With the arrival of a new hurricane season, oil and gas operators in the Gulf and on the coast are finding that insurance coverage for storm-related risks is not only extremely expensive, but scarce.

The availability of insurance for Gulf windstorm coverage this year has shrunk to about one-fifth of last year. And some policies now have limits as low as $50 million on windstorm coverage.

Bill Martin, CEO of Benfield Corporate Risk in Houston, says the shift could be causing rate shock in energy executive suites.

"A lot of senior management and boards of directors are just finding out how inadequate their coverage renewals are for the Gulf of Mexico," says Martin.

Benfield Corporate Risk, the U.S. insurance brokerage and risk management unit of U.K.-based Benfield Group, is tracking several trends.

Martin says a few companies have decided not to purchase coverage for excess windstorm damage because of the high cost.

"They're buying traditional coverage for well-related property exposures, but without windstorm coverage," he says.

The increased expense is especially affecting independents in the middle of the energy spectrum.

Explains Martin: "You can buy a limited amount of windstorm insurance at low levels of coverage, but for midsized and growing independents that doesn't allow your board members to sleep at night. It's the excess protection that's missing."

The question now is whether the 2006 season will make an already unprecedented situation even worse.

Early June is when most companies renew coverage before insurance capacity totally dries up, says Bruce Jefferis, managing director of the Natural Resources Group at Aon Risk Services of Texas, a division of Aon Corp.

Jefferis says some oil and gas companies have chosen to renew their coverage ahead of time and pay bigger premiums to get something in place before storms start forming.

Those with renewal dates during the second half of the year who don't choose to accelerate "will just have to wait it out," he says.

What is going on now, he says, has never happened before.

Says Jefferis: "We've always handled renewals year-round. I've never seen it get to the point that underwriting has stopped."

Catastrophe bonds
Scarcity of insurance coverage for windstorm damage has induced capital markets to fill the void with a long unused type of risk management instrument -- catastrophe bonds.

Unlike traditional insurance based on expected losses and payment when losses occur, catastrophe bonds are linked to low-probability events such as a 100-year storm.

Catastrophe bonds are triggered by actual storms rather than indemnifiable losses.

The trigger -- called the "parametric" -- works like this: If a Category 4 storm passes within 25 miles of assets covered by the bond, payout is triggered.

The risk is based on the assumption that assets in such close proximity would be catastrophically damaged. But even if they aren't, the bond pays because the conditions were met.

The market for catastrophe bonds surged 74 percent last year when an all-time high of nearly $2 billion in bonds was issued. And that record is expected to be broken this year.

The market potential has created some new alliances.

Benfield recently formed a partnership with investment bank Merrill Lynch & Company Inc. to focus on issuing catastrophe bonds.

Hurricane winds are blowing energy industry insurance rates through the roof.

Companies hammered by losses approaching $10 billion over the last two years in the Gulf of Mexico now face premium costs that have soared 400 percent.

Benfield will do the catastrophe modeling, while Merrill Lynch will provide expertise in capital market structure.

Catastrophe bonds transfer the risk of infrequent but extreme losses to a broad and sophisticated class of investors, including hedge funds.

At this point, however, Aon's Jefferis says there is "a lot more talk about hedge funds in this market than actual substance."

Two energy hedge funds based in Houston are managed by John Olson at Sanders Morris Harris Group Inc. investment bank and John Arnold of Centaurus Energy Advisors. Both principals say their firms have no involvement in catastrophe bonds.

Martin says Benfield is trying to structure traditional risk coverage along the same lines as catastrophic bonds.

Explains Martin "We're going to insurers and saying instead of writing coverage at the low end of risk, companies need coverage to apply to catastrophic loss, where there is low probability but high cost if they are hit."

The trend could make storm damage insurance comparable to workers' compensation insurance, according to Martin.

The good news is that with oil at $70 a barrel, companies can still afford to pay a high cost for storm insurance.

Houston energy analyst Wayne Andrews of Raymond James Financial Inc. investment bank says rising insurance costs continue to be more than offset by gains in commodity prices.

Still, the risk companies with substantial Gulf operations face is a factor in their market valuation.

Says Andrews: "Gulf of Mexico companies trade at unbelievably cheap valuations these days, and that risk is part of it."

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By Monica Perin
Houston Business Journal

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