Do depressed oil and commodity prices threaten the viability of open market cover in the energy and heavy industry sectors?

The oil price rout and a slackening demand for commodities generally as the Chinese economic slowdown bites are converging to create the perfect storm, impacting the energy and heavy industry sectors.

Whilst Opec has forecast that prices will rally this year, vindicating its avowed strategy to maintain output so as not to concede market share to rival higher cost producers such as US shale, the International Energy Agency anticipates no respite given both the resilience of non-Opec production and the return of Iran to the economic world following the recent formal lifting of sanctions; at a minimum, this will place an additional 500,000 barrels per day back on international energy markets.

The oil market’s oversupply coincides with a Chinese economy that is at its slowest (in percentage terms) for 25 years. With domestic commodity markets exhausted, notably through cutbacks in infrastructure investment, government subsidised Chinese steelmakers, for example, have been offloading their low-cost steel at deflated prices on world markets. That glut in discounted supply has hit Western manufacturing industries, particularly in the UK where the announcement of further layoffs at Tata’s Port Talbot plant merely heralds the latest round of cost savings implemented by companies in order to compete against knockdown Chinese imports.

In the insurance sphere, one palpable irony emanating from China’s economic slowdown is that the severity of the losses following last August’s Tianjin explosion in China has been exacerbated in certain sectors. For example, the downturn resulted in there being far more vehicles stockpiled at the Port (and thus damaged by the incident) than would otherwise have been the case had demand not diminished.

With energy and mining companies affected by the continuing downturn, a feature thrown into stark focus by Moody’s credit rating review of 175 oil, gas and mining companies, if funding becomes an increasing issue for businesses impacted by the current slowdown will there be an added emphasis on increasing the size of self-insured retentions and captive deployment? If so, does it beg a further question for London Market insurers as to what is left to insure, at least profitably, for what is itself an intensely competitive, over capacitated insurance market?

With risk management budgets contracting off the back of deteriorating profitability, some major corporates are naturally asking themselves how much cover they need and in some instances, even more fundamentally, whether insurance remains a viable risk transfer tool for their business at all. It is a sentiment we are seeing most clearly in the offshore energy sector where a broad breakeven figure of oil at USD 50 per barrel (admittedly varying from location to location) means the economic feasibility of exploration and production in the North Sea and elsewhere has been eradicated, forcing producers to shelve projects and axe headcount worldwide, with both BP and Schlumberger announcing largescale redundancies in recent weeks and doubtless more to follow. Historically, offshore oil and gas has been seen as a blue-ribbon industry for insurers, generating significant premium income for the London Market. And whilst the relatively benign hurricane activity of the past few years has maintained a level of profitability for many underwriters, the crude price collapse and the concomitant shrinking of producers’ exposure base undoubtedly heightens competition in a congested insurance market.

Need for cover

Ten years on from the Buncefield explosion and five years since Deepwater Horizon, disasters such as the Samarco dam collapse in Brazil can perhaps be highlighted as evidencing why there will always be a need for cover. Indeed one persistent trend over the past decade as commodity prices rose has been the growing relevance of business interruption exposures, which typically now account for a far higher proportion of energy claims and particularly so against what seems to have been a proliferation of natural disasters such as the Australian and Thai floods, and the Japanese earthquake.

The increasingly globalised economy and interdependencies between energy related companies means that contingent business interruption insurance in the context of supply chain risk has similarly assumed heightened significance for the insurance purchaser, particularly in the petrochemical and power sectors where suppliers and customers are often embedded within an insured’s site leading to an accretion of risk at a single location.

Whilst the extent of the insurance requirement might therefore fluctuate with demand, the uncertainty of commodity prices and a world of increased interconnectivity and risk accumulation in logistics hubs such as Tianjin undoubtedly present insureds with the predicament of identifying the extent of cover they require (and pay for) and adopting a more judicious approach in declaring risks in such a volatile economic landscape where the value and flow of insured assets (stock/products) may be impaired through dwindling demand.

The insurance industry continues to evolve in helping insureds meet such challenges. At a time when many are prepared to question the longevity and continued relevance of the London Market, the Insurance Act of 2015 (which will come into force on 12 August 2016) represents what the UK government describes as “the biggest reform to insurance contract law in more than a century” and will serve to increase the attractiveness of English law to buyers, assisting London in remaining competitive.

Amongst other things, the Act replaces previous disclosure requirements and introduces new duties so that instead of the insured having to predict those factors which might influence the hypothetical prudent underwriter’s judgment a new duty of “fair presentation” encompasses an active, rather than passive, engagement by insurers, encouraging dialogue around material issues. If genuine issues nevertheless arise in relation to pre-contract disclosure, the remedies available are far more proportionate than the old one size fits all concept of policy avoidance.

The present economic downturn in the energy and heavy industry sectors cannot be underestimated or ignored and insureds are understandably considering all options associated with risk management. It can be seen that the insurance industry nevertheless remains attuned to the vicissitudes of the twenty-first century and continues to adapt in meeting its many commercial challenges.

This article was first written for and published by Insurance Day on 31 January 2016