Energy Insurance and
Risk Management
Finance 4359/7397
Professor Dan C. Jones
C. T. Bauer College of Business
Risk Management Purpose to Finance
Claim Payments
• Risk Management Methods
– Retain/Self Insure
– Transfer/Insure
– Control
• Limitations
2
Lets see how well we have done
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1937
• New London, Texas
• Natural Gas explosion in school over 200
killed
• Now use t-butyl mercaptan or thioplane
4
1989
• Exxon Valdez
• Spilled 10.8 million gallon of crude off 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 1970’s.
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
11
Asbestos- Alaska Pipe Line recognition Asbestosis and
mesothelioma but was used in shipbuilding in 1940’s
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
Enron
AIG
Banking system
2001
2001
2008
2007-08
We do live in a risky world
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Others
• Draught
– Began 2008
– Will continue in 2012
• Cargo Ship Rena
– Breaks up off Tauranga Harbor, New Zealand
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• Catastrophe Losses
• Insured Losses
• Natural Disasters
• $105 Billion
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2010
Macondo
Gulf of Mexico
Transocean
British Petroleum
Halliburton
Anadarko
Cameron
Issues
– Damages
– Fault
– Liability
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Insurance Buyer
Insurance Manager
Risk Manager
Director of Risk Management
Enterprise Risk Management
Sustainability Risk Management
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Risks we have failed to manage
Banks
Investment Houses
Merrill Lynch
Lehman Bros
Bear Stearns
All from
Sub prime Credit Crises
Mortgage valued securities
CDO’s- Collateralized Debt Obligations
Credit Default Swaps
AIG- a subject all its own
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New Risks
Cyber Liability
Gamma- Ray Burst
Nanotechnology
Somalia Pirates
Global Warming
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http://www.houstonpress.com/
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Insurance Regulation
State Regulation
Federal Regulation
Optional Regulation
Insurance CZAR Candidate
Opinions
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Is the insurance market stable?
Will the regulation applying to insurance, state
vs. federal change?
Will we have federal regulation?
Will new leaders become known for the
insurance industry?
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Summary
We all have risks
Our challenge is to finance the losses that occur
Risk management is the art of selection of the
method(s) to pay
We cannot eliminate all risk nor should we
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Risk Assumption
Assume risks that are comfortable and
predictable
Transfer those risks that could negatively impact
your company
Be mindful of the risk bearing capacity of your
company
There are limitations- one is Chapter 11
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BP
April 20, 2010
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BP Blow out
Macondo Blow out
Deepwater Horizon Blow out
Vessell - $575,000,000
11 deaths
17 injured
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Gulf Issues/Energy
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BP Pollution Liability
Liability
Force Majure
Insurance
No Insurance
Available Limits
Inspections
Regulation
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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 industriesharm 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
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
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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
– Professional 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
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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
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Retentions
Self Insurance
Captives
Mutual Company
Industry developments as alternative
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Weather
Loss portfolio transfer
Finite
Securitization
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Retention
Capacity
Rules of Thumb
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Shareholders Equity2 - 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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World Market
• United States
– Stock
– Mutual
• European
• Reinsurance
• Lloyds of London
FINA 4397/7397
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∑ of the Good
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