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Superheated commodity prices:a blessing or a curse for energy insurers?

January 2008

ENERGYMARKETREVIEW

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GMI/5871/01/08

This Review is published for the benefit of clients and prospective clients of Willis. It is intended to highlight general issues relating to the subject matter which may be of interest and does not necessarily deal with every important subject nor cover everyaspect of the subjects contained herein. If you intend to take any action or make anydecision on the basis of the content of this bulletin, you should first seek specific professional advice and verify its content. Copyright Willis 2008. All rights reserved.

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A Lloyd's Broker. Authorised and regulated by the Financial Services Authority.

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Lloyd’s Upstream Property, Control of Well and Downstream Property IncurredRatios, 1993-2007 (as at third quarter, 2007)

(Incurred ratio = earned premium v. paid and outstanding claims)

The energy insurance portfolio has always been volatile – “superheated” commodity prices serveto enhance that volatility still further.

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Incurred Ratio – Upstream PropertyIncurred Ratio – OEEIncurred Ratio – Downstream Property

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

%

Source: Lloyd’s

5871 EMR Cover FINAL_New address:Layout 1 16/01/2008 15:20

Willis Energy Market Review January 2008 1

– Loss levels in the energy insurance sector haveremained low for a second successive year.Another benign hurricane season in the Gulf ofMexico from an insurance perspective hascontributed to a second year of profitableunderwriting in the energy sector.

– As a result, capacity for most lines of energyinsurance products for 2008 is set to increase byapproximately 10-15%. We anticipate some newstart-ups in the energy sector this year, as well asincreased lines from existing markets.Furthermore, following our review in our lastissue, regional markets are increasinglychallenging London and other major internationalmarkets for business.

– Further softening in the energy insurance marketis therefore inevitable during 2008. Generally,insurers believe that this portfolio can still bewritten profitably at the moment, as rates are stillrelatively high by historical standards. Globalmarket appetite for energy business thereforeremains as robust as ever, and we believe it wouldtake a series of significant losses for current ratingtrends to be reversed.

– Despite this, there is apprehension in the market.Our title refers to the recent sharp increases in theprice of oil, steel, building materials and contractorday rates that have had a significant impact on theenergy industry risk management landscape. These“superheated” prices have resulted in increasedreplacement cost valuations and provided extrascope for longer and costlier delays in the event of anaccident. Most insurers are aware that many valuesdeclared to a significant number of programmeshave not been reviewed during the last twelvemonths. This is not only preventing them fromreceiving an appropriate premium for the risk butalso effectively making them retain more exposurein the primary area of the risk spectrum.

– The potential for more expensive losses in theenergy sector has therefore been enhanced.Furthermore, the energy industry continues tooperate at full tilt; existing infrastructure is beingpushed to its limit, project activity is at recordlevels and energy companies are increasinglyinvesting in hostile terrains, often deploying new,untested technology.

– Meanwhile, insurers’ focus is on maintainingpremium income in this softening ratingenvironment. Those valuations that have beenreviewed, increased and subsequently declared to the energy insurance market have resulted inpremium income levels being maintained, therebyallowing insurers to fulfil premium income targetsand provide them with the potential to maintainthe profitability ratios of the last two years.However, this has been at the expense of a greaterexposure to risk at a time when direct insurers are generally transferring less risk to thereinsurance market.

– For clients, this means that energy insuranceproducts now provide better value for money thanat any time since 9/11. However, for insurers itraises the question of how exposed they really areto the enhanced volatility of the energy riskenvironment. For brokers, the task as ever is tobring buyer and insurer agendas together and tryand establish a more sustainable valuation ofinsurable risk.

IN THIS ISSUE…


Foreword – Phillip Ellis, Chairman, Willis Energy 4

Superheated commodity prices: a blessing or a curse for energy insurers? 6

Reinsurance 24

Upstream 26

Downstream 36

OIL Update 44

Construction 47

International Liabilities 50

US Excess Liabilities 57

Terrorism 60

D&O 65

CONTENTS

4 Willis Energy Market Review June 2007

FOREWORD


It seems we are always in a period of rapid change when it’s timeto write the foreword to our Energy Market Review, and as aresult I’m compelled to use an ‘on the one hand – on the otherhand’ approach. But this is really an illusion, because we are in atime of continuous rapid change in the energy insurance industry,and people who are absolutely sure about what the future holdsare probably spending too much time with their clairvoyant.

Today is no different; in fact, we may be at our most challengingtime ever in terms of articulating what the next six months hold for us. Our title theme is clearly not referring to prices being quotedby offshore and onshore underwriters. We are in a very soft andsoftening market; the fact that everyone says so may raise somedoubts for the contrarians among us but, as our analysis shows,prices are down, losses are at record lows, and markets are stillprofitable even as capacity is being added to important lines. Ourtitle refers instead to the superheated prices of our clients’ mainproducts and for the commodities, materials and people theyrequire to expand their businesses. These prices have driven upasset values which in turn have been an important factor in holdingoff a complete property insurance price collapse.

It is pretty clear that declared values for insurance purposes arestill shrinking as a proportion of realistic replacement values,which is not good for our industry. Clients are retaining more risk,due to their ample cash flows and also to their growing confidencethat low loss levels are the norm. In fact, neither condition isassured. We appear to be headed into a global financial crisis that‘has legs’, as our Chairman Joe Plumeri puts it. And this crisis isvery likely to affect global economic activity. As this situationunfolds, oil prices are very likely to fall; the only question is by howmuch. In this event, client cash flows will decline from the recordlevels of recent years. Insured losses have been minimal for twoyears now; a third year might suggest that our clients really areoperating their assets in ways that are far superior to the past.However, while this is no doubt true for some companies, forothers the run of good luck is just that. It is very hard for us toaccept that this run of low loss activity will continue indefinitely.Ultimately, something will break.

So here we are at another turning point. We can only hope for a‘Goldilocks’ future in which oil and commodity prices decline tolevels that are ‘just right’ to guarantee continued levels of highinvestment and returns for our clients while taking some of thepressure off of their supply chains. For brokers and underwriters,this ideal future would include more demand for our productsand services as our clients assess the changes in their exposure to risk brought about by these commodity price increases. Asever, it is up to us to innovate and improve our offerings to suchan extent that our clients’ appetite for them continues to grow.

Phillip EllisChairman, Willis Energy


SUPERHEATEDCOMMODITYPRICES:A BLESSING OR A CURSE FOR ENERGYINSURERS?

Back to the seventies – who remembers inflation?


That is, until now. Although overall globalinflation rates remain low compared tothirty years ago, recent steep increases in theprice of oil, steel and other commodities overthe course of the last five years or so, and theconsequent knock-on effect of these onrefining and E&P costs, are already having asignificant inflationary impact on the energyindustry risk management landscape.

In this article, we will examine:– The commodities whose “superheated”

price increases have had most impact – How those commodity prices have

affected potential downtime exposuresand asset valuations

– Whether they should be regarded as a“blessing” or a “curse” by the energyinsurance market

In conducting our research for this article,we spoke to several leading energyinsurers from the London energy marketas well as two well-known figures from the recruitment world. They are:

– Stanley Cochrane, Head of OnshoreProperty, Swiss Re

– Michael Cripps, Managing Director,Cripps Sears & Partners

– Paul Dawson, Energy Underwriter,Beazley plc

– Andrew Eliot, Director, Eliot Partnership– Roger Giddings, Head of Global

Energy, ACE-INA– Michael Gosselin, Senior Vice

President, Marine, Energy &Construction, Liberty InternationalUnderwriters

– Colm Kelly, Sector Head, Oil, Gas andPetrochemicals, Infrassure

Some of their observations are quoted onthe following pages. We would like to thankthem for their time and the benefit of theirexpertise. However, apart from whenquoted directly, the views expressed in thisarticle represent Willis’ own conclusions as a result of our research and should be inno way specifically attributable to anyindividual member of the panel.

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Level at which Willis estimates that today’s project activity remains generally economically viable

Superheated Prices: Current TrendsOIL

Cushing, OK WTI Spot Price FOB (Dollars per Barrel) 2002-2007

Oil prices have doubled in less than three years – and are unlikely to return to pre-2005 levels inthe future.

Source: Cushing

8 Willis Energy Market Review January 2008

The price of crude oil is now at an all timehigh, due essentially to unexpectedly high demand from emerging economies at a time when global supply is fragile.Many experts now fear that supply willcontinue to struggle to match projectedfuture demand, and so the era ofrelatively high oil prices – i.e. anythingfrom US$ 60 per barrel upwards – is pretty much here to stay.

Most experts would agree that if prices doindeed stay above US$ 60 per barrel, thenthe recent upswing in project developmentactivity in the energy industry will not only continue but may actually increase as more and more fields hithertoconsidered marginal (due to high liftingcosts occasioned by extreme water depthsand inhospitable terrains) become a viable proposition for oil companies.

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US$/tonne

Steel, Concrete and Cement

Carbon Steel Prices, 2002-2007

Source: Datastream Database

Steel prices have doubled in less than four years, with serious knock-on effects on the replacementcost valuations of energy industry infrastructure.

Although prices took a dip during 2005, our chart also shows the cost of steel ashaving increased threefold over the last fiveyears. As a raw material for the energyindustry, this steel price rise naturallyincreases the replacement cost value ofplants, platforms, rigs, pipelines and otherindustry infrastructure, and escalates theoverall contract values of new projects.

As if rises in the price of steel were notenough, significantly increased demand for building materials such as concrete and cement from the emerging economiesof China, India and Brazil has alsoescalated these materials to substantiallyincreased levels.


Contractor CostsThe high oil price (together with the desireto replace pumped reserves and developsecurity of supply) has resulted in greaterexploration and production activity.

Drilling contractor day rates haveskyrocketed as a result of increaseddemand. This has particularly been thecase for semi-submersible rigs, as deeper,more challenging activity is undertaken.

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Annual average day rates for semi submersibles, 2002-07

Semi-submersible day rates have quadrupled in less than three years, increasing the potentialcost of redrilling wells following a blowout as well as loss of hire amounts.

Existing infrastructure pushed tothe limitThe first and most obvious impact of therise in oil prices has been on the expansionof both upstream and downstream energyindustry activity. On the upstream side, rig utilisation rates are now running at100% in several areas and fabrication yardsare full to bursting with new orders for rigsand production infrastructure. On thedownstream side, existing refinery capacityis being pushed to its limit - according tothe BP Statistical Review of World Energy2007, during 2006, global utilization ratesreached the mid 80%s (with some parts ofthe world pushing into the 90%s) whilerecord margins of nearly US$ 19 per barrelwere reached earlier in that year.

Project activity at record levelsMeanwhile pressure is mounting on bothIndependent Oil Companies (IOCs) andNational Oil Companies (NOCs) to feedthe ever-increasing global demand. Theresult has been a dramatic increase in new projects worldwide, particularly inkey areas such as the Middle East, as the charts outlined on the following pages explain.

Superheated Prices: Impact on Energy Industry

Source: ODS


Total Number of Ethylene expansions excess of 100,000 tonnes per year,2003-06

The Middle East and North East Asia account for the majority of ethylene expansions in recent years.

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aisA tsaE htroNtsaE elddiMdlroW fo tseR

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Planned new refineries (primary distillation capacity)

Participants Capacity Probable(‘000 b/d) completion

Europe and EurasiaRussiaNizhnekamsk* Tatneft 140 2008

TurkeyCeyhan Calik / Indian Oil 300 2012Ceyhan Petrol Ofisi / OMV 200 2012Ceyhan Turcas / Socar 200-400 P

AfricaAlgeriaTiaret Sonatrach / Partner 300 P

AngolaLobito Sonangol 120 ˆ 2010

EgyptAin el-Sukhna EGPC / Kuwait interests 100 2012Kafr el-Sheikh Noor 350 2012

NigeriaSouth

ONGC / Mittal 200 PSudanPort Sudan State / Petronas 100 2010

TunisiaLa Skhira QP / Petrofac 150 2011

Source: CAMI


Participants Capacity Probable(‘000 b/d) completion

Middle EastAbu DhabiRuwais Adnoc 250-300 2012IranAbadan NIORDC 180 2011Bandar Abbas NIORDC 360 ˇ 2010Bandar Abbas NIORDC 300 2011

KuwaitAl-Zour KNPC 615 2011

LebanonTripoli / Zahraani QP 150-200 2012

OmanAl-Duqm Oman Oil 300 2012

QatarRas Laffan QP / ExxonMobil / Total / 146 ˇ 2008

Japanese firms

Saudi ArabiaJazan State / Partner 400 ˇ PJubail Aramco / Total 400 2011Ras Tanura Aramco / Partner 400 2011Yanbu Aramco / ConocoPhillips 400 2011SyriaDeir al-Zour State / Noor 140 P

UAEFujairah Ipic 500 P

Asia-PacificChinaGuangzhou (Guangdong) Sinopec / KPC 300 PHuizhou (Guangdong) CNOOC 240 2008Pengzhou (Sichuan) PetroChina 200 2010Qingdao (Shandong) Sinopec / Partner 200 2009

IndiaBhatinda Hindustan 180 2010Bina Bharat 120 2010Paradip IOC 300 2011

IndonesiaSelayar (Sulwesi) Hemoco Selayar 250 2011

(Kuwait / Indonesian interests)

North AmericaUSUnion County (South Dakota) Hyperion Resources 400 PYuma (Arizona) Arizona Clean Fuels 150 2012

South and Central AmericaBrazilRio de Janeiro Petrobras / Ultra 150 2012Suape Petrobras / PdV 200 2012

PanamaLocation undecided QP / Occidental / State 350 P

P Planned, start-up date uncertain.* To reach capacity in 2010.ˆ To double to 240,000 b/d subsequently. ˇ Condensate refinery. ~ Up to 400,000 b/d.

Source: Petroleum Economist


Increased operations in newtechnology and new terrainsA major challenge for IOCs now lies in meeting increased demand forhydrocarbons from the world’s emerging economies. Generally,

IOC supply is not distributed effectivelywithin these economies, given that inthese areas much of their hydrocarbonreserves continue to remain under the control of national governments (see chart below).

Europe (non-FSU)

FSU

N. America

Africa

Middle East

Latin America

Asia/Pacific

1.74%

2.52%

56.01%

8.72%

6.94%

15.23%

8.80%

IOCs therefore have to look elsewhere intheir efforts to meet production targets andmatch global demand. They need to findand secure reserves in hostile geophysicalenvironments, such as offshore locationsfeaturing deeper water depths andinhospitable terrains. Examples include the Arctic and the ultra deep waters in theGulf of Mexico, the Campos Basin offshoreBrazil and the Gulf of Guinea offshoreNigeria. IOCs have also been developing

complimentary energy sources such asLNG, tar sands, ethanol and coal to liquids,as well as developing new forms of oilrecovery techniques.

Most of these developments are likely to have involved the deployment of new,untried and untested technologies, at atime when the pressure to maximiseproduction levels is greater than ever.

Regional share of worldwide crude oil reserves, 2006

Source: BP Statistical Review of World Energy, DeGolyer & MacNaughton/OGJ

Most of the world’s oil reserves are in the hands of NOCs -making it harder for IOCs to matchprojected demand.


Increased project and replacementcost valuationsThe increase in commodity prices,especially steel and concrete, hasnaturally had a knock-on effect on thecalculation of the replacement cost ofassets in the energy sector. The upstreaminsurance market has been struck by thesignificant escalation in the values of keyassets, notably in the Norwegian sector of the North Sea, which have once againbegun to test the capacity of thecommercial insurance market.

