Disclaimer: The events depicted in this scenario are fictitious. Any similarity to any corporation or person, living or dead, is merely coincidental.
Nothing beats working with the best. That’s what Jerry Oliver, a senior vice president with Manhattan-based Lupex, told himself as he left the morning meeting.
In that meeting, executives with Lupex, an energy trading firm, voted to buy two million barrels of crude and store it offshore. A precipitous decline in oil prices was the motivation.
All the firm had to do was keep the oil safe and sound until the prices rose again, which they inevitably would. Major domestic drillers were already laying off staff and cutting production. These latest low oil prices were just another bend in the cycle.
Oliver’s marching orders from that morning’s meeting were clear. Working with other members of the Lupex team, it was Oliver’s responsibility to find the right vessel and a safe place to moor it.
The strategy was to keep the oil safe by avoiding CAT-exposed locations and hold it long enough for the firm to cover its storage costs and still make a handsome profit when the price rose.
“Let’s get this done,” Oliver said to himself before walking into his office to get on a phone call with a colleague in Texas.
After consulting with his colleague, Oliver decided to use the Miller Line, a company based in the energy hub of Houston. The Miller Line was an owner of Very Large Crude Carriers — or VLCCs.
One of the company’s ships, the Mariana, had the capacity that Lupex needed and was available. Adding to the attractiveness of the Mariana was that she was already in Southern California, not far from the tank farm in El Segundo where the oil was stored.
The Lupex team decided to moor the Mariana off of Long Beach, once she’d taken on the Lupex crude.
“We don’t want to store it in the Gulf, or anywhere near Florida,” Oliver told his team, pointing to the hurricane hazards in those locations.
“Long Beach has also got the security infrastructure we like,” Oliver said.
Lupex procured the oil at $50 per barrel the following morning, making its value at purchase $100 million. To wrap up the deal, Oliver and his associates took care of some final details, among them, getting insurance in place.
Loading at the tank farm went off without a hitch and the Mariana was moored off of Long Beach. Within days, it looked like oil prices had bottomed.
Weeks later, after a particularly sharp, sustained rise in the price of oil, Lupex executives gave the “sell” order.
With oil at $80 per barrel at the time of the sale, it looked like the company’s strategy was playing out as well as could be hoped. The Mariana made her way to Houston, to offload the oil for the buyer.
At 2 p.m. on the afternoon the oil was offloaded in Houston, Jerry Oliver got a call from Antony Ellis, his associate in Houston.
“We’ve got a problem, a very serious problem,” Ellis said.
“What is it?” Oliver asked.
“The oil’s contaminated,” Ellis replied.
“What?” Oliver said.
“It’s true,” Ellis said. “Apparently, the ship was carrying gasoline before it picked up the crude load and wasn’t cleaned properly.”
“The gasoline additives that remained in the tanker contaminated the crude, lowering its grade and market value,” Ellis further explained.
‘Somebody’s got to tell the executive committee. I’ll do it,” Oliver said.
Then he hung up the phone.
On their follow-up call, Ellis and Oliver began to put the pieces of a disturbing picture together.
“So we can re-blend it?’ Oliver said.
“In essence, yes,” Ellis said.
“It’s a lower product grade, and far less valuable, and then there’s our mixing costs and other related expenses,” he said.
“If we’re very, very lucky and we get this done in no more than two days’ time. We might be able to get $42 per barrel for this lower grade product. I don’t see how we can hold it any longer,” Ellis said.
“Nobody up here has any patience for anything more than that,” Oliver said.
Oliver wasn’t sharing with Ellis the exact tone and temperature of the conversation that he’d had with senior management when he brought them the bad news to begin with. He’d spare his colleague that extra pain.
Working as quickly as they had ever worked, with neither of them sleeping more than four hours over a 48-hour period, Oliver and Ellis arranged for the re-blending of the ill-fated oil from the Mariana.
When all was said and done, Lupex got $41 per barrel for the re-blended product. A down day in the markets worked against them, but as traders, they knew that timing was everything. They were already down millions. They could not afford to wait a day longer.Two days after the sale of the re-blended product, Oliver was speaking with a senior executive, conducting a post-mortem on what became an instant legend at Lupex, “The Long Beach Loss.”
