization and time taken to gain access to damaged property.
Underwriters need proper values to be declared for insurance purposes. Only then do they have the correct basis for their premium calculations and are they able to assess the maximum exposure (per risk and in aggregate) which is essential when determining how much of their capacity to put to any one risk or group of risks. There needs to be a growing awareness of the additional factors that contribute to the high and fluctuating cost of claims — rising steel prices, increased labor rates at the time of exceptional demand, effects of future legislation and over-stretched resources among the loss adjusting fraternity. From a business interruption angle a clearer understanding of the exposures involved, how a loss might be mitigated and the make up of the sum insured will lead to a better assessment.
Improved techniques for monitoring risk accumulation and loss simulation are necessary for good portfolio control and responding to the growing demand for high-level management reporting. Geographical spread within the portfolio serves as a useful balancing tool for underwriters (and perhaps energy companies themselves) when considering natural catastrophe and they may look increasingly towards more benign parts of the globe.
The enormous cost of the recent hurricane losses intensified the focus which was already turning towards energy underwriting, whether relating to upstream risks, downstream risks or construction risks. Without making changes to the way business is approached it is doubtful that the commercial insurance market as we know it today could survive.
Today’s energy underwriters are charged with doing better than just surviving; they are expected to return a profit to investors over the long haul. If this is to be achieved, the more disciplined approach to underwriting and improved efficiency in the use of capacity cannot be transitory. Instead they need to be sustained over time. No one said energy underwriting is easy, quite the opposite; it probably just gets tougher.
Stephen Coward has 34 years experience in underwriting international engineering and construction risks, mainly energy-related, in the London market. He joined Lloyd’s in 2002 where he is director of Non-marine and Energy Underwriting at Navigators Underwriting Agency, Syndicate 1221.