Some insurers have commented that theyhave noticed in some submissions that thevalues they receive appear to be low, giveninsurers’ knowledge of existing values atsimilar facilities (a natural tendency forunderwriters to protect these interestswould be by means of an average clause).It is perfectly possible that someinsurance buyers may have been taken bysurprise by the effect of the superheatedprices described earlier, and it may well bedifficult to take all of these into accountwhen buyers are going through their

valuation exercises. In particular,although most buyers have realised thatBI values have gone up following the oilprice rise, it may have taken some of thema little longer to realise that increases inthe price of steel, nickel, electricity pricesand the services of specialist contractingcompanies would have such a dramaticeffect on the replacement cost value oftheir assets.

As far as new projects are concerned,building costs have also increaseddramatically, due in no small measure to the scarcity of available buildingcontractors. Swiss Re has recentlypublished a paper (Energy ConstructionBoom – a Paradigm Shift for Insurers,available for download on their websitewww.swisre.com) that shows howupstream capital costs in key regions suchas the Middle East, Europe and NorthAmerica have doubled over the course of the last three years or so.

Ultra deep water (>1,500 metres)

Deep water (>1,500 metres)

Shallow water (0-300 metres)

Onshore

Production2.054m boe/d

Proved Reserves (SPE)13.75bn boe

Exploratory Area152,800 square km

“The mostimportant thing is that thepeople considerdoing thesevaluations morefrequently thanin the past. I would sayprobably everythree to fiveyears wouldhave beennormal, butthat was in atime whencosts were notmoving up sorapidly. Now it should be an annualexercise”.

Stanley Cochrane

Brazil – reserves and production compared with water depth, 2006

Source: Petrobras/World Petroleum Council Yearbook

Future oil production offshore Brazil is likely to be from much deeper water in the future.


Potential for longer and costlier delaysOil and commodity price rises havedramatically increased the potential formore frequent and severe BusinessInterruption losses.

From the information available it wouldappear that there is a much greaterpotential for both upstream anddownstream operations to be disrupted(following even a minor physical damageloss) for periods in excess of two years. This is due to the chronic global shortage ofshipyards, contractors and skilled labour.

Drilling contractors are now facing themore serious issue of lead time for replacingcritical items of equipment. In the case ofblow out preventers and risers it now takesanywhere from 18 months to 24 months tosecure replacements from manufacturers.

With semi submersible rig hire costs in theGulf of Mexico now averaging US$ 400,000to US$ 500,000 per day, should a rig be laidup for two years, a contractor may now beexposed to a loss of hire amount of betweenUS$ 288 million and US$ 360 million in theevent of damage to a critical item of rigequipment. With rig utilisation rates closeto 100%, the knock-on effects of a rig out ofcommission to a project could becatastrophic – and may even result in itscancellation.

On the downstream side, the problems of skill shortages and lack of availability of contractors are very similar. The timerequired to acquire specialist pieces ofequipment, materials and technicians toinstall them is much longer because of thecurrent backlog of projects. For example,the replacement of a wet gas compressorwill now take significantly longer than theprevious norm of nine months.

This raises the issue of whether buyers’periods of indemnity are actually sufficientto cover the extended time required toeffect repairs.

Whereas 24 months has generally beenregarded in the past as an appropriatemaximum period within which facilitiescan restart following a physical damageloss, buyers are now estimating that this period is frequently 36 months and often now as high as 48 months. In a very few recent cases, even 60months indemnity has been required by energy companies.

Implications for Risk ManagersClearly, the implication of all thesedevelopments for energy Risk Managers is that the potential for both physicaldamage and business interruption losses –both in terms of frequency and severity –has significantly escalated over the courseof the last few years. Few would suggestthat energy companies are likely to buy less insurance as a result of thesedevelopments, and it will be vital for them to be aware of the extent to whichinsurance will be able to help them tomanage their increased exposures in the future.

But what of insurers? After all, energycompany exposure to increased risk is what they are in business to protect, and increased demand for their productshould be welcome following thecompetition generated by the growth of captive and mutual participation onenergy programmes, not to mention therecent softening market conditions. But in reality will they regard thesedevelopments as a blessing or as a curse?Is the market really prepared for theincreased exposures that it is taking onat this stage in the market cycle?

“When you have to employ20-25,000contractors tobuild a world-scale facilitythese days, the logisticsand resourcesinvolved in that process isincreasing theexposure onevery insurancepolicy in theMiddle East.”

Michael Gosselin

“One observation that we have made is that rebuild times have moved out significantly in recent times, it might now well be the case that anaverage rebuild time is 36 months, whilst the average indemnity period forBI policies purchased may be 24 months. This raises the question as towhether there is adequate insurance purchased or perhaps even availablein the market and also suggesting perhaps under-insurance of the risk.”

Roger Giddings“It’s not as if thesecontractors just havenothing to do,they are tied up in majordevelopmentsaround theworld whetherit’s in the oilsands or newrefineries in the MiddleEast, Asia orwherever. Theskill base is tied up there so this willcause delays to the overallreplace andrepair process,which justenhances theclaims value.”

Stanley Cochrane


A Blessing?...

Increased valuations allows this market to fulfil premium income targetsin a softening rating environmentThe natural corollary to buyer demands for increased policy limits and offshoreconstruction coverage is an increase in premium income and a further transfer of risk to the energy insurance market.

Lloyd’s Energy Audit Codes premium income in 2006 £: 1996 versus 2006

In real terms, Lloyd’s energy premium income levels are considerably higher than at the start ofthe last major soft market of the 1990s – particularly for upstream property.

Upstream Property (ET)

1996

2006

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Downstream Property (EF) OEE (EW)

The chart above shows the full extent ofthe changes in the Lloyd’s energy marketdynamics, particularly in the upstreamsector, during the course of the last tenyears. In real terms, premium income forupstream property- Lloyd’s ET audit code– has increased by more than three times,largely due of course to rating increasesbrought about to redress thepremium/claims imbalance followinghurricanes Ivan, Katrina and Rita, andincreased project activity.

As we have pointed out in our introductionto this review, the last two years have beenremarkably benign from a loss perspectiveand following these two highly profitableyears, capital providers and underwriting

managers are keen to see existing energyportfolio premium levels maintained.Furthermore, those insurers who havepurchased reinsurance protection have aclear need to cover their costs.

However, energy underwriters are findingthat achieving this objective is becomingincreasingly challenging. The softeningrating environment, brought about by over supply of capacity, is now taking itsown toll on individual insurers signings as they fight for favourable programmes.Increased replacement cost valuations and Business Interruption indemnitiestherefore relieves some of the pressures ofa softening rating environment and helpsinsurers to maintain premium income.

“The energymarket is nowreally tight,and gettingrepairs effectedis going to bevery difficult.It’s going to bemore difficultto get hold of avessel to makerepairs, andyard spacethroughout theworld is in veryshort supply.”

Paul Dawson

“When you startrunning out ofcontractors you have got to question thequality of theones that arebeing picked upto do those lastminute jobs.There are moreand moresubcontractorsappearing thatonly get namedwith a bit moreprobing by theunderwriter, and when youdo a bit ofinvestigationinto thesecontractors youhave to questionjust how muchexperience they have in the oilfield.”

Colm Kelly

Source: Lloyd’s/Willis Energy Loss Database


Increased valuations are supporting the continued profitability of the energy portfolio

Energy insurer capacities and average rating levels, 1993-2008(excluding Gulf of Mexico Windstorm)

In general, rates for energy insurance business are back where they were just before 9/11 – butnowhere near where they were during the last soft market.

Offshore CapacitiesOnshore CapacitiesAverage Composite Percentage of 1992 rates

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Estimated AverageRate Index

(1992=100)

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 (forecast)

In a historical context, the chart aboveshows that even the softer rates that themarket is currently experiencing are higherthan they were during the last truly softmarket of the late 1990s. This factor, coupledwith the maintenance of retention levels,

sub-limits and other policy conditions,should provide a more stable underwritingenvironment in the future, with moreconsistent results and less of the volatilityexperienced by the market during the years 1996-2002.

Major Energy Losses to Date, 2007 (US$, excess US$ 1 million)

Downstream

Cause Location Country PD BI TotalFire/lightning/explosion Texas USA 50,000,000 200,000,000 250,000,000Flood Coffeyville, Kansas USA 75,000,000 125,000,000 200,000,000[unknown] Al-Jubail Saudi 25,000,000 175,000,000 200,000,000

ArabiaFire/lightning/explosion Mississippi USA 200,000,000 200,000,000Corrosion Texas USA 7,000,000 143,000,000 150,000,000Mechanical failure Ancash Province Peru 1,000,000 85,000,000 86,000,000Fire/lightning/explosion Sharjah UAE 81,000,000 81,000,000Fire/lightning/explosion Volgograd Russia 55,000,000 55,000,000

Source: Willis

“If you take ahypotheticalsituation of anE&P operation at 100,000 B/D at US$ 100/bbl that’s US$ 10m/day. 60 daysdowntimeequates to US$ 600 million– but to whom is that acatastrophicloss? The insuredis losing US$600 million, butfor the rest of the year he is making US$ 2.5-3 billionfrom that sameoperation – losingUS$ 600 millionout of US$ 3 billion is by no meanscatastrophic tothat company.And that’s justlooking at thatone location. Such a loss willcertainly have a bigger impacton the insurancemarket.”

Colm Kelly


Upstream

Type Cause Location Country PD OEE BI TotalWell Blowout Louisiana USA 80,000,000 80,000,000Platform Fire/lightning/ Haut Mer Congo 50,000,000 17,500,000 67,500,000

explosionWell Blowout Louisiana USA 52,000,000 52,000,000Well Blowout Gulf of Mexico USA 33,000,000 33,000,000Rig Grounding Gulf of Mexico USA 24,000,000 6,500,000 30,500,000Pipeline Mechanical North Sea Netherlands 26,000,000 26,000,000

failure

As we have already noted, 2007 has to datereplicated the remarkably benign 2006 and the Willis Energy Loss database hasrecorded only five losses to date in excess ofUS$ 100 million. There can be little doubtthat the reduction in attritional loss activitycan be put down to the increased retentionlevels imposed originally in the wake of thedisastrous underwriting years of 1997-2001.There are certainly grounds for marketoptimism; regardless of how the laws ofsupply and demand may affect rating levels,retention levels have stood firm forvirtually all lines of energy coverage.

Increased commodity prices shoulddirectly increase the volatility of the energy portfolio– but today’s market is less exposed tocommodity risk than in the pastMuch has been made in recent years of theincreasing sophistication of the energyinsurance market. As we have documentedin previous editions of this Review, lessonsfrom previous eras have well and truly beenabsorbed and the likelihood of a singleinsurer breaking ranks to offer markedlydifferent terms from its competitorsremains remote. Underwriting modelshave been redefined, the Lloyd’s FranchiseBoard has insisted on viable business plansand insurers have never been more awareof the details of the risks they are currentlytaking on board. There is little doubt thatthere is a greater focus by underwritingmanagers on risk selection as well as pricemonitoring. Additionally they are focusingmore on engineering expertise as well as onbusiness interruption and contingentbusiness interruption exposures in theirefforts to strive for a fair division of riskallocation between buyer and insurer.Other markets are continuing to developtheir own in-house engineering expertise.

Several have undergone intensiveassessments on the values that they aregiven from their clients and have swiftlycontacted them when the valuations haveappeared to be incorrect. On the BusinessInterruption side, some key insurers havealso conducted extensive researchexamining the margins in different partsof the world, and there is certainly more in the way of client-underwriter dialogueon this issue as well.

This has certainly proved to be the casewith regard to the commodity risk aspect of offshore loss of production income cover(LOPI). It has now become commonlyaccepted in the upstream market that withthe sudden upswing in crude oil pricestowards their current levels it has becomeall but impossible to truly understand andrate the risk of such an upswing, and mostupstream insurers take the view that theyare not commodity market speculators.One can perhaps sympathise with thisview; how should they be in a position tocomprehend the effect of spot pricemovements given that they are providedwith only one opportunity every year (atrenewal) to price the product?. Insurersare clearly much happier to absorbcatastrophe rather than commodity risk.

So market optimists are hopeful that theynow have the ability and the tools tomanage their exposure to the enhancedrisks posed by superheated commodityprices and generate a profitable portfolio.But will their grounds for optimism stand the test of the long term?

“Buyers want a product thatwill give themshort termworking cashflowrecovery. Whatthe underwritersreally want toprovide is longerterm cashflowimpact, maybewhere there is a verysignificant lossevent whichresults in asignificantdeferment ofcashflow.”

Paul Dawson

“There is a goodprobability thathigh commodityprices are hereto stay for some time. Thisprovides greatersecurity to ourInsureds whenthey invest.Ultimately weall benefit when we andour customersare able to plan with alonger termperspective.”

Paul Dawson


Or a Curse…

Higher oil prices, new technologiesand engineering skills shortagescorrelate to higher loss frequencyand severity probabilitiesNo matter how reassuring the argumentsof the optimists in the market may be,there can be little doubt that there remainsmuch about the changed risk profile of the energy industry that still leaves plentyof scope for market apprehension.

As one member of our panel reminded us,you cannot underwrite what you cannotmeasure or quantify. When energycompanies are operating in remotelocations using new technology in waterdepths of 20,000 feet and more, itbecomes virtually impossible to establishand identify the actual probability of thenumber and perhaps more importantly the severity of any losses.

It should of course be pointed out thatupstream energy insurers have alwaysbeen prepared to break new ground andoffer cover for operations using new and untried technology. However, thedeployment of new technology isoccurring at a time when there is now a chronic shortage of skilled labour tooversee the new operations.

The reasons why there has not beensufficient natural replacement from theuniversities and through the industry aretwofold. Following the oil price crash in1986, the oil companies generally stoppedinvesting in graduate engineers, andsupporting institutions to develop suchpeople. At the same time young people lost confidence in taking an engineeringdegree and going into the energy industry,due to the shortages of jobs on offer. This happened across the world as rockbottom oil prices affected everyone,particularly in western investing countries. So suddenly a number of yearslater the energy industry has an alarminggap of engineers with good experience.

Now that the oil price has risen to itscurrent stratospheric level, the demand for such skilled and experienced engineers

has naturally increased accordingly. Thecontrast with 15 years ago is stark – at thattime oil companies would have had anengineer involved with a given project from its inception, running with it throughthe construction for that project up tomaybe four years into the operationalcycle. Today, the challenge for energycompanies is finding those engineers withspecific experience who are willing tocommit to such lengths of time in a highlycompetitive marketplace.

Increased values mean thedownstream energy insurancemarket has become more “firstloss” in nature and is not attracting sufficient premium to fund future lossesIt has been some time now since full value policies have been seen in thedownstream energy insurance market.Because policies are loss limited, it is notuncommon for the Estimated MaximumLosses (EMLs) of major energy risks toexceed, or certainly run very close to, the policy limits purchased.

The effect of introducing increased BIexposures into a combined policy limit is clearly to accelerate the speed at whicha loss can reach its limit. Although thereare techniques available to mitigate andbalance this effect in underwritingportfolios, generally speaking the marketeschews them, in order to write ameaningful share of an attractive risk. As values rise, so should retention levelsin order for what insurers consider to be the correct balance of risk retainedversus risk transferred to be maintained.

