During the last three years, rates in the global energy market have shown signs of relative stability after some roller coaster years Peter Stow considers the current factors driving the market cycle and how they will affect its future.

Over the past ten years, the global energy market's client/premium base has halved. Of course, some of this reduction has been the result of company consolidation, but there is no doubt that the reduction is, in part, a reaction to the volatility of the insurance cycle over the period. We are now in a world where major league energy businesses are increasingly turning to alternative risk financing methods to meet their needs. And having used these alternatives, they are not coming back to the insurance market.

A lesson in volatility

The global energy market has had a volatile history. In the late 1990s, the cycle softened and rates dipped to their lowest level in the market's history. At the beginning of the decade this began to correct itself and, following WTC, this correction was reinforced. Global capacity, which had stood in the region of $4bn before 9/11, fell to around $1.3bn.

In 2002 rates hardened and, for the first time in the market's 30-year history, deductibles increased significantly. In 1999, the average retention on many property risks was around $100,000. Within three years this had increased tenfold. This movement was a crucial issue for carriers. For some, attritional losses had wiped out the entire premium income of certain portfolios. An increase in deductibles had the effect of cutting out the majority of these losses.

With the hardening of rates and premium increases of three to four times, new capital came to the market, attracted by the fact that the losses of earlier years had been reversed. The market remained firm over the next year, with more capital and only moderate losses.

This year, capacity stands at around $2bn and, while it is not back to the earlier levels, competition is increasing. With this comes a growing pressure on rates, resulting in a fall in prices. With deductibles and contractual terms holding well, established carriers remain happy with the market's current performance.

Future defining factors

There is a commonly held view that the market is on its way back to where it came from. This may or may not be true, but there are distinct factors that will dictate how global energy insurance performs next year and beyond.

The impact of claims is one factor. The offshore sector, covering upstream production, has experienced more stability than that of onshore business.

Rates have held and there have been no major losses. Onshore has seen more rate pressure and its loss experience in the first six months of 2004 has been heavy. There have been five significant losses so far this year with a potential exposure of $1bn, against an onshore portfolio valued at not much more than $2bn.

The market has always had a heavy dependence on reinsurance. The survival of some of the global energy's major markets has been based on the purchase of facultative reinsurance. In recent times, reinsurers have been less convinced of the viability of the portfolio, resulting in a reduction in capacity and providers. The cycle has also seen the exit of smaller, primary layer providers. Their departure has left gaps that directly impact on the ability of some markets to obtain cost-effective cover. The focus on financial security and ratings has placed even further pressure on the smaller, less well-capitalised providers.

Another important factor has been the drive for underwriting discipline and the adoption of processes and procedures designed to improve and protect the underwriter's book. The use of risk and catastrophe modeling, and engineering and regular actuarial reports, gives insurers no excuses for a failed line. Identifying under-performing or problem business early means remedial action can be taken quickly and, where necessary, nipped in the bud before it causes damage. Insurers have more control over their business than ever before and they must use it if the market is to maintain its potential.

Learning from past mistakes

The market is currently at a point where insurers feel comfortable with the premium levels. Bringing together the factors mentioned previously will ensure that these rates remain so. Any variation or move off course may well result in a return to the ups and downs of recent history. Client and reinsurer confidence will take a further bashing, and it is very likely that some of global energy's main carriers will take decisive action, or even withdraw from certain sectors rather than stay on the roller coaster for another round.