Trends in Energy Insurance and the Impact of Falling Oil Prices

Higher Cost of Claims

Although incidents across the oil and gas industry have become less frequent over time, the cost of oil and gas insurance claims continues to rise. A number of industry veterans point to the fact that the high monetary consequences associated with accidents have contributed to a reduction in these accidents. ³

One factor increasing the cost of oil and gas insurance claims is changing technology. Companies in the oil and gas industry are constantly looking for ways to maximize production from their drilling efforts. However, new technologies can make claims more complex, which can also make them more expensive. For example, recent developments in subsea technology allow companies to operate in deeper water, but pipelines in deeper water are harder to access for repairs and maintenance. Additionally, advancements in technology have led the energy industry to be more dependent on technology, such as GPS and networks that can be interrupted by natural disasters and are prone to cyberattacks. Finally, it can be difficult to understand the implications and uncertainties of new technology, making it a challenge for insurance underwriters to determine a premium for such technology. ⁴

Another cause of the higher costs of energy insurance claims is the development in emerging territories. The new technologies discussed previously allow oil companies to operate in more challenging environments. For example, many oil companies are now considering oil and gas exploration in polar regions, which have substantial oil and gas reserves. However, the long-term effects of cold and ice on drilling rigs are unknown, and the remote location makes it difficult to handle accidents. Reserves are also opening in Brazil and areas of the Asian Pacific and East Africa. Remote areas like these are more problematic to service in terms of repair and accident response, and pose greater legal and political uncertainty, which could lead to expensive claims. ⁵

Declining Energy Prices

The sharp decline in oil prices experienced over the past 6 months relative to recent historical levels is also triggering changes in the energy insurance market. First, the drop in oil prices increases the potential for mergers and acquisitions among energy companies. Consolidation of insured companies typically means fewer premiums are generated by the insurance providers. ⁶ Insurers have also indicated that, in light of dropping oil prices, many energy companies may want to change their coverage to manage costs and/or renegotiate the costs for managing claims and premiums. Additionally, larger companies may seek to change collateral requirements. ⁷

In some ways, falling oil prices may actually improve safety among oil and gas companies. With less drilling, contractors can be more selective when hiring employees and choose skilled individuals who are less likely to cause accidents. Many recent accidents in the energy industry were the result of inexperienced employees. Moreover, oil and gas companies with poor loss histories may be forced to exit the industry or combine with a safer company. ⁸

Factors Influencing the Valuation of Energy Insurers

Although it is difficult to quantify, the general consensus is that falling oil prices will have a negative impact on the value of energy insurers. Willis, a top energy insurance provider, noted that "a combination of the recent collapse in oil prices, record capacity levels, relatively benign loss records and reduced risk management budgets have all contributed to some of the most competitive energy insurance underwriting conditions in 15 years." ⁹ This is one example of increased competition that may lead to decreased valuations of energy insurers.

Low oil prices may encourage some oil and gas companies to review insurance coverage with their insurers and take measures to reduce insurance costs, which would negatively impact the insurers' revenue and/or profit margins. ¹⁰ Also, as discussed previously, lower oil and gas prices typically drive consolidation in the energy industry, which leads to less premium generation by insurers. ¹¹ Lower revenue generation typically reduces operating leverage and hurts profitability. As such, both pricing pressure and industry consolidation are potentially having a negative impact on energy insurers' financial performance, which could lead to lower valuations.

However, many of the largest energy insurers are diversified in providing insurance for a variety of business lines, mitigating the additional risk associated with energy insurance for these companies. What may have a greater impact on the value of larger insurers is exposure to energy in their investment portfolios. For example, Travelers Companies, Inc., a major energy insurer, holds approximately $224 million of bonds tied to the energy industry. ¹² Energy bonds constitute 5.8 percent of the bond portfolio of American International Group, another large energy insurer. ¹³

The prices of energy bonds have dropped significantly since oil prices began to fall in 2014, as investors worry that exploration and production companies will struggle to pay their obligations. The drastic changes in the value of energy bonds can have a significant impact on the value of insurers' overall portfolios, increasing their risk. Accordingly, energy insurers who are also exposed to energy through their investments may be more affected by a volatile oil and gas price environment than those that are not. On the other hand, although changes in the values of the investments of insurance companies are considered in evaluating a firm's financial strength, they do not factor into earnings, making the impact of exposure to energy investments on an insurer's value difficult to quantify. ¹⁴

Conclusion

Overall, there are a few major trends that are influencing the energy insurance industry today. Generally speaking, the energy industry has become safer over the past several years, as oil and gas companies have come to realize the high costs associated with accidents. However, when accidents occur, insurance claims are generally higher than in the past, as a result of the utilization of more complex technology and penetration into emerging markets. The improvements in safety over the past several years, along with tighter risk management budgets at energy companies, have created an increasingly competitive energy insurance market, which may negatively impact the value of energy insurers.

The recent decline in oil prices is also having a significant impact on energy insurers. While cost-cutting measures may actually make energy companies safer, they can also reduce premiums paid for insurance coverage. Premiums may also be negatively affected by the consolidation of energy companies and by customers renegotiating contracts to cut costs, both of which often occurs in a declining oil price environment. Reductions in premiums paid for insurance coverage as a result of either of these factors would negatively impact the value of energy insurers. Furthermore, energy insurers with higher exposure to energy risk in their investment portfolios may ultimately be affected to a greater degree by a volatile oil and gas price environment than those with fewer energy investments.

In response to the current oil and gas market, Willis believes "the time has come for more innovation, for new products and services to be developed to attract the interest of the buyer." ¹⁵ Innovation and adaption will be the keys for energy insurers to retain value in a volatile oil and gas price environment.