As ever in a softening market, thereremains the temptation for insurers totake a large share of a loss limited policy.This makes the task of balancing theportfolio that much harder, because theeffective result of increased plant andbusiness interruption values is that thedownstream book has become one ofextreme severity. The adequacy of ratingis much harder to test when overall policylimits are maintained as the marketeffectively becomes one of “first loss”. As such, this will almost certainly lead

“Worldwidethere is a greatshortage ofengineers and I think you willhave seen itreported thatthe average age of an energyexperiencedengineerworldwide is 45 and in the US 50.”

Mike Cripps

“Upfrontpayments toengineers tojoin oilcompanies and retentionbonuses arefairly normalnow. It’sunbelievable,that wasinvestmentbanking tenyears ago, now it’s the oil industry.”

Mike Cripps


eventually to an inadequacy of risktransfer premium.

This inadequacy is of course exacerbatedby softening market conditions. Despitethe benign loss record of the last twoyears, there is nothing to suggest thatcatastrophe losses will not continue tohappen. Meanwhile existing facilities,particularly in the United Sates, aregetting older, and in the wake of therecent Texas City loss the focus has beendirected towards personal safety andrisk-based inspections rather thanmaterial integrity. But given a relativelymature industry such as the US Refiningand Marketing industry, perhaps thefocus should still be sufficiently directedtowards maintenance and inspection,rather than less.

In the United States, no new refinerieshave been built over the last 30 years, andin the wake of the recent oil price rises, we have seen that demand is such thatexisting infrastructure is operating at near capacity levels.

This scenario is one that inevitably iscausing some anxiety in the market and there are now real fears within thedownstream underwriting communitythat when losses do occur, they willcertainly be much more severe.

Increased values mean thevolatility of the BI portfolio hasincreased still furtherEven those underwriters who writebusiness interruption insurance sometimesconcede that the market doesn’t alwaysdetermine an accurate and fair premium forthe exposure that they take on. Over the last10-15 years, insurer sources estimate that BI losses – whether insured or uninsured -have generally outstripped PD losses to themarket by a factor of approximately three to one. These sources have also indicated to us that one major recent incident in theMiddle East, which resulted in a physicaldamage loss of approximately US$ 100million, would have also resulted in a claimfor business interruption of between US$ 500 million and US$ 600 million hadthis exposure been insured.

However, if the historical premiumrelationship between BI and PD isexamined, BI premium constitutes aboutone third of the premium attributable toPD exposures. From our conversationswith insurers we have determined thatthere have been some historical reasonsfor this anomaly. One of these reasons isthat when BI adjustments are due onpremiums payable at inception, the BIvalue tends to be the one that fluctuatesthe most. So there is a tendency in themarket to allocate a higher proportion of the premium at inception to the PDexposure, which means, since this part of the portfolio is generally regarded asbeing more stable, that underwriters areless likely to have to return as much oftheir deposit premium income.

Clearly when one looks at the statistics,the PD element of the energy portfolio has been subsidising the BI element. At a time when margins were quite small this was regarded by the market as beingquite sustainable but now that margins on the BI side are approximately fivefoldwhat they were just five years ago on the E&P side – and significantly greater in the refining sector – there is now aserious imbalance.

Given that a large segment of the clientbase continue to purchase businessinterruption insurance for the traditionaltwenty four months indemnity, thisdevelopment reinforces energy marketperceptions that they are becomingincreasingly a market of “first loss” – andfrom an actuarial perspective are thereforeperhaps not receiving sufficient premiumfor the actual exposure incurred. From anunderwriting perspective, this problem isof course exacerbated further by today’ssoftening market conditions.

“A lot of ourclients areunder-insuredright now, they are notlooking at a36-48 monthdowntime, theyare only buyingfor 24 months,so we are afirst lossmarket – a verybig first lossbut a typicalEML now for a world-scalerefiningcomplex is US$ 3.5 billionwhen it used to be maybe US$ 2 billion afew years agoso it’s a hugeswing.”

Michael Gosselin

“The adequacyof rating isharder to test when “first lossing”occurs, and will eventually lead to aninadequacy ofrisk transferpremium.”

Roger Giddings


The trouble with BI – WELD recorded major plant incidents where BI lossesoutstrip PD losses, 2000-07

Year Cause Location Country PD/LIAB BIActual US$ Actual US$

2005 Fire/lightning/explosion Alberta Canada 187,000,000 1,280,000,000

2005 Windstorm Texas USA 32,551,000 147,166,000

2007 Flood Coffeyville, Kansas USA 75,000,000 113,000,000

2007 Fire/lightning/explosion Texas USA 50,000,000 100,000,000

2001 Fire/lightning/explosion California USA 26,000,000 73,000,000

2000 Mechanical failure Guangdong Province China 20,000,000 70,000,000

2005 Windstorm Louisiana USA 30,000,000 60,000,000

2001 Fire/lightning/explosion Louisiana USA 21,737,000 60,000,000

2004 Fire/lightning/explosion Haifa Israel 5,000,000 75,000,000

2005 Design/workmanship Cumbria UK 3,000,000 75,000,000

2000 Fire/lightning/explosion Le Havre France 20,736,550 46,398,403

2006 Fire/lightning/explosion Oklahoma USA 20,000,000 41,000,000

2003 Flood Michigan USA 0 60,341,500

2000 Mechanical failure Alberta Canada 10,358,000 42,500,000

2001 Fire/lightning/explosion Illinois USA 4,600,000 46,400,000

2001 Fire/lightning/explosion La Rabida Spain 10,200,000 35,000,000

2004 Design/workmanship Quebec Canada 4,000,000 39,076,277

2004 Design/workmanship Cumbria UK 6,000,000 35,500,000

2002 Mechanical failure St. Croix Virgin Islands 10,000,000 30,000,000(USA)

2000 Mechanical failure Queensland Australia 3,989,272 35,762,130

2006 Mechanical failure Point Lisas Trinidad 7,000,000 31,000,000

2000 Mechanical failure Sicily Italy 4,828,871 29,747,917

2005 Windstorm Mississippi USA 5,600,000 25,000,000

2004 Mechanical failure Vlissingen Netherlands 6,197,681 20,614,087

2000 Design/workmanship Stenungsund Sweden 2,891,000 23,000,000

2003 Flood Michigan USA 0 22,010,000

Source: Willis Energy Loss Database

“BI is theunderwritingchallenge in balancing a portfolio ofdownstreamenergy risksand it probablyapplies to allspecialty riskswhere largevalues and BI is involved. BI changes thedynamic of theloss activity;sometimes inthe past wehave likened the effect ofwriting BI topiling dynamitearound a highquality propertyrisk.”

Roger Giddings

“The oil and gas downstream line of business is already a first loss exposurebase, because generally policies are loss limited, and so it’s not uncommonfor the EMLs of major energy risks to exceed or certainly run very close to the limits purchased so often there isn’t much redundancy in the limit and in some cases it’s none at all. The effect of introducing BI exposures intothat limit is to accelerate the speed at which a loss can reach its limit.”

Roger Giddings


So what should insurers do about it?We believe that insurers should investmore in:– Recruitment– Training– Improving their skill base in terms

of engineering, legal and underwritingresources

We have already referred to the quality ofthe present generation of underwriterswho make up the energy insurance market.However, several of our underwriting panelacknowledge that the strength in depth ofunderwriting teams is less than it was inthe past, and many underwriting firms donot run what might be called a “deepbench”. The main reason for this may wellbe that the long period of weak market inthe 1990s coincided with a period when ageneration of underwriters was reachingthe end of their careers and beginning toleave the market. This factor, coupled with a period of intense acquisition andmerger activity amongst the broking andunderwriting communities, resulted in thepopulation of qualified underwriters in theenergy sector declining a little too fast tomeet broker and client requirements.

Another contributing factor has been thatthe resources available in terms of bothmoney and time and skill for training isless than it was, whilst time that was onceavailable for mentoring and training in thepast could perhaps be being directed moretowards compliance and regulatory duediligence as opposed to risk assessmentdue diligence.

As a result, recruitment consultants tell us that there is an increasing demand fortechnically adept junior underwriting andback office staff in the London market,with professionals offering legal andactuarial skills particularly in demand.More emphasis is being placed on postgraduate qualifications such as the FCIIand the MBA, and those with the ability,experience and qualifications to handlecomplex claims are now being particularlyhighly valued.

Conclusion: a mixed blessing, at best…

The reality at the beginning of 2008 is thatthe market is facing significantly increasedexposures as a result of steeper commodityprices - at a time of increasingly softmarket conditions. Despite two profitableunderwriting years, is the market reallyprepared for more expensive future lossesthat must inevitably result in the long termfrom these developments?

There can be no doubt that individualenergy underwriters are fully aware of the changed risk landscape in the energysector and that they are not gettingsufficient premium income to underwritethese exposures effectively. The difficultythat many – but by no means all – of them face is that their organizations arecommitted to the energy portfolio astreaty reinsurance protection for 2008 has already been purchased. As a result,they are committed to generate sufficientdirect market premium to pay for thisprotection. So despite everything, the good news for buyers is that they will becompeting vigorously for premium income and market share during 2008.

During the course of this decade, theenergy insurance market has considerablystrengthened its ability to withstandcatastrophic losses. It has shownremarkable resilience following thecatastrophes of Ivan, Katrina and Rita and retention levels and coverageconditions have continued to remainroughly at post-9/11 levels. However, theeffect of any potential upswing in lossamounts brought about by superheatedprices cannot as yet be estimated with anyreal degree of accuracy. Buyer demand fortraditional commercial market productsmay have increased, with potentially morepremium flowing into the market; but anypotential premium increase in real termshas been absorbed and even negated bythe softening pressures instigated by twobenign loss years.

“We used tohave a lot oftraining bycompanies likeFM and IRI andthe like thatwould bring in a group ofengineers andunderwriters,and train themup over a threeyear period andput them out into the field – we don’t havethat any more, it stopped years ago.”

Michael Gosselin

“Forprofessionallinesunderwriting, currentlydemand iscertainlyhigher thansupply. In general,salaries areincreasing,which is partlya measure ofthe overall lack of good peopleavailable.”

Andrew Eliot


So how long will today’s softening marketconditions last? Some underwriters like to suggest that they will lay down theirpens and withdraw once rates have reacheda certain pre-determined level. We believethat market history tells a different story.At some point, losses will once moreoutstrip premium income, and only thenwill disappointed capital providerswithdraw and the softening process willbottom out. The problem is that the energyinsurance market, already inherentlyvolatile, has now become potentially morevolatile still; now the market is facing amuch more severe risk landscape, once loss ratios turn negative once more theyare very likely to do so with a vengeance.

Despite all the positive underwritingresults achieved during the last two years, there is a considerable degree ofapprehension in the market at the dawn of 2008. Meanwhile, as ever we wouldencourage clients to continue to re-examine their risk exposures and assetvaluations, in order to ensure that theyremain in a position to be properlyindemnified by insurers in the event of more expensive losses in the future.

“From a teamperspective in a company you must haveengineeringknow howsomewhere inthe unit,whether that’swith dedicatedunderwriters or specialistengineers whoare providingback-up servicessuch as we havehere at Swiss Re – you needsomeone in the entity thatis doing thebusiness, theability to knowexactly what is going on inthese complexplants.”

Stanley Cochrane

“There is absolutely nothing tosuggest that the losses will notcome back. We have been looking at two benign years, but if youlook further back there have beensignificant billion dollar lossesover the last five years. The onething that is different this timeround is that the market has helddiscipline on retentions, but thecatastrophic losses are stillhappening and will continue to happen.”

Colm Kelly


“We’ve been through this cyclebefore and we can’t look at it andsay it can’t happen again – we willsee naïve, unregulated capacitycoming in thinking that the energymarket is a great place to invest.”

Michael Gosselin


REINSURANCE


In June 2007 we said:

– The reinsurance market of 2007 remains a cautious one

– The January 2007 renewal season was characterisedby the degree of differentiation shown by thereinsurance market towards the most attractiveenergy portfolios

– Some softening of market conditions was evidentfollowing 2006’s favourable catastrophe loss record

– In particular, slightly more competitive terms were in evidence for Gulf of Mexico Windstorm cover,whilst signs of more significant softening could be discerned for the remainder of the portfolio


Settling or sinking?With a very profitable 2007 now all butassured, the last 24 months represent aperiod of exceptional profitability for the reinsurance industry. Nevertheless,despite many statements about theimportance of cycle management, theindustry is showing signs of reverting toits historic pattern of feast or famine.

As reinsurers are finding themselvessqueezed between their primary

clients, who continue to experience ever-softer conditions, and their own very strong recent results, the 1 January2008 renewals were characterized bycompetition. While nearly all sectors are showing signs of softening, theintensity of this competition varies byclass, line, and region. Certain segments,such as Marine, are demonstrating onlymodest softening, while others, such as US Property, are posting moreprecipitous declines.

January 1 2008 Reinsurance Market Renewal Season – in a Nutshell

US Marine Rate reductions were beginning to appear in 4th quarter 2007

International Marine Reinsurers mostly held firm, except on small indigenous accounts

US Property Market softening accelerated with a late renewal season

Europe Property Strong downward pressure on pricing

Middle East/Asia Property Modest rate reductions (10-15%)

Latin America Property Modest rate reductions (0-15%)

Australia Property Flat

US Casualty Some softening (10-15%), some carriers dropping reinsurance layers

International Casualty Increasing appetite of mainstream market to engage in this business

For a more detailed description of the current reinsurance market, please see Willis Re – 1st View published this month on the Willis website (www.willis.com).

It is also interesting to note that meaningfuldisparities have developed between themajor reinsurance hubs. For example,Bermuda has taken a more aggressiveposture than London on Property businessfor many regions, including the UnitedStates. Not surprisingly, when combinedwith the ongoing gap between insurance andreinsurance pricing trends, this lack ofconsistency across markets and classes hasfostered a “late” renewal season as insurerstry to reconcile reinsurer offerings withtheir own financial objectives.

Clearly, a level of uncertainty is alsoprevalent in the larger financialmarketplace, as the sub-prime crisis hasdominated recent headlines. Nevertheless,issues in the credit markets have notproduced any meaningful impact on the 1 January renewals. Reinsurer impairmentfrom the sub-prime debacle appears limited, and although losses are ultimatelyanticipated in specialty segments, such as

Directors and Officers Liability,conventional classes appear to remain well insulated from exposure. Equally, thedownturn in the wider credit markets has in no way dampened capital marketappetite for insurance risk, as US$ 1.4 billionof catastrophe bonds were issued in the lastthree months. In total, public cat bondtransactions amounted to US$ 6.4 billion in 2007, and this activity sits on top ofcontinued and robust appetite for privateplacement transactions.

As the general activity in the ILSmarketplace continues, insurers andreinsurers alike are also devoting increasingattention to management of their owncapital structures. With recent record profits juxtaposed against a declining rateenvironment, stock buy-backs by quotedcompanies are commonplace, a number of sidecars have been allowed to lapse, andsome Lloyd’s Syndicates are reducing theirstamp capacities for 2008.

