Last year our Review presented a very gloomy picture of a significant hardening of the Downstream market. With 2019 losses continuing to surpass premium income in a similar fashion to both 2018 and 2017, we had very little good news to offer buyers in hope of better market conditions on the horizon.
This year however, we can at least report some easing of the overall hardening dynamic in this market. Figure 1 to the right shows a summary of the current situation, with positive factors in green on the left and negative factors in purple on the right. By far the most important green factor is the radically improved loss record in 2020; however, this is balanced by the continuing impact of the unprofitability of other parts of the overall Property & Casualty (P&C) portfolio, not least in light of the recent arctic weather in Texas. We think this extraordinary event is likely to result in additional downstream losses being reported as 2021 unfolds, as well as impacting the P&C portfolio as a whole.
The key issue for buyers is a simple one: will 2020’s improved underwriting results enable them to negotiate more favourable terms from the market as we move further into 2021 – or will insurers, impacted by the Texas cold weather losses, be able to maintain the existing challenging market conditions? Let’s look first at the supply side, and the recent developments in underwriting capacity.
Figure 2 above shows how overall capacity for this class has ebbed and flowed over the course of the last 20 years. It can be seen that theoretical (i.e. that advised by insurers) capacity has been decreasing from 2018 onwards until this year, where we show a marginal improvement – a total of US$6.2 billion for International (non-North American) programmes, up from US$5.9 billion in 2020, while capacity for North American risks has increased more significantly, up to US$4 billion from US$3.5 billion last year.
However, this theoretical increase has made little difference to the realistic amounts of capacity on offer. Last year we advised this to be US$4 billion for International risks and US$2.8 billion for North American risks; we see no reason this year to change this. As we reported last year, insurers will usually advertise more capacity than they are willing to deploy in practice, and in the current market atmosphere underwriters remain cautious, fully aware that to deploy more capacity than last year might send the wrong signal, both to buyers and to their own senior management. As it is, even these figures represent the very most currently available for the most attractive projects; for an average refinery located in even a non - Nat Cat area for example, perhaps only as little as US$2.5 billion can be realistically accessed.
Despite this, we have seen some insurers quietly increasing their offered capacity; several have their eye on the profits secured for 2020 (see Figure 3 above) and are positioning themselves to be the first to take advantage of any opportunity to augment their premium income.
Figure 3 above shows how the Downstream loss record has developed over the last 20 years, compared to estimated global premium income. It shows that the last really good underwriting year for Downstream was 2015, which was the only year in the previous decade where premiums definitively outstripped losses. Since then, the picture has hardly been a rosy one from an underwriter perspective; 2017 was a particularly horrendous underwriting year while 2019 was not much better, and the deterioration of both the 2018 and 2019 figures continue to cause apprehension in the market.
However, to date the picture for 2020 looks considerably more promising; it is interesting to note that in a year which was notable for a highly active Gulf of Mexico hurricane season, only one windstorm loss in excess of US$100 million has been recorded by our database. So although the overall loss figure for 2020 will deteriorate further - for example, our Database has yet to register a major African incident last year that is likely to generate a loss in excess of US$200 million - the chart shows that there is still likely to be a significant gap between the final loss total and the increased premium income pool for last year.
Indeed, insurers will be pleased with our own estimate of the premium income pool for Downstream business, which stands for 2020 at US$3.5 billion, up from US$3.2 billion in 2019. This increase reflects the dramatic hardening of market conditions since the nadir of 2018 – furthermore, 2020’s total would have been higher still if it were not for the significant reduction in BI values prompted by the COVID-19 pandemic, which we discuss later in this section.
It is perhaps typical of the inherent volatility of this market that such a rise in premium levels should coincide with one of the lowest loss totals this century. Under traditional market conditions, such a scenario would lead to pressure on insurers to respond immediately by offering more competitive terms; however, this is no ordinary market and we will see later that this simple economic logic no longer applies in quite the way that it once did.
Our final chart in the section (Figure 5 overleaf) reflects the only external statistics available to us to corroborate our view that this market has returned to profitability.
The chart shows Incurred Ratios (net premiums versus paid and outstanding claims) for the Lloyd’s Onshore Energy portfolio for the last ten years or so. Given that overall underwriting profits can only be guaranteed if the Incurred Ratio falls below 50%, the chart seems to indicate that this class of business has been inherently unprofitable for the last ten years, with the potential exception of 2011. However, with an Incurred Ratio to date of only 11%, it seems that 2020 is likely to break this long-running trend.
