Crude Awakening

Who would have imagined in January 2007, when the average price of a litre of gas in Canada was 87.1 cents, that the average price of gas would soar up to $1.36/litre just one year and a half later?

The price of gas now sits at approximately $1.29/litre, having coming down to just below the average gasoline price in May 2008. Only a few months ago, analysts expected gas prices to crack the $1.50/litre barrier.

Of course with the higher price of fuel comes a higher cost of doing business. As a result, risk managers now find themselves charged with the task of considering ways in which the higher fuel costs will affect their companies — and whether these risks can be transferred by means of insurance or other financial products.

At first glance, it would be easy to dismiss the volatile fuel prices as a purely financial issue for companies that can be resolved through purely financial instruments such as hedge funds. Some argue rising fuel prices don’t have much to do with property and casualty losses, per se, as much as they have to do with profit margins and shareholder interests.

But scratch beneath the surface and risk managers will tell you a variety of ways in which escalating fuel costs could ultimately affect the insurance industry’s bottom line.

One of those ways has to do with insurance to value. As fuel costs increase, so too do the prices of other commodities — including labour costs and material costs. So the question becomes: If your plant goes up in flames one night, will it be more expensive for you to repair? And will you have enough insurance to cover the escalating repair costs?

“The linkage between the global cost of commodities and the insured values people are keeping I think is a huge issue,” says Bertil Olsson, an executive vice president and Houston energy practice leader at Willis Group Holdings. “And it’s not an unknown issue. People in the industry are aware of it, but a lot of people are missing the boat. We see every now and again, there are big accidents and people don’t have enough insurance. Two years ago, you knew that if you had $100 million limit on your policy, that was more than enough to fix anything that might go wrong or maybe rebuild this plant. And then boom, it blows up in the middle of the night and now you find out it’s going to cost closer to $200 million.”

This means company risk managers will be under more pressure to look at all of their assets and check out the valuation to make sure it is correct, says Olsson. If the updated valuation isn’t correct, the company may have to buy more insurance, which in turn will put pressure on insurance premium pricing.

Risk managers will also need to look into their crystal balls to determine how the effects of higher fuel rates might ultimately filter down and put pressure on traditional commercial lines of insurance.

The effects of escalating fuel prices might be seen in any number of areas, most notably directors and officers insurance, says Shelley Lloyd, the operations manager for Aon’s financial services group. In particular, Lloyd observes, directors and officers are under the microscope when it comes to disclosing any material changes that could affect their public budget forecasts.

“There may be an obligation, at least for some industries, for the directors to be looking at whether there are alternative sources of energy that the company can use to lessen their dependency on fuel,” Lloyd notes. “I think there will be more scrutiny on the decision-making process companies go through at this point in time with respect to fuel costs and dependency. From that decision-making process, you may see more liability that could possibly trigger some D&O claims. Some E&O claims if you are involving your accountant in forecasting.”

Some smaller transportation companies in the United States have become insolvent as a partial consequence of the higher fuel costs, sources note. And where there is insolvency, there is usually litigation against the company directors. Such litigation may also be related to employment and pension liability insurance.

“Generally we’re seeing some talk, if not hard statistics, about increased insolvency and increased layoffs,” says Lloyd. “You certainly see that in the auto industry. That certainly may lead to a higher volume of lawsuits around wrongful termination [or] discrimination based on age, if you’re laying off your most highly-paid workers. In that respect, you could have employment practices liability coverage implicated.”

Policies covering commercial crime and employee theft may also see a hit due to the rise in certain fuel costs. In Atlantic Canada, for example, Ecclesiastical Insurance issued a public statement in mid-July expressing concern that two churches had significant amounts of oil stolen from their exterior oil tanks.

Fuel prices may also affect business interruption and other traditional modes of insurance products. “There [may be] more of [an impact on] classic credit insurance, credit default insurance and political risk insurance,” says Beth Enslow, the senior vice president of supply chain risk management at Marsh. She notes a number of carriers have started to come out with specialized, supply chain risk insurance products. “That provides broader and more customized coverage for a company’s supply chain, so they can say,’Okay well, I’m really worried about this part of my supply chain and the supply of these commodities in these countries,'” says Enslow. “They can really narrow down where you are most concerned and then place a broad-ranging policy across that. That can not only be against your direct suppliers, but your suppliers’ suppliers as well. It could be a named product and so forth… This goes to the notion that a delay to the supply chain can be just as disruptive as a tornado hitting [your company].”

Many observe hedging is more likely than traditional insurance to be the risk transfer mechanism of choice for high fuel prices. They also point out that, at face value, hedging appears to have less to do with risk managers than it does with the company accountants. But that doesn’t mean there isn’t a role for risk managers in the hedging process.

“Where I think the risk manager can come into play — because often these hedging strategies are done by the finance department, not the risk manager — is just making sure the right questions are being asked,” says Enslow. “Such as: Is there going to be some replacement ingredient or material, or some new product introduction we’re planning on doing in the next year, that would make the hedge commodity less vital? Have we looked beyond just the impact on us and what the [fuel] price impact may be on our suppliers? And do we need to think about buying raw materials for them? The way the risk manager can play a role in hedging is just making sure companies are looking at the big picture.”

Risk managers, Enslow adds, should also be able to help pinpoint the ultimate consequences of the “domino effect” of high fuel prices on the company. This would be done through fuel cost simulations and scenarios, which can be modelled using available computer technology.

“The company should know the impact [of rising fuel costs] on its cost structure,” Enslow says. “There are tools out there, supply chain strategy tools, that can let you model that effect. You can say: ‘What if oil goes to $175-200 per barrel, or $70 per barrel?’ and be able to say, ‘This will be the impact on our balance sheet.'”

Knowing this will give risk managers the knowledge to explore risk transfer strategies. “It will help you to understand that if [fuel prices] rise to this price, maybe we [in the company] need to open some more local warehouses, so we don’t have to ship things quite so far away. Maybe we don’t source quite as much from China. Maybe we do more local sourcing from Canada and Mexico. The risk manager is a great person to ensure the right scenarios are being done and this is all cross-funct ional.”

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The linkage between the global cost of commodities and the insured values people are keeping is a huge issue.