Bob Dylan was not singing about climate change or atmospheric conditions back in 1965 and upon entering the summer of 2007, offshore E&P companies can only wish weather was a non-issue. Sadly, the answer blowing in the wind is that insurance costs now comprise a major component of lease operating expenses (LOE) and a company cannot transfer all of its natural catastrophe risk to insurers.

The main question following the 2005 storm season was whether Gulf of Mexico business could be underwritten on a profitable basis for a sustainable period given past performance. The market reaction was an exponential rise in the total cost of risk for the offshore sector through increased premiums and risk-retention levels, combined with reduced limits and coverage.

One area on which underwriters focused attention was in the distribution of their capacity. An aggregate amount of windstorm limit for the entire season was allocated to each buyer. As this represented only a fraction of the insured asset base, it was problematic for an E&P company, exposing it to a potentially large self-insured loss.

Fortunately, storms did not affect the offshore infrastructure in 2006, so the lack of adequate limits and higher deductibles was uneventful; nonetheless, the premium increase was painful. From underwriters' perspective, these draconian measures were a requisite for survival. Yet, from the offshore sectors' standpoint, it was obvious that technical underwriting and risk differentiation had been placed on hold with windstorm insurance simply an overpriced commodity.

The aftermath of an uneventful 2006 season for the first time in several years has been met with cautious optimism as insurers announced record profits. Property and casualty insurers in the U.S. market reported record earnings of $63.7 billion after taxes. This amount is nearly $20 billion more than their earnings in 2005, when the prior record was set. Warren Buffett cites good luck rather than managerial brilliance for his company's record results. The broader energy-insurance market led by Lloyd's likewise benefited from strong underlying conditions and the lack of storms.

The insurance industry, for a large part, renewed its catastrophe reinsurance in January, which is what insurers purchase to spread their risk of losses from hurricanes and other events. The bottom-line consequence was that reinsurance costs continued to rise due to loss deterioration from the 2005 windstorms, so many underwriters purchased less reinsurance due to cost or improved confidence in their own risk modeling. With a modest influx of new market capacity for energy risks though, there has been limited ability of underwriters to pass these rate increases onto the E&P sector.

The state of Florida's expansion in the property insurance market to stem rising premiums also resulted in commercial insurers purchasing less reinsurance. Unfortunately, all Florida has really done with its quixotic actuarial modeling is concentrate the risk of future hurricane losses within the state rather than spread it around the world through the insurance industry. This will ultimately result in huge liabilities that will have to be paid by the residents when the next storm surge comes ashore.

Certain underwriters whose capacity has not been utilized in Florida as planned provided additional capacity for offshore E&P windstorm risks. Still, this capacity did not attract much support due to pricing levels and essentially remained sidelined and unused.

By now most offshore E&P firms have renewed their insurance programs for 2007, or are in the final stages of negotiations and will be complete by July 1. Unlike this time a year ago, underwriters' attitudes have been generally positive. A profitable 2006 when one major storm was anticipated eased apprehension on justifying underwriting Gulf of Mexico business and buoyed confidence. To that end, this has resulted in increasing line size on the more attractive offshore risks and supplemental windstorm limits being available for smaller offshore asset-based risks at no additional cost.

The rising amount of market participants has led to some appetite to price risks more aggressively, but the traditional Lloyd's underwriters were not inclined to roll back prices.

Nonetheless, most buyers have seen nominal reductions in pricing or more windstorm limit for the same price and it has been easier to subscribe renewal programs. Some energy-package programs have been placed on a bifurcated basis with differential terms between sets of underwriters. The composite effect improved the overall reduction to a meaningful savings.

So while the traditional energy-market leaders reacted more conservatively to pricing improvement, certain insurers, particularly those who did not sustain significant losses in 2005 or were new capacity, did underwrite risks on a more competitive basis. Overall though, the newer capital has not been dramatic enough to counteract the established energy-insurance syndicates, whose concerted efforts were to maintain stability in pricing levels.



Lessons learned

It was prudent that all offshore companies review their post-loss experience from the 2005 season and engineer accordingly to "de-risk" assets, purchasing insurance in a more efficient manner. There are risk-management measures certain offshore companies enacted during 2006, which should have a long-term benefit with reduced losses, and to a lesser extent, marginal premium savings.

Following the storms, oilfield inflation essentially doubled the expected cost of repairs. These costs have not declined, so a careful review of insured asset values is crucial. The value to replace and remove a destroyed platform may be far greater than the amount for which it is insured.

Given the dramatic increase in insurance rates, coupled with the finite windstorm limit, it is difficult to properly insure one's entire asset base to value. It is recommended that the key economic contributors be highlighted and insured accordingly for replacement cost, with the marginal assets weighted more heavily to reimbursement for wreck removal.

Obviously, there will be assets that are between this range of importance and these should be insured more towards replacement cost. This approach does have limitations but the reality is that all of an operator's assets cannot be fully insured unless premium is not an issue-and it never is.

Some operators are reviewing plans for new offshore facilities to be built beyond the minimum API design standards. While these improved design costs may add 20% in upgrading expenses, the likelihood of wave damage is diminished. Also, some firms are designing structures to handle fewer wells so the amount at risk with a smaller structure is reduced.

On existing structures, there is not much that can be done to modify design characteristics. Taking a proactive approach on plugging and abandoning shut-in wells can reduce the amount of plugging costs following a windstorm, as these escalate dramatically when the platform is damaged. While this is an additional upfront expense because the operator is not waiting until all of the reserves are depleted, potential claims costs are minimized. Additionally, these wells may not need to be insured for "control of well," so the insurance premium from these non-productive wells is eliminated.



Deal-making

Following the widespread damage to the offshore infrastructure from hurricanes Katrina and Rita, it was a difficult environment for E&P companies looking to buy or sell offshore properties. Production was shut in and repairs took longer than expected to effect. Although there were a number of acquisitions and divestitures completed, this will likely be surpassed during 2007.

Care then needs to be given by an acquisitive company to properly factor in the cost of insurance in its economic modeling. Insurance represents a large portion of LOE and it is not just a one-time purchase but must be considered over the entire reserve life.

Insurance premiums for a moderate-size acquisition (based on physical assets and wells compared with oil and gas reserves) can easily exceed $10 million for assets acquired this year-and diminish the overall windstorm limit the buyer has, warranting the purchase of supplemental windstorm capacity.

While industry experts do not expect insurance costs to remain at current levels for an indefinite period given the industry's cyclical nature, no one expects them to dip down to the pre-2001 price deck. It is also unlikely that windstorm limits will be unaggregated again.

Several recent deals seem questionable from a pure economic standpoint. Granted, there is an enormous amount of capital available, but a bad deal is still a bad deal. When accounting for insurance costs over the long term, discounting back and assuming improved insurance conditions, there was seemingly no way to justify the successful bid barring a significant increase in commodity prices to levels not yet seen.

The insurance representative should therefore be brought into the process early on to help forecast premiums and windstorm-limit requirements so that the bid is successful, yet it is not in the long run a losing proposition due to inaccurate insurance projections.



Mark R. Mozell is senior vice president, marine and energy, for insurance-services provider Lockton Cos. He is based in Houston.