UPSTREAM


2007 hurricanes avoidenergy infrastructure

In the previous edition of this Review weadvised that much would depend on the outcome of the 2007 Gulf of Mexicohurricane season as to how the marketdynamics of this sector would developduring the later part of 2007 and into 2008.Despite all the forecasts, the 2007 seasononce more confounded the experts andproduced only one hurricane of note thatmade US landfall, Umberto, which came and

went so fast that the industry barely hadtime to register it. The windstorm seasonhad no discernible effect on any energyindustry infrastructure, and given therelatively favourable loss record elsewherein the upstream portfolio, insurers are nowalmost certainly looking at a secondconsecutive year of profitable underwriting.Consequently, we are witnessing a secondconsecutive year of softening marketconditions, exacerbated in the case ofLondon insurers by the negative effects of the current US$/£ exchange rate.

Given the loss ratio figures for the last twoyears, underwriting managers and capitalproviders can perhaps be forgiven for hopingthat 2008 will provide more of the same byway of return on equity and there can be littledoubt that, with rumours of more start-ups in Lloyd’s and elsewhere for 2008, overallcapacity for operating risks will be at least as

much as for 2007, and will probably increaseby approximately 10-15%. However, as usual a distinction needs to be drawn betweentheoretical and “working”/“realistic”capacity, and in reality the maximumcapacity that can be competitively andrealistically accessed is still limited toapproximately US$ 2.5 billion.


93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

0

50

100

150

200

250

300

350

Incurred Ratio - Upstream Property

%

Another profitable year as capacity climbs still further…

Lloyd’s Upstream Property, Control of Well and Downstream PropertyIncurred Ratios, 1993-2007 (as at third quarter, 2007)

It is still early days, but the Lloyd’s 2007 upstream property portfolio result looks set to matchits predecessor.

Source: Lloyd’s


Upstream operating underwriting capacities, 2000-08 (excluding Gulf of Mexico Windstorm)

Source: Willis

Capacity in this sector is now almost back to pre-9/11 levels.

US$m

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2000 2001 2002 2003 2004 2005 2006 2007 2008 (estimate)

Changes afoot in marketleadership profile?

2007 saw some changes in the leadershipprofile of the upstream market. Two highlyrespected underwriters, Tim Burrows ofCatlin and David Cooper of Gard, haveretired, while Charles Franks of Kiln hasbeen promoted to a higher managementrole within the company. In the meantimethe remaining team at Catlin, consisting of Doug Howat, Huw Jones and SteveHawkins has now been augmented by thereturn to underwriting of the experiencedenergy specialist Clive Magnus.

These developments may leave space forothers to enhance their market profile in2008. The market’s overall leadership panelhas grown steadily since 9/11 and there arenow up to seven or eight prominentunderwriters who are suitably qualified andhave sufficient market following to leadmajor placements. In our last edition of this Review, we referred to the differentunderwriting approaches of the Lloyd’smarket compared to their counterparts

from the global insurance companies.During 2007 this fragmentation process has continued, and we can now report thatas many as three separate underwritinggroupings have emerged within the Lloyd’smarket alone in recent months.

Insurers continuing todifferentiate in favour ofquality business

These developments are clearly providingastute brokers with further opportunities to maximise competitive pressures in the upstream sector, and with premiumincome targets remaining the key driverfor most, the battle to secure requiredmarket signings for the choicest businesshas now begun in earnest. We are nowseeing rate reductions of up to 30% for the most sought after business, withreductions of 10-15% at minimum for non-loss impacted programmes. Thesereductions are often disguised in manyimaginative ways, some of which being the familiar and traditional adornments of a softening market – No Claims


Bonuses (which are then protected),Renewal Incentive Bonuses and PackageCredits – and others involving the offsettingof increased valuations (discussedelsewhere in this Review) by providingcover for the re-valued assets for the samepremium as was charged the year before.

Having said this, we would stress that thequality of risk remains the key to securingthe most competitive terms in 2008, asunderwriters will have made commitmentsto their reinsurers and to their managementthat these will be the programmes that theywill target in order to maintain premiumincome levels.

Furthermore, the upstream market remainsfirm on retention levels. As we remarked inour previous Review, retention levels are oneaspect of the overall upstream terms andconditions that the market has not reduced.Given the increased valuations that are nowbeing presented to the market, as well as therecent increase in contractor day rates, someinsurers are even suggesting that to providethe same monetary amount to a buyer in2008 as was provided in 2007 is tantamountto providing a reduced deductible in realterms. So instead of relenting on existingretention levels, insurers are if anythingseeking to increase levels so that they fallinto line with increased values.

Offshore CapacitiesOnshore CapacitiesAverage Composite Percentage of 1992 rates

0

1,000

2,000

3,000

4,000

5,000

6,000

US$m

0

20

40

60

80

100

120

Rate Index(1992=100)

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 (forecast)

Rates back to pre-9/11 levels – and set to fall further…

Energy insurer capacities and average rating levels, 1993-2008(excluding Gulf of Mexico Windstorm)

In general, rates for energy insurance business are back where they were just before 9/11 – butnowhere near where they were during the last soft market.

Where do these developments position thismarket in terms of the underwriting cycle?To take a historical perspective, we havereproduced our chart from page 16 of thisReview to show how overall averageupstream and downstream market rating

levels, following a brief spike in the wake ofthe 2005 hurricane losses, have now comefull circle and at the beginning of 2008 arenow roughly at the same level as they werebefore 9/11, with softening pressuresshowing no sign of easing.

Source: Willis


So despite two profitable years, upstreaminsurers now find themselves in asomewhat uneasy position, and thegeneral feeling of apprehension, sotangible following the 2005 hurricanelosses, continues to prevail. We mentionedin the last edition of this Review the extentto which “intelligent capital” is nowdeployed in the market, but as we haveseen, capital provider enthusiasm for thisclass remains high following recentpositive underwriting results. To varyingdegrees, upstream underwriters aretherefore under pressure from their

management to maintain (or evenhopefully increase) premium income.

This ultimately has the effect of distorting the natural market dynamics of supply anddemand, since in the absence of thesepressures most insurers’ natural inclination,at a time of falling rates, would be to scaleback rather than increase their deploymentof capacity in this sector.

Moreover, upstream insurers have plentyof other factors to ponder as they take stockof the softening market in this sector.

Potential for existing loss record to deteriorate

2007 Upstream losses excess of US$ 5 million recorded by the Willis EnergyLoss Database as at 04/01/08

Type Cause Location Country PD/LIAB OEE BI TotalActual US$ Actual US$ Actual US$ Actual US$

Well Blowout Louisiana USA 80,000,000 80,000,000Platform Fire/lightning/ Haut Mer Congo 50,000,000 17,500,000 67,500,000

explosionWell Blowout Louisiana USA 52,000,000 52,000,000Well Blowout Gulf of Mexico USA 33,000,000 33,000,000Rig Grounding Gulf of Mexico USA 24,000,000 6,500,000 30,500,000Pipeline Mechanical failure North Sea Netherlands 26,000,000 26,000,000Pipeline Anchor/jacking/ Unknown Benin 19,500,000 19,500,000

trawlWell Impact Louisiana USA 15,000,000 3,500,000 18,500,000Pipeline Anchor/jacking/ Persian Gulf Qatar 18,000,000 18,000,000

trawlWell Blowout Texas USA 16,000,000 16,000,000Well Blowout Monagas State Venezuela 15,000,000 15,000,000Well Blowout Louisiana USA 14,700,000 14,700,000Pipeline Anchor/jacking/ Gulf of Mexico USA 14,250,000 14,250,000

trawlWell Blowout Louisiana USA 14,100,000 14,100,000Rig Design/ Newfoundland Canada 2,500,000 9,000,000 11,500,000

workmanshipSSCS Anchor/jacking/ Unknown Angola 11,020,000 11,020,000

trawlWell Blowout Texas USA 11,000,000 11,000,000FPSO Design/ Unknown Tunisia 10,375,000 10,375,000

workmanshipWell Blowout Louisiana USA 10,000,000 10,000,000Rig [unknown] North West Shelf Australia 10,000,000 10,000,000Well Blowout Louisiana USA 7,600,000 7,600,000Well Blowout Louisiana USA 7,000,000 7,000,000Well Blowout Deir es Zor Syria 6,500,000 6,500,000Rig Design/ Newfoundland Canada 3,500,000 3,000,000 6,500,000

workmanshipRig Fire/lightning/ Texas USA 6,500,000 6,500,000

explosionWell Blowout Louisiana USA 6,350,000 6,350,000Well Blowout British Columbia Canada 5,560,000 5,560,000Well Blowout Texas USA 5,000,000 5,000,000



A quick glance at the losses generated todate in 2007 (see chart opposite) wouldseem to indicate that 2007 is about toemulate its predecessor in producinganother relatively benign loss year to the upstream market. However, weunderstand that there are currently severaloutstanding losses that have not yet beenfinalised and so therefore not yet registeredon our database. These include damage to a platform in the North Sea, damage to anSBM buoy offshore Sakhalin Island inRussia, damage to a jack-up rig following ablowout offshore Mexico, two complexconstruction claims in the North Sea andoffshore China and various blowouts in the United States. It is of course verydifficult to provide any accurate picture of the full extent of these losses, but ourunderstanding is that it is entirely possiblethat the overall additional cost to themarket may exceed US$ 300 million.Should this eventually turn out to be thecase, the final loss tally for 2007 may evendouble the figures recorded by ourdatabase to date. We estimate that thiswould be enough to erase approximately65% of the current worldwide upstreampremium income, and although this initself would be insufficient to change theoverall nature of the current softeningmarket dynamics, it may well causeinsurers to think twice about breakingranks and offering markedly differentterms for next year.

This perception of a possible increase inthe number of future upstream losses isstrengthened by reports of the currentcondition of many of the ageing platformslocated in the North Sea. The UK’s Healthand Safety Executive (HSE), following aninspection of over 100 installations, hasrecently condemned the condition of oiland gas platforms in the North Sea andhas warned energy companies that theyare running the risk of a major accidentbecause of years of under-investment.Specifically, the HSE has criticised seniormanagers for not giving sufficient priorityto maintenance and have threatened to“name and shame” companies unless theyimprove their facilities.

Given the fact that most North SeaPlatforms are operated by the same globalenergy companies that are responsible for the maintenance of other similarplatforms around the world, some insurersmay assume that there is no meaningfuldifference between the condition of North Sea platforms and the remainder of the global upstream infrastructure.Furthermore, if the effects of increasedcommodity prices as outlined in thefeature article of this Review is alsofactored into the equation, the potentialscale and extent of future upstream losesbecomes more apparent.

Rise of regionalunderwriting will exacerbate softening process

The emergence of regional markets fordownstream energy business wasdocumented in the previous edition of this Review. At the time, we advised thatsuch was the specialist nature of theupstream sector that very little regionalcapacity existed for this class, with thevast majority of capacity located inLondon. Six months later, this remainsessentially the case, but there are nowsigns that this dynamic is also beginningto affect the upstream sector.

In Singapore, following the establishmentof a Lloyd’s representative building, noless than 12 Lloyd’s syndicates are nowrepresented in the city and are open forupstream business. Whilst most of thecapacity available in Singapore is providedon a “referral to London” basis, several ofthese underwriting outfits have beenestablished specifically to underwriteenergy business.

Although the stated aim of theseunderwriting operations is generally thatthey have been established to attractbusiness that would not normally havefound its way to the London market, andthe question of whether or not suchventures will ultimately prove successfulhas yet to be answered, the deployment ofupstream capacity in Singapore can onlyadd to the overall softening process in thissector. Ultimately, these new operations


will have to be prepared to take onbusiness at rates somewhat below thosethat might be expected in London, and inorder to sustain a profitable portfolio –and attract clients who have always valuedtheir London relationships - will have toensure that they subscribe to as manyprogrammes as at all possible in order toachieve the necessary spread of risk, evenif this means expanding from a purelyenergy book of business into classes suchas marine, cargo and construction.

Meanwhile in the Middle East marketthere is now firm evidence that severalglobal insurers, having also deployedunderwriters with energy expertise to the region, are now mounting a seriouschallenge to London’s share of the region’sportfolio, especially for risks that havebeen specifically targeted as qualitybusiness. Willis understands that in themain these underwriters have a degree of autonomy that perhaps the new outfitsin Singapore do not, and therefore these insurers have little hesitation inundercutting their London counterparts’participation on a given programme ifrequired – even though they are sourcingthe same reinsurance treaty as the London office.

This autonomy also provides a fig leaf forthe London underwriters of these globalinsurers, as they can maintain that theloss of a certain piece of business to theMiddle East market was nothing to dowith them personally.

Gulf of Mexico Windstorm:demand remains limited

Another loss-free Gulf of Mexicohurricane season has meant that capacityhas increased marginally and rating hastherefore softened a little for this class.Willis estimates that at least US$ 200million - and possibly more - of offshoreGulf of Mexico capacity is now available in the commercial market, and whilst this figure is still nowhere near what usedto be provided before the 2005 windstormseason, it still represents an improvementon what has been available over the lasttwo years.

Be that as it may, little further softening is expected in the future, and insurers arecertainly doing everything they can tomaintain rigorous discipline in terms ofmodelling their exposure to Gulf ofMexico windstorm on a detailed basis.

The market’s continued cautiousapproach to this class is doing little totempt buyers back into the market. As aresult, premium income from this part of the portfolio continues to dwindle- at a time when the international market islooking for additional sources of revenueto alleviate the softening in the rest of the upstream sector.

One further ramification of the Katrinaand Rita losses has been the introductionby some markets of a new pipelinerepositioning clause. One of the majordifficulties faced by some energycompanies following the hurricanes hasbeen that insurers have resisted claims for the expense incurred in repositioningpipelines following instructions fromMinerals Management Services or otherregulatory authorities, on the basis that no loss had been sustained to the pipelineitself. The significance of the new clause is that the trigger for loss payment withregard to repositioning expenses is nolonger limited to any actual physical lossor damage to the pipeline itself, but is nowextended to include simple proof that thepipeline has shifted due to the fortuitousoccurrence, as a result of a namedwindstorm, of a mudslide or actions of a fishing vessel. This new proactiveapproach will hopefully help to rebuildbuyer/insurer relationships that havebecome strained as a result of the numberand degree of contentious claimsfollowing the hurricanes.


Operators Extra Expense: same limits, but higher AFEs…

Costs of Gulf of Mexico Crude Oil and Natural Gas Wells Drilled, 2000-2005

Rising AFEs have increased the possibility of more severe OEE losses.

Crude Oil

Natural Gas

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

US$000’s

20012000 2002 2003 2004 2005

Stand-alone Operators Extra Expense(OEE) cover has never been upstreaminsurers’ favourite part of the portfolio.Our chart show how Authorizations For Expenditure (AFEs) have generallyescalated in recent years, due to the effectsof changes in the global economy discussedin the feature article of this Review.However, as yet there is little evidence thatbuyers are electing to buy increased overalllimits for the coverage provided by theEED 8/86 form, despite the fact that theirexposure to increased re-drilling expensesis generally universal. This of course hasthe effect of making the OEE policy more“first loss” in nature – in a similar way thatwe have described for other parts of theenergy portfolio elsewhere in this Review.

At the moment, insurers are reacting tostatic policy limits for OEE by ratingrenewal programmes as if higher limits

had been purchased and then only giving a relatively insignificant credit for theexpiring limit continuing to apply.However, today’s softening conditionswould suggest that they will be unlikely to be able to maintain this stance for much longer. The real issue here is thefinancial risk that buyers run of beingexposed excess of their purchased policylimits in the event of a major OEE loss – a risk which can only increase as drillingcontractor day rates increase still further.

