#FutureEnergy: Market Update Q2 2021

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This is a series of articles related to the news and development of the global energy sector with focus on Europe, Russia & CIS. The Group Practice Energy, Power & Mining comprises of dedicated group of risk and insurance professionals providing risk and insurance related advice to the companies active in broader energy sector.

Foreword

In this edition of our quarterly update we decided to reflect on the changes to the insurance market for conventional power and renewable energy during the past several months.

A lot is being written, said and analysed on this matter. We tried to provide insights from the broader financial services industry, which will shape the insurance market in the future while the energy sector is undergoing significant reforms.

According to the BP Statistical Review, energy consumption in Europe (including Russia) fell by 1.1% in 2019, between 2008 and 2018 energy consumption in Europe contracted by 0.7%. Energy consumption in developed markets such as a North America and Europe has been steadily declining in contrast to growth in the emerging markets. The decline in energy consumption is set to continue in 2020 as the Covid-19 outbreak coupled with the economic downturn across Europe will weaken energy demand, and in the medium and long run, demographic changes in Europe, in particular a rise in the share of its ageing population, will continue to cause a decline in Europe’s global share of energy demand. On the other hand, as fossil fuels will be phased out from the fuel mix of the European Union, United States and other developed economies, the demand for electricity will keep growing, making investments in the power generation, transmission and distribution systems grow at an ever faster pace.

Several countries in the region have pledged to invest in developing their renewable energy sectors and have set internal greenhouse gas emission targets supplementing those set in the 2016 Paris Agreement.

The energy sector has reduced CO2 emission by 63% since 1990s, according to the report published by Energy Research Partnership. In an article which appeared on Business Insurance on March 16, 2021, Swiss Re pledged to exit all exposures from thermal coal in OECD countries by 2030 and the rest of the world by 2040. The move goes together with the investment policy to achieve net-zero emission by 2050. The reinsurer is one of the founding members of the United Nations Convened Zero Asset Owner Alliance, which includes global carriers like AXA, SCOR, QBE, Generali, Munich Re etc., who are likely to follow suit. The Alliance is representing USD 5,6 trillion assets under management and shows unified action to align portfolios addressing Article 2.1c of the Paris Agreement.

Assuming all projects proceed as planned, the current pipeline of projects will deliver 170.6GW of generating capacity in Europe in 2020-2024. Installed capacity is expected to peak in 2023, with 47GW projected to be installed as new capacity.

Europe – Power Generation, Construction Project Pipeline, Top 10 Countries by Value and Stage (US$ million)

Source: Global Data

Europe – Power Generation, Construction Project Pipeline by Type, Value and Stage (US$ million)

Source Global Data

Focus on Wind Projects

There are several important factors contributing to the sharp rise of rates and deterioration of coverages offered by international re/insurance markets from 2019.

  • Projects are getting larger and more complex. This increases severity of risks significantly.
  • Natural catastrophes occur more frequently and are more severe in nature. This is the reason for concern for the insurers and is rated as top 5 risks according to the Allianz Risk Barometer.
  • Defective products, design and quality control losses are on the rise.
  • Supply chain complexity, just-in-time production and interdependencies are more likely to cause project delays.
  • Political tensions, sanctions, compliance and political violence has become one of the top concerns for project risk managers.

All of them are the result of operation of market forces. At this point it is important to keep in mind that the overall performance of an individual insurer, or the market, is the combination of the result on underwriting activity and investment activity. Continuing underperformance results in either re-underwriting of the existing portfolio or complete withdrawal from writing certain classes or business (or less often, winding down of the whole company). It is also important to understand that the insurance market, unlike many other financial markets (such as public equity and fixed income markets) is not transparent and objective market information is not available usually other than at very high granularity information made available by national regulators and industry trade associations.

Market Performance and General Underwriting Considerations – Hard Phase of the Insurance Cycle

The rating of Engineering and Construction classes of business for Onshore Wind would depend on the following factors:

The Profitability of the entire Insurance Industry

2020 was a year of continuing deterioration of underwriting result and net result. For example, in the Lloyd’s market which provides substantial reinsurance capacity to insurers worldwide, the underwriting loss was GBP 2.67 billion, down from GBP 538 million of loss in 2019. As the investment return also contracted significantly, the market ended 2020 with a total loss of GBP 887 million, down from a profit of GBP 2.53 billion in 2019. As in practical terms it means the erosion of capital across the market, the result is the pressure for immediate action by their shareholders or the Society of Lloyd’s (or any other regulator). The Lloyd’s combined ratio (measure of underwriting profitability) was 110%, however, excluding losses from Covid-19 it was down to 97%, still a very poor result for the entire market. It is estimated that the total amount of underwriting losses suffered by re/insurance markets worldwide were in excess of USD 100 billion across 2020.