“What do our insurance carriers have to say about this?” the executive asked.
“Ummm, I haven’t talked to them yet,” Oliver said. He was back in his office and on the phone with Lupex’s broker within a minute, his ears still hot from the tongue-lashing his superior had given him.
The broker, Danny Parker, a young gun with a multinational firm, listened to the details of the loss as relayed by Oliver.
“Well, I’ve got a question for starters,” Parker said.
“What?” Oliver said.
“Why didn’t you contact me earlier?” Parker asked.
A List of Ills
Falling oil prices in 2014 were something that got everybody’s attention. Everyone of driving age could see it as gasoline prices at the pump plummeted.
Lupex executives couldn’t be blamed if they were practically obsessed with the rate at which oil prices were going down. After all, this was what they did; it was their bread and butter.
They had the capital and the connections to do very well on what looked like a historic trading opportunity. A two-year average oil price of more than $110 per barrel was becoming a dream-like memory as oil prices fell to below $80 per barrel, then $70 per barrel and on and on down.
Lupex executives were bright and well-schooled. They knew the history of the energy sector. They’d worked extremely hard, done very well over the years and felt they had earned this moment.
As with anyone, it was what they didn’t know that dealt them such a painful blow.
It fell to Danny Parker, the energy insurance broker, and his colleague, Lee Ann Farmer, a cargo specialist, to give Lupex the most painful messages of all.
“Jerry and Antony … let me ask you something. When you arranged to lease the Mariana from the Miller Line, did you ask them about what the Mariana previously held, and whether the vessel posed a contamination risk?”
“That’s on me,” Antony Ellis said. “The short answer is no. You have to understand — we weren’t the only traders on the planet that had their eye on this opportunity. VLCC rates were showing a lot of volatility of their own in late 2014,” he said.
“A lot of people were after this opportunity,” Oliver said.
“We understand …” Danny Parker managed to get out before Antony Ellis interrupted him.
“We’re talking about storage rates of tens of thousands of dollars per day, and in one week alone in November, we saw a 20 percent increase in those leasing rates. There was a lot to consider here,” Ellis said.
“I’m sure there was,” Lee Ann Farmer said.
“I know you had a lot to consider,” she continued. “But you should have thought about a cargo policy. After all, once that product leaves land and goes into a ship, you’re in a completely different ballgame from a coverage perspective.”
“Okay, but how exactly?” Jerry Oliver began.
“Just hold on a second,” Danny Parker said.
“That contamination issue you had? I bet you I could have covered that for you,” Lee Ann said.
Oliver felt nausea roil his stomach.
“You’re kidding me,” he said. “All of it?”
“I’m pretty sure the carrier would have you retain some of it,” Lee Ann said. “But in our world, these days, there’s a lot of capacity out there.”
“I never knew,” Antony Ellis said.
“Sorry. But now you know,” Danny Parker said.
Lupex would live to seek other opportunities in coming months and years, but its insurance coverage lapse in the Long Beach loss cost the company an opportunity that might have been once in a lifetime.
Risk & Insurance® partnered with XL Group to produce this scenario. Below are XL Group’s recommendations on how to prevent the losses presented in the scenario. These “Lessons Learned” are not the editorial opinion of Risk & Insurance®.
1. Consider an Ocean Cargo Policy: For a relatively low cost compared to the value of goods, an ocean cargo policy can be structured to cover perils of the seas (i.e. sinking, fire, collision, explosion, heavy weather), General Average, Theft, Fire, Acts of War, Shortage, Leakage and contamination. In the “Tainted Goods” risk scenario, if Lupex had purchased an appropriately structured ocean cargo policy, the company would have been covered for the loss due to contamination.
2. Choose Appropriate Limits: When evaluating an ocean cargo policy, risk managers need to ensure that the amount of insurance will be sufficient to cover the goods at the maximum foreseeable financial interest. This is especially important in dealing with commodities, like oil, where there’s a chance of financial fluctuations.
3. Valuation of Goods: For an effective ocean cargo policy, it should be structured to allow the buyer to be indemnified for the highest value of goods for several different situations, including:
- The invoice value + 10% (for ancillary/related costs)
- The selling price (if sold)
- The market value on date of loss
With these different evaluations structured into the policy, this will allow for recovery of the amount paid at a minimum, or the full mark up if sold or unsold at a maximum.
