One risk category that continually comes up in the area of enterprise risk management is commodity price risk (CPR). Learn how the new Financial Accounting Standard (FAS 133) affects the accounting treatment between derivatives and insurance when the risk is a CPR and how new alternative risk financing products may develop as a result.
In my last two columns, I wrote about the emerging field of enterprise risk management (ERM). One category of risk that continually comes up in this area is commodity price risk. Companies are often exposed to the price of raw materials or other supplies, as well as to the sales price of goods produced based on fluctuating market prices. A related problem is fluctuation in the U.S. dollar value of foreign sales (for a U.S. manufacturer) caused by changes in foreign exchange rates.
What Is a Commodity?
For the purposes of this article, the term "commodity" includes both physical commodities, like wheat or oil, as well as financial commodities, like interest rates or foreign exchange rates. Therefore, while most people think only of physical commodities when they hear the term "commodity," it is important to be aware that in the field of corporate risk management, commodity includes some important financial risks, like interest rates or foreign exchange rates.
The interesting question for the insurance industry is whether insurance can be used to address these commodity price risks (hereafter referred to as "CPR").
Examples of Commodity Price Risk Financing Situations
CPR creates several types of risk financing challenges, for example:
Managing Volatility of Production Costs: CPR on the supply side can impact budgets or profits, especially if the company can't pass cost increases along to its customers. An extreme recent example is the California electricity market, where utilities must purchase power from an unregulated wholesale generation market, but must sell power at regulated, capped rates to consumers.
Revenue Floors: Sometimes the impact of commodity price fluctuation is greater on the sales side. Some finished products, such as steel, for example, may have market price volatility that is somewhat decoupled from the cost of raw materials. Often the concern here is ensuring that price levels are sufficient to support fixed plant and equipment costs in capital-intensive industries.
Margin Protection: Since costs of production often do move in tandem with prices for finished product, sometimes the concern is to manage the impact of an unusual narrowing of the spread between input prices and output prices. This is somewhat a variation on the first two categories mentioned immediately above, but in terms of structuring risk financing solutions, it is a distinct category.
There are a couple of other relevant considerations in this area. The first is whether there is an actively traded futures or over-the-counter market for the commodity in question. For some commodities, like oil, there are large liquid markets that industry participants use to hedge and manage risk.
There are many commodities, however, that are not traded on organized futures exchanges or over the counter markets. In these areas of non-liquid commodities, companies may use long-term supply or sales contracts or other risk management techniques to lock-in supply prices or sales prices. There can be severe problems in these industries if the supply side risks are not properly managed in tandem with the sell side risks (again, the California power market is a good example). This area of non-liquid commodity risk is an area that insurers can potentially add value by creating hedges not otherwise available in the market.
A second consideration is whether the company seeking to hedge the risk is a normal corporation or falls within the "project" or special purpose entity (SPE) category. In the SPE category, one or more sponsors create a special purpose entity to carry on a particular business activity, say a new oil refinery or a stand-by power generation facility. Here, the sponsor(s) provides a certain amount of equity capital, with the rest of the required capital to be sourced as non-recourse debt. The key is that the sponsors' liability is limited to the amount of equity invested. The lenders have no recourse to the sponsor if the project fails.
In these situations, lenders try to identify key risks affecting the long-term viability of the operation. Quite often, commodity price risk on the supply side or the sales side will be identified. The lender will ask the sponsor to either put in more equity capital to fund the risk or to furnish a suitable hedge. The design of such a hedge is a risk financing issue. This an area in which the use of insurance is sometimes referred to as "contingent capital." The idea is that the insurance relieves the sponsor of having to invest more equity capital in the project, and therefore can be thought of as a substitute form of capital. It is contingent in that it is only triggered if some event, such as the price of a specified commodity falling below a specified level, happens.
A final comment is that it should be recognized that the management of a particular CPR is often a key value proposition for the firm in question. The risk may be so integral to the company's business that it develops very in-depth knowledge and understanding of the risk. Some would say that the economic purpose of the company is to manage that risk. In such cases, it may not make sense for the company to seek to completely transfer that risk to an insurer, since managing the risk is one of the main purposes for the company's existence in the first place.
To summarize, the situations in which insurance or other "ART" products may add value are as follows.
The exposure is incidental to the company's operations, and the company wants a simple prepackaged solution for managing it.
There is no traded market. There are many commodities that have no organized futures or dealer markets.
Illiquid areas of traded markets. Even traded markets tend to be illiquid and inefficient for some risks. This typically occurs with options that are very far out of the money or are very long-dated.
Contingent options. Sometimes the price risk is contingent on some event occurring. This makes option pricing difficult and results in an illiquid market.
What about Commodity Price Risk Insurance?