Construction: an easy solutionto premium income problems?

Given today’s energy industry climate, it is not surprising that offshoreconstruction activity, after a period ofinactivity because of full shipyards, is set to increase significantly now that yardshave been freed up following completion

Source: ODS


of earlier projects. Those insurers who specialise in this part of theportfolio might therefore have cause to be pleased that additionalsources of premium income are becoming increasingly available asa result. However, offshore construction insurers have had theirown grounds for concern recently. We mentioned earlier that thereare currently two outstanding offshore construction claims thatthe market has recently recorded, one of which we believe has thepotential to result in one of the largest non-catastrophe losses inthe upstream sector for several years.

These new developments perhaps serve as a timely reminder that the current standard market policy form for this class, the Welcarform, has only been deployed in the market for the last six years or so. Although we have noticed a nominal improvement in theoffshore construction record over the last few years (which wehighlighted in the last edition of the Review), the projects whoseinsurance programmes were the first to be placed using this form have only now just come to the end of their discoveryperiods. Loss Adjusters often point out that a significant degree of construction claims result from occurrences that only becomeapparent during the course of the project’s discovery periods, and so perhaps there are grounds for suggesting that a longerperiod of time is required before the innate profitability of thissector can be truly measured correctly.

In today’s economic climate the contractor is king, and in light of this insurers are once more examining – or at least should beexamining – the exact nature of the liabilities that they areassuming by underwriting the contractual obligations of individualoperators. They are also concerned that some of the fabricationyards that are now being used for offshore construction projectsdue to 100% utilisation rates at recognised yards are not suitablyqualified for operations of this nature, and are looking to introducesome form of qualification process to ease their concerns.

As with the operating portfolio, the increase in commodity pricesand subsequent contractor shortages and increases in the price ofraw materials has had a similar effect on offshore construction risk profiles. Willis is aware of several recent projects where theEstimated Final Contract Value has increased by as much as 50-60%during the course of the project. In particular, underwriters arebeginning to examine values in their portfolio declared under“Schedule B” of the Welcar policy, and it has become evident thatalthough individual operators are presenting revised values on their operating programmes, very few such revisions have been presented in respect of “Schedule B” amounts declared toconstruction programmes.

When Wellington first introduced the Welcar form, the intentionwas that any “Schedule B” values would be constantly reviewed and updated during the course of the project period. The inevitabledifficulty of potential under-insurance for buyers in the event of aloss is the natural consequence of under-valued “Schedule B”declarations. We therefore have no hesitation in urging buyers toreview their “Schedule B” declarations as urgently as possible.


One other factor that buyers should take note of is that thosebuyers that have purchased Delay in Start-up cover are even moreat risk of under insurance as massively increased Contractor costs,and the reduced availability of contractors in the future, willescalate replacement and the overall cost of delays still further.

In the meantime more upstream insurers are starting to show aninterest in this class, as the upswing in project activity presents anexcellent opportunity for insurers to augment their existingpremium income. As a result even this hitherto unpopular sector of the portfolio is finally beginning to soften, although as with theoperating portfolio, retention levels and policy coverage remaingenerally unaffected.

Outlook – accurate replacement costs nowbecoming vital for proper protection

Insurance market cycles have scant respect for economic conditions,and upstream insurers are looking back at another profitable yearwith mixed feelings. On the one hand, 2007 is to a large extent“mission accomplished”; however, they are perfectly aware thatrecent revaluations and the increased exposure to risk that they bringwill mean that at some stage claims will overtake premiums oncemore, capacity will withdraw and the next phase of the market cyclewill begin. Until this happens, they remain prisoners of their ownmarket dynamics and reinsurance pricing structures, with only theconsolation of increased opportunities to purchase facultativereinsurance for comfort. For buyers, the issue is clear; insurancecover for upstream risks is becoming cheaper to purchase, and so this is an opportune moment to ensure that exposures havebeen covered for the correct value.


DOWNSTREAM

In June 2007 we said:

– There is a continuing deployment of underwritingauthority on regional basis

– Capacity increased significantly, most particularly for International non-catastrophe exposures

– The International market softening evident by theend of 2006 is now extended to the US Portfolio

– The market perceived that 2006 rating levels had beenkept artificially high by the 2004/05 hurricanes andthat some form of market correction was inevitable

– Accurate values for both physical assets and businessinterruption exposures were issues that were beginningto trouble the market


Rise of regionalunderwriting continues

Following the previous edition of thisreview, we can confirm that the trend ofmore downstream energy business leavingLondon continues. In particular, theMiddle East energy market is beginning

to gather significant momentum for small to medium size business, although thesheer size and scale of some projects inthe region is ensuring that the Londonmarket remains of real significance.Furthermore, the Asia Pacific market,primarily based in Singapore, continues to expand for regional business.

Recent loss record still relatively benign

2007 Downstream losses excess of US$ 5 million recorded by the WillisEnergy Loss Database as at 04/01/08

Cause Location Country PD/LIAB BI TotalActual US$ Actual US$ Actual US$

Fire/lightning/explosion Texas USA 50,000,000 200,000,000 250,000,000Flood Coffeyville, Kansas USA 75,000,000 125,000,000 200,000,000[unknown] Al-Jubail Saudi Arabia 25,000,000 175,000,000 200,000,000Fire/lightning/explosion Mississippi USA 200,000,000 200,000,000Corrosion Texas USA 7,000,000 143,000,000 150,000,000Mechanical failure Ancash Province Peru 1,000,000 85,000,000 86,000,000Fire/lightning/explosion Sharjah UAE 81,000,000 81,000,000Fire/lightning/explosion Volgograd Russia 55,000,000 55,000,000Fire/lightning/explosion Massachusetts USA 25,000,000 13,000,000 38,000,000[unknown] New York USA 31,000,000 5,000,000 36,000,000Fire/lightning/explosion Rio de Janeiro Brazil 6,400,000 16,400,000 22,800,000Fire/lightning/explosion England UK 8,101,000 12,876,000 20,977,000Fire/lightning/explosion Lavera France 20,000,000 20,000,000Mechanical failure Cordoba Colombia 2,000,000 18,000,000 20,000,000Fire/lightning/explosion Durban South Africa 6,000,000 12,000,000 18,000,000Fire/lightning/explosion British Columbia Canada 4,800,000 12,000,000 16,800,000Windstorm Texas USA 16,000,000 16,000,000Fire/lightning/explosion Durban South Africa 11,000,000 4,500,000 15,500,000Mechanical failure Connecticut USA 9,950,000 5,000,000 14,950,000Impact Mississippi USA 13,000,000 1,300,000 14,300,000Mechanical failure Queensland Australia 12,000,000 12,000,000Subsidence/landslide Unknown Bolivia 11,000,000 11,000,000Collapse Ar Razi Saudi Arabia 11,000,000 11,000,000Fire/lightning/explosion Oklahoma USA 10,500,000 10,500,000Design/workmanship Yucatan Mexico 8,499,000 2,000,000 10,499,000[unknown] Brazil 9,000,000 9,000,000Impact Georgia USA 5,600,000 1,500,000 7,100,000Windstorm Santo Domingo Dominican Repub. 6,000,000 1,000,000 7,000,000Design/workmanship California USA 6,500,000 6,500,000Fire/lightning/explosion Louisiana USA 6,000,000 6,000,000Impact Indiana USA 6,000,000 6,000,000Mechanical failure California USA 5,500,000 5,500,000


Whilst 2007 has seen one or two majorlosses in the Downstream sector, theoverall record has done little to slow thesoftening momentum that we described in the previous edition of this Review. Aswe go to press, we are aware of one recentloss in the Middle East which we believehad the potential for a major 48 month

indemnity business interruption loss.However, such is the current softeningpressure in this market that even shouldthis loss materialise into a paid marketclaim, it will have little effect on marketconditions, other than to focusunderwriter concerns that indemnityperiods need to increase.


More capacity adds to competitive pressures

Downstream International underwriting capacities, 2000-08

Source: Willis

We estimate that capacity in this sector is back above US$ 3 billion for international risks – for the first time since 9/11

US$m

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2000 2001 2002 2003 2004 2005 2006 2007 2008 (estimate)

If the downstream energy market was over-capitalised six months ago, it is even moreso as we move into 2008. Although as yet itis to early to give an accurate assessment(the effect of any market entry bypotential newcomers such as the much-heralded David Hope/Tim Fillinghamenterprise is yet to be determined) we believe that overall capacity forInternational business will reach US$ 3 billion in 2008, with slightly lessavailable for US domiciled business. Ofthis amount we estimate that the mostcompetitive element of the market cannow offer in excess of US$ 1.8 billion, upfrom US$ 1.3 billion in 2007. This figure ismore than sufficient for the vast majorityof downstream programmes, bearing inmind the level of today’s policy limits.Meanwhile total “realistic” capacity – i.e.the amount which is actually put out inpractice by the whole market – shouldincrease in 2008 to approximately US$ 2.5 billion, up from US$ 1.8.billion at the beginning of 2007.

Notwithstanding these estimates, during2007 we saw several insurers deploy thelimits of the capacity at their disposalmore aggressively and more frequentlythan at the beginning of the year. Thereason for this is relatively simple;throughout the market, programmes arebecoming increasingly over-signed and soinsurers, perhaps in some cases somewhatbelatedly, have been keen to counter theeffects of oversubscription whereverpossible in order to keep their premiumincome figures on target and to use theiradditional capacity.

At the beginning of 2007 we saw freshcapacity from Lancashire Re, Ironshoreand Starr Excess enter the market, andadditional capacity was provided byexisting downstream insurers such asAIG, Arch and Allianz. In 2008, we expectcapacity to be extended further, withZurich, Ace and Brit all expected to offerincreased line sizes. In particular Allianz,under fresh management appointed last


year, has recently taken a more positiveunderwriting stance, Starr Tech will nolonger be required to proceed with thecaution of a new start-up for Internationalbusiness, whilst Lancashire Re isbeginning to move from their establishedpositions on excess layers towards agreater participation on quota shareplacements. In the meantime, bothIronshore and Zurich are starting totarget smaller business.

So all the signs point to an increasinglycompetitive market. However, in the lastedition of the Review we indicated thatthe leadership panel for this class stillremained relatively consistent, and thatthis was perhaps to some extent acting asa break on the softening process. Now webelieve that this may be about to change.

London and Europe bid more effectively for USdomiciled business

Following another benign windstormseason, this year has been a year ofconsolidation in the US market. Althoughsome US-based insurers, including AIG,Allianz and Starr Tech, have increased their capacity, there are still no signs ofsignificant aggression, as most programmesrenew with modest reductions of around10-15% being the norm. However, we doexpect some competitive pressures to be generated by AIG and Starr Tech as they seek to occupy leading positions in this market.

At the end of 2006 we reported that for US domiciled risks London and Europewere increasingly uncompetitive againsttheir US counterparts. This year, we haveseen London and European insurerscatching up with the US markets and inmany cases are now offering comparableterms, with the result that they arewinning some business whereas in 2006they were much less successful.

Gulf of Mexico windstormcapacity increases

Gulf of Mexico windstorm capacity is stillsomething of a moveable feast, and howmuch capacity can be secured is as alwaysdependant on the extent to which individualbuyers are prepared to pay. We would nowestimate competitive capacity for this coveras being in the region of US$ 350-400million, a modest increase from the 2006figure of US$ 300 million.

However, this figure is also dependent onthe exact location of the asset concerned.Today, insurers’ modelling techniquesenable them to focus more heavily on individual locations, with models beingable to identify individual refinery ZIPcodes and establish the insurers’ aggregatecommitments to the region in question,using data acquired from Google FloodZone and other sources to assist them.

A renewed bid for leadership positions?

Although this over-capitalised market hasnow been with us for a little while,following another relatively loss-free yearthere is now a genuine appreciation in themarket that, now rating levels havebecome truly soft, insurers are going tohave to compete more vigorously forpremium income. We believe thatinsurers may be considering severalalternatives open to them, including:

– where possible, writing larger shares ofthe most highly regarded programmes –not an easy option, bearing in mindcurrent oversubscriptions

– putting pressure on current treatyreinsurers to provide more capacity,thereby allowing existing margins tobe maintained

– encouraging the purchase of greaterindemnity periods, and insisting on areview of values

– approaching alternative, morecompetitive sources of reinsuranceprotection than their currentreinsurers, who may have been slow toappreciate the degree of softening inthe direct market


With the price of reinsurance beginning toslide in the face of two good underwritingyears, insurers now know that they have totry to be more proactive towards buyers(and their brokers) if they are to guaranteetheir required minimum signings.

This of course provides brokers with agolden opportunity to maximise existingcompetitive pressures. Our own view is that, if a given insurer is prepared to setcompetitive lead terms, then we mightrecommend that this insurer be permittedto set their own signing, while followingmarkets would have to await the direction of the client in order to determine the extentof their participation in the programme.

This raises the interesting issue of howbuyers might maximise the new advantagesof this market, and the criteria that theymight use in determining the finalsubscriptions to their programme, withinsurers’ security ratings being potentially a major consideration.

If this consideration proves to be popularwith buyers, it may lead to some insurerswith relatively modest security ratings,having subscribed to a given programmeearly in the marketing process andthereby having made perhaps a significantcontribution to its momentum in themarket, finding that their final line is laterreduced to a meaningless figure by theunexpected and last minute decision by aAA rated insurer to participate. This inturn may lead to increased bidding byinsurers for the choicest programmes.

Differential marketing - the end of the subscription market?

These are therefore the kind of marketdynamics that are increasingly becomingevident in this sector, and which mayindeed lead to the eventual dissolution of the subscription market. So far,subscription market dynamics remain inplace. For example, every time a brokersuggests to a downstream insurer that they ignore the market consensus andprovide a more competitive price, thebroker will make a degree of progress until

the insurer realises the relative isolation of his position relative to his competitors. Furthermore, the reinsurance market areunlikely to give preferential terms tosmaller downstream insurers who make apoint of taking their own position ratherthan following established leads.

Despite this, however, we believe thatdifferential marketing, whereby a buyertakes out multiple policies at each insurer’sindividual terms and conditions and therebyreaps the benefit of the most competitiveterms available, may soon become acommon feature of the Internationalmarket, as has already been seen in the USmarket. The logical rationale behind thisidea is that the insurer should in theory behappy with the terms he has supplied andshould therefore be unconcerned by howthe remainder of the market responds to the buyer’s programme. Such is the pressureon existing programme signings in today’sclimate that this scenario, resisted for solong by the market, may well be the only way that individual insurers can guaranteetheir required signings. One potentialproblem with differential marketing from abuyer perspective is of course that differingterms can often mean differing policyconditions for the separate participations,resulting in an unwelcome “patchworkquilt” of coverage for the buyer’sprogramme, with little or no followingprovision for claims settlements.

Rate reductions dependent on risk quality and accuracyof valuations rather than loss records

As a result of today’s market conditions,rates are clearly continuing to soften by double digit percentage amounts,driven by the over-capacity we havealready mentioned.

Unlike previous market eras however, the extent of any rating reductions willnot depend so much on whether theprogramme has been loss free or not.Today’s downstream insurers take the viewthat each buyer contributes to a commonpool of premium. If a buyer sustains asingle loss, and it has been demonstrated


that this was a straightforward fortuity, thisshould not significantly affect the price.However, it will be a different story if thebuyer demonstrates a high frequency oflosses or is unable to resolve issues arisingfrom an event.

