Sustainable Energy Underwriting - Is it Achievable?

With rumours of new capital entering Lloyd’s to support the Energy market, will underwriters improve their long-term performance or will there be more pain for the providers? And how will the Corporation enforce underwriting discipline? Paul Moorshead of EMB says some assumptions will have to change. 

If the reports are true, the Lloyd’s Energy sector is heading for a mini-boom, with around four new operations preparing to launch by the end of the year. Apart from the underwriting expertise at Lime Street, the attraction doubtless includes the current high rates and a predicted return to pre-Katrina hurricane patterns. With high prices and reduced loss prospects, at least as far as catastrophes are concerned, profits are there for the making.

So much for the short-term, but look at past performance and you will see grounds for even the most gung-ho insurance executive to be cautious. Let’s be charitable for the sake of argument and ignore last year’s devastation in the Gulf of Mexico; the Energy insurance market’s record over the past decade is still covered in red ink. The new entrants, like the established players, will be expecting to see profits; not just next year, but on a consistent basis.

To quote Dominick Hoare, chairman of the IUMI Energy Committee: “Capital is looking at energy insurance and wants to see a sustainable model. The capital providers are controlling the show right now.” (Lloyd’s List, September 20).

Those words encapsulate the challenge facing underwriters and their bosses. It is also, one assumes, exercising the Franchise Performance Directorate at Lloyd’s. After all, their brief is to ensure that all active syndicates can have a reasonable expectation of making a gross underwriting profit on each of their lines of business. And then there is the FSA to consider, more of which later.

The problem is, underwriting profits do not happen just because everyone says they should. If the Energy market is to stay in the black over the long term, premiums must reflect an accurate assessment of exposure; before they can do that, underwriters must understand the risks they are accepting.

We have seen the same tendency in other classes. The more underwriters have to guess, the more they will be driven by competitive forces rather than their own calculations. When rates are hard, there is a good chance of a profit. When there is overcapacity, they will chase prices down, sometimes to suicidal levels. And when things go really wrong – as in the Gulf last year – they simply will not have factored sufficient catastrophe exposure into their pricing.

The only way to develop controlled underwriting conditions in any type of insurance is to know your risks. This, in turn, depends on data: its quality and the way it is used. Energy underwriters, like their colleagues in many other areas of commercial insurance, will say that they simply do not have the loss information they need. I would respond that it depends on how they exploit the data they already have.
A typical approach to the pricing of an Energy risk is to base this year’s price on last year’s, modifying it for any recent loss experience and market trends. This is what happens when you underwrite on a case-by-case basis.
However, it fails to take into account that every risk in this market is individual and different, and the impact of each individual rating factor needs to be understood. If you analyse the individual characteristics that go to make up the risk you can examine your loss data by individual factor.

Assume, for the purpose of this illustration, that it is a rig: Who owns the rig? What type is it? What age is it? What is the water depth? Where is it located? How would you rate the geo-political risks?

Each of these factors will help build up a picture of the expected frequency and severity of both small and large claims, including the cost of claims needed for premium setting. It will also predict the distribution of claim sizes and so assist decisions about reinsurance purchase.

This is exactly the kind of information that the Lloyd’s franchise board will require of underwriters, at least in theory. It would be interesting to know what their strategy for the Energy market is in practice. How are they assessing underwriting controls and how do they know they are effective? One of the Corporation’s Realistic Disaster Scenarios assumes a $100m Gulf of Mexico windstorm – just 1% of the total cost of Hurricane Rita.

I suspect the answer to the conundrum of sustainable underwriting might reside not at Lime Street but with the FSA. The ICA models that the regulator expects (soon likely to be replicated Europe-wide under Solvency II) require one-year capitalisation. Insurers must demonstrate that they have modelled the risks in all they do and set aside sufficient capital. The experience will be quite bracing for some underwriters.

Put simply, the new regime demands a higher level of data detail than has historically been the case. It requires information to be recorded electronically, to be easily accessible and to show policy risk characteristics, terms and conditions plus claims split by head of damage. Any insurer aware of its obligations has already begun to update its data processes along these lines, but what can be done now to satisfy regulators and capital providers that existing data is adequate?

There are two ways to make better use of what you already have. Firstly, a high-level comparison of policy and claim information allows an assessment to be made of the absolute level of expected claims and hence premiums to be charged. Then a detailed study of policy terms and sections versus premiums charged can provide an implied historical underwriting rate book to sit beneath this level. Underwriters can then adjust historically under-priced areas in a targeted fashion.

Not only does this approach lift the technical standard of pricing, it helps avoid the swinging rate changes we have seen so frequently in the past. You can expect prices in general to rise as additional capital is allocated to meet the regulators’ demands. With this new powerful information at its fingertips, and with the FSA breathing down its neck, maybe the Energy market really will find the Holy Grail of sustainable underwriting. 

This article appeared in Lloyd's List in October 2006