Withdrawal of Underwriters from writing certain Classes of Business

Since 2019 this affected Marine Cargo, Engineering and Construction as well as Renewable Energy. It was driven either by Lloyd’s which has the power to accept or reject individual syndicates’ business plans, or the insurers’ own management as a result of changes in their risk appetite. There have also been withdrawals of capacity from major MGAs writing Renewables business such as Pioneer, which unfortunately had to be placed into run-off. Having said that, there have been some new insurers launched across 2020 and 2021, taking advantage from improved rating environment and not burdened with previous years’ losses. Several existing markets have also successfully raised new capital to support their business in the hardening market.

Reinsurance Considerations

The market consensus is that the 1/1 2021 treaty renewals for Power and Renewables sector were higher than a year earlier. Also, the restructuring of treaty provisions, in many cases insurers are no longer protected by their obligatory treaties with respect to active loss attrition on their books. This will affect both direct insurers and facultative reinsurers alike.

Portfolio Rebalancing

For the companies that chose to continue providing coverage this took the form of:

  • Increasing rates – from 10-30% year-on-year on loss-free accounts to 90-100% or more for troubled insureds. Similar adjustment took place across 2019 with 25-50% typical rate increases or even upwards of 100% for complicated or distressed accounts.
  • Deterioration in the length and breadth of coverages provided, increased deductibles and decreased sublimits for certain perils.
  • Decreasing line sizes at renewal, sometimes significantly, or
  • Not offering renewal terms for distressed accounts. For example, according to one reputable London market, their retention rate of Renewables accounts was around 40% in 2020.

Accounts Performance

With the trough of the pricing cycle for Onshore Wind in the Summer months of 2018, 2020 was yet another year which brought about deteriorating claims and reserves development experience for the Renewable Energy insurances. For example, the adverse development of losses incurred in 2018 moved the loss ratio for that period for an initial estimate of 66% to 80% as of 2020, which made the 2018 year of account unprofitable. This of course needs to be reflected in rating adjustments for insurances sold in future years.
Notable causes of rating increases for Onshore Wind projects typically include:

  • Natural Catastrophe losses – even though no spectacular losses occurred throughout 2020, smaller scale catastrophes give rise to increasing loss activity.
  • Ageing of the fleet – increasing number of attritional losses and the need to replace ageing assets with modern technology, which is affected by costs, materials and labor inflation.
  • Constant upscaling and upgrading process of generators, which make them significantly larger and more expensive, also in terms of replacement and re-erection costs. Also, the boundary between the upscaled and the prototypical becomes ever more blurred as a result of the process.
  • Adequacy of “old” deductibles is being questioned by insurers, as it the view of many they no longer reflect the specifics of new technologies and substantially larger and more powerful units.
  • Concerns about the performance of the Engineering and Construction book – it has been noted that the contractors may be taking on too much workload (due to fast-increasing demand) which causes them to rush some projects to the point where there is a perceived increase risk of losses in the construction phase. In fact, data from some markets show that for 2020, contractor error losses amounted to about 36% of the quantum of all wind losses. As a result, the construction phase attracts the highest rating increases in the wind farm life cycle. The same applies to the increase in deductibles required by insurance markets. Unfortunately, the increasing demand pressure on major contractors makes them unwilling to give concessions to their clients as their order book is filling up quickly as old conventional assets are being phased out, making their bargaining position ever stronger.
  • The Covid-19 pandemic affected some routine claims handling (such as inspection dismantling, re-erection), risk engineering, as well as manufacturing processes. This affects both loss settlement times and – more importantly – the quantum of Business Income (BI/ALOP/MLOP/DSU/MDSU) losses.

Diminishing Returns on Investing Activity

For many years, deficiencies in the performance of the underwriting function would normally be corrected by returns on the investing activity. It used to be normal that in certain classes of business combined ratio of 110% was accepted for prolonged period (meaning that on every USD100 of premium there were losses and costs of USD110 incurred). With negative interest rates environment prevailing for a prolonged time and increased asset price volatility this is no longer the case and the insurers are pushed towards technical (underwriting) profitability.

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Zviadi Vardosanidze

Group Practice Leader Energy, Power and Mining

T +43 664 962 39 04