Instead, the extent of this rating reductiondoes now to a large degree depend on therisk quality of a given programme. It alsodepends significantly on the degree towhich the insurer feels the client has anaccurate understanding of the validity ofthe values and indemnity periods that arebeing declared to business interruptionand property programme schedules.

Retentions remain firm, but undermined by increased valuations

Certainly in a market in need of increasedpremium income very little credit iscurrently being given for buyers offeringto increase their retentions. But unlikeprevious soft markets, no downstreaminsurer today is prepared to break ranksand offer lower retentions in order togenerate additional income either, despitesignificant broker pressure to do so. Thisis because it is almost universallyrecognised that the higher retentionsimposed in the wake of 9/11 have played amajor role in restoring the market toprofitability. Most insurers recognise thatas soon as retention levels begin to drop, it will not be long before profitabilityratios become seriously affected and thissoftening stage of the market cycle willcome to an end. In any event, it is certainlytrue that many buyers now believe thathigher retentions are necessary to avoidthe “dollar swapping” brought about byswamping the commercial market withattritional claims that buyers can inreality well afford to pay.

However, as we have explained elsewherein this Review, given the inflationarypressures generated by increasedcommodity prices, asset values have nowincreased across the board, so any buyerwho has succeeded in obtaining termsfeaturing unchanged retention levels hasin fact secured an improved position

compared to last year. In real terms, itcould therefore be argued that the markethas not managed to keep retentions at thesame level as last year and consequentlymay suffer for this in the long run.

Synergies with Construction marketbecoming more apparent

One other key factor in today’sdownstream market is the growth ofenergy construction activity, which isaddressed elsewhere in this Review.Virtually all the major downstreammarket insurers are also heavily involvedin the Construction portfolio, as well as itsaffinity classes such as Marine, Terrorism,Casualty, Cargo and D&O insurance.There are obvious synergy opportunitieshere for major composite insurers and animportant factor in determining a giveninsurer’s stance towards a particularoperating programme will therefore bethe extent to which he has been involvedon the construction programme.

One good example of this developmenthas been the creation of three yearoperating programme for a major EasternEuropean refining company that has beenspecifically designed to run parallel to amajor construction project that willdouble the size of their existing refinery.The Construction market has effectivelyagreed to underwrite a 36 month policy to take over the EUR 1 billion +construction contract, and the project isbeing financed by effectively mortgagingthe operational assets at the site. In thefirst deal of its kind, the DownstreamEnergy market has most unusually agreedto provide the client with a 36 monthprogramme to mirror the product offeredby the Construction market.

This closer correlation of the DownstreamEnergy market with the Constructionportfolio is very significant for insurers,because they are now in a better positionto understand the inflationary pressuresand shortages of suitable contractors that we referred to in the leading article of this Review.


Market appetite for longterm programmes diluted byreinsurance considerations

The softening market pressures are nowensuring that long term programmes areonce more being seen in the market.However, rather than the traditional Long Term Agreements (LTAs) thatcharacterised the last soft market of thelate 1990, the current trend is beingcharacterised by the proliferation of thePreferred Risk Agreement (PRA). Underthis, an insurer is prepared to offer a longterm commitment with a financial benefitto the client, based on certain criteriabeing met or not being breached in orderto commit to a long term contract. ThesePRAs contain specific provisions in theevent of a breach and are based around thepremise that both parties have wanted toenter into a long term agreement for theirmutual benefit.

For the buyer, these arrangements offerthe key advantages of certainty andstability, at a time when the risk arenalooks as volatile as ever. However, theproblem faced by the market in the face ofthe emergence of these agreements is thattheir treaty reinsurances are conductedon a 12 month losses occurring basis.

The obvious risk to insurers is that, in anyattempt to manage this volatile portfolioon a long term basis, there is a danger of misaligning the pricing cycles of thereinsurance and insurance markets whichmay create a serious managementproblem. Several insurers suggest that,bearing in mind that increasingly severelosses are forecast for this sector in thelong term, any dramatic future marketcorrections may lead to a significantdifference between the conditions offeredby reinsurers and those offered by thedirect market.

So whilst there have been some signs ofmarket appetite for more imaginative long term arrangements, the generalreliance of the downstream market onreinsurance has prevented these frombecoming widespread.

Are full value policies makinga comeback?

Another significant recent marketdevelopment has been an initiative bycertain markets to provide full valuepolicies – the first of their kind for manyyears. These insurers believe that they can secure preferential reinsurance terms if they are seen to be providing fullvalue cover whilst basing their line on an accurate Probable Maximum Loss(PML) assessment, in the same way as isprovided to the Construction market.Furthermore, the aim would then be toforce other insurers who continue toprefer writing on a Policy Limit basis tohave their subscriptions signed down still further.

Very few insurers have these kind ofreinsurance treaties in place and to date,there are no signs of these efforts havingbeen successful. Indeed, Willis believesthat these initiatives are unlikely to gainsufficient market momentum, and will beresisted by the majority of the market tothe point where they will be defeated –unless of course differential marketingreally takes hold in this sector. Thosebuyers considering such a programmeshould perhaps reflect on the value ofsecuring slightly improved terms andconditions set against the possibility ofinsurer failure in the event of a major lossbecause the full implications of such apolicy were not sufficiently understood orappreciated. We would continue to stressthe value of dealing with well-known,established carriers with whom buyershave good relationships and who are goingto pay valid claims when asked to do so.

Index-linked valuations areno longer the answer!

The upward spiral of commodity pricesreferred to elsewhere in this Review hasbeen so severe that those buyers that have traditionally relied on index-linkedvaluation methodologies to ensure theaccuracy of their underwritingsubmissions would be well advised toreconsider their position on this issue.


Up until now, should a company wish toreplace an asset, it has been able to rely onindex-linked estimation of those costs,because a genuinely competitive tender hasbeen able to be conducted amongstcontractors and project leaders. Companieshave also instead been able to rely on areasonably fixed oil price, and relative grossprofit margins have been generally stable.

Today, given the shortages of manufacturers,contractors and raw materials that acompany needs in order to replace adamaged item, considerably more money is needed to secure its replacement. Theimplication for business interruptionexposure following a physical damage loss is even worse.

Given the current level of insurer focus onthe issue of accurate valuations, there islittle doubt that buyers will be in a muchbetter position to maximise the potentialadvantages of today’s market conditions if they conduct regular, independentvaluations that reflect the specific detailedreplacement value of their assets, as well as providing regular updates andadjustments on the business interruptionvalues declared to the programme.

We would suggest that BusinessInterruption reviews should be conductedon at least an annual basis, and indeedthere is a strong argument to suggest that,in the current economic climate, quarterlyreviews could also be appropriate. Forproperty values, a proper independentvaluation should now be carried out everythree years, although buyers should beencouraged to review existing values asoften as possible.


OIL UPDATE


Twenty years ago OIL was a relativelyuncomplicated vehicle which serviced theoil and gas industry consistently andeffectively. Since 1988, two importantdevelopments took place which significantlychanged the dynamics of the mutual:

– The Flat Premium option wasintroduced, which was designed toaddress new GAAP accounting rules thatapplied to OIL's Retro policyholders

– Risk differentiation between businesssectors was added, which was designedto make OIL more appealing to abroader group of energy companies

As a result of these changes, the mechanicsof OIL have become somewhat morecomplicated, at a time when membershipgrowth has increased significantly,especially after 9/11 (see chart). However,the recent expansion of the business sector risk differentiation to include thetwo new windstorm sectors (see theprevious edition of this Review) has allowed OIL to support its membershipduring the company's most challengingperiod after the storms of 2005.

Number of OIL members, 1990-2008

Source: OIL

The number of OIL members has declined over the last two years, but the number of members isstill higher than in the 1990s.

0

10

20

30

40

50

60

70

80

90

100

1993 1994 19951990 1991 1992 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

As our chart shows, OIL membership grewrapidly during the five years leading up to2005, when hurricanes Rita and Katrinacame ashore on the US Gulf of Mexicocoastline. We have noted in our lastReview that losses from these hurricanesmarked the first time in OIL’s history thatthe Aggregation Limit was actuallyimplemented, and it could be several moreyears before the entire 2005 hurricaneclaims to OIL are actually quantified andfinal payments made.

Following these catastrophic losses, thenormal functioning of the Rating andPremium Plan was effectively shortcircuited because OIL deemed it necessaryfor premiums to be prepaid. This decisionwas taken because it allowed OIL to keeptheir A- S&P credit rating and to avoidadverse Bermuda regulatory action. This setof circumstances caused some shareholdersto withdraw, and our chart shows that thereare now to be only 57 members for 2008 –the lowest number since 2000.


However, one of the more positivedevelopments to come out of theKatrina/Rita catastrophes is that OIL and sections of the commercial market are now working together to help settleclaims for members who purchased OIL“wrap” policies from the commercialinsurance market.

During the week of November 5, 2007 OILheld briefing meetings for brokers andshareholders. Some highlights from thesemeetings were:

– OIL’s 2007 loss experience up untilNovember 2007 was good and belowexpected levels. This positive outlookfor 2007 follows on from the goodresults achieved during 2006.Shareholder equity as at September 302007 was in excess of US$ 3 billion

– As we mentioned earlier, membershipdecreased from 74 at January 1 2007 to57 at January 1 2008. Additionally, themembership count also decreased byone before the end of 2007 followingthe merger of two current OILmembers

– The minimum deductible increased toUS$ 10 million at January 1 2008

– OIL management perceives a need forOIL to communicate the risks inherentin being a shareholder more effectively,especially in respect of absolutepremium levels, premium volatilityand aggregate limits

– Following feedback received fromShareholders, there could beadjustments made to the Rating andPremium Plan as early as the 2009policy year, as well as to the deductiblelevels and limits currently offered

– OIL is looking to promote itself moreactively within the energy companycommunity, with a view to focusingmore closely on companies offeringattractive, quality risk profiles

– OIL may look once more at thepossibility of reinsurance protection,which was purchased in the early1990s, as a tool to increase theAggregation Limit

Although Willis believes that OIL willcontinue to represent a significant partof insurance programs for a large number of energy companies around the world, we do indeed concur with them when theysay that they need to communicate the risksinherent in being a member of a mutualorganization to prospective members moreeffectively. It is also essential that anyoneconsidering becoming a member of OIL orany other mutual organization fullyunderstands their obligations so that thedifficulties of the last two years can be finallyovercome and the necessary lessons learnt.

CONSTRUCTION

In June 2007, we said:

– We reported an increase in mid-market capacity as a result of new/returning carriers; specifically AlbaSyndicate, Infrassure, Chaucer Syndicate, WRBerkley, Aspen Re and the O’Farrell Syndicate

– Even though there has been softening of markets,coverage has not changed significantly

– Deductible levels have remained high, but static

– The downward cycle has not been as dramatic as insome other markets, largely due to the longer-tailnature of the construction market

– Future developments depend upon the treatyreinsurance market and the catastrophe lossessustained in the market

– Volatility is evident due to increasing demands for Delay in Start-up (DSU) and total marketpremium volumes


Significantly increasedcapacity for 2008

The continuing absence of any significantnatural catastrophes in 2007 has led to afurther softening in market conditions.The rate at which market conditions aresoftening is greater for UK domesticmarket programmes than for those in theInternational sector.

Increasing market capacity has continued,with mid-market carrier entries as follows:

– Royal & SunAlliance has expandedinternationally, opening offices in

Shanghai, Hong Kong, Dubai & Bahrain– Korean Re is a new entrant to the

market, providing capacity of US$ 50 million

– QBE has re-entered the constructionsector, providing additional capacity of US$ 30-40 million

As a result of these further developments,we now estimate total capacity for 2008 to be in the region of US$ 1.7 billion on aMaximum Probable Loss (MPL) basis for‘A-’ rated security or above. This representsa significant increase of US$ 400 million on the corresponding figure for 2007.

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

US$m

(Estimated)

2003 2004 2005 2006 2007 2008

Onshore construction capacity for energy business, 2003-08

Source: Willis

Capacity for construction risks in 2008 is at a five year high.

Whilst none of these new carriers havetaken lead market positions, theiradditional capacity has reduced theconstruction market’s dependence on

existing leading insurers. It has alsosupported a number of aggressively pricedplacements that may have otherwise haddifficulty in attracting capacity.


Key market drivers

A number of key factors contributed to shaping the profile of the onshoreconstruction market during 2007, whichcan be summarised as follows:

– Reinsurance treaty issues– Unified lenders’ clause – Longer project periods – Inflation– Demands on EPC contracts – Project delays– Contract certainty regulations

imposed on the insurance industry

However, as markets have softened, therehave been changes in underwritingphilosophies. Local and regional marketsare increasingly showing hunger forbusiness in the small/medium-sized riskcategory. As a result, more direct businessis now being placed into local marketswhich would have previously been placed in London.

Outlook – further softeningexpected in 2008

As market conditions continue to soften,insurers are becoming more selective in the way that they treat particularinsurance programs. The market still valueshigh levels of personal contact, which can be used to create a competitive advantagethroughout the underwriting process. This is a key differentiator, which remainsessential in markets where risks are wellmanaged, proven technology is utilised andthe projects are located in areas with little or no catastrophe exposure.

Coverage offered has still not significantlyaltered, with broad-form cover still beingavailable as it was during the harder phasesof the market cycle. In general, buyers arepressing for premium expenditurereductions rather than seeking to use thesame premium spend to obtain wider cover.

Deductible levels still remain consistent,with insurers challenging currentdeductible levels for defective partscoverage (LEG/3/2006). This usuallyoccurs where process technology may benew or unproven or where significant“scale-up” issues arise.

We now have strong evidence to suggestthat rates will continue to softenthroughout the first half of 2008. The path of this cycle is dependant upon thesustainability of these rate reductions;insurers in the downstream constructionmarket have previously found out thehard way what happens when they havechased rates down to a level that provesunsustainable, as they did to their costduring the last cycle of 1999-2000.

The future direction of the reinsurancetreaty market, as well as the occurrence of any natural catastrophes, will also havea significant impact on the path of thiscycle. Furthermore, the global impactfrom the sub-prime lending crisis is still tobe fully felt by the market. This crisis maydirectly cause global economic growthrates to slow, which indirectly may have a significant impact on the number andvalue of new projects.

Even though the downward cycle ishaving an impact of the constructionsector; this may not be a drastic as inother markets due to the long-tail natureof the construction market. The lag-timemay prove to be a matter of years, bywhich time the market may be able toreposition itself appropriately to dealwith the consequences.

INTERNATIONALLIABILITIES


Recent Developments

In the June 2007 Energy Market Review we characterised the market as significantlystretched. There were at least some signsthat capacity increases were levelling off and the possibility of firmer conditions in2008 could not be ruled out. At the time of writing, we are concluding a number of liability placements with end of yearattachments, and we are detecting somepushback on rate reductions.

However, the reality remains that mostprogrammes are benefiting from furthercuts in rating levels, at least through thecurrent renewal season. Insurers remainvery reluctant to lose business and therehave been no significant events impactingthis sector of the market. Until insurers’profitability is clearly under pressure, it seems unlikely that there will be asufficient change in sentiment to produceadditional resolve to hold the line on ratesor to prompt a significant withdrawal of capacity.

Aggressive competition for morestraightforward liability business remainsa feature of many local markets, withcapacity flowing in from established globalinsurers. We are also now seeing some ofthe more difficult programmes beingquoted locally, at least at primary level.

