Conditions in the Upstream market have been uncomfortable for insurers for several years now. In previous editions of this Review we have explained how the Upstream premium income pool has been whittled away over time due to a combination of a number of factors, including excess capacity, lower oil prices and increased captive retentions.
For years, insurers have been concerned about falling rating levels and finding a means of continuing to write this portfolio on a profitable basis. Following the 2017 Gulf of Mexico hurricane season, it was widely assumed (but not by all) that increased reinsurance costs resulting from record windstorm losses would lead to a definite Upstream market turnaround; however, not only were there virtually no direct Upstream losses from hurricanes Harvey, Irma and Maria (HIM), but there were also no severe increases in reinsurance market rating levels, except for Whole Account programmes featuring significant Hull exposure.
Despite this, underwriters have been under significant pressure to raise rates across the board from their own management, whose overall portfolios have taken a big hit from the 2017 hurricanes. As a result, the softening process has been brought to a halt and a modest upswing in rating levels has become the norm.
But can this turnaround be sustained? How long might it be before softening pressures re-assert themselves in this market? Let’s have a look at our market data to identify the underlying trends that are shaping today’s underwriting conditions.
While 2017 saw a significant flattening in the rate of increase of overall Upstream capacity, if anything the rate of capacity increase in 2018 seems to have increased slightly. This is largely (but not entirely) due to two new start-ups beginning in 2018 who we understand are intending to enter the Upstream market for the first time in many years, as well as there being no withdrawals other than Partner Re. Our research now indicates that there is almost US$8 billion of ”theoretical” (i.e. what insurers state is their maximum) capacity - yet another record level at a time when premium income streams continue to decline.
In terms of what might be realistically achievable in the market (rather than relying on insurers’ stated theoretical maximums) we consider that the same figure that we used last year, US$6.5 billion, remains the most that any buyer can realistically hope to purchase for a single programme. It should be pointed out that such a limit would be expensive to purchase (as it would require the participation of most of the market to achieve it) relative to more modest programme limits.
So again, although we have suggested for several years that some insurers might decide that enough is enough and withdraw from this sector at some stage, our capacity figures confirm that once more we have seen no signs of any withdrawals during 2017.
Why does capital continue to flow into this market? As we have pointed out before in previous editions of this Review, insurance remains a safe haven for capital in this low interest rate economic environment, and on a macro level any lost Insurance Linked Security capital as a result of the 2017 Gulf of Mexico windstorms was easily replenished. What’s more, the Upstream sector remains one which contains an unusually large number of programmes featuring attractive levels of premium income – even in this soft phase of the underwriting cycle. And to top it all, the Upstream market has just had one of its most benign years on record, leading to what appears to be a profitable portfolio for 2017.
As can be seen from Figure 2 above, in terms of catastrophic losses the market has found that the number of such losses has been steadily reducing. Only two such losses have been recorded by our Database to date in 2017, while in contrast there were ten such losses in 2015 and four (including a very large BI loss offshore Africa) in 2016.
Even more significant from the market’s perspective are the overall loss figures for 2017 excess of US$1 million (Figure 3 above). It can be seen that the figures for 2017 are currently the lowest in recent memory and are less than a third of the corresponding figure for 2015. As a result, the gradual decrease in premium income that the market has been experiencing since 2012 has not generally resulted in underwriting losses in 2017; instead, just at a time when underwriters are being instructed by their managers to raise rates across the board, the Upstream portfolio is currently looking in good health.
Insurers have begun 2018 with mixed feelings. In the immediate aftermath of the 2017 Gulf of Mexico hurricanes, some leaders were certainly giving the public impression that it was only a matter of time before a significant market upswing would take place during December as the full impact of over US$100 billion worth of hurricane losses impacted the entire Property & Casualty portfolio. As a result, and bearing in mind the losses sustained by their organisation on the rest of their portfolios, some of these leaders began to take a more aggressive stance at the end of 2017 in an attempt to generate the turnaround that they had been predicting.
Three months on, we can say that these leaders have been somewhat disappointed. Yes, there have been reinsurance treaty rates increases, but these have been milder than predicted, with virtually all quota share reinsurance programmes being renewed intact. As a result, while there has certainly been a halting of the softening process, in terms of an upturn this has proved to be quite gentle.
While welcome news for the market, such a modest upturn hardly represents a dramatic change in market conditions and those leaders that had originally quoted much more punitive terms in the immediate aftermath of the hurricane season have quickly found that such stances have not been sustainable, apart from some programmes requiring full market capacity or with a significant natural catastrophe component.
As the market softening has ground to a halt, in overall terms the numbers of leadership options open to buyers has reduced, allowing the existing leaders to maintain the modest upswing that we have seen for the last few weeks. In this market climate, there are precious few underwriters prepared to undercut existing programme leadership panels, despite the theoretical increase in capacity.
Readers with long memories will remember a similar “false equilibrium” during the years 2008-14, when despite increased capacity rating levels in the Upstream market continued to rise. Then, as now, Upstream insurers were able to seize on significant market losses (for example hurricane Ike and the Gryphon A disaster) to keep prices rising – mainly because the leadership options in the market were restricted to a handful of respected individuals.
