Marine insurance

MARKETREVIEW 2006

Contents 01 02 04 07 10 12 14 16

Executive summary: Growing risks Shipping market: Too many ships, not enough crew Global marine insurance market: New dynamics Hull: Competitive cover Cargo: Capacity, containers and commodities P&I: Double whammy Conclusion: Change and challenge in a stable market Notes

Market review || 2006 || Marine insurance

01

Executive summary: Growing risks Ships on a scale never seen before are a sign of a healthy shipping industry which is thriving thanks to a strong global economy. However, maintaining an even keel in a rapidly changing world will not be easy for the world’s shipowners. Sustaining current economic growth rates is by no means certain, particularly in the US. In the shipping industry itself, manpower is already in short supply and the situation looks set to worsen. At the same time, the level of new ship building is at an historic high while scrappings are lower than usual. Taken together these factors all suggest a period of consolidation is inevitable in the next few years. In contrast to shipowners, marine insurers are surviving rather than thriving. Contrary to initial expectations, hurricanes Katrina and Rita had almost no impact on the 2006 renewals. Since then, fierce competition and new capacity are ensuring that prices remain broadly stable. In the longer term, the arrival of bigger ships poses a tough challenge because of the concentration of risk. Cargo – and to a lesser extent hull – insurers are already having to revise their underwriting strategies and realistic disaster scenarios. P&I insurers are also having to adjust to the potential for massive liability claims from the super-size vessels. At the same time, new laws and financial regulation are forcing fundamental change on P&I clubs including how they assess their risk exposure. Internationally, the London market is under increasing pressure to overhaul outdated trading practices and finally embrace the electronic age. In addition to internal reform initiatives, competition from other markets is rising. Norwegian insurers are becoming more ambitious and Asia is steadily developing its own insurance infrastructure.

Shipping industry highlights • • • • •

Strong demand continues Larger vessels coming on stream High level of new building Potential over-capacity ahead Looming manpower shortages.

Marine insurance highlights • • • • •

Competition ensures broadly stable prices Bigger ships equal unprecedented insured values, especially for cargo Hull market attracts new capacity New laws and regulations force change on P&I market London needs to reform in face of growing Norwegian and Asian competition.

02

Market review || 2006 || Marine insurance

Shipping market: Too many ships, not enough crew After several years when profit has been easy to come by, the next few years may not be so rosy for shipowners. Red flags are on the horizon, in particular signs of oversupply of vessels on the one hand and crew shortage on the other. As a result, sectors of the industry are no longer in full control of their destiny. However, the outlook is not totally bleak, especially for those in the shipping industry willing to act now to overcome the problems on the horizon. As this scenario plays out, the winners will be those who face reality and go on to identify, understand and manage the new risks.

Over-capacity For some time now, demand for shipping has been outstripping or matching fleet availability. Following the laws of supply and demand, high fleet utilisation has resulted in high prices and sizeable profits for owners. However, even in these buoyant times, competition led to shipping rates falling in 2005. Profits are likely to come under even greater pressure in the coming years when supply is expected to outstrip demand. One statistic sums up the scale of the challenge: shipyards have orders for or are building more than 20% of the current world fleet. Many of these new vessels will become available in 2007/8. Much of the additional capacity may be absorbed by a continued expansion of world trade. After all, strong growth is forecast for China, the rest of Asia and India. However, less certain is the outlook for the US economy which is much more important to the shipping industry because of the huge volumes of trade between Asia and North America.

The creation of a new fleet could herald the advent of a golden age of shipping.

The arrival of significant additional capacity at the same time as a downturn in transpacific trade would have significant consequences for the industry. Firstly, it would prompt increased scrapping of older vessels. Comparatively few vessels have been scrapped in recent years as owners have kept them sailing in response to high demand. Secondly, a combination of over-supply and falling demand would increase the pressure for industry consolidation in the form of increased merger and acquisition activity. This would in turn lead to the disappearance of many small operators, especially those with sub-standard vessels. In the long term, such a cyclical shake-out over the next two or three years would probably benefit the industry. It would result in the creation of a relatively new fleet and could herald the advent of a golden age of shipping. However, this favourable outcome would only be achieved after a certain amount of pain.

