“ Boom, Bust or Balance ?” by Martin Schweighauser

“Boom, Bust or Balance?” by Martin Schweighauser Global Head Energy & Natural Resources, Swiss Re MARINERS CONFERENCE 2006 Houston, 18th September 2006

Balance…

Contents • Insurance industry from a macro perspective • Why buy insurance……? • Corporate finance and the “right kind of cover” • And how should we deal with NatCat? • Insurance for Energy Companies: “quo vadis”? • Insurance for Offshore exposures • Some Thoughts and Conclusions

Macro perspective Stock market returns and change in commercial premium rates Stock index1990 = 100 Price index1994 = 100 Sources: Datastream, Thomson Financial, CBS Private Capital Ltd,, Swiss Re

Macro perspective Industry Profitability market hardening already started in 2000, asbestos and Sep11 just accelerated • stock market “fragile” since 2000 • some upswing but not widespread • uncertainty remains • earnings volatile selective market hardening (e.g. offshore) - but not widespread ? • operational income (from u/w) is key • big losses in 2001 and 2005 • premiums are not really offsetting losses • magnitude of future losses increasingly difficult to estimate ? ?

Macro perspective Sensitivity of ROE to investment yield and underwriting result • high(er) investment yields (for insurers) do not necessarily lead to higher ROEs • performance in core operations is key to healthy ROEs ( Combined Ratio) • a combination of a poor yield and poor Combined Ratio leads to: • equity loss • rating downgrade • (expensive) recapitalization • etc.  spiral….. ROE Year B investment yield Year A investment yield 10.7% 7.0% 2.4% Combined Ratio 97.9 for Year B 108.1 for Year A Sources: A.M.Best, Swiss Re Economic Research & Consulting

Macro perspective New capacity did not fill the gap left by destroyed capital Capital inflows and the creation of new players in 2002 were not enough to restore health to the industry… • New capital inflow was ~$30billion + • Decline in capital funds of established players since year-end 2000 was ~$180 bln • Security of raised/new capital was not top quality; many security downgrades too • New capacity has not been upgraded and downgrades have not been reversed - this will continue to limit availability top-quality capacity • There was some capital base improvement in last 3 years, but not enough • Improvement of the industry’s overall capital funds and earnings stability will be key to limiting premium volatility Source: Sigma No. 4/2002

Macro perspective What drives cycles and hence, the cost of insurance…….? • Fluctuations of capital base • Need for insurance market to be “paid back” • Underwriting losses recovered by market via higher rates in macro cycle • At micro level, companies who make claims are priced as higher risks • Low equity market returns and broad underwriting losses in recent years • Lack of real substitutes and insufficient exploitation of alternatives to insurance  insurance remains the main vehicle for cover • Cost of insurance vs. cost of debt and equity (e.g. GoM today) • Big loss events which cause great uncertainty and general inability to plan adequately • Asbestos and 09/11 were just accelerators adding additional challenges – and now we have (many)hurricanes too….. • Vicious circle of: terrorism; war; general uncertainty; major losses; slower economic growth; etc……

Macro perspective So where do insurers stand today? • Still affected by: • i) Asbestos claims; ii) 9/11 impact; iii) massive hurricanes etc. • Investors’ confidence continues to be rocked by: • i) Average (at best) performance of insurers, ii) accounting scandals & compliance issues, iii) hurricanes, iv) still low interest rates etc…. • Equity capital for insurance companies hard to get and/or expensive • Several years of solid profitability necessary to restore balance sheets • (Some) strengthening in stock markets helping – but it is not enough • Some strengthening of capital bases through core (u/w) operations • Share prices of insurance companies flat to languishing • Significant regulatory changes: compliance and business scrutiny • Nat Cat events (and losses) on the rise

Why buy insurance? Let us step back and reflect … why do insureds want insurance in the first place? • To keep shareholders from bearing risks they don’t want • To reduce impact of non-core events on earnings • To reduce capital required to support debt capacity needed to finance infrequent loss events • To enhance financial flexibility: • diversify funding sources by using the insurance market • enables access to liquidity for funding losses • potential lower overall capital cost (through better risk profile) • For signaling: • demonstrates identification and management of (potential) financial consequences of risk exposures; • avoids disclosure “noise” about things that are ancillary to core strategy; • regulatory or quasi-regulatory compliance

