With recalibration of the catastrophe models expected in 2006, Alistair Lockhart-Smith highlights the unique challenges posed by the energy sector

The offshore energy insurance market was badly shaken in 2005 as Hurricanes Katrina and Rita swept through the Gulf of Mexico, leaving energy underwriters with an insurance bill expected to exceed $15bn. As we move into 2006, the market is still feeling the shockwaves, and their impact was evident at the January 2006 reinsurance renewals, when premiums for the Gulf of Mexico energy business soared by up to 300%.

Despite the fact that hurricanes do happen in the Gulf of Mexico, the insurance and reinsurance market did not anticipate the scale of these disasters. There is a general feeling that the cat models have dramatically failed the market. Are the models really the problem, or is this a case of the workman blaming his tools?

Unlike risks to buildings on land, those to offshore energy platforms are notoriously difficult to model, due to the lack of data, the complexity of coverage, the structure of the value chain and the physical attributes of the platforms themselves. In some cases less than half of the total coverage in a policy can be analysed using reasonable assumptions. Certain elements, such as business interruption, have proved especially hard to model. Therefore, it is hardly surprising that while the market was relatively free of catastrophe losses, catastrophe models were less prevalent in the energy market than in other classes.

Despite the disappointments of 2005, catastrophe modelling is set to become more important, especially as rating agencies, regulators and investors are demanding a more transparent approach to estimating potential cat losses. Some underwriters are reluctant to write business that they cannot model accurately. There is a general realisation in the market that models are, after all, just models. Katrina has demonstrated the danger of adopting a "black box" approach, where the innermost workings (and weaknesses) of the models are not clearly understood by those relying on their numerical output.

To avoid the disappointments of 2005, underwriters, brokers, regulators, actuaries and catastrophe modellers will need to work together to improve the quality of data and strengthen their modelling assumptions. Despite the challenges posed, the future does not look bleak for energy modelling.

If anything, we will see more innovation in the market.