As we have reported in previous editions of the Review, the hardening insurance market conditions continue to persuade some buyers, notably those with sufficient financial muscle and scale, to consider alternative risk management strategies that enable them to be less reliant on conventional risk transfer. Indeed, only within the last few months we understand that a major energy company, following a large loss, has this year elected to retain its entire programme within its captive insurance company as the “payback” prices being charged by the market for the renewal were considered to be too high. We have also seen other clients elect to take larger retentions and purchase lower programme limits in response to the current hardening market dynamic.
Needless to say, these decisions perplex the insurance market in its search to find an equilibrium; not only do they prevent the market from obtaining any redress for any losses that they have incurred but they also deplete the premium income pool at the very time when underwriters are under significant management pressure to increase it. It seems clear to us, however, that these decisions to retain more risk are likely to increase in future, as prices increase and buyers turn to analytical tools to determine how much of their risk is really worth transferring to insurers. And of course this development will put pressure on the market to restrict the imposition of draconian rating increases for those programmes where buyers can always select the option to retain more risk.
An encouraging development for both the direct Downstream market and for their clients has been a more modest reinsurance market renewal season than was anticipated a few months ago. Our understanding is that, in general terms, rating increases were restricted to single digit territory, which is sufficiently modest to allow them to be absorbed by direct insurers rather than being passed on directly to the end buyer.
While it is difficult to estimate the actual financial impact of COVID-19 on the Downstream sector itself, with few claims being submitted citing the pandemic as the actual cause of the loss, it is clear that from a general Property & Casualty (P&C) perspective the market has been significantly affected by the pandemic during the last 12 months. We also have yet to see whether the reintroduction of hydrocarbons after a period of shutdown will result in further incidents in the future.
What we can say is that Business Interruption (BI) values in the Downstream sector have been generally reduced since the onset of the pandemic, as oil prices plummeted at the start of the outbreak some 12 months ago; the dramatic reduction in economic activity has also led to market suppression for a large number of Downstream companies. This has had obvious knock-on effects on premium income levels, although at the time of writing the Texas Freeze has caused a notable upturn in crude oil prices which may well be sustained well into 2021.
However, buyers should be aware that the current volatility in oil prices and economic activity is likely to have a profound effect on the volatility of their own BI values for the foreseeable future. Given the introduction of the new clause LMA 5515, this is going to be a vital issue for buyers to keep abreast of as there is a real danger of under-insurance if the values declared are not consistent with reality. LMA 5515 ensures that not only will insurers factor in a maximum percentage of the margin of error that whey will allow between actual and declared values, but they will also factor in any premium adjustments to ensure that they continue to receive what they consider to be the correct premium for the risk in question.
To illustrate: suppose a buyer had declared a total BI value of US$1 billion to the programme for the previous 12 months. The policy wording provides for a maximum of a 30% monthly swing (upwards) and a 20% overall annual swing. Now suppose because of the COVID-19 effect, the values declared for the ensuing 12 months have reduced, to say US$500 million. The buyer must bear in mind that the 30% monthly maximum will still be applying, but annually only to 20% of US$500 million, not US$1 billion as in the previous year; the percentage allowance has therefore effectively been reduced by 50%.
We therefore continue to urge buyers to keep their BI values under constant review, as they will have to redeclare them when economic activity picks up again as the effects of COVID-19 recede during the next 12 months or so. Failure to do so may result in some very unexpected and unwanted surprises in the event of a major BI loss, as the amounts recovered from the market may well be considerably less than the amounts actually suffered by the buyer.
Furthermore, insurers are not only taking a keen interest in BI values; they are also keeping abreast of asset values as well from a Physical Damage (PD) perspective, although we suggest that buyers should not need to undergo a revaluation exercise for asset values more often than every three to five years.
As we continue to remind buyers regularly in the Review, the Downstream portfolio remains part of a much wider “heavy industry” general Property portfolio, encompassing Power, Mining, Renewables, Textiles and Steel Mills among other lines of business. Despite the improvement in the loss record, the overall Property portfolio has continued to be impacted by significant natural catastrophe losses - not least the recent Arctic freeze in Texas which, as we indicate elsewhere in this Review, may produce overall insured loss totals of anything between US$8-18 billion. Although reinsurance will compensate the direct market for much of this amount, its impact on the P&C market is likely to be profound. From a Downstream perspective, we are aware at the time of writing that several facilities were shut-in as a result of the freeze; it remains to be seen as to how many valid claims will be submitted in excess of existing BI waiting periods or PD deductibles/retentions.
The final factor driving today’s Downstream market conditions is related to all the others – the continued influence of senior management on underwriting decision making and overall strategy. We have commented in past Reviews on the increasing degree of centralisation developing in the Downstream market, with regional underwriting hubs increasingly coming under the control of a central centre of excellence; now even those centres have found that their freedom of manoeuvre continues to be restricted by senior management. Perhaps it is not so surprising that with so much of the general P&C portfolio still remaining unprofitable, the Downstream market continues to harden, despite 2020’s positive underwriting results.