Why buy insurance? The Energy world is an environment full of risks… “How much falls between the cracks?” • Examples of risks • Counterparty exposure • Collateral posting (rating dependent) • Commodity price / Spreads • Examples of risks • Business growth • Future (unforeseen) Liability Renewable Energy Ene r gy C o m p a n y • Solar • Wind • Emissions trading • Biomass • etc…. • Spark spread trading • Power plants Gas to Power • Liquefaction plants • Shipping • Regasification plants • End products Petrochemicals End User LNG Trading Exploration & Production Refining & Marketing Transportation • Crude oil & gas • Pipelines • Shipping • Crude --> Refined • Pipelines • Shipping • Oil & Gas • Finding & Extraction • Separation Basic, Integrated Value Chain • Examples of risks • Casualty/Environmental • Volumetric risk • Property damage • Business interruption • Construction • Other operational • Earnings volatility • Examples of risks • Casualty/ Environmental • Property damage • Business interruption • Construction • Other operational • Examples of risks • Casualty/Environmental • Property damage • Business interruption • Construction • Other operational

Corporate finance and the “right kind of cover” Ultimately, a client needs to satisfy corporate finance objectives … how well are these objectives met? = very well = very poorly

Corporate finance and the “right kind of cover” The worry of every CFO and CRO …. “Could this happen to me?” Hardware loss: a fractionation column Magnitude of loss:> US$ 1 billion (PD + BI)

Corporate finance and the “right kind of cover” Contingent Capital Insurance & Derivatives Insurance-Linked Securities Risk Management is a Corporate Finance matter“it is aboutfinding an economically efficient balance” All sources of capital help manage a firm’s risk:Firm Capital = f (Firm Risk) Corporate/Firm Capital Off-Balance-Sheet Paid-Up Low Senior Debt Exposure to risk Mezzanine Finance Equity High Transferred Retained by Firm Transferred Corporate/Firm Risks

Corporate finance and the “right kind of cover” Off On-Balance Sheet Off On-Balance Sheet Low Low (Senior) Debt (Senior) Debt Mezzanine Finance Exposure to Risk Exposure to Risk Insurance & Derivatives Insurance & Derivatives Mezzanine Finance Equity Equity High High Transferred Retained Risk Transferred Retained Risk Linking risk, stakeholders and finance “How much cover? How to reduce the premium?” Company with low D/E ratio Company with high D/E ratio Stakeholders involved Creditors (Banks) Company Employees Creditors (various) Insurers Share- holders • Some questions/dilemmas/pressures/responsibilities etc….. • Which stakeholders do you want/can you afford to expose to risk? • How much risk? How much cover? How much premium spend?  What is the right balance? • What would the financial consequences of a (large) loss be? • Would the Company go under or would the Debt and/or Equity holders just be angry? • So…… how much cover? And could the (premium) bill be lowered? How?

Corporate finance and the “right kind of cover” Risk Management becoming more strongly linked to Corporate Finance • The financial dimension of firms’ risks are increasingly better understood • Tools to manage risks, both operationally and financially, are more plentiful and sophisticated • Increasing pressure from the various stakeholders creates the need to understand and properly manage risks • Increasing compliance pressures likewise It follows that all financial tools to mitigate the financial exposures associated with risk, including insurance, appear on a CFO’s agenda

Large Refinery (PD + BI loss) Loss offshore India Hurricane Katrina Hurricane Rita All Other TOTAL Nat Cat……? What happened in 2005 ?(global energy only) LOSSES (some numbers are rough estimates) > US$ 1.0 bln +/- US$ 0.4 bln > US$ 5.0 bln > US$ 4.0 bln > US$ 0.5 bln US$ 10-15 bln ? Man made NatCat was the major loss contributor by far! Nat Cat Mix

Nat Cat……? Changing risk landscape: more unpredictable & greater in magnitude Many of the losses are due to NatCat events …..