Market review || 2006 || Marine insurance

03

Manpower shortage The surge in tonnage is exacerbating another challenge facing shipowners – the shortage of experienced officers and crew. Many ships’ officers are approaching retirement age and several factors are deterring younger people from entering the profession or moving to the higher ranks. Firstly, the time it takes to qualify as an officer, typically up to 10 years, is regarded by many as too long. Secondly, tougher environmental and safety laws, while welcome in themselves, mean that masters are increasingly likely to be jailed pending trial for events which are sometimes beyond their control. This is hardly an incentive for younger officers to take greater responsibility. Thirdly, moves to cut crew members’ hours and improve working conditions are putting additional strain on the already limited supply of manpower. Once again, such initiatives are to be welcomed but it is unfortunate that they coincide with an increase in the number of vessels when experienced crew are already hard to find. Finally, more stringent port safety rules due to the threat of terrorism mean that mariners are frequently confined to ship when in harbour. As a result, a six month voyage increasingly means six months on board ship with no chance of shore leave, a very disheartening prospect for crews. On a positive note, fleets can take steps to attract, train and retain seafarers and some are already doing so. The options open to them include: identifying their own ratings with the potential to develop, introducing a more rigorous selection process for fast track scheme candidates and liaising with international maritime training institutions to attract graduates.

04

Market review || 2006 || Marine insurance

Global marine insurance market: New dynamics The arrival of larger LNG tankers, cruise ships and container vessels has clear benefits for shipowners’ operating costs but is likely to have a very different impact on insurance dynamics. Placing very large risks will require a high proportion of available market capacity, potentially putting underwriters in a much stronger bargaining position than they are now when it comes to price.

London is fighting to maintain its lead position in international marine business while other markets are eager to compete.

Marine insurance premium income. Source: IUMI

In the meantime, though, marine insurance prices remain broadly stable and highly competitive since the market continues to attract new investors despite generally low profits. For example, in the past 10 years or so the industry as a whole has not once recorded consistent profits over a three to five year period. Nonetheless, some companies and syndicates have outperformed the market and the recent return of Berkshire Hathaway to marine insurance through a new CV Starr syndicate suggests that some believe better times are ahead. It is against this background that London is fighting to maintain its lead position in international marine business, while other markets are eager both to compete and develop new opportunities.

Premium in US$ billion Global hull

Transport/ cargo

Marine liability

Offshore/ energy

Total

2005

4.772

9.279

1.231

1.696

17.26

2004

4.54

9.923

1.145

1.551

17.178

2003

4.026

9.129

1.152

1.753

16.076

8.7%

-0.6%

-11.5%

6.9%

-6.5%

7.5%

9.3%

0.5%

Index 200312.8% 2004 Index 20045.1% 2005

London Thanks to its concentration of expertise and experience, London (Lloyd’s and the IUA) remains the largest single market for marine insurance. At the same time, though, 300 year old traditions add to London’s cost base and adversely affect its efficiency. As a result, business continues to seep away to other markets. Several London insurers are establishing operations in lower cost bases such as Bermuda. Others are setting up in developing markets such as Singapore and Hong Kong. Moreover, London’s pull remains strong as is shown by the decision of Bermudan based insurer Lancashire to set up a marine operation in London in 2006.

Market review || 2006 || Marine insurance

05

Nonetheless, London does need to reduce its cost base if it is to retain its current dominance. This is particularly true at a time when all areas of marine are highly competitive and other markets are keen to grow. Moving to efficient ways of transacting business is therefore imperative.

Norway Norway’s marine market is on course for expansion and increasingly able to challenge London in terms of providing large amounts of capacity. Among its strengths are the broad cover of the Norwegian Marine Insurance Plan and the competitiveness and stability of its insurance companies. Norwegian insurers play an important role in the competitive builders’ risk market around the world. At home, they insure most construction risks in Norwegian shipyards, as a rule calling on London and other markets for co-insurance only on very large projects. At the corporate level, Gard and NHC continue to dominate the Norwegian market. Among smaller companies, Icelandic investors have acquired the Nemi insurance company but this is not expected to result in a change of course. Separately, Norway’s Skuld announced in August 2006 plans to merge with Swedish mutual The Swedish Club. The two P&I insurers see opportunities for reducing costs and exposures at the same time as improving their risk bearing ability.

