Author: John Munno
The year 2020 will be remembered for many things: a global pandemic, a contentious presidential election in the US, and wildfires that swept through Australia and the western US. For energy producers and related industries, 2020 brought new challenges to managing technical risks. In 2019, as the energy property insurance market began to harden due to significant losses, we saw not only a shift in premiums, but a change in the way risks are evaluated by technical insurers. In 2020, this shift accelerated. This article will highlight some of the impacts to the engineering review of technical risks in 2020 and key strategies for 2021.
Large premiums, small difference in risk perception
Clients in the energy sector of the insurance market include petro chemical, oil & gas, power generation, utilities and more. Premium ranges for these type of accounts upwards of ~$1M+. With such large premiums, a very small difference in how risks are perceived will translate into significant cost differences.
More uncertainty in renewal market
In the past, there was less differentiation in premiums than what is happening now. It was talked about, but now we watch it play out at every renewal. During one renewal, in reference to a six-month-old recommendation, the underwriter asked for an updated status of the recommendation. In his request for the update, he plainly stated "No action = no quote."
Less experienced underwriters leaving the market
While higher premiums help offset risk for an underwriter, there is still the matter of exposure to address. Some insurance companies completely withdrew capacity from the energy sector in 2020. Others drastically cut their line sizes. Withdrawal of the naive following capacity is not necessarily a bad thing, but it does force insureds to seek coverage elsewhere. In 2020 it was not only naive following capacity which withdrew it was the market leaders. Companies that are large enough to take 100% of a $400M or $1B limit with robust internal risk engineering staffs began slashing capacity by 50% or more. Some made very strong demands that recommendations needed to be completed before renewal even if the cost was in the millions, non-renewing or doubling the premiums, if the recommendations were not complete.
London brokers looking to write fewer accounts in 2021
During a visit to London for client presentations to underwriters in March of 2020, I was fortunate to have some time with the London brokers before meeting with the client. They told us that the focus in London was to increase rates by "20% in 2020." I said, "Well, great, the insurers will start making money again and capacity will come back." They said, "Unfortunately the Lloyd's syndicates will not be permitted to write any more revenue than they had in 2019." I asked how they could charge more but only make the same amount. The answer was that they would write fewer accounts.
Poor engineering reports are not considered by underwriters
As capacity left and needed to be replaced on accounts, the option of approaching other incumbent markets for increases in line size could not make up the difference in capacity. Brokers were marketing their client's risks to new underwriters, who likely already had a stack of submissions to wade through for the month from other brokers in the same situation. New underwriters could be very selective. Very quickly in 2020 we found that engineering reports with an overall rating of poor did not get considered.
Renewal process for energy risks more complex
Back in 2018 we saw quota share markets ask to participate in risk engineering inspections for power generation risks, which is typical for petro-chemical risks. For chemical manufacturing risk engineering surveys, we routinely participated in site visits with 10-12 various insurance company risk engineers. In 2020, travel restrictions prevented the "typical" risk engineering process. As brokers we try to market a client's risk, which relies very heavily on the risk engineering reports. But there is really no better way for an insurer to understand a risk than to look at it and talk to the people managing the risks. That's why so many engineers participate in the higher risk inspections. So, with capacity withdrawals combined with travel restrictions, underwriters are caught in a catch-22. Write better risks, but you can't send your engineers out to verify the risks. It's no wonder that the renewal process for energy risks has become so involved.
Greater risk management transparency
The new risk engineering process which is becoming routine, is to set up shared file directories for information exchange, conduct digital meetings and manage the back-and-forth of data acquisition and review. Previously, risk ratings were not considered or really reviewed. Loss history drove renewal premiums more than risk assessments. But now, when a report includes any ratings of "Poor" for segments or the entire risk, it should be an immediate warning to address the cause before the reports are submitted at renewal.
Reasons for a 'poor' rating
Sometimes a "Poor" rating is given because the risk engineer was not provided a simple test report. Sometimes, a test report indicates reason for further diagnosis, if the report was not acted on, it really didn't help to perform the original inspection or test. Sadly, it is very common to see facilities who hire outside contractors to perform things like transformer Dissolved Gas Analysis, fire pump testing, door fan tests, etc. get a test result and the invoice with no guidance. They are usually made aware of system degradation during the next insurance company inspection. By that time, the risk engineer is ready to get their "Poor" stamp out. It's better to read the results of the test reports.