Nat Cat……? Some facts and what is being heard… • Insurance industry’s (non-life) underwriting operations will post/have posted a loss for 2005 • OIL aggregate limit (of US$ 1 bln) breached twice (?) in 2005 (due to hurricanes Katrina and Rita) • Several insurers of the Energy offshore segment very severely hit by hurricane losses of 2005 (some to the point of extinction?) • Property onshore segment has had some large losses in 2005 - beyond just hurricane damage • Reinsurance rates have gone up significantly – and must not drop

(Energy) Insurance: “quo vadis”? 2000 40 1800 35 1600 30 1400 25 1200 1000 20 800 15 600 10 400 5 200 0 0 Market Performance ? Commercial Market Losses (Energy – Property onshore) ? Premium Loss Number of loss incidents 5-yr Mov. Avg. (Premium) ? 5-yr Mov. Avg. (Loss) Number of Incidents millions USD ? 2005 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Accounting Year

(Energy) Insurance: “quo vadis”? Major trends • Insurers deploying capacity more selectively and scaling back in some cases…. • …while for many (large) insureds availability of capacity is an issue • Pressure for more risk (and rate) differentiation • Large insurers better positioned to offer solid security • Compliance is affecting and defining business behaviour significantly • NatCat losses leading to reassessment of models • Enterprise risk increasingly a part of strategic corporate finance  this will create pressure for more discipline….

(Energy) Insurance: “quo vadis”? Premiums, coverage, security, risk quality etc….. …… while we still grapple with some difficult issues: • Pricing for risks is “all over the place”  we need to differentiate • (Quite a few) insureds take an opportunistic attitude towards their carriers • Pricing squeezes lead to coverage squeezes  meaningful coverage requires “proper pricing” • The industry must avoid excessive price volatility: there has been too much, historically • Often, insureds seem willing to sacrifice security for (lower) price • Underwriters struggle to underwrite and rate as they should - extreme price volatilty forces them to go with market • Differentiation becomes very difficult – regardless of risk quality

(Energy) Insurance: “quo vadis”? Compliance is here to stay….. • Focus on processes, documentation standards, transparency, ethics and behaviour • Regulatory bodies have been created or strengthened (e.g. FSA) • One must demonstrate execution of good/compliant business practices • Penalties are levied for deviations (e.g. Enron) • Responsibility and accountability even for highest executives • This is a global phenomenon • Adoption of enterprise risk management frameworks in Companies • Integration into enterprise achitecture • Actively managed and measured compliance  in- and external audits • Establishment of a Chief Risk Officer

Offshore Insurance Specific Changes in Underwriting……. • Coverage restrictions in Nat Cat areas per occurrence and in aggregate for season • Offshore price rise: up to 500% in GoM, 10% - 30% elsewhere • Onshore Property pricing: up to +20%; more for very exposed locations and facilities • Basis of BI changing – much more restrictive. CBI all scheduled and sublimited; cover of costs & expenses, not pure loss of profit. • Much more control over accumulations – much more limited Gulf of Mexico capacity available • Emphasis on risk quality and differentiation of certain types of assets

Offshore Insurance Conclusions for offshore insurance • Capital bases must be restored to health – and stay healthy • This means appropriate pricing - for direct and re-insurance • If not, capacity of some key players (even major ones) will be reduced or disappear completely • NatCat models must (and will) be reviewed and adjusted • As insurance becomes an integral part of Corporate Finance, Risk Managers and CFOs will move ever closer together • New insurance capital will flow in as rates rise (Bermuda) • More stringent compliance and regulatory requirements will force more business discipline and transparency

Thoughts and Conclusions Boom, Bust or Balance……? Given that: 1. Boom is good but actually “spoils” us……. and 2. Bust is bad for everybody… then 3. Balance really is the best, since we can all happily live with that…

So what should we be doing (to avoid busts)? Insureds • Make insurance an integral a part of corporate finance strategy • Help prevent high rate volatility - by balancing quality and price Insurers • Know better what is being underwritten and price accordingly • Help prevent high rate volatility – by sticking to “true economics” Brokers • As risk consultants, encourage clients to think beyond just price • Help create stability by avoiding a “win the deal at all cost” mentality All of us together: Take a long term view……

Balance… so we can end up here……….

Thoughts and Conclusions A last thought…. "If you think insurance is expensive……. try a loss." Stelios Haji-Ioannou (CEO Easyjet Group)

“ Boom, Bust or Balance ?” by Martin Schweighauser