The Property of Power Generation: Determining the Right Limit of Insurance
By PATRICK MAGUIRE, an insurance broker with McGriff, Seibels & Williams who focuses on servicing insurance and risk management programs for domestic and international electric and gas utilities.
In recent property renewals, risk and financial management have been increasingly concerned over the accuracy of property limits. Specifically, a steep increase in commodities such as steel and concrete and an aging fleet of base-load equipment have increased the concern for a multiple event or a catastrophic single-event that could puncture a client's total program limit. How, then, do you properly represent the value of your specific fleet and justify the limits against your industry peers?
Typical valuation methods are based on the premise that the only exact method to determine whether assets are either above or below the regulatory, net book value is to require such assets be sold in fair and open markets. This is suitable when valuing the assets for sale, but what about replacement in the event of a claim?
The replacement cost of an asset should be based on what it would cost to replace the equipment of like kind and quality at a given time. Replacement cost valuations rely on the evaluator to hypothesize or predict the market conditions at the time of a claim. This helps in determining the size of the claim to make sure that the asset is adequately financed and the company is properly indemnified for its loss.
Usually, as part of the property-limit decision-making process, the broker would conduct a benchmarking analysis. A property limit benchmark would involve placing a client in comparison with other companies of similar size and operations. The criteria to determine the similarities would depend upon the extent of the data (e.g., how much data the broker has access to) and the relevancy of that data.
For instance, electric utilities should not be benchmarked against gas utilities. In some cases, independent power producers should not be benchmarked against regulated utilities because the cost-recovery methods are different and they do not purchase certain types of coverage.
For this reason, business interruption should be recognized within or extracted from the peer group data.
Criteria for benchmarking can include: total assets, top value location, revenues and retention. From this, analyze the insured percentage of the top-value location and reasons for the limits.
Benchmarking is a helpful tool to find out what a company's peers are doing, but it still relies upon an established pool of data--in this case, the replacement cost value numbers.
The formula for valuation should take into account many of the variables, including unit size, age of unit, fuel costs, cost of capital and marketing opportunities. This formula should include a flexible data input, based upon an intangible figure, or "indicator," representing the predicted market conditions over the renewal period.
This indicator is particularly helpful in developing a client's strategy for the renewal, depending upon the accuracy of the indicator and the confidence of the client in their valuation.
A model for valuation should also be based upon a standard cost with periodic adjustments for five different sets: coal, coal with scrubbers, combined-cycle, simple cycle, and hydro. In insurance terms, this should be calibrated and readjusted at each year's renewal or every other year's renewal.
In one recent renewal, we marketed and bound a property program with a two-year timeframe after using this valuation method. The recent valuation of this client's power generation portfolio found that they were underinsured by 20 percent.
By calibrating a replacement cost valuation and weighing market indicators over the next 24 months, we were able to raise the limit of their property program to a figure more representative of the RCV for the time period while taking advantage of market conditions.
This produced an increase in limits with a net premium equal to the previous year's renewal. Furthermore, the underwriters participating on the property program were pleased to see such an in-depth analysis of the property program and became more confident in the company's risk management.
December 1, 2008
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