Asia The Asian market is steadily developing critical mass, both in terms of capacity and expertise. Over the past year, several overseas insurers have set up operations in the region or enhanced existing services, among them Norwegian P&I club Skuld which has opened an office in Singapore. Other overseas insurers and P&I clubs are expected to follow, either with representative offices or a larger presence. As the market grows, it is also becoming more professional and particularly on the client side in centres such as Singapore, Hong Kong and to a lesser extent Taiwan. However, in terms of wholesale, the potential for Asian expansion is currently limited by a shortage of expertise and experienced insurance professionals. Nonetheless, Asia is gradually developing clusters of insurance excellence, a trend which is fuelled by the arrival of more and more shipowners and decision makers in the region. Naturally enough, they want to deal with insurance professionals in their own time zone.

China For China, like Asia, the main story is one of expansion. Over the coming years, the country is determined to enhance trade with its neighbours in Asia, particularly Japan and Korea. This will result in the exponential growth of tonnage in China, particularly in the north east region of Bohai Rim, the Yangtse River Delta in central China and the Pearl River Delta in south China.

06

Market review || 2006 || Marine insurance

Such rapid expansion inevitably brings challenges. In China’s case we have identified two main challenges. The first is the tendency towards cost-driven competition at the expense of a risk management conscious approach to underwriting. The second challenge China faces is one it shares with the rest of Asia, namely a shortage of marine experts.

US A key feature of the US marine insurance market in 2005 was very high profit levels, particularly in cargo which to some extent supported other lines. Cargo insurers recorded an overall combined ratio of 75% for the year, dispelling concerns voiced late in 2005 about possible losses from hurricanes Katrina and Rita. This high level of profitability resulted in the continued availability of very broad coverages at competitive prices in cargo in 2006. Aon was able to secure almost any cargo cover requested by clients, usually without having recourse to foreign markets thanks to a strong supply of local capacity. This was boosted by newcomers to the market and by the more active stance taken by previously somewhat dormant capacity. In addition to aggressive pricing on cargo, the excess liabilities market was also very competitive, while other lines were generally stable. In terms of the scope of cover offered by underwriters, the situation was largely unchanged on hull, P&I and liabilities.

07

Market review || 2006 || Marine insurance

Hull: Competitive cover New players, increased competition and broadly stable rates sum up the key trends in the global hull market during 2005/6. The quantum of major losses was not out of the ordinary. Even hurricanes Katrina and Rita resulted in comparatively few marine hull and cargo losses, contrary to some initial fears. Consequently, marine reinsurance rates were largely unaffected and most shipowners were able to renew their cover on the same terms and conditions as before. In the case of fleets with a good record, many were able to negotiate a small improvement in terms or conditions. On the claims side, although the frequency of claims is stable or falling, the severity of claims is increasing. This is particularly true for loss of hire claims as many ships needing repairs are waiting longer for a shipyard slot because of the high levels of new building.

Hull premium chart. Source: IUMI 2006

6.3% 13.2% 32.8%

USA UK (Lloyd’s) UK (IUA)

5.8%

Spain Japan

5%

Italy France

9.2%

Norway RoW

13%

6.7% 8%

Capacity In London, the CV Starr and Argenta syndicates brought additional capacity to liabilities and cargo. Separately, Bermuda insurer Lancashire has set up a marine company in the UK with the potential to write large lines of hull business. Consequently, there is no shortage of capacity in hull and the benign 2006 hurricane season will have made the market more attractive to underwriters. Other markets too are seeing capacity increases. Singapore, for example, can now provide up to US$180 million in local capacity. As a result, Aon can often place Asian risks locally or regionally, although larger, more complex risks still rely on the London and Norwegian markets. Lloyd’s Asia has seen rapid growth both in premium volume and number of syndicates. Hull market pricing remains largely stable. The US hull market is largely self-sufficient in terms of capacity but is strongly influenced by London on blue water rates.

08

Market review || 2006 || Marine insurance

In the Norwegian market, the country’s smaller insurers are showing a preference for particular lines of business and, more significantly, a marked willingness to consider a wider range of risks. Moreover, when writing their chosen business they are offering competitive prices and more creative solutions than in the past.

