Many of the factors that make up today’s bleak underwriting landscape for energy insurers are interrelated and can be summarised as follows.
Cutbacks in Exploration and Production Activity
In our analysis of why pressure is coming onto premium income streams in the natural resources sector, we should first of all start with the declining oil price and its consequent effect upon investment and future activity, particularly in the oil and gas sector.
The recent collapse in the price of oil has impacted the entire upstream energy industry, especially well-developed but marginal fields such as in the North Sea. While recent alarmist prophesies of the complete demise of the North Sea oil and gas industry are perhaps somewhat premature, there can be no doubt that some projects are being mothballed or postponed, there is likely to be much less drilling activity and business interruption values are bound to come down. For example, only recently oil and gas UK published a report in which they stated that only 14 out of the 25 expected exploration wells were drilled in 2014 and that only between eight and 13 wells are planned in 2015.
The US shale industry has also been significantly impacted. The primary effect of the fall in oil prices has been a knock-on effect on the share prices of the key players in this industry. Indeed, it is thought possible by many that those shale producers who are financed by a high level of debt and cannot withstand these low prices could even go out of business.
However, the pain is being felt all over the world, far beyond the North Sea and the US shale fields. From the Barents Sea to the Black Sea, from the Canadian Oil sands to the South China Sea, from Brazil to the fledgling sub-sea developments in the Arctic Ocean, the story is the same – investments are being withdrawn, projects are being postponed, yard orders are disappearing and workers are being laid off. Meanwhile the knock-on effects on rig day hire rates and on the fortune of oil supply companies are already proving to be as equally dramatic. Perhaps only in areas where labour costs are relatively low compared to other areas of the world and where USD50 oil would still deliver meaningful returns, will the worst of the downturn in Exploration and Production activity be avoided.
Increased Mergers and Acquisitions Within the Energy Industry
As if reduced exploration and production activity were not enough, the scope for increased merger and acquisition activity among energy companies which has become an ongoing trend recently will almost certainly mean a further consolidation within the energy industry. This in turn will mean less premium finding its way into the insurance markets.
Moreover, another potential worry for upstream insurers is whether some medium-capitalised companies, who are now the owners of a significant amount of upstream infrastructure in some regions, have the risk management resources and acumen to ensure that the high safety standards inherent in the working practices of the super-majors will be maintained. To date, there is little evidence of these fears being well-founded, but some apprehension in the market remains.
Reduced Risk Management Budgets
More generally, there can be no doubt that the oil price collapse is going to have a negative effect on individual energy company risk management budgets. We have already seen several instances at Willis recently where, as a result of management directives, some of our major clients have significantly reduced their programme limits, with a corresponding dramatic reduction in premium spend.
In such situations buyers have the choice as to whether to reduce the participation of each and every insurer on their programme or to take the decision to discard a proportion of the existing market. There can be little doubt that, as 2015 progresses and we see more of the impact of these risk management budget cutbacks, we expect some buyers to opt for discards, with the result that those discarded insurers suddenly faced with the prospect of a reduced – and less attractive – portfolio.
Falling – and Even Negative – Interest Rates
As a deflationary factor, the oil price collapse has also contributed to the continuing pressure on interest rates and yields from traditional safe investment opportunities such as government stocks. The macro-economic reasons for low interest rates across the globe – including aging populations and other demographic factors – are beyond the scope of this review, but the received economic wisdom available to the layman today suggests that interest rates are not only going to stay low for the foreseeable future but in some cases have already actually become negative – an unprecedented economic phenomenon in modern times.
Given this extraordinary development, there seems to be little on the horizon to encourage capital providers currently committed to the global (re)insurance market to look elsewhere for a return on equity. What possible reason can there be to transfer capital out of the (re)insurance industry – where it has at least earned a generally more positive return, up until now – to other traditionally safe and solid investment opportunities where there is now no guarantee of a return at all? So if anything, we can expect even more capital to enter the (re)insurance industry in the next few years rather than expect any meaningful withdrawals.