4. Ensure Professional Handling of Goods: Bulk liquids and solid goods pass through a number of loading mechanisms, holding tanks/locations, pipelines, conveyor belts, loading machinery and pumps when moving from shore to vessel and vice versa upon unloading. This opens up the potential for many types of losses, including: shortages, contamination and loss in weight. In order to reduce this risk, companies should take the steps to ensure professional handling of their goods by working with tenured logistics providers.
5. Reduce Your Contamination Risks: It’s common for companies to conduct and pay for testing and approval of tanks as well as a certificate by a qualified surveyor. However, it’s important that additional samples are taken at loading and unloading to determine if, where, or when the contamination occurred. This is also recommended for barges, lighters, tank cars and port side tanks. Most of all, a company operating in this space should make sure the handling guidelines are adhered to. By following the handling guidelines, the insurance coverage will remain valid.
6. Consult with your Marine Broker & Underwriter: Marine brokers and underwriters can offer specific knowledge and experience that can be leveraged in certain classes of businesses. They can discuss best practices and provide recommendations to reduce your risk. In addition, they can provide value added services in terms of Risk Engineering, Claims, and various technical white papers, which can serve as readily available resources.
Capital Flows Into CAT Bonds
AACapital is increasingly flowing into property catastrophe bonds, with an industry record — $8 billion — being issued just in the fourth quarter of 2014.
Overall, total risk capital outstanding as of year end, was $22.868 billion, the highest level of outstanding risk capital the market has ever supported, according to a report by Guy Carpenter.
In addition, the reinsurance broker noted that “persistent year-on-year growth issuance” indicates that the market is maturing and stabilizing.
“The continued influx of third-party capital from new and existing market participants also favorably impacted ILS [insurance-linked securities] pricing for protection buyers,” according to a year-end report by Guy Carpenter.
“The continued low interest rate environment encouraged institutional investors (such as pension funds and hedge funds) to seek the higher yields offered by natural CAT notes.”
CAT bonds are also increasingly being used by insurers of the last resort to transfer some of their peak exposures to the capital markets, according to a rating agency A.M. Best.
Insurers of the last resort are those that include Fair Access to Insurance Requirements (FAIR) plans, quasi-state-run insurance companies and beach/windstorm plans.
According to a report by A.M. Best, these entities have welcomed the growing availability of insurance-linked instruments such as CAT bonds, insurance-linked funds and industry loss warranties (ILWs).
“Given an increase in exposure to loss for insurers of the last resort, CAT bonds have provided another alternative for these entities to cede part of their peak exposures as a complement to the traditional reinsurance market,” said Asha Attoh-Okine, managing senior financial analyst of insurance-linked securities at A.M. Best and author of the report.
“Catastrophe bonds also provide multiyear coverage as opposed to most traditional reinsurance programs,” he said.
Approximately $5.6 billion in CAT bonds were issued by seven of these entities from 2009 through Sept. 30, 2014, according to the A.M. Best report.
The two main perils covered were hurricanes and earthquakes occurring in the respective regions that the bonds were placed.
Hurricanes accounted for approximately $4.53 billion, or 81 percent, with earthquakes taking the other $1.05 billion, or 19 percent, for these entities during the period reviewed by the ratings agency.
“The increased use of these insurance-linked instruments is due to growth in investor demand,” said Attoh-Okine.
Below Average Activity
As insurers and investors consider CAT bonds, however, it may be important to note that 2014 was a relatively quiet year for natural catastrophes, according to Munich Re. This year may not be.
“Though tragic in each individual case, the fact that fewer people were killed in natural catastrophes last year is good news,” said Torsten Jeworrek, a Munich Re board member.
“And this development is not a mere coincidence. In many places, early warning systems functioned better, and the authorities consistently brought people to safety in the face of approaching weather catastrophes, for example before Cyclone Hudhud struck India’s east coast and Typhoon Hagupit hit the coast of the Philippines.
“However, the lower losses in 2014 should not give us a false sense of security, because the risk situation overall has not changed. There is no reason to expect a similarly moderate course in 2015. It is, however, impossible to predict what will happen in any individual year.”
Nonetheless, usage has expanded a great deal in recent years.