Competition London continues to handle most large global marine accounts. Its success is due to the expertise and niche cover available from the 27 Lloyd’s syndicates writing marine business together with the IUA company market. On large and complex risks, London underwriters often work closely with markets in the Netherlands, Norway and Asia to provide complementary capacity. However, London is coming under increasing pressure, both on local business and from its nearest rival in terms of size, the Norwegian market. Figures from IUMI show that, for the first time, Norway almost matched Lloyd’s hull premium volume in 2005 when builders’ risks are included (see graph below).

Global hull premium, major markets, 19992005 (US$ million). Source: The Central Union of Marine Underwriters, Oslo, Norway – Global Marine Insurance Report 2006

700

600

500

400

300

200

100

Norway’s expansion is due to aggressive marketing, greater risk appetite and its broad cover.

0 1999

2000

2001

2002

2003

2004

2005

Accounting year

France

Spain

Italy

UK (ILU/IUA)

Japan

UK (Lloyd’s)

Norway

USA

Norway’s expansion is due to aggressive marketing, greater risk appetite and the broad cover it offers through the Norwegian Marine Insurance Plan (NMIP). The NMIP was developed by insurers and shipowners working together, making it very attractive to the latter as is the stability of its insurers and its claims-led system.

Market review || 2006 || Marine insurance

09

Asian hull markets are developing too, albeit largely in the form of foreign owned insurers in the region. In a sign of growing confidence, though, Singapore in particular has become a hub for writing sizeable risks without the need for insurers to refer to their parent companies. It is in response to this development that London based syndicates such as Kiln and Alba have set up in Singapore. The growing importance of Singapore and Hong Kong also explains why insurers such as Royal & SunAlliance and Catlin have reinforced their presence in the region by appointing marine hull claims specialists locally.

10

Market review || 2006 || Marine insurance

Cargo: Capacity, containers and commodities Two issues dominate the cargo market: increased capacity and the arrival of larger container ships. In addition, highly volatile prices for commodities such as oil and copper are making life more difficult for underwriters. On a positive note, demand for project cargo insurance related to infrastructure investment is strong on the back of civil engineering projects in the Middle East. 2.4% 1.9%

Cargo premium chart. Source: IUMI 2006

21.1%

7.5%

14%

8.6% 5.4% 8.6% 2.4% 2.4% 1.6% 3% 3.8%

Belgium

Spain

Taiwan

Sweden

France

Switzerland

Germany

UK (IUA)

Italy

UK Lloyd’s

Japan

USA

Netherlands

RoW

17.2%

Capacity and competition Despite being a competitive market, cargo continues to attract capacity from newcomers such as CV Starr and Argenta in London. Interestingly, CV Starr is backed by Berkshire Hathaway which pulled out of marine several years ago but has chosen to return. Other markets are increasing their capacity too and we expect the global appetite for cargo business among insurers to keep on growing. In the highly profitable US cargo market, for example, we are confident that cover will remain available for risks which in the past may have been considered difficult to insure. We also believe the market will continue to offer capacity for stock throughput coverages combining ocean, inland cargo and location insurance. Although competition is good for clients, it does not follow that poor risks will find competitively priced cover as has sometimes been the case in the past. In general, underwriters are not competing over unattractive, badly managed risks with a poor loss history. Their preference is for well risk managed accounts and this is where competition is strongest. Equally, price is not everything and clients who buy insurance on price alone may be ignoring long term issues such as stability, relationships and coverage at their peril. Clients should be aware that some underwriters are reluctant to quote on accounts which are tendered every year. Consequently, Aon puts great emphasis on promoting and nurturing the relationship between underwriter and client.

Market review || 2006 || Marine insurance

11

This year, Aon has improved its ability to obtain the best deals for clients by setting up the Global Cargo Group. The GCG makes it easier to share knowledge and expertise internally with the result that we can develop innovative products for clients based on best practice from around the world. The GCG also highlights the fact that broking is no longer simply about selling insurance products. Increasingly broking is about adding value based on a broker’s skills and intellectual capacity in designing products and constructing placements. In some circumstances, for example, Aon advises clients on options other than buying insurance such as the proper level of self-insured risk retention and other methods of risk transfer.

