In overall terms, the Upstream market has had another satisfactory underwriting year. We reported last year that the hardening process in this market was considerably less dramatic than in some of its related classes of business, and that if the recent profitability of the portfolio could be maintained, then perhaps the degree of rating increases would abate as we moved further into 2021. However, the usual factors that we examine in some detail every year in this Review – capacity, loss record, premium income and leadership options – have been superseded this year by three key additional factors - the continuing impact of COVID-19 on premium income levels, the overall underwriting performance of those Lloyd’s syndicates and composite insurance companies that make up this market and the poor performance of specific areas of the Upstream portfolio, most notably Offshore Construction. These factors are putting a significant break on what would normally be a softening process at this stage of the underwriting cycle.
Figure 1 below summarises the various dynamics at play in the current market. Although there are some positive factors to take into account, summarised by the green boxes on the left, there is no doubt that the purple boxes still carry more weight, resulting in a continuation of the mild hardening that has characterised this market for the last couple of years or so.
But of course there is more at play in this market than the basic general trends and questions remain about the future. How long will the basic upward trend last? Are there any signs that the overall underwriting consensus, in place for so long, is now beginning to wear a little thin? As usual, this section examines the issues of capacity, loss records, rating movements and profitability; we think that this is becoming a two-tiered market, with contrasting attitudes being made apparent for the very different risks that make up the market’s constituent parts. This year, we are going examine these issues by taking each of the “bricks” in Figure 1 in turn, beginning with the green positive blocks and then moving onto the purple negative factors.
Not for the first time in the last decade, we can report that total theoretical capacity (i.e. that officially provided by insurers) is now at record levels; indeed 2021’s figure of US$9 billion is over US$1 billion higher than at the very bottom of the old soft insurance market in 2018. Furthermore, our own estimate of the maximum realistic capacity available (i.e. what we believe can be accessed in practice for the perfect risk) has also increased, up to US$7 billion from US$6.75 billion last year. And as in previous years, there are currently no signs of any withdrawals being contemplated by any of the existing market participants.
However, it is important to remember that these are maximum stated capacity figures, and the amount available for individual programmes will continue to be subject to a host of other factors. As we will discover, capacity itself is becoming less significant than perhaps it was in previous underwriting eras; today, it is rather more a question of the underwriting decision to deploy it rather than its simple stated existence. What Figure 1 does show at least is that the supply is still there for the right risks; this factor is therefore still an important offset against some of the negative factors that we will discuss later in this section.
Perhaps the very first sign of a change in overall market dynamics has been a new-found enthusiasm of a small number of insurers who are usually not regarded as part of the traditional leadership panel to take advantage of the current favourable trading conditions and begin to grow their Upstream portfolio. Logic suggests that in the absence of underwriting losses, it will not be too long before sufficient numbers of the following market adopt a similar approach and begin to want to grow their portfolio as well. So from a buyer perspective this development can only be good news, even if in the short term it is making little difference to the overall market dynamic.
In previous editions of the Review we have shown that changes in direction within the direct Upstream market are often driven by developments in the global reinsurance markets; indeed, since 2018 increased reinsurance costs have been a very significant factor in driving rates upwards. In our October 2020 Update, we warned that increased reinsurance costs at January 1 2021 may well lead to further rating increases, as it might not be possible for the direct insurance market to absorb these increased costs without passing them on to the direct buyer.
We are pleased to advise that these increases turned out to be not as bad as some Upstream insurers had feared. Although there were some significant escalation in rates in respect of some of the higher, Energy-specific excess of loss treaties, the bulk of the reinsurance costs – mainly whole account treaties shared with other disciplines such as Marine – were limited to single digit rating increases, with considerations such as COVID-19 yet to make an impact on this portfolio.
As a result, in general terms we do not think that such increases have been passed onto the direct buyer and this has done much to take the sting out of the overall upward momentum in direct rating levels.
For the last two years, we have been able to report relatively benign years for the Upstream portfolio, as evidenced by Figure 3 to the right. Although the data for 2020 is still relatively immature (it takes a while for our Database to fully reflect all loss activity for the year) it very much seems as if the same dynamic is going to hold sway again in 2020 as it did for the previous two years. However, this year there is one important caveat – we are very much aware of a recent explosion at an LNG plant in Scandinavia that is likely to generate a very substantial Contingent Business Interruption loss for several North Sea Joint Venture Partners. We are also aware of a potentially significant Construction loss in the Middle East, as well as damage to an Upstream facility in North Africa.
Figure 5 above shows the development of Incurred Ratios (premiums earned versus claims paid & outstanding) for Lloyd’s of London Energy business during the last decade. Although by no means an entirely reliable indicator of overall sector profitability, these figures do at least provide a profitability comparison with previous years and indicate the general direction of travel of the three basic classes of Upstream business, namely Offshore Property, Operators Extra Expense (OEE) and Onshore Property. As we have mentioned in past editions of this Review, although an Incurred Ratio in excess of 100% obviously represents an unprofitable portfolio, following several conversations with underwriters on this issue in recent years we now would suggest that an Incurred Ratio anywhere in excess of 50% may also result in a negative overall underwriting result. The chart therefore shows that since 2016 both the Onshore Property and the OEE have been in consistent negative territory; indeed, the Onshore Property element has only once ended up at less than 50% during the entire decade. In contrast, the Offshore element of the portfolio has proved to be consistently profitable (apart from 2014 and 2015).
Although the figures for 2020 are still too immature to be germane, it does seem that all three elements of the portfolio are likely to end up profitable, despite the looming Contingent Business Interruption loss we referred to earlier. This is likely to add to the first signs of competitive pressure that we alluded to earlier in this section.
