In last year’s Review, we suggested that the Upstream market was on the verge of a significant hardening – particularly if the loss record began to deteriorate - as insurers were looking for any excuse to push for steeper rate increases in line with other parts of the overall Property/Casualty portfolio. Buyers will therefore be delighted that no such significant hardening is yet apparent in the Upstream market. Capacity is up; the loss record, including Gulf of Mexico windstorm losses, remains benign; and so the catalyst to spark increased rate rises has simply failed to materialise, at least in general terms. In normal times, we would therefore be reporting a continuation of the old soft market dynamic; no one needs to be an economist to understand that increased supply leads to lower prices, in the absence of any other factor. But these are not normal times. As we emphasised last year, Upstream remains part of the wider heavy industry Property & Casualty portfolio; and as we report on the Downstream chapter of this Review, the remainder of that portfolio is still being heavily impacted by major underwriting losses across the board.
A market virtually in balance As a result, we have a situation illustrated by Figure 1 left that shows how individual insurer management and Lloyd’s Performance Management Directorate (PMD) pressures are counter-balancing increases in capacity and the benign loss record. We now have a market that is steadfastly maintaining the new status quo established last year, with virtually no rating reductions being permitted by senior management at almost every insurer. This has meant that rate rises have generally been perfunctory in nature; just enough to satisfy senior management but nowhere near the levels seen in other sectors such as Downstream. But does this fragile stability mask some interesting developments in some sub-sectors of the Upstream portfolio? Is the current Upstream premium pool sufficient to guarantee long term profitability? Will this market continue to buck the overall current market trend? As usual, we shall look at capacity, losses and overall profitability to find out.
The chart in Figure 2 left is hardly reflective of a hardening insurance market. Instead, it shows that once gain overall “theoretical” (i.e. what insurers advise they can offer) maximum capacity levels have increased once more, from US$8.10 billion in 2019 to US$8.73 billion in 2020. Some of this increase can be put down to the introduction of Convex into the market- a development which has certainly kept existing Upstream leaders on their toes - but mostly this increase has resulted from other insurers’ determination to maintain their current position in the market and, where possible, to maximise their lines sizes on the most profitable programmes. There is also no doubt that, for certain insurers, being able to advertise a larger maximum capacity figure brings with it certain branding advantages and an assurance that their capacity will be taken seriously by brokers.
Maximum realistic capacity at record levels We have therefore increased what we think is the maximum “realistic” (i.e. what insurers actually put out in practice) market capacity to US$6.75 billion – more than was ever available even during the ten-year soft insurance market of 2011-19. However, a note of caution needs to be sounded; insurers only generally deploy their maximum capacity on assets located in specific regions such as the North Sea. In practice, the amount of capacity available is also curtailed by the maximum percentage line size that a given insurer is permitted by their reinsurers to put out. Be that as it may, we can still confidently assert that there is more capacity available to Upstream buyers as there has ever been in the past.
In the past, the Upstream industry has been a byword for loss volatility: think Piper Alpha, Enchova, Hurricanes Katrina, Wilma and Ike, Deepwater Horizon and Gryphon A. But our chart in Figure 3 right shows a very different story in recent years. In fact, we have to go back to 2015 to find a year with significant Upstream losses; since then, loss levels have declined year-on-year. (Indeed, there has been only one Upstream loss recorded to our database to date in 2020, making this column hardly visible at all on our chart - however, we have included it for consistency with previous Reviews.)
$2 billion of Upstream premium income lost in last nine years This is all good news from an insurer perspective; however, this welcome development should be considered in conjunction with our estimates of the overall global premium accredited to the Upstream market. Since the beginning of the soft insurance market in 2011, premium income levels have also continued to decline year-on-year; although we think there has been a small uplift since 2018, overall premium income levels remain low by historical standards. Indeed, since 2011 we estimate that the market has lost nearly US$2 billion of premium income, due to a combination of softening insurance market conditions, increased captive retentions and reduced programme limits. So we think that there is still a long way to go before Upstream insurers can rest easy in their beds. It would only take a small number of major losses in excess of US$1 billion – losses that the industry has suffered many of in the past – to change existing market dynamics.
The statistics for this chart come from Lloyd’s of London and show overall Incurred Ratios (i.e. received premiums versus paid and outstanding claims) for three different classes of Upstream business – Offshore Property, Operators Extra Expense (OEE) and Onshore Property, which includes various onshore energy infrastructure/assets that can be underwritten in the Upstream market such as land rigs, gas plants and onshore pipelines. As most readers will quickly deduce, an Incurred Ratio in excess of 100% (and probably in excess of 80%) guarantees portfolio unprofitability; however, due to the reduced premium income pool and the gradual escalation of operating costs, we now think that any Incurred Ratio within the shaded area of the chart (50-80%) is also likely to produce an overall underwriting loss. What can we deduce form this chart? Sadly, the latest figures available from Lloyd’s are too immature to be germane for 2019, but we can take a closer look at 2017 and 2018. The purple line, showing Offshore Property, is well in profit for both years; given that this is where the vast majority of Upstream insurers’ premium revenue derives from, that is highly encouraging news for the market.