For the situations described above, commodity price risk insurance is an interesting concept. Things have been complicated, though, by the creation of a new Financial Accounting Standard (FAS 133) that seeks to normalize the accounting treatment between derivatives and insurance when the risk is a CPR. The rule basically states that an insurance policy covering a CPR should be accounted for as a derivative, and not as an insurance contract. From the insured's point of view, derivative accounting is more complicated than accounting for an insurance policy. More importantly, derivative accounting often creates as much income statement volatility as was created by the original exposure, especially since the exposure would frequently otherwise be off-balance sheet until an actual loss is realized.
The unfortunate thing about FAS 133 is that it requires both the insurer and the insured to account for an insurance policy covering commodity price risk as a derivative rather than as an insurance contract. This means that many insurers will be reluctant to offer insurance because they don't want to deal with new accounting issues, while the customer will not likely get the financial statement protection that is typically afforded by insurance accounting. Nevertheless, companies are concerned with obtaining economic protection form some of these risks, and so there are new opportunities for insurers.
Summary of FAS 133
FAS 133 is complex, and even the experts differ on how it should be applied. But since this is an area that will generate discussion in risk management circles, the following is an attempt to provide a summary of the key aspects of FAS 133 as they pertain to insurance.
FAS 133 defines accounting standards for derivative instruments and hedging activities. There is a crucial difference between accounting standards for derivatives and insurance contracts that should be highlighted at the outset. The difference is that the cost of an insurance policy is recognized as an expense that is usually spread evenly over the coverage period, while a derivative is recognized as either an asset or a liability whose periodic changes in value should be recognized as a gain or loss as they occur.
This is a very significant difference as the goal in managing or hedging risk often boils down to a desire to smooth out cyclical volatility of a commodity price. (In fact, most commodity prices do tend to be cyclical and "mean reverting" over time). As a general rule, U.S. Generally Accepted Accounting Principles (GAAP) disfavor artificial smoothing of costs, revenues, or profits; the belief is that the investor should be able to witness the impact of these volatilities within the company's published financial statements.
The accounting for insurance contracts tends to achieve smoothing, while the accounting for derivatives (with some exceptions) does not. However, insurance contracts are conceptually similar to options, one of the main kinds of derivative. Thus, FASB had to go to some lengths to address the overlap between insurance and derivatives in an attempt to delineate when "insurance accounting" should be used instead of "derivative accounting."
While a thorough discussion is beyond the scope of this article (not to mention being beyond the scope of the author's expertise), following is a summary of the provisions of FAS 133 directed toward insurance.
FAS 133 defines the term "Derivative" as follows:
A derivative is a financial instrument or other contract with all three of the following characteristics:
It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both…
It requires no net initial investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
Its terms require or permit net settlements, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. (Paragraph 6)
"Underlying" is defined as follows:
An underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable. An underlying may be a price or a rate of an asset or liability but it is not the asset or liability itself... (Paragraph 7)
Paragraph 10(c) presents the "carve out" for traditional insurance contracts:
…a contract is not subject to the requirements of this Statement if it entitles the holder to be compensated only if, as a result of an identifiable insurable event (other than a change in price), the holder incurs a liability or there is an adverse change in the value of an asset or a liability for which the holder is at risk.
This paragraph goes on to exclude traditional life and traditional property and casualty contracts. Paragraph 10 provides further exceptions for contracts covering weather risk, financial guaranties, and a few other items.
There is a concept of indemnity that lies underneath the distinction between insurance and derivatives that is worth highlighting. The value of a derivative moves in relation to some defined price or index value. There is no requirement that the holder of the derivative suffer any economic loss to be able to collect on the derivative; in fact, the holder can profit by cashing in the derivative. Insurance normally is intended to compensate the holder if, and only if, it has first suffered a loss form the destruction of property or some other casualty. Then the insurance only compensates to the extent of the loss.
The last major item to be mentioned here is the concept of "embedded derivatives." In the insurance policy context, this addresses the situation where an otherwise permissible insurance contract includes coverage of an "underlying" as one of the subjects of the insurance (Paragraph 12). Unless the price risk is clearly and closely related to the host contract, the embedded derivative must be identified and accounted for as such.
As an example, a contract that covered an electric transmission company from increased wholesale electricity prices should be accounted for as a derivative, whether it's titled as an insurance policy. However, a contract that covers for the increased cost of replacement power if a generator suffers an unplanned outage is bona fide insurance. There is an identifiable insurable event (the unplanned outage). The increased cost of replacement power is essentially a consequential loss and is therefore considered closely related to the insurance contract.
In a sense it is unfortunate that FAS 133 limits the usefulness of insurance contracts to address the commodity price risk component of enterprise risk management. It creates a lot of complications for transactions with legitimate goals. Yet, where there is a real concern over an important risk exposure, there is plenty of room for creating new alternative risk financing products.
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