In Figure 3 on page 3 we showed how our estimate of the overall Upstream premium income has actually declined slightly since last year, down approximately 5% since 2019 at some US$1.75 billion. This may come as a surprise to some observers, given the fact that rating levels have been rising for the last two years or so. However, others will not be surprised to learn that our estimates have had to incorporate the impact of the decline in Exploration and Production activity during the COVID-19 crisis, as well as the decline in Business Interruption/Loss of Production Income values during the same period; premium income levels associated with the Offshore Contractor portfolio have been especially impacted. The result is that the overall premium income pool continues to stagnate, despite underwriters’ best efforts to increase revenue by raising rates. Indeed, most insurers are painfully aware that a major Upstream tragedy such as Piper Alpha in 1988 or Deepwater Horizon in 2020 would remove the entire annual premium income stream from the market at a single stroke.
It is therefore only the very choicest business, featuring significant premium income in well-regarded areas of the world, that are coming under any sort of rating pressure. In contrast, insurers are still looking to redress the issue of the premium pool by attempting to raise rates as far as they can on the remainder of the portfolio.
In last year’s Review we expressed concern that the Offshore Construction portfolio was starting to deteriorate significantly. This year, we would suggest sadly that this development has only got worse; Figure 6 on the previous page illustrates the unhappy situation, with each of the last three mature years in significantly negative territory (the 2020 statistics are still too immature to be germane). With this portfolio led almost entirely by the major operating leaders, this development has alarmed the market; indeed one of the major leaders of the last few years has recently gone so far as to rationalise their portfolio. Others maintain a presence, but the enthusiasm for subsea projects in particular is much diminished.
Another major impediment to the easing of the current hardening rating environment has been the continuing unprofitability of several significant lines of business within the overall Property & Casualty (P&C) portfolio, as evidenced by Figure 7 on the next page, which shows first half results for 2020 at Lloyd’s of London. Although Energy (Upstream and Downstream combined) seems to have secured an underwriting profit, it can be seen that the same can hardly be said for either general Property or general Casualty, while Lloyd’s Reinsurance portfolio has also made an apparent underwriting loss for the first half of the year. These figures throw into sharp relief the dilemmas facing the Upstream market; as much as they can see that their portfolio in isolation is making money, any attempt to broaden their premium base by growing their own business by adopting a more competitive approach is being overridden by the need of their organisation as a whole to be seen to be insisting on rating increases across the board.
Our final negative factor is the continued management scrutiny of the Upstream portfolio, whether within Lloyd’s or from the major composite insurance companies. For several years now we have highlighted the growing trend towards a centralisation of underwriting authority; now we are seeing decisions that used to be taken by even that centralised authority being ultimately handed over to senior insurer management. Often operating at some considerable distance from the Upstream portfolio itself, these managers are generally taking an overall Property & Casualty portfolio approach to their business strategy; while currently profitable, Upstream is only one cog in a much wider business wheel.
Given the various positive and negative factors affecting the Upstream market that we have outlined, the reader would be forgiven for being somewhat confused by the contrasting trends which we have identified. How is the conflagration of these trends being evidenced in the rating levels currently being imposed by the market? In very general terms, Figure 8 on the next page shows how a two-tiered market is now developing in Upstream; of course there are always exceptions to these rating guidelines, and much will depend on individual risk profiles, premium income streams, past loyalty to existing leaders and loss records.
This chart shows that there is much more to the gentle overall rise in rating levels than might be supposed. Indeed, we can now see the beginnings of a two-tiered market, with a distinctly different tone been taken for each tier.
We have published the chart in Figure 9 above in every Energy Market Review since 2006 and it is always interesting to compare historic capacity and rating levels using data collected all the way back to 1993. What is immediately apparent is that the volatility of the Upstream market has significantly decreased during the last seven years or so; although during this period we have moved from a softening to a hardening market, the effects on overall rating levels have been modest by historical standards. For example, if we compare the seven-year period between 1999 and 2006 with 2014-21, we can see a much more stable supply of capacity, as well as a less turbulent rating environment.
That being said, the chart once again shows that both capacity and rating levels are increasing, just as they did between 2008 and 2013 - another “false equilibrium”. The reader may wonder how long this strange state of affairs will continue for this time; simple economics suggests that this dynamic cannot remain in place indefinitely. In the previous “false equilibrium” era, a relatively restricted panel of Upstream leaders were able to point to a number of notable losses – Hurricane Ike, Deepwater Horizon and Gryphon A to name three – as an excuse to continue to insist on increased rates. This time round the market has no such excuse, as the loss record has continued to be basically benign. So surely, some would argue, in time rates will begin to fall again?
If only it were that simple. As we have seen, the vice-like grip that senior management has on a range of overall Property & Casualty portfolios suggests that any softening process is still some way off. And as we saw in Figure 7, various parts of the Upstream portfolio continue to be loss making, despite the overall profitability of the sector.
That being said, we do see signs of an increased appetite for this class from some insurers keen to expand their portfolio and lead more business; the question remains as to how much support these leaders will generate from a still cautious supporting market. The opportunity for buyers to secure more advantageous terms as 2021 develops may arise should this current meagre level of support increase exponentially.
In the meantime, our advice to clients remains very similar to last year:
In short: please engage with us as soon as possible to ensure an optimal result in the market.
Paul Braddock is Head of Upstream, Willis Towers Watson London. paul.braddock@willistowerswatson.com
Richard Burge is Head of Upstream Broking and Chief Broking Officer Natural Resources, Willis Towers Watson London. richard.burge@willistowerswatson.com