Container concentration Booming world trade, especially exports of manufactured goods from Asia to North America and Europe, has led to the construction of the first container ships capable of carrying more than 14,000 TEU. This new breed of ship helps cut shipping costs and speed up delivery of electronic goods, clothes and other products from factories in Asia. However, from an insurance perspective, bigger ships concentrate risk on an unprecedented scale. A fire on board the Hyundai Fortune in March 2006 shows the potential cost of such a loss. Although only a 5,500 TEU vessel, the combined cost of the ship and lost cargo is estimated at over US$300 million. The aggregate loss from an incident involving a 14,000 TEU container ship could be much higher. Calculating the size of the risk is difficult, given the variable value of goods carried. It is not unknown, for example, for a single container to carry goods worth more than US$1 million. Moreover, the challenge to insurers is set to grow, since plans exist for even larger ships (Malaccamax) with a capacity of 18,000 TEU. To limit their exposure to such big ships, underwriters may have to reduce the proportions on each risk they write. How the industry will manage this challenge is too early to say.

Commodities and infrastructure Recent volatility in commodity prices presents a challenge to cargo insurers.

Recent volatility in commodity prices such as oil and metals presents a separate challenge to insurers. When commodity prices rise, underwriters sometimes struggle to maintain their percentage participation on risks. In many cases, the only solution is to buy more reinsurance. At the same time, they often cut their rates so that premiums are the same or only slightly higher. However, when commodities subsequently retreat from their highs, as oil did during 2006, clients generally expect rates to be maintained with a resulting reduction in underwriters’ premiums. Project cargo, on the other hand, is a very positive market for insurers, particularly in the Gulf States and Saudi Arabia due to the number and size of infrastructure projects in the region. Much of the insurance for these large projects is placed through London which has the ability to handle complex risks combining cargo, construction and financial covers such as business interruption. However, although project cargo is currently a good source of new business, insurers cannot rely on it lasting indefinitely.

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Market review || 2006 || Marine insurance

P&I: Double whammy Tougher regulation will limit P&I clubs’ ability to dictate their own affairs.

The P&I market is going through a gradual but fundamental change as a result of two linked processes. One is new legislation and changes to existing laws affecting the shipping industry. The other is tougher insurance regulation of P&I clubs due, for example, to the proposed introduction of Solvency II in 2010. Together they will limit P&I clubs’ ability to dictate their own affairs. Instead of acting as independent mutual operations solely for the benefit of their membership, the clubs will have to adopt a more conventional insurance company approach driven by regulation. New and proposed legislation will inevitably increase the claims paid by P&I clubs in the longer term. Solvency II and other regulatory changes mean that clubs are having to factor in those potential risks now, instead of calculating their exposures based on an analysis of historical claims. Consequently, P&I rates will continue to rise as clubs strengthen their finances to meet the expected increase in claims as well as to satisfy the tougher solvency demands of regulators and rating agencies.

Legislation P&I clubs have made great progress in recent years in reducing underwriting deficits, cutting their reliance on potentially volatile investment income and improving solvency. By historical standards, they are generally now in a strong financial position and should be able to withstand most of the scenarios they have faced in the past with little difficulty. However, the past is not necessarily a guide to the future, especially when the future is set to change radically. The US has already raised the limits on damages payable under its Oil Pollution Act. If proposed changes to the Athens Convention are ratified, then passenger shipowners too may have to pay much higher levels of compensation. At the same time, the introduction of other conventions, for example for crew, is being considered. In addition to paying higher levels of compensation, past experience shows that legislative changes often result in shipowners being much less able to defend themselves than in the past. A recent example is the new European Directive on criminal sanctions for shipboard pollution. In some circumstances an accidental oil spill, for example, may now give rise to criminal liability.

Regulation The introduction of new legislation coincides with the arrival of a more demanding regulatory environment. As a result, clubs will have to prove to regulators and rating agencies that they can withstand not only the liabilities they have managed in the past but also the additional liabilities (from a revised Athens Convention for example) that they will face in the future. They will therefore have to start making provision for events which may happen several years in the future as well as for one in 200 year events.

