This might be a new one for you:
Imagine an exploration company has a license to do exploratory activities on a piece of land. Initially, a relatively small amount (at a high risk/low probability of success ) is spent on the property in order to determine if there are any mineralized areas of interest on the property. When initial prospectivity has been established, more is spent on the property through drilling and sampling and chemical analysis. At some stage when the investors are confident that there is enough potential to proceed, they might decide to spend more money on doing a feasibility study in order to determine the economic feasibility. If, after this study, the findings indicate that they have a viable project, they might decide to spend the really big bucks (at a lower risk/higher probability of success), and build a mine and construct processing facilities. If all goes well, they will have an operating mine earning revenues a year or so after that. My question is this: When during this process of gradually “proving up” the viability of this project does the risk become insurable (insuring the expenditure anticipated during the current/next phase). Keep in mind that the probability of failure initially is very high - only about one out of hundreds of natural resource projects turn out successful in the end…Let me know your thoughts on this.
Replies
Agreed David, there might be opportunities for insurance companies to get in volved in types of risks which they might not traditionally have considered...as long as they are comfortable with the types of probabilities we are talking about and as long as the exploration companies realise that the premiums might be relatively high...
David Beer said:
By convention we think of these as distinct, belonging in separate markets – insurance, warranties, leases, equity, debt. Each market takes only what it is accustomed to managing, either through familiarity, or more likely because that’s what distribution for that particular market recognizes and can handle.
A far better way is to lay out the full bundle, and create smaller packages for various markets, based not on tradition, but rather on the real underlying expertise and appetites of those several markets.
In the mining example, traditionally the specialist venture capitalists known as wildcatters would sponsor a number of explorations, hoping through spread that one big win would pay for the many fails. No good quantification other than intuition and experience, so no proper analytics.
Likewise, traditional insurers might take on the workers’ comp risk of the miners, property cover on equipment, and perhaps truck liability. Not for lack of many other low-beta risks in the example, but rather that traditional insurance brokers are not equipped to recognize, collect and bundle any but the classic risks.
Now consider instead all the geology available, in part driven by earthquake science. Mines and wells are now far more amenable to statistical methods.
Likewise, the real downstream risks come from factors like say the weather (which may drive the use of oil or coal), jointly with energy prices (which drives the value of the extracts). With proxies for both revenues (weather) and margin (energy costs), we can construct a fair match to profit.
Note that the joint distribution of weather and energy costs is itself low-beta risk, since weather is random. That means it is amenable to actuarial pricing. But insurers are never offered that bundle, even though it is properly in their wheelhouse. (Think of insurers are simply specialist hedge funds for low-beta risks, with long-term lockups.)
Right now, those quantifiable risk bundles all fall inefficiently on common. Just imagine if venture capital could focus on just what’s left, after the quantifiable risks are placed elsewhere.
Thanks David, would you be able to venture a guess as to what an upper limit might be on the total premium as a percentage of the covered loss amount? Also, w.r.t your comment on the fact that risk is insurable along the curve: surely there will be a point where the probability of failure (say 50/50) might be just too high (with equally high premium) to be insurable...In addition, I have been reading in insurance related literature the insurance companies typically shy away from insuring so-called speculative risks i.e. risk where you could be worse off or better off than expected. Appreciating you comments.
David Beer said: