Energy Insurance and Risk Management Finance 4397

1. Energy Insurance and Risk ManagementFinance 4397/7397 Professor Dan C. Jones C.T. Bauer College of Business

2. FINA 4397/7397 2 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

3. FINA 4397/7397 3 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

4. FINA 4397/7397 4 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

5. FINA 4397/7397 5 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

6. FINA 4397/7397 6 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

7. FINA 4397/7397 7 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

8. FINA 4397/7397 8 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

9. FINA 4397/7397 9 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

10. FINA 4397/7397 10 Hard market Soft market Hurricane Andrew 9/11 Today

11. FINA 4397/7397 11 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

12. FINA 4397/7397 12 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

13. FINA 4397/7397 13 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

14. FINA 4397/7397 14 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

15. FINA 4397/7397 15 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

16. FINA 4397/7397 16 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

17. FINA 4397/7397 17 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

18. FINA 4397/7397 18 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

19. FINA 4397/7397 19 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

20. FINA 4397/7397 20 Personnel losses - human assets Injury Disability Death Retirement Resignation Kidnapping Which consumes most time?

21. FINA 4397/7397 21 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

22. FINA 4397/7397 22 Internal Factors Increased firm value � the emphasis Reduces inefficiencies inherent in traditional approach Improving capital efficiencies Stabilize earnings Reduce expected costs of external capital

23. FINA 4397/7397 23 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

24. FINA 4397/7397 24 Enterprise Risk Management (ERM) Synonymous with: Integrated Risk Management (IRM) Holistic Risk Management Enterprise-wide Risk Management Strategic Risk Management

25. FINA 4397/7397 25 Alternatives to Insurance Retentions Self Insurance Captives Mutual Company Industry developments as alternative Weather Loss portfolio transfer Finite Securitization

26. FINA 4397/7397 26 Retention Capacity Shareholders Equity 2 - 3% Pre-tax Earnings 5 - 10% Cash Flow 4 � 5% Total Assets 1 � 2% Earnings 10%

27. FINA 4397/7397 27 Risk Management Continuum

28. FINA 4397/7397 28 Lets see how well we have done

29. FINA 4397/7397 29 1937 � New London, Texas Natural Gas explosion is school over 200 killed Now use t-butyl mercaptan or thioplane

30. FINA 4397/7397 30 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

31. FINA 4397/7397 31 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

32. FINA 4397/7397 32 2005 � Hurricane Katrina & Rita Failure of flood gates New Orleans Inadequate wave clearance & offshore platforms for class 5 storm Inadequate response FEMA

33. FINA 4397/7397 33 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.

34. FINA 4397/7397 34 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

35. FINA 4397/7397 35 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

36. FINA 4397/7397 36 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

37. FINA 4397/7397 37 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

38. FINA 4397/7397 38 US Air Flight 1549 Sulley Sullenberger Airbus A 320-214 N10GUS

39. FINA 4397/7397 39 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

40. FINA 4397/7397 40 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.

41. FINA 4397/7397 41 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.

42. FINA 4397/7397 42 EJ Smith Captain-Titanic 1907

43. FINA 4397/7397 43 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