OEE and Onshore Property remain unprofitable However, it’s a different story for the other two sectors. OEE, the yellow line, is very likely to have lost money for insurers in 2017 and may well have done for 2018 as well. Meanwhile, the Onshore Property portfolio represented by the blue line (which does include an element of Downstream assets which the Upstream market is prohibited from underwriting) for both years has been highly unprofitable. No wonder that Upstream insurers have been paying particular attention to the Onshore Exploration and Production (E&P) and OEE areas of the portfolio.
The combination of increased capacity and fewer losses means that unlike other lines of business, this is still a market where the broker is setting the terms. All too often, brokers head out to the market with a good-looking insurance programme and can return to their offices having placed the business without a single amend to the proposed terms and conditions: unlike Downstream, Upstream is still very much a subscription market.
Current rating increases very modest for most business No wonder brokers can keep average rating increases to nominal amounts – ranging from as little as 2.5 to 5% in most cases (for loss-free business). Indeed, the overall market appetite for Upstream business - particularly offshore - is preventing some well-known market leaders from attempting to push for more significant rate rises; over the last few weeks their initial quotes requiring steeper increases have not been accepted by clients and their brokers, with the result that they have had to accept a reduced rate increase to secure a firm order from the buyer along the lines of the modest rating increases indicated above.
Convex entry leaves market undisturbed - for now While it is true that the introduction of Convex has had an impact, particularly on smaller insurers with more modest programme lines, they have not yet assumed a full leadership position in the market. This has enabled the existing leadership panel to remain intact, with Convex keen to focus on building and establishing their portfolio without any undue disruption to the current market status quo.
Following market offer benchmarking services Meanwhile some member of the following market have sought to differentiate themselves from their peer group by offering brokers ancillary services such as benchmarking to assist brokers in formulating their broking strategies. Again, this is hardly the sign of a hardening market and amply demonstrates that the broker still has command over the general market situation.
Reductions still out of the question - with rare exceptions Despite all of these factors, however, brokers remain essentially up against a brick wall when seeking actual rating reductions – which they should be able to achieve in any other market displaying these characteristics. With some rare exceptions, the position of both the Lloyd’s PMD and senior corporate management in the big composite insurance companies remains the same – individual Upstream underwriters are generally still not permitted to agree to any form of rating reduction, regardless of whether the insurer in question had participated in the expiring programme or whether the broker is keeping the original rates but applying other credits in some form or another. To break this injunction would almost certainly have significant consequences for the underwriter in question, unless there are some special mitigating circumstances where senior management can sign off on a deal. That is perhaps the one issue that even the most plausible and skilful brokers can do absolutely nothing about.
The one area of the Upstream portfolio that is causing alarm in the market is Offshore Construction. Although this line of business represents only 10% of the overall Upstream portfolio, the loss record has recently been so poor it seems that in this sector at least insurers are successfully enforcing much more significant rating increases. A glance at Figure 7 above should explain why. Although the loss figures in the purple columns do include both insured and uninsured losses, and although there is a significant proportion of this part of the portfolio that is absorbed by the participation of captive insurance companies, these figures still make disturbing viewing for Offshore Construction underwriters. One of the problems for this class of business from an insurer perspective is that rating levels were driven artificially low by the steady advance of the previous soft market while the attritional loss record, particularly for 2017 but also to a lesser degree for 2018, has been maintained.
Subsea issues drive underwriting losses Furthermore, a significant proportion of these losses can be attributed to the increasingly prevalent use of subsea completion systems. Some insurers have reacted by refusing to participate in subsea projects, and in making that decision they have been supported by their senior management, who are alarmed not only by the prevalence of subsea attritional losses but also by the long “tail” which is a significant aspect of many Offshore Construction projects.
Excess layer a focus for insurer attention As a result, rating increases for this sub-class have been sharp – to the extent that it has often been more prudent for the broker to layer the larger programmes, whereas in the past virtually all of them had been placed on a quota share basis. On these excess layers in particular, there has been a special focus on rating levels as the market, sensing an opportunity, has enforced what would have been considered punitive rating levels on programmes that have had to be layered in this fashion. Meanwhile a section of the following market are holding back from participating on these programmes, preferring it seems to wait until the situation improves still further from an insurer perspective. To mitigate these challenging conditions, it is critical that the buyer provides a sufficient degree of underwriting information. For those buyers who don’t, we have seen instances recently where the price has continued to increase as the programme has become more and more distressed.
Do some leaders sense a Construction opportunity? Meanwhile we do detect that, as prices increase in this fashion, several Lloyd’s syndicates who have held back from this class in recent years are beginning to sense an opportunity to begin to lead this class of business, now that pricing has returned to their comfort level. It will be interesting to see later in the year if such additional leadership options provide brokers with the opportunity to leverage more competition to what has been previously been a very restricted leadership panel.
