Energy Insurance and Risk Management Finance 4397/7397

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Energy Insurance and Risk ManagementFinance
4397/7397

• Professor Dan C. Jones
• C.T. Bauer College of Business

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• Risk financing vs. Risk management
• Risk and the world
• As a society, always sought to reduce
  uncertainty-tribes/clans
• Business but an extension and risk is at heart
  of ALL business operation
• Decisions cross borders and industries-harm to
  stakeholders

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• Language of risk insurance
• Risk
• Speculative risk
• Pure risk
• New term-enterprise risk
• Management of Risks
• A process
• Identification and evaluation
• Exploration of Techniques
• Implementations and review
• Current Risk management
• Losses without gain
• Holistic approach

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• Fundamentals of risk uncertainty
• Risk- variation of outcomes
• Uncertainty- the doubt from inability to predict
  future (outcomes)
• Arises from risk
• Add managers and becomes complicated

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• Corporate demand for insurance
• Risk managers assumed risk neutral
• Assumption
• Increasing wealth leads to inc. Satisfaction
  AND
• Marginal utility constant as wealth increases
• Individuals risk adverse but
• Owners / shareholders are not
• Investors require higher return if unable to
  diversify or systemic risk
• CAPM theory

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• Shareholder risk aversion does not explain why
  corporations buy insurance why?
• Insurance companies have comparative advantage
• Insurance can lower cost of financial distress
• Insurers may have service efficiencies
• Insurance can lower tax liabilities (property)
• Regulated industries have higher demand
• Compulsory insurance laws
• Financial consideration of stock price

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• Practitioners increasingly taking holistic
  approach
• Conceptual and applied economic knowledge
  continues to expand
• Private markets can not deal with some societal
  risks
• Publicly traded companies undergoing evolutionary
  changes
• Resources committed to understanding capacity of
  capital markets
• A challenge for ALL

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• Economic development
• Benefits
• More competitive
• Better values
• Shareholder value increased
• Cash flow leveling
• Reduces insolvency
• Expands credit availability
• Loss control / risk control
• Reduced costs results and better able to compete

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• Property rights and economic freedom
• Right to own real personal property
• Right to enter into contracts
• Right to be compensated for tortious acts
• Needed
• A system and a means to enforce
• Markets are means of exchanging property rights
• Insurance can not function without defined
  ownership interests
• Restrictive - monopolies, insider trading

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• Hard market
• Soft market
• Hurricane Andrew
• 9/11
• Today

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• Value of insurance company services
• Pricing, underwriting, claims handling
• Pricing - statisticians / actuaries
• Time lag of loss payments and premium payments
• Competitive premium is of expected losses,
  expenses, profit
• Investment return
• Life companies -calculable
• Non-life - long tail claims
• Government treatment

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• Internationalization of business creates
  internationalization of financial services
• No one market can provide all needed coverage
• Oil refineries
• Oil tankers
• Off shore rigs
• Satellites
• Jumbo jets
• Environmental impairment
• National markets benefit
• Increase competitiveness

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• The financial environment
• Finance and insurance have much in common
• Each provide its customers tools for managing
  risks AND
• Valuation methods are the same
• Fair value of the security
• An insurance policy
• Based on discounted cash value of future cash
  flows

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• Same definition of risk- the variation of future
  results from expected values
• Rely on same fundamental concepts
• Risk pooling
• Risk transfer
• Therefore we have convergence as insurance
  company managers, owners and customers must
  recognize and understand

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• Risk management fundamentals
• What is risk?
• Is risk different if building a new plant in
  Jakarta?
• Currency
• Language
• Training / hiring
• Laws
• Separate
• Hazard risk management
• Financial risk management

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• Objective of risk management - to contribute to a
  firms value
• Factors
• Unmanaged risk reduce value of firm
• With increase in risk, cost of doing business
  increases
• Results in lower levels expected cash flow
• Reciprocal is that
• Reducing risk increases cash flow
• Increases value of firm

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• Risk assessment
• Identification of exposure
• Analyzing to determine potential impact
• Assets subject to loss
• Tangible, intangible, human
• The analysis should answer
• What assets are exposed
• What perils can cause harm
• What are potential consequences

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• Financial loss
• Property
• Real property
• Personal property
• Intangible property
• Net income losses (revenue less expenses)
• Fire losses
• Auto accident
• Employee injury
• Magnitude function of revenue decrease
• Insurance terms - time element or business
  interruption because it is time dependent

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• Liability losses
• Occur when parties assert legal rights
• Many types - mostly civil in nature
• Defective products
• Environmental impairment
• Injury to employees
• Breach of contract
• Profession errors or omissions
• Huge cost associated with defense even if no
  liability

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• Personnel losses - human assets
• Injury
• Disability
• Death
• Retirement
• Resignation
• Kidnapping
• Which consumes most time?