Guy Carpenter cited deals that include Turkey’s Turkish Catastrophe Insurance Pool, Mexico’s FONDEN and New Zealand’s EQC.
“Most large U.S. insurers of last resort, such as CEA, Citizens, North Carolina Joint Underwriting Association and the North Carolina Insurance Underwriting Association (NCJUA/NCIUA), and Texas Windstorm Insurance Association, are utilizing capital markets capacity including collateralized reinsurance and catastrophe bonds,” it said.
A.M. Best’s Attoh-Okine noted that investors are “attracted to these products given the low-interest environment for fixed income securities of similar quality and the perceived minimal correlation to the general financial market.
“Sponsors have also continued to increase the use of CAT bonds and other insurance-linked instruments to cede their peak exposures.
“Lately,” he said, “we have seen a decrease in spread [price] for the same level of risk for CAT bonds, providing sponsors cost relief when compared to the traditional property catastrophe reinsurance market.”
“Catastrophe bonds also provide multiyear coverage as opposed to most traditional reinsurance programs.” — Asha Attoh-Okine, managing senior financial analyst, A.M. Best
His report noted that other areas that might benefit from the use of alternative risk transfer instruments include terrorism risk exposure; assigned risk non-property plans facing inadequate pricing/capacity issues (e.g., workers’ compensation, auto, accident/health), and the National Flood Insurance Program, which provides flood insurance to approximately 5.5 million U.S. properties with total insured values exceeding $1 trillion, and growing.
While alternative products reduce credit risk for the insurer, the main drawback for CAT bonds and ILWs “is the lack of reinstate features when compared to the traditional reinsurance program,” he said.
Reinstate implies the restoration of the reinsurance limit of an excess property treaty to its full amount after payment by the reinsurer of a loss as a result of an occurrence.
“Another criticism for the use of these instruments,” he said, “is whether investors’ participation will continue in case of property catastrophe insurance market disruption as result of a huge catastrophe event or if we start seeing a continuous increase in returns for other fixed income instruments.”
According to Attoh-Okine, if a major hurricane or other natural disaster triggers one of the CAT bonds, the sponsor of the bond will be reimbursed for the loss amount up to the amount of the CAT bond.
In such a case, investors will lose part or all of the principal amount and the corresponding interest proceeds.
Such vehicles also improve coverage terms (transforming programs from per occurrence to annual aggregate responses) and provide leverage “to keep traditional capacity sources honest and to facilitate their willingness to adjust coverage terms that may not have been feasible without the use of capital markets-based risk transfer capacity,” it said.
“At the time of loss, governments may be spared these enormous costs and they may have enhanced flexibility to finance economic and social development or reduce taxation.
“Because entities such as windpools tend to be limited in geographic scope and/or peril, with more of an affinity for single limit/aggregate coverage, they present an attractive profile to collateralized reinsurers and catastrophe bond investors.
“Competition and excess capacity for this business has significantly reduced price and in just the past year, the growth in both limit purchased by these entities and share of overall limit placed into the collateralized market has been significant.
“As an example, profiling limits purchased by U.S. windpools in 2014 compared to 2013, catastrophe bond limits increased by almost 50 percent while rated and collateralized reinsurance limit purchased grew by approximately 30 percent, leading to a total growth in coverage of roughly 35 percent. In addition, the collateralized market share of the limit purchased has outpaced the growth in rated carriers’ increased participations … .”
$110 Billion in Losses
According to Munich Re, overall losses from natural catastrophes totalled $110 billion in 2014, down from the previous year’s total of $140 billion, of which roughly $31 billion (previous year $39 billion) was insured.
The loss amounts were well below the inflation-adjusted average values of the past 10 years (overall losses, $190 billion, insured losses, $58 billion), and also below the average values of the past 30 years ($130 billion overall / $33 billion insured).
At 7,700, the number of fatalities was much lower than in 2013 (21,000) and also well below the average figures of the past 10 and 30 years (97,000 and 56,000, respectively). The figure was roughly on a par with that of 1984.
The most severe natural catastrophe in these terms was the flooding in India and Pakistan in September, which caused 665 deaths.
