October 20th, 2016 17:00 GMT
Published in WEEKLY
For many years there has been constant talk about the soft hull and machinery market, where insurance premiums float below economic norms.
One hopes that at least this would have helped shipowners during the devastating freight market downturn. Unfortunately, this decrease in insurance costs will not last forever. Market capacity will eventually shrink and premiums will begin to rise again. Let’s hope such a change does not happen before freight rates recover to a sustainable level.
Even though correlating freight market and insurance premium levels has been mooted, these rates are completely different, being based on variables that have little to do with each other. However, there is a similarity between the freight and insurance markets: both are working in an environment where there is overcapacity, which has a detrimental effect on their income.
Freight market movements are related to the volume of world trade and the number of ships and tonnage on supply, whereas insurance premiums are directly related to the capacity of the capital invested in the insurance markets and loss ratios. In the insurance sector, the higher the capacity of capital at stake, the more competition we see, and therefore softer premiums, in spite of negative loss ratios in respect of claims. This is the main reason behind the soft insurance markets over the past nine years.
I believe that protection-and-indemnity (P&I) insurance, with its ‘inherent vice’ character, is more important than hull and machinery insurance within the industry. Due to their unique character and composition, P&I clubs have been able to keep premium fluctuations under control, and have not experienced the huge fall in premium levels of the hull and machinery markets. However, in late 2015 and early 2016, premium reductions, mainly in the energy sector, have begun to have an impact.
General increases in the P&I market have floated between zero and 2.5%, with the exception of one or two clubs. As long as the abundance of capacity in the hull insurance market continues, so will the competitive environment, but what’s scary is that the softness of the P&I sector will not last long.
Within current parameters, the worst marine tragedy would theoretically cost the International Group (IG) clubs in excess of $8bn. Considering that the insured world fleet reached 1.07 billion gross tons (gt) in February 2015 and is steadily increasing, the burden on the IG will continue to rise commensurately. Furthermore, the increase in liability limits could raise claims, with the financial consequences not good news for assureds.
‘Worse than Costa Concordia loss’
An incident of this magnitude — even though the likelihood of its occurrence is quite low — would far exceed the cost of the Costa Concordia loss; consequently most shipowners will not be able to pay the additional catastrophe premiums, which will eventually be called by the clubs.
Such an $8bn hypothetical claim would cost reinsurers almost $3bn, and the remaining $5bn would have to be covered by the shipowner members. This means the members’ liability would be around $5 per gt. In other words, a shipowner with a fleet of one million gt would have to pay an additional premium of $5m as a catastrophe call, or “overspill cash call”. These figures are rough calculations — an overspill cash call is, of course, calculated simply on the basis of gross tonnage — but we can’t even begin to think of shipowners (who are already facing all sorts of financial difficulties in running their ships on a day-to-day basis) dealing with a liability to this extent.
The contribution of shipowners to overspill cash calls is limited to 2.5 times their liability limit. The liability limits of ships at sea is defined by the 1976 International Convention on Limitation of Liability for Maritime Claims (LLMC), with a fixed figure defined in SDRs (special drawing rights). The 1.07 billion gt size of the world fleet insured by the IG clubs as of February 2015 had doubled since 2003, demonstrating the potential exposure of the world’s commercial fleet to a catastrophic claim.
The P&I clubs, as the liability insurers of the world commercial fleet, have taken all necessary precautions to minimise the financial responsibility of the shipowners against such unexpected circumstances. Each IG club retains the first $10m of each claim from 20 February 2016. Claims up to $80m are covered within a special reinsurance established by the IG itself. Any claim exceeding $80m is reinsured in a single reinsurance agreement, in which all IG clubs are participants, an arrangement that provides a protection to the clubs, and ultimately to the members, for up to $3bn. This is the world’s largest single reinsurance contract.
After these protections, club members would have to bear any claim exceeding the above-mentioned limits, contributing to overspill cash calls within the framework of LLMC limits.
I regret bothering you with such unpleasant issues in these devastating market conditions, but somebody has to bring these issues to light.