Equipment could lead to multi-million dollar losses
In addition to the market issues and travel restrictions in 2020, we saw insurers take very strong positions with certain known equipment with fleet wide catastrophic loss history. Without discussing specific manufacturers, the types of equipment that were looked at critically in 2020 were certain High Voltage Bushings, power transformers and a steam turbine design that was susceptible to rotor burst. These specific pieces of equipment, will lead to multi-million dollar losses if not appropriately managed.
Specific equipment risks require capital
Unfortunately, they could cost millions of dollars to replace. When insurers are made aware of specific equipment issues through their claim departments or directly from OEM's, they become very interested in corrective actions. If you have any such troubled equipment, don't be surprised to have concern come from several of the quota share players, not just the lead and not just at renewal. The problem with addressing such specific equipment risks is that they require capital.
Payback in conflict with risk mitigation safety systems
Capital budgets for energy facilities are usually filled with items that have a payback period of just a couple of years. Payback for a retrofit of a variable speed controller on a pump is easy to calculate. But what is the payback for a project that replaces operating equipment with other operating equipment of the same capacity? What is the payback for replacing the impeller on a fire pump? The problem is that safety systems are only needed in emergencies (like parachutes). So for most of their existence safety systems are just costs that need maintenance dollars. Then maybe once in the life of a facility or never at all, the safety system actuates to mitigate an accident. When that happens, there is no loss, so again, how do we establish payback for a recommendation? Payback needs to be thought of in different terms for risk mitigation safety systems.
Underwriters look at worse case scenarios
To make the analysis easier, we can estimate the cost-of-risk associated with not replacing the particular piece of equipment. Basically, an estimate is made of what damage will occur if nothing is done to stop it. The analysis includes business interruption exposure even if no policy is bought. Why include BI costs, if the insurers are not on risk? Because the owner takes ALL of that risk. Damage estimates are routinely performed and are usually included in the risk engineering reports. Some insurers even provide Loss Expectancy for recommendations not completed. The real problem comes when trying to address the frequency of such events. Insurers refrain from discussing likelihoods. One underwriter told me that they "expect everything that can happen, will happen." Clearly not a technical opinion, but it serves as an example of the conservatism of underwriters.
Cost-of-risk analysis gives guidance
Once a damage estimate is complete and a likelihood is established (with basis) we can generate the annual cost-of-risk associated with the recommendation. We can compare the cost-of-risk to the cost of implementing the recommendation. Sometimes the answer is so clear, that the finance department asks why the recommendation wasn't done sooner. Sometimes the cost-of-risk is so low, that it makes no sense to address the recommendation from a risk perspective. In either case, the next steps are clearer.
Capital projects as insurance replacements
Capital projects that mitigate risk should be thought of as insurance replacements with no expiration date. If an owner spends $100K on an insurance policy. At the end of the term, they will have an expired piece of paper. If the owner spends $100K on a new sprinkler system, at the end of the year, they still have that system mitigating risk for years to come. Obviously, this example shows the longevity of fixed safety systems and does not suggest that insurance can be eliminated by managing all known risks. There are always unknowns that will need to be managed as they arise.
Impactful recommendations that go beyond managing risk
Technical underwriters and their engineers need to feel like they are working with partners who don't only say they are interested in managing risk, but demonstrate that they are. Many owners get stuck at the point of whether the recommendation is required. Pushing back with code requirements will not go far in the process of convincing an insurer to accept your risk. Remember, they have a stack of other prospective client submissions to get through before they go home.
Cyclic nature to risk assessment
I can say that after a few decades in the industry that it does run in cycles. There are even examples of some slight flexibility returning to the process. The increase in attention to fundamental risk management will not likely wane when/if premiums start to ease. It will take meaningful injections of capacity before the energy property insurance market improves.
Pent up risk engineering demand due to COVID
When travel restrictions are eased, there will be a stampede of risk engineers trying to get out to facilities. They are already chomping at the bit. There will be scheduling issues, then reports will be delayed, because expense reports need to be completed again. There is no doubt that 2021 will be another intense experience for the energy property market.
Here to help
If you need help interpreting the results, I'm happy to help. I'd prefer to point out an issue to our clients before the renewal so they have time to correct the issue or at least demonstrate proactive attitude towards risk management.