In total, 980 loss-related natural catastrophes were registered, a much higher number than the average of the last 10 and 30 years (830 and 640). Broader documentation is likely to play an important role in this context, since, particularly in years with low losses, small events receive greater attention than was usual in the past.
The costliest natural catastrophe of the year was Cyclone Hudhud, with an overall loss of $7 billion.
The costliest natural catastrophe for the insurance industry was a winter storm with heavy snowfall in Japan, which caused insured losses of $3.1 billion.
More than nine of 10 (92 percent) of the loss-related natural catastrophes were due to weather events.
A striking feature was the unusually quiet hurricane season in the North Atlantic, where only eight strong — and thus named — storms formed; the long-term average, calculated from 1950 to 2013, is around 11.
In contrast, the tropical cyclone season in the eastern Pacific was characterized by an exceptionally large number of storms, most of which did not make landfall.
One storm in the eastern Pacific, Hurricane Odile, moved across the Baja California peninsula in a northerly direction and caused a loss of $2.5 billion (of which $1.2 billion was insured) in Mexico and southern states in the U.S.
In the Northwestern Pacific, a relatively large number of typhoons hit the Japanese coast, but losses there remained small thanks to the high building and infrastructure standards in place.
“The patterns observed are well in line with what can be expected in an emerging El Niño phase,” said Peter Höppe, head of geo risks research at Munich Re. “This characteristic of the ENSO (El Niño Southern Oscillation) phenomenon in the Pacific influences weather extremes throughout the world.”
Water temperatures in the North Atlantic were below average and atmospheric conditions such as lower humidity and stronger wind shear also inhibited the development of tropical cyclones. Even events like the severe windstorms and heavy rainfall in California in December following a long drought fit in with the El Niño pattern.
Höppe added that most scientists expect a light to moderate El Niño phase to persist until mid-2015.
“Following the below-average incidence in 2014, this could increase the frequency of tornadoes in the USA. If the El Niño phase does, in fact, end towards the middle of the year, there would be no cushioning effects from the ENSO oscillation in the main phase of the tropical storm season.”
The reinsurer added one last point — that the greatest losses in North America over the past year stemmed from cold temperatures. Heavy frost in many parts of the USA and Canada, along with blizzards, particularly on the East Coast, caused losses of $3.7 billion in 2014 alone, of which $2.3 billion was insured.
Munich Re’s point is a rather sobering one — what if 2015 is a very different year than 2014 in terms of catastrophes?
The catastrophe bond market will soon find out.
2015 General Liability Renewal Outlook
There was a time, not too long ago, when prices for general liability (GL) insurance would fluctuate significantly.
Prices would decrease as new markets offered additional capacity and wanted to gain a foothold by winning business with attractive rates. Conversely, prices could be driven higher by decreases in capacity — caused by either significant losses or departing markets.
This “insurance cycle” was driven mostly by market forces of supply and demand instead of the underlying cost of the risk. The result was unstable markets — challenging buyers, brokers and carriers.
However, as risk managers and their brokers work on 2015 renewals, they’ll undoubtedly recognize that prices are relatively stable. In fact, prices have been stable for the last several years in spite of many events and developments that might have caused fluctuations in the past.
Mark Moitoso discusses general liability pricing and the flattening of the insurance cycle.
Flattening the GL insurance cycle
Any discussion of today’s stable GL market has to start with data and analytics.
These powerful new capabilities offer deeper insight into trends and uncover new information about risks. As a result, buyers, brokers and insurers are increasingly mining data, monitoring trends and building in-house analytical staff.
“The increased focus on analytics is what’s kept pricing fairly stable in the casualty world,” said Mark Moitoso, executive vice president and general manager, National Accounts Casualty at Liberty Mutual Insurance.
With the increased use of analytics, all parties have a better understanding of trends and cost drivers. It’s made buyers, brokers and carriers much more sophisticated and helped pricing reflect actual risk and costs, rather than market cycle.
The stability of the GL market also reflects many new sources of capital that have entered the market over the past few years. In fact, today, there are roughly three times as many insurers competing for a GL risk than three years ago.
Unlike past fluctuations in capacity, this appears to be a fundamental shift in the competitive landscape.
“The current risk environment underscores the value of the insurer, broker and buyer getting together to figure out the exposures they have, and the best ways to manage them, through risk control, claims management and a strategic risk management program.”