Although in recent years the leadership panel had widened since that era, we are now finding that the options open to buyers and their brokers have once again become more restricted, because markets are currently able to hold their position.
Furthermore, with the pressure of previous years’ unrealistic premium income targets now significantly eased, it could be said that Upstream insurers are perhaps now in a more realistic position than they were in the recent past. Figure 4 on the previous page shows the latest Lloyd’s Incurred Ratios (i.e. written premiums versus paid and outstanding losses) figures for Upstream lines of business since 1993. Last year we suggested that for some insurers to be sure of being pro table, the Upstream portfolio needed to be below 50%, given today’s operating costs and relatively low premium levels). It can be seen that both 2016 and 2017 currently fulfil that criteria (although the 2017 figures in particular are still relatively immature at this stage). Perhaps the atmosphere is now not quite as gloomy in the Upstream market as might be expected.
But for how long can the existing leadership panel sustain the current gentle increase in rating levels? Not only is there marginally more capacity in the market, but the premium income pool continues to remain under threat. The threat is fourfold:
Although insurers can expect to see some increased premium income in the form of more E&P activity given the recent higher oil prices (see Selwyn Parker’s article elsewhere in this Review) and possibly an uplift in new Construction business, the effect of these four factors is more than likely to o set any premium income gain from higher oil prices.
What’s more, any increased premium revenue to the market will depend greatly on which company is involved in any increased E&P or construction activity; if the company concerned is a large one with a significant captive and/or OIL participation, then the net effect on the commercial market’s premium income levels is likely to be reduced.
Some insurers that do not already do so might be tempted to augment their existing premium income streams by entering the highly specialised Gulf of Mexico Windstorm (Gulf Wind) market. There can be no doubt that following the 2017 season Gulf Wind is going to be a significantly more expensive product for the upstream industry than it was last year. The Gulf Wind renewal season does not generally begin until late March so it is a little early to say how attractive this portfolio might be to the direct Upstream market, but it would be a very brave underwriter who would be able to predict the profitability of the Gulf Wind portfolio from year to year.
In previous editions of this Review we have described how long it has taken for genuinely plausible Upstream Cyber products to be created and offered by the market, and indeed the slow take up of the first fledgling products that have been on offer to the buyers. We are pleased to report a more sustained take-up of these products by our clients during 2017, particularly from some companies keen to demonstrate to their shareholders that they have bought as much cyber protection as possible. This is obviously a part of the market that can only grow in the years ahead. However, despite the year-on-year increases in cyber product take up, we are still a long way from the position whereby cyber income might form a meaningful part of the overall upstream premium income pool.
One final consideration for Upstream insurers as they take stock of the recent uplift in overall rating levels and positive Incurred Ratios is the potential for cash calls resulting from the finalisation of previous years’ claims. A study of our Database charts from year to year often suggests that claims can significantly deteriorate some considerable time after the loss and before final settlement is negotiated and agreed; it is understood that there are a number of Upstream losses from 2015/16 that have not yet been finalised which do indeed have the potential to make a major inroad into the 2017 (or even the 2018) premium income pool. Should that prove to be the case, the minor market upswing in rating levels currently in play may be insufficient to prevent the portfolio from becoming unprofitable again.
So what can buyers expect as we head further into 2018? There can be no doubt that for the moment, the market is in no mood to generally offer improved terms to buyers from those provided in 2017 and virtually every Upstream underwriter is being encouraged to maintain this stance, not least from their own management.
However, we think that it is still possible for the softening process to re-assert itself later in the year. A glance at Figure 5 above shows that supply (underwriting capacity) remains at record levels, at a time when the pressures on premium income levels remain as onerous as ever. Meanwhile despite the recent uplift, overall rates remain at historically low levels.
Those insurers that elect to withdraw from programmes that they believe are being renewed on terms contrary to their own philosophies will therefore still need to answer the burning question that will be at the back of their minds: how to make up the lost premium income that will inevitably result if their own underwriting stances are not matched by those of their competitors.
One way or another, no underwriter can stay in business if their premium income stream does not allow them to pay for their operating and reinsurance costs, and once that position is reached, then either the original underwriting stance has to be abandoned or the underwriting operation has to close down. Naturally, history teaches us that it is the underwriting stance that is usually abandoned first.
From our market soundings to date, it seems that there are a variety of different approaches being adopted by the market at the moment. It is clear than some insurers are under more pressure than others to maintain underwriting discipline; it will be up to the brokers, working carefully with their clients, to identify the most competitive section of the market and deliver an optimum result.
Notwithstanding the positive underwriting results in 2017 we still think that Upstream insurers are caught “between a rock and a hard place” as we move further into 2018. On the one hand they can’t be seen to break ranks and solve their premium income issues by increasing their market share by being more competitive; on the other, if they step back from the most sought after programmes early in the year they will have to find a way to make up for it later.
It will only be later on in the year that we will see whether or not the current leadership panel can hold the line that has been established since the aftermath of the 2017 hurricane season – or whether the line will break, ushering in a fresh round of competitive underwriting.
Paul Braddock is Head of Upstream Energy at Willis Towers Watson.
