Graf v.d. Schulenburg & Ute Lohse: Risk management and insurability in the age of energy transition

Striving for security is one of mankind’s fundamental needs and the necessity for a risk-bearing community is firmly embedded in insurance principles. From a historical perspective, the insurance of fire hazards, along with seafaring, is among the oldest insurance fields.
The basis for the insurance business is the knowledge from probability theory and the so-called “Law of large numbers”. Observing the frequency of specific loss events in the past allows deriving forecasts on the probability of a damage event occurring in the future. These val­­ues form the basis for the premium calculation in insurance contracts. The “Law of large numbers” can only be called upon by an insurer if he has a sufficiently large number and mix of risks in his insurance portfolio. Only then is there a “collective balancing of risks”, with the stipulation that there is no positive correlation between the risks, meaning they are related to one another. Examples of positive correlations are major fires in factory compounds or damage in an urban district due to hail. In addition, the “balance of risks over time” applies, meaning that not all insured persons suffer an insured loss during the same period (for example within one year).

It is this consideration that provides the definition of insurance: “Insurance is the coverage of an nominally unknown, but in total estimated financial requirement on the basis of the collective balancing of risks and over time”.

Risk management and insurability as a challenge.

Managing risks is generally regarded as a core competency of in­­sur­ance companies. Basically, the risk ma­n­­agement process can be divided into four phases: risk identification, risk ana­l­­ysis and evaluation, risk management as well as risk control and reporting.

After identifying risks and creating a risk inventory, it is necessary to store the recorded risks with occurrence prob­­abilities and damage potential so that the significant risks for the company can be taken into account. These risks are then influenced by the following four options in the management phase: risk avoidance, risk reduction, (differentiated by number of damages and amount), risk transfer (for example to an insurance company) and, lastly, ac­­ceptance of the residual risk. The last pro­­cess phase, evaluation and documen­tation, not only serves the coverage in case of liability issues, but also to ex­­pand expertise.

The insurance market is currently un­­dergoing serious changes in almost all sectors: the increase in major and nat­ural hazards (for example storms and floods) and the occurrence of new hazards (for example terrorism) has resulted in a higher demand by insurance com­­panies seek­­ing higher de­­duct­ibles, increased capacities, products with in­­tegrated coverage of multiple risk class­­es as well as coverage of new risks that were previously considered uninsurable.

The state, as a so-called “lender of last resort”, is becoming more and more important as a result of increasing dam­­age volumes and volatilities. For example, the state assumes a portion of the in­sur­ance coverage against terror risks, so that customers can be insured against the risks at reasonable premiums, and it also provides quick assistance in case of natural disasters and in mastering fi­­­nancial and corporate risks.

In addition, new challenges emerge in the course of the energy transition, which has gained political significance since the nuclear disaster in Japan in March 2011. The Kyoto Protocol illustrates the dangers and solutions for a global en­­ergy policy. The climate targets proposed by the German government for 2050 require a sustained change in the risk landscape.

KfW_2542The energy transition and its interdependence with the insurance sector.

The energy transition, meaning the change from conventional power generation to renewable energy and the related ex­­pansion and restructuring of the energy infrastructure, results in changes not only to the composition, but also to the occurrence probability of already existing risks. The development of onshore and offshore wind parks serves as an ex­­ample of this. When the use of onshore wind energy parks began to intensify around the year 2000, the insurance sec­­tor possessed little expertise in in­­suring such systems. The damage po­­ten­­tial of their main components, such as rotor blades, drives, generators and foundations, was largely underestimated and amounted to up to 300 per cent in some cases. The continuous monitor­ing of these systems by the insurance sector resulted in an increased level of experience with regard to damage de­­velopment (experience-based rating) and enabled insurance companies to develop increasingly more adequate insurance solutions against risks. Today, in­­suring onshore wind parks is part of daily business.

The situation of the insurance sector with regard to onshore wind energy parks back then is comparable to the current situation when it comes to offshore parks. Nonetheless, the new risks arising from the testing of offshore wind energy parks have a different dimension than the tech­­nical risks posed by onshore parks. While the increasing dimensions can be seen as a further development of known tech­­nical risks, the location at sea entails previously irrelevant or previously un­­known risks: these include, along with logistical and technical challenges in con­­struc­­tion and maintenance of the wind parks (special ships, weather-re­­lated ac­­cessibility, etc.), the difficulties of a time­­ly and efficient power connection of these parks.

Laufwasserkraftwerk_ID38855_300dpi-KopieThe role of insurance companies in these challenges is quite diverse. After clarifying the insurability of such new risks, the question of the required total of the insurance premium arises in the different business segments. Often, risk as­­sumption is tied to conditions specified by the insurance companies. These con­­sist, for example, in complying with spe­­cific process and technical standards. In­­surance companies thus often contrib­ute to setting new standards, for example in the area of safety technology. How­­ever, despite the risk expertise, they often remain the corporate decision on the part of the insurance companies with regards to risk bearing ability. Based on the expected potential, the German insurance sector consistently accompanys new technologies as part of the energy transition.

 

Insurance companies are often re­duced to their role as pure claim ad­­justers. Their value, however, is considerably higher: insurance companies are an essential production factor within an economy and their capital volume alone does not justify underestimating their significance. In many cases the provision of insurance protection makes it possible to implement economically sensible projects in the first place. All types of project financing are a good example of this. A characteristic of project financing lies explicitly in the risk sharing be­­tween project partners. In this context, insurance companies play a key role based on their broad and diversified risk expertise, because they can identify risks, which, for example, a bank could not manage due to its lack of know-how. They enable a constant cashflow com­­mitment from a project, which is often the basic re­­quirement for participation by additional debt cap­ital providers.

Germany’s insurance sector not only accompanies the energy transition as an insurer, but also as an investor. To this end, the German legislature has passed an amendment to the capital investment regulation. Insurance companies have long identified the economic advantages of such investments in addition to this politically desired fi­­nancial arrangement. Thus, investments in wind parks, for example, now and then not only guarantee long-term cashflows, which are particularly suitable for the business model of the life insurers, but they also guarantee above-av­­erage re­­turns during low-interest periods.

Summary.

The role of insurance com­­­panies has become more and more di­­versified in the context of the en­­ergy tran­­sition. The core business of in­­surance companies lies in dealing with risks. Based on their risk expertise, but also because of their finan­cial strength, they are an indispen­­sable part­ner in the promotion of inno­­va­tions. The close co­­operation between business and gov­­ernment can push back the borders of insurability, thus making it possible to offer versatile insurance solutions at acceptable market con­­ditions. How­­ever, the question arises wheth­er the considerable amount of capital required can also be realised via alternative in­­sur­ance concepts on the cap­ital market (captives or securitisations, et cetera).

15_J-MSch-0050bThe author completed his doctorate and postdoctoral habilitation in Munich. Matthias Graf von der Schulen­­burg is professor for risk and insurance and health economics at Leibniz Uni­­ver­­sity Hannover and director of the Com­­pe­­tence Center for Risk and Insurance. He is also publisher of the Zeitschrift für die gesamte Versicherungs­­wissen­schaft as well as the European Journal of Health Economics.  

DSC_4572Dr. Lohse earned a doctorate in Eco­­nom­­ics and has been the long-time re­­­search director at the Institute for Risk and In­­surance at Leibniz University Hannover. Dr. Ute Lohse is active as a lecturer for various education providers and financial services providers.