Insurance markets and trading markets have traditionally looked at risks from
very different perspectives. Insurers worried about 100-year storms while traders
focused on three-day value-at-risk measurements. Insurers focused on historical
loss experience while traders worried about forward price curves. Rarely did
the perspectives of the two worlds meet.

Recently, this comfortable separation of trading and insurance worlds has started
to change. Both insurance and trading companies have been active in developing
and marketing “convergence” products, products that combine trading and insurance
market features. This convergence has been evident in risk management products
for the energy market, especially electric power.

Trading vs. Insurance Perspectives

Trading markets thrive on highly liquid products that support the trading of
standard risk positions. This allows market participants to build a portfolio
of well-understood, standardized risks. Frequently, traders can match counter
parties with offsetting risk exposures, developing large portfolios with relatively
low net risk positions.

Extensive analysis is done to understand risk volatility and correlation to
enable the modeling of forward-looking risk exposures. Risk positions can be
monitored in real time, while market prices tend to be transparent. Typically,
traders are confident that they can enter into subsequent market transactions
to unwind risk positions or change the risk profile of their portfolio.

Insurance markets, on the other hand, thrive on illiquid, customer-specific
risks. Insurers focus on underwriting individual risk characteristics, using
a database of historical experience to help classify exposures and price risks.
Insurance risks are usually a one-way transfer from the customer to the insurer.
While an insurer can share risks with other insurers or re-insurers, there are
typically no counterparties with natural offsetting risk positions.

Insurers normally expect to hold the net risk position on their policies until
they expire. They may inspect specific risks prior to binding or during the
policy terms to make sure that the risk is properly classified. Any re-insurance
or risk sharing is in place before a policy is bound.

As
illustrated in Figure 1, these traditional perspectives have created some interesting
contrasts:
• Trading is typically less capital intensive than insurance.
• Insurers are typically more receptive to products tailored to an individual
customer’s risk.
• Risk management for trading is typically more dynamic than insurance.
• Insurers are typically more comfortable with longer time frames than
traders.

Figure 1 – Traditional vs. Insurance Perspectives

Convergence products blend these perspectives to create more efficient risk
management solutions for customers.

Why Convergence for Electric Power?

Both sellers and buyers of risk management products have been important factors
in the development of convergence products.
The increasingly competitive economic environment has forced buyers to challenge
the efficiency of every aspect of their operations. This has included taking
a broader view of risk management, challenging companies to better understand
their risk exposures, and taking a close look at creative risk management alternatives.

On the selling side, insurers and traders began to push against the traditional
barriers of their businesses to find growth opportunities. They turned to convergence
approaches because traditional products were maturing and they needed to find
a way to expand their business with customers as well as develop higher margin
products.

Electric power is an industry segment where the convergence of trading and insurance
products has been particularly successful, as both traditional insurers and
traders offer convergence products. The success in the electric power segment
can be attributed to two major factors:
• The electric power industry is, of course, undergoing sweeping structural
changes. More than almost any other industry, this segment has been forced to
rethink its risk exposures and risk management. The changing regulatory environment
and market structure has created new risk exposures that existing products did
not address. This, in turn, encouraged product innovation.

• The risk exposures for this industry include a blend of factors familiar
to both markets. The commodity nature of electricity and a volatile wholesale
price environment are comfortable dimensions for traders. The significant impact
of weather conditions and unexpected equipment failures are comfortable dimensions
for insurers.

As a result, the electric power segment has seen the most successful development
of convergence risk products, with both traders and insurers offering products
that combine elements of traditional product features into new products.
The most common convergence products for buyers and sellers of power to consider
are forced outage coverage and weather risk programs. The objective of both
program structures is to successfully reduce business risks while protecting
the bottom line.

Example #1: Forced Outage Coverage

The risk from an unplanned outage at a generating unit has been significantly
changed by the deregulation of wholesale power prices. The owner of a generating
unit that has fixed delivery commitments or a buyer that purchased power on
a unit contingent basis needs to be much more concerned about the impact of
an unplanned outage in the current environment. If the outage occurs during
a spike in wholesale power prices, the cost of replacement power can be very
substantial.

Forced outage coverage provides protection for the cost of replacement power
due to an unplanned outage. This protection can be obtained through physical
delivery of replacement power at a pre-determined strike price or through a
financial settlement for the difference between spot market power prices and
a pre-determined strike.