Increased (Re)insurance Market Capacity
So it’s no surprise that the global (re)insurance markets remain awash with capacity, with the total amount of capital in play increasing from about USD350 billion in 2008 to about USD575 billion today. In our January 2015 Energy Market Newsletter we referred to Willis Re’s new year market report which almost universally described a softening in both general and specific lines of reinsurance treaties in virtually every region, whether quota share or excess of loss. Willis Re estimate that the current trajectory of growth in “third party capital” suggests it could account for up to 30% of the global property catastrophe reinsurance market within a few years, representing approximately USD100 billion of capacity. This includes capital from non-traditional sources, such as pension funds, hedge funds and investment banks. Apparently, this could rise to as much as USD150 billion by 2020.
These heavily over-capitalised global reinsurance markets, combined with a glut of new capacity from non-traditional providers, have naturally increased competitive pressures in the direct energy insurance markets like never before. In the various chapters of this review dedicated to individual markets, the reader will very quickly see that overall global (re)insurance market theoretical capacity increases are made themselves evident in 2015, in particular in upstream and downstream oil and gas where capacity levels now top USD7 billion and USD6 billion respectively.
Following the recent high profile merger announcements involving Catlin and XL, Brit and Fairfax holdings and Axis and Partner Re, some might suggest that this might serve to reduce available capacity. However, it is our understanding that while such mergers reduce operating costs and enable capital to be deployed more efficiently, the same total amount of capacity will still be offered as was available on a combined basis before these mergers are completed.
Market Regionalisation and Increased Global Competition
With capacity continuing to increase in every line of business, the softening dynamic in the energy markets has been exacerbated by the growth in regional underwriting. In particular, the downstream and power markets have become increasingly decentralised, allowing local markets without the global footprint of the major composite insurers to compete with them for the choicest regional business.
At the same time, as we reported in last year’s Energy Market Review even at a global/London market level there are generally more insurers now ready to lead business than in the past. And for those buyers for whom price is the dominant buying determinant, some eager new entrants to these markets represent an attractive choice, regardless of their experience and actual ability to lead.
The Absence of Catastrophes
Later in this Review we provide the latest updates for each of our market sectors. In brief, individual loss records for these sectors remain generally favourable, particularly for upstream energy business. Unlike previous years such as 2008, 2010 and 2011, overall loss records have not been sufficient to threaten the portfolio of any of the energy sectors. So with no natural catastrophe losses of any substance to report in 2014, either in terms of earthquake, flood or windstorm, the energy portfolios continues on balance to make healthy margins for the insurance market, especially for those insurers who report results on a combined upstream/downstream basis. Whereas in previous years insurers could always point to a major loss to justify a specific underwriting stance, 2014 has provided them with no such excuse to do so.
Increased OIL Limits and Use of Captive Insurance Companies
Finally, we must also take into account the continued, and in some instances increased, trend of increased captive utilisation by major energy companies, together with the effect of the new OIL limits (OIL has elected to increase its per occurrence limit from USD300 million to USD400 million and the event aggregation limit from USD900 million to USD1.2 billion effective January 1st, 2015) which will provide additional pressure on premium income levels coming into the commercial insurance market (for example, we are aware of one particular project which would normally be regarded as a capacity risk which is now 75% underwritten by captives.)
The trend towards greater use of captives in recent years and the reasons behind it is examined in more detail later in this review. But for the commercial insurance market this trend has become a very worrying one, particularly for following insurers. Far too often, from their point of view, they have seen attractive business, particularly on the offshore construction side, swallowed up by expanded captive participations – and this at a time when lower oil prices are casting their own shadow over future project activity.
Conclusion: a Reduced Premium Pool for 2015 a Virtual Certainty!
All of these factors mean that premium income, particularly for upstream insurers, is likely to be seriously threatened as 2015 progresses. And for those insurers who are hoping that such a dramatic fall in oil prices is bound to be followed by a significant a rebound, all the perceived wisdom points to the possibility of a further fall in oil prices later in the year as the over-supply continues to be maintained. Indeed, the current supply-demand imbalance – inherent as a result of the insistence of some countries in maintaining full production at a time when the growing global economies, particularly that of China, are starting to slow down – seems to suggest that a significant long term upturn in prices is unlikely in the short term.
So there can be little doubt that these eight factors are going to have a major impact on our markets in the coming months. Although premium levels have essentially held firm for the last three or four years, as a gradual softening process has quietly gathered pace, insurers can now expect levels to decline significantly.