There is now clear evidence of areallocation of capacity to regionalunderwriting operations by some of the international insurers. It remains to be seen whether decentralisation ofunderwriting will lead to loss of controlover underwriting philosophy. We haveseen examples of actions by regionalunderwriting operations that do not reflect messages coming from the centre,for example, the way that capacity isstructured across an individual risk. We have commented before that whilstinsurers have been prepared to chase ratesdown, they have focused on maintainingdiscipline in terms of underwriting criteria including wordings and depth ofinformation required. If underwritingcontrol slips to any significant extent, then the downward slope of the market

could become steeper again. However thiscould eventually precipitate the end of the soft market if lax underwriting terms,combined with still lower rates, push themarket into deficit.

Once treaties are finalised for 2008, weawait feedback from the reinsurancemarket with interest. Currently thesignificant feature remains increasedretentions by the direct market and the softpricing of treaty protection. There arereports that reinsurers are focusing on thecoverage issues flowing from the Europeanenvironmental liability Directive. Thissubject is covered in more depth later inthis article.

Impact

From the perspective of the insurancebuyer, the situation is still positive, as we advised as earlier in the year. Ratereductions are slowing for the larger riskswhich have benefited most from the softmarket over the past few years, althoughdeals are still being done. Careful co-ordination of marketing across the globe can achieve the best possible results by maximising competitivepressure between local and internationalmarkets. Insurers continue to demandgood quality information and wellpresented programmes continue toachieve better results when marketed, and we would anticipate that thiscontinues to be the case through 2008.The pressure on income is intense, withmarkets in London seeing reduced newbusiness. The short-term temptation to relax underwriting standards is real,particularly when competing with local markets.

Capacity

Overall market capacity is buoyant. Ourchart shows a tailing off of growth in2008, although for most exposures thereis no difficulty in achieving the policylimits required.


Realistic capacity available for refineryand heavy chemical exposures is lower,but still sufficient for most needs. Wherecapacity for such risks is required inexcess of US$ 500 million, it willprobably be on a Bermudan occurrencereported form, although Willis hasrecently been able to achieve a limitsignificantly excess of this on a followform basis.

We do not anticipate that any significantadditional capacity focused on the energysector will emerge in 2008. However, newcapacity announced in 2007 will now becoming on stream, the most significantbeing the new Dublin operation of Aspen.An experienced excess casualty team ledby Bob Patton moved from XL to form thenucleus of this new venture, which widensthe Aspen offering as they are bringing anadditional US$ 50 million to the market.

Tax and compliance

In the last edition of this Review we focussedon the issues related to premium tax andregulatory compliance for internationalprogrammes, and we described the lead thatthe Zurich was taking in introducing astructured approach to handling the issue.

XL Europe has now introduced theirapproach, named “World Pass”. As withZurich, they offer information on regulatoryand tax compliance, together with anapproach to structuring programmes whichthey believe will allow both their clients andthemselves to operate in a compliant wayacross many jurisdictions.

This development reinforces the messagethat this is an issue that has becomestrategic in that it can, and does, affectdecisions on programme design and evenwhich insurers to use. Some buyers maytake the view that the systematic approachadopted first by Zurich and now XL iscumbersome and does not reflect theirview of how these issues should be handled.

We anticipate however that in the end itwill be those insurers who cannoteffectively handle these issues who willsuffer, as compliance is increasingly seen as a key component of global programmedesign and management. The launch of an investigation by Belgian tax authoritiesto establish whether tax has beencorrectly paid by foreign insurers andinsurance buyers illustrates the highprofile of this issue.

International Liability capacity for energy business, 2003-08

Capacity for energy liability risks in 2008 for non-US domiciled business remains stable.

2000 2001 2002 2003 2004 2005 2006 2007 2008

0

500

1,000

1,500

2,000

2,500

Source: Willis


Outlook

In summary, our present view is that themarket will remain soft through 2008. In the absence of major claim events orother factors affecting the market as awhole, we see no pressure for change.

Change in market conditions will probablybe a process of attrition as margins aresqueezed. Less stringent underwriting, inthe continued fight to maintain premiumvolumes, could accelerate the process butthis is unlikely to become apparent until2009 or even 2010.

The European Environmental directive and the growth ofdemand for environmental insurance

Transposition of EU Environmental Liability Directive (2004/35/EC)Understanding of position as of November 2007

Member State Comments Transposed?

Austria Federal draft law was published in February 2007, and public Noconsultation ended on 23 March 2007.

Belgium Flemish Region: Amendments to a draft decree due to have been Nosubmitted to the Flemish Parliament July 2007 – furthergovernment legislation will then be required.

Walloon Region: The process is under way (second reading at Nothe Walloon Parliament – waiting for the opinion of theCouncil of State).

Brussels Region: Still in internal consultation process, not yet Nosubmitted to the Brussels Parliament.

Federal Authority: An amendment to the law of 31 December No1963 on civil protection and a new period of limitation for the recovery of costs by the public authorities in the civil code was published in the Belgian Official Journal of 8 May 2007. Further government legislation is needed.

Bulgaria Draft legislation was issued in September 2006. No

Cyprus Transposition was originally expected in February 2007 Nobut not yet implemented

Czech Republic Draft legislation was issued in July 2006, awaiting Expected interdepartmental consultation. summer 2008

Denmark Proposal from the Minister of Environment was presented in Noparliament in March 2007. Minister for Environment has proposed amendments, which will be discussed during the next Parliamentary session commencing in October 2007.

Estonia Draft Act on Environmental Liability was approved by the YesGovernment in May 2007 and adopted November 2007.

Finland Government proposal was issued for public consultation on No14 May 2007. It is expected that legislation may be adopted in January 2008 at the earliest, following Parliamentary debate.

France Draft legislation was published in November 2006. Following Nopublic consultation, the bill is awaiting discussion and adoption by Parliament into the French Environmental Code.

Germany At the federal level the directive has been implemented by the YesUmweltschadensgesetz, however this Act will also need to be (at federal implemented at the regional level. level)

Greece Not aware of any public consultation or draft legislation to date. No

Hungary The Directive was transposed in April 2007, by amendment of Yesthe framework environmental act (Act LIII of 1995) and adoption of various decrees covering different aspects of the Directive.


Member State Comments Transposed?

Ireland A public consultation exercise has been currently underway, Nowhich closed on 19 September 2007.

Italy The Directive was implemented in April 2006 by Part VI of Law Yes152/2006, commonly referred to as the “Environmental Code.”

Latvia The Directive was transposed by the required deadline of Yes30 April 2007

Lithuania The Directive was transposed by legislation passed in YesMarch 2005

Luxembourg Not aware of public consultation or draft legislation No

Malta Not aware of public consultation or draft legislation No

Netherlands Draft legislation has been submitted to Council of State Nofor approval.

Poland The Directive has been transposed through the Act on YesPrevention and Remedying of Environmental Damages, in force (partially)since 30 April 2007. Annexes I and II to the Directive are to be transposed through executive regulations issued by the Minister for the Environment.

Portugal Not aware of any public consultation or draft legislation to date No

Romania The Directive was implemented by an emergency ordinance in YesJune 2007, however the ordinance will enter into force only (subjectupon its confirmation by the Parliament. The future Law on the to approval) approval of the Emergency Ordinance may therefore be subject to amendment.

Slovakia Transposed Yes

Slovenia Not aware of public consultation or draft legislation. NoA preliminary study was undertaken to identify the measures necessary to implement the Directive.

Spain A Bill (Proyecto de Ley de Responsabilidad medioambiental) Yeswas published by the government in March 2007. This was approved by Parliament. In October 2007 and is backdated to 30th April 2007.

Sweden Legislation transposing the Directive came into force on Yes1 August 2007.

United An initial public consultation exercise has been completed, NoKingdom with a further stage of consultation planned for early 2008

We venture to predict that 2008 will be theyear that environmental insurance stepsfrom the shadows and starts to take itsplace as a mainstream product, at least forEuropean exposures in the energy sector.

From the point of view of the insurers whospecialise in this area, there have beenmany false dawns with limited interestbeing demonstrated by risk managers.Environmental risk exposure and itsrelated risk transfer strategy are nowmoving much further up the agenda of therisk management community. As we havealready suggested, it is also moving up theagenda of the reinsurance market. Theprincipal concern of treaty reinsurers on

the general casualty portfolio is to limitany extension of the limited pollutioncover provide in liability policies.

The catalyst for the change in priorities is the EU Directive 2004/35/EC onenvironmental liability with regard to theprevention and remedying of environmentaldamage, (the “EU Environmental LiabilityDirective”). This came into force in April2004 with a deadline for implementation by Member States of 30 April 2007. EUdeadlines being somewhat flexible, moststates missed that date, although progress is now speeding up. The table summarisesthe position at 31/12/2007 for the largerEuropean countries.


Obligations under the DirectiveThe Directive establishes a liabilityframework for the following categories of “environmental damage”:

– Harm/damage to species and naturalhabitats protected under the 1992Habitats Directive and the 1979 WildBirds Directive, for example Sites ofSpecial Scientific Interest, SpecialAreas of Conservation and SpecialProtection Areas

– Pollution of waters covered by the2000 Water Framework Directive

– Land contamination that creates asignificant risk to human health

The Directive is based on the “polluterpays” principle. Operators of certain listedactivities, which include many energy andchemical processes, will be strictly liablefor environmental damage caused by theiractivities. All other operators will be liablewhere they have been negligent.

The Directive does not apply retrospectivelyand therefore applies only to environmentaldamage caused by incidents occurring after30 April 2007. The scope of remedialmeasures required following environmentaldamage to water or protected species isbroader than is currently required under EU and most local environmentallegislation, and includes the following:

– Primary Remediation – returning thedamaged natural resources to (ortowards) their original “baseline”condition.

– Complementary Remediation –measures to be carried out if baselineconditions cannot be achieved throughPrimary Remediation, potentiallyincluding the creation of an alternativehabitat elsewhere.

– Compensatory Remediation –compensation for an interim loss untilPrimary or ComplementaryRemediation is completed. This doesnot include financial compensation tomembers of the public.

Whilst it was much debated whilst theDirective was being developed, there is norequirement for compulsory insurance,

although this aspect will be reviewedagain in 2010.

The impact of the Directiveon demand for insurance

We are seeing increased interest inenvironmental insurance from the energyindustry in Europe. This has beenhappening over a period of time, as therehas been an increased focus on themismatch between exposures faced andthe limited cover in liability programmes.National legislation has been tighteningsignificantly over the last 10 to 15 years inmost countries. The Directive in Europe is therefore a catalyst for change in theperception of the importance of this issuerather than a fundamental change in thelegal environment.

It is apparent that companies basedoutside the EU, in particular the USA, alsowant to understand the impact of thedirective on their operations in Europe.They have great awareness of the issues, in particular the parallels between theDirective and Natural Resource Damages(NRD) legislation in the USA (please seethe next section of this Review).

The Directive and liability insurance

A key question is the extent to whichexisting liability policies will cover Directiveliabilities. The most fundamental issue isthat most policies only cover sudden eventsthat result in pollution damage, whichrepresents a significant shortfall of covereven before the directive is considered. Inaddition it is doubtful that many policieswill cover the new liabilities, and it iscertainly clear that liability insurers aregenerally reluctant to extend existing cover.

The specialist environmental insurers seethe Directive as an opportunity and areprepared to offer explicit cover for theDirective as part of their environmentalliability forms. Some insurers haveexpanded their standard policy wording,whilst others have developed new productsor coverage sections which are offered onrelevant enquiries.


Key uncertainties arising fromimplementation of the Directive

The key uncertainty is the absence of guidance on theimplementation of the Directive. In particular, it is unclear how environmental damage is to be evaluated under the Directive,and what scope of complementary and compensatory remediationmay be required. These issues will be decided by the designated“competent authority” in each Member State, potentially leading to a variable approach to enforcement throughout the EU.

The Directive allows non-governmental organisations (NGOs)and other affected parties to request that authorities take actionagainst operators. Insurers have mixed views as to whether thiswould increase their exposure. However, there is some concernthat claims could be driven more by political factors thantechnical considerations, particularly where media coveragegenerates public unrest. Insurers agree that the Directiveincreases the importance of operators maintaining goodstakeholder relations.

Again, the role of the authorities in enforcing the Directive andensuring credible claims are pursued will be of real significance.

Conclusion

The environmental insurance market has developed significantlyover the past few years. Programmes covering both sudden andgradual pollution can be implemented on a multinational basisand as we have suggested, they can now include the new Directive liabilities.

Total market capacity, even for relatively exposed sectors such asthe energy and chemical exceeds US$ 2 billion. With the cost ofthe main casualty programme falling, now is probably a good timeto evaluate environmental exposures and analyse and comparethe cover available from the specialist market. It is certainly thecase that a number of companies in the energy sector have donethis or are planning to in the near future.

In the next edition of this Review we intend to look in more detailat how an environmental programme can be structured and thepractical issues of implementing cover for onshore energy risks.

US EXCESSLIABILITIES


Favourable marketconditions for buyers tocontinue into 2008

Pricing conditions as respects excessliability insurance for energy risks(including petrochemical and chemicalrisks) continued to be favourable toinsurance buyers. Gulf of Mexicohurricanes during 2006 and 2007 failed to materialize to the point of adverselyaffecting the liability markets andfurthermore there have not been anyother excess liability loss events thus farin 2007 that have had the effect ofcountering the softening trend. Thesefactors, combined with an abundance ofexcess liability capacity and affordabletreaty reinsurance costs, have resulted in a continued gradual softening in excessliability market conditions through thethird quarter of 2007 and will most likelycontinue into 2008.

Modest rate reductions set the benchmark

At the end of 2007, reductions of 5% to10% are setting the benchmark for theenergy sector. However, these are averagefigures and for accounts that do notpurchase full market capacity, i.e. wherecompetition amongst insurers can becreated and that enjoy a clean loss record,premium reductions exceeding 10% wereachievable. Conversely, premiums forsome programs either from a quality ofrisk, acquisition or losses incurredstandpoint, have actually increasedslightly. As a general comment, there isstill some residual nervousness amongstinsurers, particularly in relation toexposures located in the southern states.

As respects policy form, a softeningmarket does not always produceenhancements in coverage. Generally,breadth of coverage is not being expandedand there is still close scrutiny ofwordings, with certain exclusions notbeing removed easily.

No major changesanticipated in 2008

We cannot readily identify any potentialdrivers of significant change in marketconditions in 2008. However, there issome possibility that early 2008 may see a steadying of the market as there has beensomething of a disconnect between directrates and reinsurance treaty costs. If thistrend continues in the next treaty renewalseason, falling direct rates may meet rising reinsurance premiums as well asincreased attritional losses. The latter arealways present, and in our view must atsome point create a floor under the marketwhen set against the lower revenue of asofter market. Moreover, if the investmentenvironment deteriorates further due tosub-prime issues, or if there is fallout fromthe fires in California, it is possible that the insurance marketplace as a whole could be affected.

These issues aside, we see no immediate ordirect indication that the current marketsoftening will subside in 2008. There is anabundance of excess liability capacity formost risks in the range of US$ 1.2 billion,insurers remain well capitalised and therehas been an absence of market changinglosses that would have any serious impacton insurers’ capital. However, it should benoted that for most energy risks the rate of premium softening in 2008 will be at amore modest rate than the excess liabilitymarket as a whole.