Market review || 2006 || Marine insurance

13

Consequently, most clubs asked shipowners for more money during 2006. The West of England club surprised the market with a very large cash call to make provision for future solvency requirements. We believe that the club is being overly cautious and that most other clubs will gradually raise rates and solvency levels between now and 2010 when Solvency II comes into force. For 2007, we expect rating levels to rise by an average of between 5% and 6%. Despite the challenges it presents, we welcome the move to greater transparency and more consistent accounting standards which will result from increased regulation. It will reduce pricing volatility for shipowners and will help us to better advise our clients about the choices they make.

Hurricanes and tonnage Other factors influencing P&I rates include reinsurance costs and increased world trade. Despite hurricanes Katrina and Rita, 2006 reinsurance rates were unchanged. We attribute this to the clubs’ strong historic relationship with reinsurers, the lower than expected impact of the hurricanes on marine and the bargaining strength provided by the Hydra cell captive. We expect a similar outcome for the 2007 renewal. The continuing growth in world trade means a greater number of ships sailing the seas and, in correlation, an increase in claims. In theory, the increase in volume should be matched by an increase in premium. However, that is not the case at the moment. In addition, as with the cargo market, P&I underwriters warn that the trend towards bigger ships carries the risk of losses on a previously unseen scale. One particular problem for P&I underwriters is the tradition of new vessels paying a lower premium than old ones. Some owners have renewed their fleets and cut their premiums but have not changed the way they operate those fleets. Consequently, although clubs have less premium income, this has not been matched by a fall in the volume of claims.

14

Market review || 2006 || Marine insurance

Conclusion: Change and challenge in a stable market Despite the challenges facing marine insurers, and absent any major claims, the outlook appears relatively stable for the next few years. On the question of very large ships, it is difficult at this juncture to accurately predict their impact on the marine market. The question of how underwriters would react to this phenomenon was debated at the IUMI conference in Tokyo but as yet there is no clear common approach. However, in our opinion, larger ships should not require additional capacity. More capacity would only serve to destabilise the marine market, a development which would benefit neither insurers nor insureds. The marine market is more stable than most and the continuity it offers is a valuable commodity.

Electronic trading Turning to individual markets, the key challenge for London in the year ahead is to cut costs by embracing electronic trading. Marine has been slow to accept this challenge, often preferring to stick to traditional face to face trading, even though it is a costly way to place risks and handle claims. Brokers and underwriters should only trade face to face when it adds value to clients. In contrast to past attempts at reform, tried and tested electronic systems are now in place. They are already used on a daily basis when dealing with overseas markets such as Bermuda. Given that London continues to lose market share, it is time to take full advantage of this technology to restore London’s ability to compete internationally.

Hungry dragon For Asia, the key issue is recruiting experienced staff. The growth in demand in the region is being matched by increasing confidence among underwriters and brokers. Asia has been likened to a hungry dragon. The capacity of that dragon for all classes of insurance will definitely develop in the next few years.

Chinese attraction The projected promising growth in China has persuaded many international insurers to make forays into the market. It has also attracted some Chinese insurers to venture into the marine sector with the result that more capacity than ever is now available in Asia. As with Asia, though, China is struggling to cope with a shortage of marine insurance expertise.

Market review || 2006 || Marine insurance

15

US stability In the US, the recent trends of flexible coverage and competitive pricing look set to continue in the cargo market in particular as long as profitability remains strong. However, clients should be wary of taking lower prices or broader coverage for granted. Excess liability lines, for example, have already reached the minimum possible premium and we see no room to reduce them further.

Nordic ambition Norway clearly has its sights set on matching Lloyd’s in terms of size at the very least. Even though the market consists of no more than a dozen companies compared with the 27 Lloyd’s syndicates writing marine, underwriters in Bergen and Oslo are taking on very large shares of risks compared with London. And there is no sign of their appetite failing.

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Market review || 2006 || Marine insurance

Notes

For further information, contact: Nigel Roberts Chairman of Aon’s marine unit in the UK 020 7216 3554 [email protected]

Media and press enquiries Alexandra Lewis

tel: 020 7882 0541

fax: 020 7216 3491

email: [email protected]

Whilst care has been taken in the production of this report and the information contained within, Aon does not make any representation as to the accuracy of the report and accepts no liability for any loss incurred by any person who may rely on it. In any case, the recipient shall be entirely responsible for their use of this report .

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