Energy companies and their insurers are living through one of the most challenging times in decades. But those that can best balance operational efficiency and the changing risk landscape will survive and thrive in the inevitable upturn.
Over the past year, the price of oil has remained stubbornly low; at around a third of its 2008 peak, before recovering slightly in recent months. The energy industry has responded rapidly in expectation of a prolonged period of low oil prices, which some are calling “lower for longer” or the “new normal”.
This has seen offshore oil companies and service providers adjust their business models, drastically cutting operating costs, shedding staff, squeezing contractors and slashing capital expenditure and exploration. Capital expenditure in the US fell by 36% in 2015 and by 25% through 2016, while day rates for drilling contractors have been 65% off their peak.
Coming off a boom time, oil and gas companies had plenty of excess to trim, but, by any measure, cost-cutting has been brutal, with drilling contractors and other service providers being particularly hard hit.
These changes in the offshore energy market have implications for insurers, from the risks they are asked to underwrite, to the emergence of new credit risks and challenges around risk accumulations.
Demand for offshore insurance
With the focus on cost-cutting, as well as a reduction in drilling activity, offshore insurance demand has slowed significantly. According to International Union of Marine Insurance (IUMI) statistics, offshore energy premiums, including captives and mutuals, fell 20% in 2015 to $4.5bn. And current forecasted offshore premium numbers for last year do not paint a better picture.
The number of construction projects in the market has plummeted, greatly shrinking an important source of premium income for insurers. Demand for operational insurance has also declined, as contractors have fallen on hard times.
With a reduced premium base, offshore energy insurers are likely to face increased volatility. While a reduction in drilling should benefit loss activity, the energy sector is characterized by high values and complex risks, which can still give rise to large claims.
For example, upstream incidents during 2016 included potential losses of up to $1.3bn at an installation in the Atlantic, west of Africa; $178m from a rig in North America; and around $150m from a platform incident in the Gulf of Mexico.
Cost-cutting measures can alarm insurers, who are concerned with the potential implications on maintenance levels and, subsequently, resulting claims activity. Over the past year, insurers have been worried that cost-cutting may be putting pressure on health and safety standards for some upstream energy infrastructure companies in particular. The recent experiences of South Korea’s ailing shipbuilding sector acts as a further warning. Faced with a sharp reduction in orders, Korean shipyards have been cutting costs, contributing to a spike in losses.
However, it is hoped that the need to maintain a good reputation for safety and efficiency in the offshore sector should see oil companies and contractors remain focused on maintenance.
There is a growing emphasis on companies’ financial strength and their ability to demonstrate that maintenance budgets are protected and that the most experienced people are retained.
However, as yet, there has not been an overall increase in claims frequency, and the reduction in budgets could be offset by lower levels of drilling and the need to protect reputation.
New risk challenges for insurers
The tough operating environment also presents new challenges for insurers. For example, AGCS has been working with credit insurer Euler Hermes, also a subsidiary of Allianz SE, to assess the credit risk of companies in the offshore sector, benchmarking the individual financial fundamentals with the parameters of the global oil and gas industry. This exercise should allow all our global energy clients to master one of the big new challenges for the oil and gas sector - financial risk.
The low oil price has also seen rig utilization rates fall to around 68% worldwide at the beginning of 2017 from around 90% in 2015, which means many have been put into temporary or long-term storage. With so many rigs sitting idle, this poses a different set of risks for oil companies, drilling contractors and their insurers.
Rigs are designed to be working, and will deteriorate much faster when they are not in use. This is new territory for contractors, and an area where there is little guidance. But insurers are able to conduct surveys and send out engineers to assess the quality of lay-up and advise clients accordingly.
The stacking of rigs in large numbers at a single location presents a potential accumulation risk for insurers. Rigs are being stacked in unprecedented numbers - some 350 rigs are thought to be laid-up at time of writing, often in areas exposed to hurricanes or cyclones.
Rigs once worth up to $500m each can be stacked, often just meters apart, in exposed areas in Scotland, Trinidad and elsewhere. Risk assumptions once made by insurers to review individual exposures are becoming obsolete. Natural catastrophe accumulation control (e.g. for Gulf of Mexico windstorm) becomes an almost unsolvable challenge.
Accumulation is also a potential issue with consolidation in the energy sector. Operators and contracts are looking to shed non-core assets, while some are predicting a wave of mergers as they seek efficiencies.
Managing operational efficiency and risks
For oil and gas operators, service companies and insurers alike, the focus of the “new normal” is on managing both operational efficiency and risk.
At AGCS, the focus now is on risk management, effective loss control and efficiency of underwriting processes, as well as reinsurance solutions, modeling and data to manage increasing volatility.
AGCS’ technical approach to underwriting energy risks – it has recruited specialist engineers in areas like shale gas – has proven to be sustainable. The energy insurance market has made a technical loss in three out of the four past years, but AGCS has grown profitably in the same time period.
This is still a viable industry and there are still opportunities for underwriters. Beyond technical underwriting, however, we have increased our focus on due diligence and loss prevention.
Oil companies, like insurers, have to plan for the long term. Despite the current difficult market conditions, demand for oil continues to rise with a growing global population. But the reduction in exploration is expected to eventually result in a gap in supply.
Today’s supply glut will be absorbed and demand will overtake supply.
Insurers, as a supplier to the energy industry, need to support clients, while at the same time managing a prolonged bottom of the cycle. The companies that survive the next few years, and that maintain market share, will be well placed when the market finally returns.