The energy sector does have some featuresthat tend to make it more volatile. Thenumber of lead markets is relatively smalland there is a finite premium pool. Acatastrophe involving a major refinery orpipeline which involves a liability claim that exhausts all the layers on a largeplacement could shift sentiment.


Regional underwriting may strengthen thesoftening process

Regional variation is becoming animportant factor. In certain territories anoversupply of local capacity has fuelledcompetition, leading to higher averagerate reductions. This process has beeninfluenced by an expansion of globaloperations by a number of insurers suchas QBE and Catlin. They are seeking toaccess markets directly, relying less onbusiness flowing into London. Otherinsurers who already have a global footprintare allowing their local operations morefreedom to underwrite and are in somecases increasing the capacity available.

Underwriting issues

Despite competitive market conditions,insurers remain focused on exposures andthe quality of risks. The energy sector doesindeed have significant liability exposuresas illustrated by major events such as theToulouse explosion and more recently theBuncefield loss in the UK, pollution eventsfrom Katrina and the flood affecting theCoffeyville Refinery. From insurers’perspective, falling prices mean that thequality of their underwriting is key tomaintaining profitably in the longer term.

Quality of site maintenance is seen as an important issue for sites with a fire,explosion or environmental exposure.Property surveys are a valuable source of information and can be used todemonstrate that a risk is well managed.Conversely, where a property surveyhighlights problems it is important to be able to demonstrate that correctiveaction is in progress. Insurers will declinerisks where critical maintenance or plantimprovement is outstanding. Offsitepipelines are a particular concern.

Other areas that some insurers aremonitoring include the following:

– MTBE claim activity– Benzene claim activity– Global warming

– Exposures in hurricane prone areasand resultant pollution losses that can occur

– Polyethylene Terephthalate (PET) -packaging material for food andbeverage (plastic) bottling

– Nanotechnology– Teflon and other non-stick surfaces – Perfluorooctanoate/PFOA (C-8) – A

processing aid in the manufacture offluoropolymers to produce items suchas non-stick surfaces on cookware(TEFLON), protective finishes oncarpets (SCOTCHGUARD,STAINMASTER), clothing (GORE-TEX), and the weather-resistant barriersheeting used on homes under theexterior siding (TYVEK).

– Isocyanurate - Forms rigid foam and isuseful in the building and constructionindustries as well as mining.

– Perchloroethylene (Perc) – A chemicalused in the dry cleaning process.

– Fire Retardants/Hexabromocyclododecane andpolybrominated biphenyl ether.

US Natural Resource Damage

There are similarities between the EUEnvironmental Liability Directivementioned in the preceding section andNatural Resource Damages (NRD)legislation in the USA, Enforcement actionhas been taken by the relevant authorities(referred to as the Natural ResourceTrustees) to claim the costs of restoring adamaged area as well as compensation forthe interim loss of services occurring prior to full restoration. A number of suchclaims have been insured through the USEnvironmental Insurance Market, manyresulting in seven figure settlements.

Evaluation of the costs of compensation for NRD is often performed using HabitatEquivalency Analysis (HEA), whichessentially seeks to determine the “value”of the damaged habitat represented andthus what costs or services should be metby the liable party. The approach to valuingdamage in Europe may well draw fromexperience in the US.


TERRORISM


Market remains hungry for premium income

As we move into 2008 the terrorismmarket is still very hungry for premiumincome and, as in other sectors, rates have continued to fall.

However, there are now several programmeswhere rates cannot realistically fall anylower because of the need to generateminimum premiums. Other programmes,especially those which feature significantpremium income, could still see rates fall by 20-30% and achieve the necessary take-upin the market. Overall, we believe that ratesfor 2008 may reduce from anywherebetween 10-40%, depending on the extent of the premium on offer.

The loss record in this sector continues tobe modest, with only the recent attacks bylocal factions on Mexican pipelines andthe consequent business interruption lossworthy of note, although even some theselosses may have been absorbed by BIwaiting periods. Certainly the 2007 lossrecord has not been sufficient to make anyimpact on market dynamics.

Insurers balk at available returns

Rating levels in this sector have nowreached the point whereby potentialnewcomers to the market have finallybegun to be put off by the meagre premiumto capital ratios on offer. We understandthat some of the major European insurershaving been considering offering“watching” lines for this class, but giventhat most of these insurers have minimumpremium requirements they have decided,perhaps understandably, not to enter themarket at this stage.

Although we do expect that more capacitywill be available in this market in 2008,there are markets threatening to reducetheir line sizes as minimum premiumlevels are reached. In particular Hiscox,who has traditionally been the majorterrorism market in London and whocurrently have US$ 100 million lines attheir disposal have said that they will be

using their capacity less extensively in2008. The rationale for such an approachis that if rating levels have reached thebottom of this soft market, insurers willnot be wishing to commit their capacity to programmes which cannot be writtenprofitably at these prices. Bearing all this in mind, realistic total capacity forthis class is now expected to reachapproximately US$ 1.3 billion in 2008.

New Hiscox product clarifieswar/terrorism ambiguities

Meanwhile, demand for the productremains strong, and we are noticing moreorders as rating levels continue to fall.One noticeable feature has been that moreand more clients are looking to broadentheir cover to include political violence aswell as just terrorism. 2007 saw theintroduction of the new Hiscox politicalviolence product, which was developedspecifically following the Israel/Lebanoncrisis. There was some uncertainty afterthe crisis as to which events could beclassified as acts of terrorism and whichcould be classified as acts of war, andopposing and confusing views quicklydeveloped within both the buyer andinsurer communities.

The Hiscox product was developed inorder to avoid any confusion and ensurethat any losses from such events in thefuture would be covered by this wording.To date, few others have followed Hiscox’slead, but we anticipate that this product,albeit relatively expensive, will certainlybe in high demand in key regions of theworld where the threat of terrorist activityis at its highest.

Meanwhile Lloyd’s syndicate MAP hasdeveloped their own policy wordingcalled T3X, which gives clients capacityfor nuclear/chemical/biologicalexposures. The syndicate is encouragingbrokers to provide buyers with a sub-limitfor these perils, in return for which theywill underwrite 100% of the sub-limit on the programme.

There is very little pressure on existingretention levels, and in reality this is less


of an issue than it has been in the past.Certainly the market views this product as a protection for catastrophe rather thanattritional exposures, and both buyers andinsurers seem comfortable with retentionsat their existing levels.

TRIA extension maychallenge commercialmarket business

In the previous edition of this Review westated that there was some uncertainty asto the extent of the cover provided byTRIA in 2008. Originally TRIA was due toexpire on 31st December 2007, and theauthorities have previously indicated thatthey would not leave it quite so long thistime to work out how they were going totake this issue forward in the future.

On December 18, only hours beforeadjourning for the holiday season, the U.S.House of Representatives voted to extendthe Terrorism Risk Insurance ExtensionAct (TRIEA) for an additional seven years,using the version of the bill approved bythe Senate Banking Committee onOctober 17 and deemed to be acceptable tothe Bush administration. On December26, President Bush signed the bill into law.

While the final bill is not ascomprehensive as that originallyproposed by the House, it is nonetheless aclear improvement over the expiringprogram, ensuring longer-term continuityof the program and eliminating thepreviously blurred distinction betweenforeign and domestic acts of terrorism.

In summary, the legislation will:– Extend the program by seven years –

from December 31, 2007 to December31, 2014

– Eliminate the distinction betweenforeign and domestic acts of terrorismby eliminating the requirement thatsuch acts be “committed on behalf ofany foreign person or foreign interest.”

– Retain the insurer deductible level of20% of direct earned premium forinsured terrorism losses

– Continue the current “make available”provision for insurance for acts ofterrorism as redefined under the act

– Continue the current level of federalcompensation and insurer co-pay at85% and 15% respectively

– Maintain the current US$ 100 millionaggregate industry loss to triggercoverage

The provisions of the original House billthat did not survive include:– A program extension for 15 years

– Inclusion of NBCR – acts of nuclear,biological, chemical and radiological –terrorism within the “make available”provision

– Inclusion of Group Life as a coveredline of insurance

– Provision of a “reset mechanism” forsignificant attacks – lowering thedeductible from 20% to 5% forinsurers affected by an event exceedingUS$ 1 billion in insured losses

– A reduction to US$ 50 million of theaggregate industry loss required totrigger coverage

As a concession to the House, the SenateFinance Committee has agreed to "revisit"the issues of NBCR and Group Life in thenear future and to address the feasibilityof future expansion of the program.

Property Insurance ProgramsEven before the President inked themeasure, Property underwriters whoserenewal capacity commitments wereconstrained by uncertainty surroundingTRIA’s fate began signing binders forJanuary 1, 2008 renewals.

Their collective sigh of relief was echoedby Construction risk underwriters whohad been trying to determine how theycould support multi-year projects withoutthe benefit of Terrorism Risk InsuranceProgram Reauthorization Act of 2007(TRIPRA) backstop.


For some policyholders with sunsetprovisions, underwriters will now beissuing pro rata TRIPRA additionalpremium notices to cover the period fromJanuary 1, 2008 to their respective policyexpirations. Most buyers will view this as a minor inconvenience when measuredagainst the benefit of the continuation of terrorism protection.

TRIA and Captive UtilizationWhile the focus of this legislation hasalways been to provide a source ofreinsurance support to mainstreaminsurance markets, TRIA and its extensionas TRIEA in 2005 have also had asignificant impact on the development ofthe alternative risk transfer marketplace,particularly in the utilization of captiveinsurance companies. As the programpertains to any U.S. Property or Casualtyinsurance company licensed to engage in the business of providing primary orexcess insurance and receive direct earnedpremiums, it was subsequently determined(in the Treasury Department’s set of finalregulations issued in 2003) that “statelicense captive insurance companies” and“admitted risk retention groups” wouldalso be eligible for the protections affordedunder TRIA.

As a result, certain insurance regulators –e.g., those in Vermont, New York, SouthCarolina and Arizona – have approved thecreation and funding of captives designedspecifically for the purpose of accessingprogram coverages.

Captives that are used to accessing TRIA(now TRIPRA) coverage have theopportunity to achieve potentiallysignificant savings in the long-term cost of risk for terrorism insurance, and theyalso have the latitude to obtain broadercoverage than that which may be availablein the traditional marketplace – includingaccess to coverage for nuclear, biological,chemical and radiological terrorism.

With the federal government’s longer-termcommitment to this legislation nowconfirmed, we expect to witness continuedexpansion of captive formation in 2008.

Outlook

We would suggest that the terrorismmarket may finally be reaching the end of this phase of the market cycle, as moreinsurers begin to reduce their line sizes.However, such is the extent of theavailable capacity in this market that itwill take considerably more than this forany impact to be felt on rating levels. Byhistorical standards, premium levels inthis market have been very robust since9/11 and they have actually grown everysingle year, even as rating levels started to decline during 2002. Indeed, marketsources indicate that the third quarter of2007 was the first quarter since 9/11 thatLloyd’s premium for this class has actuallyreduced. So perhaps things will change alittle in this market in 2008 as insurersrealise that rating level reductions can no longer be disguised by increasedpremium income.


Comparison of Terrorism Risk Insurance Act of 2002 (TRIA) and SubsequentExtension Legislation

TRIA (2002) Terrorism Risk Insurance Terrorism Risk Insurance Revision and Extension Program Reauthorization Act of 2005 (TRIREA) Act of 2007 (TRIPRA)

Duration Three years Two year extension through Seven-year extension through (expired December 31, 2005) December 31, 2007 December 31, 2014

Covered Lines Most commercial property Same lines covered by the Same lines covered by the and casualty lines, including program established in 2002 current program (no change workers’ comp and surety except deletes the following: from 2005 amendments)but excluded crop, private commercial auto, professional mortgage, medical malpractice, liability (other than D&O), financial guarantee, reinsurance surety, burglary & theft, and and flood provided under NFIP farm-owners multi peril

No health or life, including group life insurance

Act of Limited to violent acts certifiedTerrorism by Treasury Secretary, inDefinition concurrence with Secretary

of State and Attorney General, to have been committed by oron behalf of a foreign personor interest to coerce or influence US policy

Insurers All licensed insurers; IID-listed No change No changeCovered by surplus lines insurers andBackstop and insurers approved under “Make Available” Federal insurance programs Mandate for marine, aviation, and

transport; state residual marketinsurance entities or workers’ compensation funds


DIRECTORS’AND OFFICERS’LIABILITY


Since July 2007 the D&O market forFinancial Institutions is showing signs of hardening and, given the amount ofmedia coverage of recent sub-prime debtdefaults, it will come as no surprise to ourreaders that this has been felt especially inthe United States. Indeed, in the past 3months there have been approximately one hundred claims against U.S. companies(largely financial institutions) as the resultof the sub-prime fall out.

Unlike all the other sectors that we havereported on in this Review, we can reportthat D&O insurers are under pressure toincrease rates on many lines for this classof business, and financial lines insurersare now at the position where they arewilling to walk away from a programme if they cannot secure what they regard asthe correct rate for the exposure.

However, outside the USA there have so far been very few claims against financialinstitutions because of the sub-prime issue.So for commercial programmes, both in and outside the USA including companiesin the energy sector, rates still remain fairly competitive. Indeed, reductions ofbetween 10% and 15% are still available on programmes that have not benefitedfrom premium reduction in the past year or so, whilst we are seeing some largerprogrammes with limits of over US$ 150 million achieve rate reductionsranging between 15 and 20%.

CoverageMost insurers over the past year haveproduced new and improved policywordings, the highlights of these being as follows:

– No pollution exclusion, or at least lessrestrictive pollution exclusion language

– Additional limits available for non-executive Directors

– Broader coverage for externaldirectorships

– Improvements to the severability andwarranty language

Furthermore, for certain programmesreductions in retention levels are achievable.

The worldwide capacity for D&O policylimits remains fairly stable, with many ofthe large D&O insurers actively seeking toincrease market share and opening officesin several of the emerging markets such asRussia, China and India to capitalise ongrowing awareness and the need for D&Oin these jurisdictions.

As we commented in the previous editionof this Review, many companies nowpurchase local policies in countries wherethe global policy is not acceptable. This isbecause in a number of countries thepolicy needs to be an "admitted" policy.This means that the carrier has beenapproved and the policy form has beenformally submitted and approved by thelocal regulator as required by local law.There have been no significant increasesin capacity recently, nor do we anticipatethat there will be over the near future.

OutlookWith the sub-prime issue creating a creditcrunch around the world, a potentialrecession looming and the US economy not performing as well as in the recent past, this could well lead to a greaternumber of D&O claims against commercialcompanies. We anticipate that the D&Omarket, both in the US and elsewhere, willbegin to harden towards the end of 2008.


The following Willis Associatescontributed to this edition of the Energy Market Review:

– Martin Beagley– Justin Blackmore– Jack Camillo– David Clarke– Alex Clayton– Tim Culhane– Frank D'Ambrosio– Martin Daniels– Peter Fritz– Phillip Ellis– Jerry Garner– Lesley Harding– Peter Hearn– Roger Kaye– Gerard Maginn– David Nicholls– Mark Sluman– Neil Smith– David Thomas– Michael van der Gucht

Editor: Robin SomervilleDesign: Valeria Mazzitelli

Superheated commodity prices:a blessing or a curse for energy insurers?

January 2008

ENERGYMARKETREVIEW

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