The coverage blends a number of traditional trading and insurance elements.
The coverage has dual triggers: (1) an unplanned failure of a generating unit
component (a traditional insurance risk), and (2) a spike in spot market prices
for power (a traditional trading risk). The risk is not readily tradable, but
there are dynamic risk management strategies that can be used to help management
price risk exposures. Due to the contingent nature of the protection, this is
a lower cost alternative for the customer than simply buying options.

Uses for this coverage have been diverse, ranging from systemwide coverage to
accomplish strategic risk management goals, to tactical applications to improve
the economics of a specific power purchase transaction.

An example of how a utility handled its concern about the cost of replacement
power to meet their base load needs is described in Figure 2. This case demonstrates
that a program can be designed to protect a utility if one of their owned generating
units has an unplanned outage during a heat wave and spot market power prices
are very high. Other examples of applications of forced outage coverage include:

• An independent power producer expects to use the output from its owned
generating facility to meet fixed delivery commitments and is concerned about
the exposure to price spikes if the unit fails.
• A power marketer wants to “firm up” power it has purchased on a unit
contingent basis for resale into wholesale markets.
• The operator of a cogeneration facility that has excess generating capacity
and wants to sell it at more attractive “firm” rates.
• A power cooperative that expects to meet member needs from a jointly
owned generating unit and wants to reduce the potential for additional assessments
to its members if that unit has an unplanned outage when there is a spike in
wholesale prices.

Figure 2 – Replacement power coverage

Example #2: Weather Risk Programs

See Larger Image

Another convergence product that has been successfully established in the electric
power segment is weather risk programs. Weather has been a major factor in influencing
the revenues and expenses of electric power companies for some time, driving
demand from end-user customers and impacting operating costs.

With the changing environment for the electric power segment, weather risks
that used to be only operating challenges now involve potentially significant
financial consequences as well. A variety of weather risk programs have emerged
to help address these concerns.

Energy trading companies, insurers and banks have all actively participated
in providing capacity for weather risks. Products have ranged from short-term
standardized degree-day contracts to long-term customized multi-trigger contracts.
Objective data sources (i.e., the government) and standardized contract terms
have established a base of market liquidity that allows participants to capitalize
on trading-oriented dynamic risk management approaches, while less liquid risks
can be considered using an actuarial or insurance-oriented approach.

Figure 3 – Hydro generation program for managing risk

See Larger Image

As a result, customers have a full range of product structures available,
from very liquid, low margin standard structures to higher margin, more customized
structures. The range of products allows customers to select the product structure
that delivers the most value for their particular circumstance.

Examples of applications of weather risk programs include:
• Demand management — Using seasonal degree-day coverage to manage
the impact of a cool summer or warm winter on demand for electricity. Contracts
pay a fixed amount for each cooling degree day or heating degree day below a
seasonal threshold. The payoff helps offset the revenue lost due to lower than
expected demand.

• Peaker start-up: — Using temperature maximum coverage as a proxy
for peak demand periods to fund the start-up costs for peaking units. Contracts
pay a one-time fixed amount when daily maximums exceed a given temperature for
three consecutive days.

• Wind generation — Wind speed coverage for wind generation assets.
Contracts pay when sustained winds fail to meet threshold levels. The payoff
from the contract can be used to fund the purchase of power that was expected
to be generated by the wind facility.

• Hydro generation — Rainfall coverage for hydroelectric generating
facilities. Contracts pay a fixed amount for each inch of precipitation below
an annual threshold amount. The payoff from the contract can be used to fund
the purchase of power that was expected to be generated by the hydro facility.
An example of this program is shown in Figure 3.

• Financing — Using seasonal degree-day coverage to support the financing
for a peaking unit. The payoff from the weather contract helps fund debt service
when revenues are low because of unseasonable weather.

Other innovative program structures have also blended weather risk with energy
price risks. For example, precipitation structures that pay based on market
prices for power — which provides a better match for the hydro facility’s
risk for the cost of replacement power — are currently available. Also
available are temperature contingent gas contracts that allow customers to purchase
gas at a predetermined price when temperatures fall to a threshold level, effectively
creating synthetic storage for users.

Conclusion

The market for convergence products has created a wide range of innovative
risk management alternatives for customers. Blending insurance and trading market
perspectives allows customers to design coverage that better fits their needs.
The structural changes occurring in the electric power industry have made convergence
products quite successful.
Insurance companies now offer a wide range of innovative convergence products.
The need for new products will continue to grow as traders and insurers become
more comfortable with the alternatives for pricing and managing risk. The growth
of the convergence market allows customers to choose from a full range of products.
While traditional products will continue to meet the needs of most customers,
convergence products provide more efficient alternatives for those willing to
consider unique approaches to managing risk.