As we outlined in Figure 6, the onshore part of the Upstream portfolio has been suffering heavily from attritional losses. One way to rectify this – and to achieve some much-needed premium income spread - has been for certain Upstream insurers to consider expanding their onshore book to include assets that have more traditionally been insured in the Downstream market, such as tank farms, gas plants and onshore pipelines. Because the Downstream market has been hardening much more significantly over the last two years, Upstream insurers are finding that their terms for these assets are sufficiently competitive for them to receive firm orders - even if the terms quoted are significantly increased from what they would have charged 12 months ago. Other Upstream insurers are taking a more cautious approach, preferring to abstain from programmes that have little by way of offshore exposures to allow for them to take a positive view.
Upstream insurers filling in distressed Downstream placements Be that as it may, we have found on a number of recent occasions that the Upstream market has been able to complete some Midstream programmes that had started life in the Downstream sector but where the broker had simply run out of available capacity. This can often happen where, for example, European programmes have a small (but significant) asset base in the United States that has proved unacceptable to the European Downstream market. In such circumstances, we have been able to find a home for the outstanding elements of the programme without any undue difficulty - even to the extent of putting together a separate Gulf of Mexico windstorm placement for the US assets in question. It remains to be seen whether this trend will result in wholesale transfers of Midstream business to the Upstream market from its Downstream counterpart. From our experience, we would suggest that buyers in many ways prefer an Upstream programme, by virtue of the fact that it remains generally a subscription market and so guarantees the same terms and conditions to the buyer for every underwriting line.
Midstream business smooths onshore volatility There is no doubt that an enhanced Midstream portfolio does much to offset much of the volatility from Upstream insurers’ Onshore Energy portfolio, for example from uneven drilling schedules prompted by oscillating oil prices. However, it remains to be seen whether these insurers have priced this new and expanding area of their portfolio correctly. Clearly, at the moment the Downstream market‘s view is that the Upstream pricing for this business is too competitive for their liking; time will tell as to which market has called the pricing correctly. In the event of increased losses from this part of the portfolio, we should expect Upstream insurers to beat a rapid retreat from assets of which they have relatively little knowledge or experience compared to their Downstream counterparts.
Figure 8 left shows the historical correlation between Upstream market capacities and average rating levels. A careful examination of the chart shows that during the beginnings of the old soft market from 2008 to 2012, the Upstream market was actually successful in securing rating increases at a time when capacity was also going up. What is to stop them doing the same thing for the next four years? After all, our chart also shows a rate increase for 2020, at a time of increasing capacity.
Previous market hardenings prompted by major losses The difference between the period 2008-12 and 2020 is quite simple - the rating increases that were instigated in 2008 were prompted by the significant losses incurred by the market in the aftermath of hurricane Ike. They were swiftly followed by the Deepwater Horizon loss in 2010 and the Gryphon A loss in the North Sea in 2011. All of these losses provided the perfect excuse for Upstream leaders to insist on rating increases; in a subscription market, if all the leaders are united in their determination to increase rates, there are few options open to the buyer other than to accept them.
However, this is by no means the situation as we move further into 2020. We have already seen that there are no major losses to provide the impetus for more significant rate rises. We have also seen that when a small selection of leaders has tried to enforce more stringent rate rises, they have not received the backing from their fellow leaders, nor the rest of the following market. In short, the relentless rise in capacity levels is capping rate rises to today’s modest amounts. But at the same time, management diktats that apply across the full spectrum are keeping any prospect of rate reductions off the table for the time being - with rare exceptions.
Can the current status quo last? So the question we have to ask is this: in the continued absence of major losses, how long will it be before the need to secure additional premium income from a profitable portfolio such as Upstream outweighs these diktats?
It is of course difficult to know exactly how long managers will be happy to artificially restrict income growth by preventing their underwriters from engaging in the usual activity of competing for additional premium income. But as we have pointed out, the overall premium income pool for this class of business remains at historically low levels - levels that won’t be increased much by today’s modest rises. At some point, to ensure the viability of the portfolio by covering their operating costs, it is likely that some of the smaller insurers will come under enormous pressure to increase their line sizes on the more profitable programmes. If the only way to do so is to offer more competitive terms, there must surely come a point when senior managers at some insurers accept the trade-off between an increased line size and more competitive terms in their drive for more income – the current standoff can surely not last for ever. And if the smaller Upstream leaders start generating more income and the larger leaders find that their income pool is draining away as a result, that could be the one scenario that might break the current impasse. Of course, it is instead possible that a succession of large losses will provide the impetus the market requires, and today’s conditions will simply be the launching post for a much harder market. Only time will tell.
Our perennial advice – preparation is key! In the meantime, our advice to buyers remains as simple and consistent as ever. To prevent the market from having an excuse to increase your rating levels further than is necessary, engage with your broker early in the renewal process and develop a sufficiently professional underwriting submission to enable your leader to maintain confidence in your programme. And should the current market cohesion finally break - as it has done at the end of every hard market in living memory – you will be first in line to reap the undoubted benefits.
Paul Braddock is Head of Upstream, Willis Towers Watson London.
Richard Burge is Head of Upstream Broking, Willis Towers Watson London.