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• External influences broadening scope of risks
• Globalization
• Industry consolidation
• Deregulation
• Regulatory attention to corporate governance
• Sarbanes-Oxley
• Technological progress enabling better risk
  quantification and analysis

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Internal Factors

• Increased firm value the emphasis
• Reduces inefficiencies inherent in traditional
  approach
• Improving capital efficiencies
• Stabilize earnings
• Reduce expected costs of external capital

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Forces Creating Uncertainty

• Technology and Internet
• Increased worldwide competition
• Freer trade and investment worldwide
• Complex financial instruments, notably
  derivatives
• Deregulation of key industries
• Changes in organizational structures resulting
  from downsizing, reengineering, and mergers
• Higher customer expectations for products and
  services
• More and larger mergers

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• Enterprise Risk Management (ERM)
• Synonymous with
• Integrated Risk Management (IRM)
• Holistic Risk Management
• Enterprise-wide Risk Management
• Strategic Risk Management

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Alternatives to Insurance

• Retentions
• Self Insurance
• Captives
• Mutual Company
• Industry developments as alternative
• Weather
• Loss portfolio transfer
• Finite
• Securitization

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Retention Capacity
Rules of Thumb

• Shareholders Equity 2 - 3
• Pre-tax Earnings 5 - 10
• Cash Flow 4 5
• Total Assets 1 2
• Earnings 10

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Risk Management Continuum
Mitigate
Retain
Transfer
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Lets see how well we have done
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• 1937 New London, Texas
• Natural Gas explosion is school over 200 killed
• Now use t-butyl mercaptan or thioplane

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• 1989 Exxon Valdez
• Spilled 10.8 million gallon of crude of coast of
  Alaska, Prince William Sound
• Now require double hull crude carriers in all US
  ports
• March 2009 Korean vessel found a drilling rig
  lost after IKE, Double Hull prevented any spill

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• 2004 Explosion BP plant Texas City
• Extensive damage. BP admitted fault but ignition
  came during recovery cycle but fatalities due to
  location of work trailers

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• 2005 Hurricane Katrina Rita
• Failure of flood gates New Orleans
• Inadequate wave clearance offshore platforms
  for class 5 storm
• Inadequate response FEMA

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• 2008 Hurricane Ike
• Class 2 winds offshore
• Class 5 storm surge Galveston Bay and Trinity Bay
• Now referred to as Integrated Kinetic Energy
• Over 2,000,000 million customers lost power.
• Unforeseen especially by CenterPoint.

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• 1984 - Bhopal India- Union Carbide pesticide
  plant
• 300 killed, thousands injured release of 42 tons
  of methyl isocyanate
• Plant was not following safety and operating
  guidelines of Union Carbide

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• 1986
• Chernobyl, Ukraine explosion released more than
  400 times the radioactivity than with atomic
  bombing of Hiroshima
• Built a sarcophagus a cover for the reactor
• That and Three Mile Island incident stopped any
  nuclear construction, in US in 1970s.
• Now 4 projects being considered in Texas

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• 2002
• Approved repository site in Yucca Mountain Nevada
• Operational 2010, to be sealed 2035
• Repository in solid rock 1000 feet underground
  and on average 1000 feet above water table
• Holds 77000 metric tons of waste
• Plulonuim-239 has half life of 24000 years
• Cost 9 billion
• 2010 budget includes no funding for Yucca
  Mountain
• Present 100 nuclear plants-20 of electricity
• 30 plants in planning stage

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• Asbestos- Alaska Pipe Line recognition Asbestosis
  and mesothelioma but was used in shipbuilding in
  1940s
• Used by the Ancient Greeks because of its soft
  and pliant properties- the miracle mineral
• Over 80 companies involved with asbestos have
  filed for chapter 11 beginning with Johns
  Mansville

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• US Air Flight 1549
• Sulley Sullenberger
• Airbus A 320-214
• N10GUS

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• 1988
• North Sea- Piper Alpha Platform
• Explosion many workers killed platform severely
  damaged.
• Equipment stacked near crew quarters
• Due to economic effort for more production

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SEMPRA Energy

• Owners of San Diego Gas Electric- SDGE
• 2007 Wildfires in California
• Have 1.1 billion tower of liability insurance on
  aggregate basis and now totally consumed.

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• But in all my experience, I have never been in
  any accident of any sort worth speaking about I
  have never seen but one vessel in distress in all
  my years at sea. I never saw a wreck and never
  have been wrecked nor was I ever in any
  predicament that threatened to end in any
  disaster of any sort.

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• EJ Smith
• Captain-Titanic
• 1907

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• We can add others not directly part of energy but
  which impact us all
• 9-11 2001
• Enron 2001
• AIG 2008
• Banking system 2007-08
• We do live in a risky world