— David Perez, executive vice president and general manager, Commercial Insurance Specialty, Liberty Mutual
Dynamic risks lurking
The proliferation of new insurance companies has not been matched by an influx of new underwriting talent.
The result is the potential dilution of existing talent, creating an opportunity for insurers and brokers with talent and expertise to add even greater value to buyers by helping them understand the new and continuing risks impacting GL.
And today’s business environment presents many of these risks:
- Mass torts and class-action lawsuits: Understanding complex cases, exhausting subrogation opportunities, and wrangling with multiple plaintiffs to settle a case requires significant expertise and skill.
- Medical cost inflation: A 2014 PricewaterhouseCoopers report predicts a medical cost inflation rate of 6.8 percent. That’s had an immediate impact in increasing loss costs per commercial auto claim and it will eventually extend to longer-tail casualty businesses like GL.
- Legal costs: Hourly rates as well as award and settlement costs are all increasing.
- Industry and geographic factors: A few examples include the energy sector struggling with growing auto losses and construction companies working in New York state contending with the antiquated New York Labor Law
David Perez outlines the risks general liability buyers and brokers currently face.
Managing GL costs in a flat market
While the flattening of the GL insurance cycle removes a key source of expense volatility for risk managers, emerging risks present many challenges.
With the stable market creating general price parity among insurers, it’s more important than ever to select underwriting partners based on their expertise, experience and claims handling record – in short, their ability to help better manage the total cost of GL.
And the key word is indeed “partners.”
“The current risk environment underscores the value of the insurer, broker and buyer getting together to figure out the exposures they have, and the best ways to manage them — through risk control, claims management and a strategic risk management program,” said David Perez, executive vice president and general manager, Commercial Insurance Specialty at Liberty Mutual.
While analytics and data are key drivers to the underwriting process, the complete picture of a company’s risk profile is never fully painted by numbers alone. This perspective is not universally understood and is a key differentiator between an experienced underwriter and a simple analyst.
“We have the ability to influence underwriting decisions based on experience with the customer, knowledge of that customer, and knowledge of how they handle their own risks — things that aren’t necessarily captured in the analytical environment,” said Moitoso.
Mark Moitoso suggests looking at GL spend like one would look at total cost of risk.
Several other factors are critical in choosing an insurance partner that can help manage the total cost of your GL program:
Clear, concise contracts: The policy contract language often determines the outcome of a GL case. Investing time up-front to strategically address risk transfer through contractual language can control GL claim costs.
“A lot of the efficacy we find in claims is driven by the clear intent that’s delivered by the policy,” said Perez.
Legal cost management: Two other key drivers of GL claim outcomes are settlement and trial. The best GL programs include sophisticated legal management approaches that aggressively contain legal costs while also maximizing success factors.
“Buyers and brokers must understand the value an insurer can provide in managing legal outcomes and spending,” noted Perez. “Explore if and how the insurer evaluates potential providers in light of the specific jurisdiction and injury; reviews legal bills; and offers data-driven tools that help negotiations by tracking the range of settlements for similar cases.”
David Perez on managing legal costs.
Specialized claims approach: Resolving claims quickly and fairly is best accomplished by knowledgeable professionals. Working with an insurer whose claims organization is comprised of professionals with deep expertise in specific industries or risk categories is vital.
“We have the ability to influence underwriting decisions based on experience with the customer, knowledge of that customer, and knowledge of how they handle their own risks, things that aren’t necessarily captured in the analytical environment.”
— Mark Moitoso, executive vice president and general manager, National Accounts Casualty, Liberty Mutual
“When a claim comes in the door, we assess the situation and determine whether it can be handled as a general claim, or whether it’s a complex case,” said Moitoso. “If it’s a complex case, we make sure it goes to the right professional who understands the industry segment and territory. Having that depth and ability to access so many points of expertise and institutional knowledge is a big differentiator for us.”
While the GL insurance market cycle appears to be flattening, basic risk management continues to be essential in managing total GL costs. Close partnership between buyer, broker and insurer is critical to identifying all the GL risks faced by a company and developing a strategic risk management program to effectively mitigate and manage them.
This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Liberty Mutual Insurance. The editorial staff of Risk & Insurance had no role in its preparation.