Edward Krapels looks at the role of insurance companies in energy commodity risk management.

FOR MORE THAN two years, Energy Security Analysis, Inc. has been working to bring the insurance industry more actively into commodity risk management. With the exception of the New York-based AIG group, the insurance world has been slow to get involved in energy price management.

This absence has been damaging to both industries. For energy derivatives, the energy industry has had to procure its price protection from the capital markets whose guardians are the investment banks. Commercial banks then entered this market. But all agree that the investment banks and the energy companies who behave like them - Enron Corporation, Koch, The British Petroleum Company, and Elf -originated the energy derivatives that, we believe, are on the way to becoming a trillion dollar market.

Risk awareness is about probability distributions and requires an extensive appreciation of a financial product. In insurance, that measurement has typically been performed by actuaries -statisticians - studying actuarial tables. An insurance premium is based largely on the insurance companies' statistical analysis of what it is seeking to insure. Once the client is insured, the insurance industry has access to an elaborate secondary market - the reinsurance industry - that enables a given insurance company to obtain the benefits of diversification without actually having to diversify its frontline business.

In derivatives, risk measurement is performed by capital markets. In today's oil market, the price of a put or a call is determined, not by an actuary, but by the simultaneous bids and offers of investors and hedgers in a transparent marketplace. Such markets, if successful, become an influential source of price information.

Thus, a successful derivative market presents constant information about the value of a very specific insurance policy. Once a successful futures and options market gets established around a benchmark energy commodity, then investment bankers and commercial bankers can design a vast array of ancillary financial instruments that facilitate energy hedging in whatever ways end-users and speculators want.

There are three forces that will motivate insurance companies to be more involved in energy commodity price management:

1) insurance companies may become confident that they can take on some energy price risks more efficiently than the capital markets

2) insurance companies will be pushed to provide energy risk management services by companies interested in exploiting some tax advantages that insurance obtains

3) as intense competition forces the energy industry to consolidate into fewer companies, insurance companies lose clients in their traditional casualty business lines and look more eagerly for new areas of business.

The insurance industry's reticence to get involved in energy derivatives is due, in part, to the importance that the industry attaches to its fiduciary duties and to its policy-holders. Some insurance companies are also reluctant to challenge the wisdom of capital markets in making pricing decisions. But why would insurance companies be interested in this business? There are two reasons.

First, sophisticated users of derivatives are interested in insurance complements to their derivatives positions because insurance has certain tax advantages. Premium payments are generally deductible from income for tax purposes, and insurance claims generally escape taxation. Insurance companies are already designing insurance-cum-derivatives in bundled packages that wrap together commodity, currency, and interest rate risk protection with protection in areas traditionally served by insurance. AIG, as usual, is involved in these efforts.

This area of finance involves the accounting firms, the quasi-governmental Financial Accounting Standards Board, the Inland Revenue Service in the US and abroad, and financial engineers. Most deals are designed to follow the path of least tax resistance. If insurance products render an advantage, then some companies will pursue it. And, if a client of a large insurance company asks for a package that wraps up fuel price exposure with traditional insurance products, it would be foolish for the insurer to turn it down.

Secondly, there is increasing pressure to find new areas of investment. Assets, like power plants, are getting hot. We believe that some pools are already forming to provide funds for energy commodity risk management. With more and more intensive analysis of energy price fluctuations in newly deregulated energy markets, insurance companies will get more and more comfortable with strategies whereby they can participate in energy risk management under terms and conditions they can live with.