So what impact have all these positive and negative developments had on overall rating levels? As in other Energy lines of business, we can detect a distinct two-tier approach developing in the market, as reflected in Figure 6 above.
Given the different positive and negative factors that we have outlined earlier, perhaps it's not so surprising that such a two-tiered market has emerged. The positive factors, including 2020’s overall underwriting result, are encouraging insurers to feel that the best business needs to be retained – sometimes at all costs - but the negative factors, including the overall unprofitability of the P&C sector, are continuing to discourage them from writing the less attractive areas of the portfolio.
It's true that insurers have always maintained that they do differentiate between good and bad business; however what we have not seen until recently is the schism between business whereby the technical rate has been achieved and that where it has not - regardless of location, Nat Cat exposure or type of asset. In the past, insurers have differentiated far more on the basis of these criteria; however, after two years of market hardening, it is now not so much that one type of asset or location is responsible for more losses and therefore needs to be addressed more vigorously than other asset types of locations. Instead, each programme is being judged more strongly on what comes down to two simple metrics above all others:
If the answers to these questions is yes, then we are seeing more modest rises being applied; if the answer remains no, then the drive to impose the draconian rating increases that we have seen over the last two years remains.
Of course, within the two tiers, there is still plenty of variation possible, and the previous criteria that we have mentioned will still come into play within the ranges identified in Figure 6 on the previous page. It’s also true that different types of asset continued to be rated differently – an LNG plant, for example, will never attract the same rates as a refinery in the same location – and the Nat Cat element amongst others continues to be an important factor in underwriter calculations. Furthermore, those programmes featuring plenty of spread of risk and premium income will continue to be looked on more favourably than others.
But what needs to be remembered is that the continuing rate of market hardening going forward. It is the new rate which will be less for those programmes where the insurers feel that the price has already been paid, whereas the new rate of increase for those programmes that are still technically inadequate will be much more significant.
This development simply supports the message we have been suggesting for some time now in this market; shopping around to get the best price at all costs is unlikely to prove to be the best strategy in the long term under these market conditions. In the event that a given programme now requires the support of more orthodox markets due to an increase in values or - more probably - the impact of a sizeable loss, such buyers are inevitably going to have to put themselves at the mercy of insurers who will most decidedly place their programme into the second of these tiers.
In contrast, those buyers who have remained loyal to their key insurers during the last two years will almost certainly be placed in the first tier, as the correct underwriting measures will have already been imposed on the programme by the existing insurers.
Our final chart (Figure 7 above) is useful from a historical perspective in that it shows how official capacity and average rating levels have interacted over nearly 30 years. It can be seen that the level of volatility in both capacity and pricing has smoothed especially during the last five years or so; the period between the demise of the 1990s soft market and the ten years following the tragic events of 9/11 were particularly turbulent. It should be noted that rating levels are still only where they were ten years ago after four years of consecutive market hardening, and nowhere near where they soared to in the immediate aftermath of 9/11 20 years ago.
Figure 7 also shows that both prices and capacity are increasing at the same time - a “false equilibrium” of price and supply. As we referenced in the Upstream market section, this does happen sometimes (for a while, at least) and reflects the degree of control that senior management currently is exerting over conventional economic laws. In light of the pandemic, Texas freeze and the unprofitability of the remainder of the P&C portfolio, it seems that this control will continue to be maintained for at least the next 12 months.
So many of these “softer” factors – management control, increased retention levels, better risk management, better data, tighter wordings, lower sub-limits and an improving loss record – have to be factored into this chart to explain what’s really happening in this market. But figure 7 chart does demonstrate that this is a much less volatile market than in the past, even if conditions are by no mean perfect from a buyer perspective. While we do think that the curve is flattening for “Tier One buyers” – and the signs are that there is potentially more capacity waiting in the wings for to compete for this part of the portfolio - unfortunately the same cannot really be said for those buyers who, for whatever reason, are still being labelled “Tier Two.”
What can buyers do to ensure that they qualify for “Tier One” treatment? As the world begins to emerge from lockdown, there is no doubt that climate risk is becoming an increasingly significant factor in insurer assessments, as well as all the other factors that we have discussed in this section. We recommend consulting with your risk intermediary on all of these issues; only when a modern, relevant strategy is in place to convince the market that they should partner with you will your company be able to reap the benefits of a long term rather than a short term risk management strategy.
Adam Barber-Murray is head of Downstream Broking, Willis Towers Watson London. Adam.Barber-Murray@WillisTowersWatson.com
Michael Buckle is Head of Downstream, Natural Resources, Willis Towers Watson London. michael.buckle@WillisTowersWatson.com
