Despite the mounting evidence of wrongdoing and alleged illegal activity, energy giant Enron has managed to bring solid value to the commodified risk transfer method with energy and weather derivatives will the approach survive without Enron?

The collapse of an empire begins with its own

When Enron's foundation began to crack and weaken, the questions began, but were tempered by confusion over Enron's financial statements and veiled answers by the company's chief. Then the CEO's resignation came out of the blue, after Enron had leveraged itself to the sky. Within nanoseconds, harder questions came laced with nervous suspicion from investors and Wall Street. Word leaked to the media of possible misdeeds and the federal government began asking questions.

As the corporate darling began to implode under the weight of mounting scrutiny, demanding questions about its business dealings were sounding down the halls of the corporate world. When the kingdom crumbled through the floors of Wall Street, all eyes turned to the federal investigations for answers. Allegations about creative accounting practices arose. Letters spelling out misconduct surfaced. Damning evidence of destroyed documents were uncovered. Enron executives faced indictment alongside their Arthur Andersen accountants. When the dust settled, the emperor was indeed stripped naked in front of his subjects.

Within days of Enron's filing Chapter 11, the estimates were out. Sixty-three companies from across the world estimated a total loss of $6.1 billion because of the collapse. Among them were some from the insurance world: Chubb Corp., St. Paul Cos., and Hartford Financial. Additionally, insurance holding company W. R. Berkley established a $12 million reserve for potential losses from the filing. A December Reuter's story stated that the insurance industry will bear the burden of the losses.

But in the rubble of Enron's collapse lies value. Enron was a leader in a new method that poured risk into categories once ignored, from energy and weather derivatives to broadband and advertising space. Although competitor UtiliCorp United's Aquila subsidiary lays claim to a significant part in the creation of the commodified risk transfer approach, Enron is credited with advancing the concept in areas beyond the energy market. Enron was able to take the idea and run with it, building value upon the ability to successfully commodify and transfer risk into areas such as weather derivatives and even an attempt into the broadband sector, which in the end proved to be one of Enron's mistakes. Enron took the lessons it had learned in the energy commodities business and applied them across new markets. Markets that were once ignored were thrust into commodities markets and performed successfully in most cases. In the world of risk transfer, Enron took chances.

Enron's demise does not mean that the concept was faulty, industry watchers say. On the contrary, several companies have been successful with regard to the commodified risk transfer approach.

Value in Unusual Spaces

Experts agree that Enron brought tremendous value and potential for commodifying future risks in new areas that may have once been overlooked. Some argue that the idea isn't new, but a twist on commodity practices within old areas, such as pork bellies. Others view it as a hybrid of both insurance and financial arenas. "It's not insurance companies doing banking things or banks doing insurance things. It's changing some of the products so that there are capital markets features and insurance market features," says Tom McCarthy, senior VP of Kemper Solutions, a division of Kemper Insurance Cos., Philadelphia.

"There are a couple of themes," he says. "Most of the activity in this area has evolved around energy companies. We've had a lot of success with a forced-outage product where, say, a company owns an electric generator and it is at risk if there's an unplanned outage at that generator. If there is an unplanned outage, they're forced to buy electricity on the open market. The idea of blending the traditional insurance coverage, which is when the equipment fails, with the capital market coverage, which covers the price of power when the equipment fails, is what I see as a blended insurance capital market product. It's a good example of how an insurance approach to these blended products can bring value to the customer. It's a more effective hedge."

It may also be a necessary arena for reinsurers. "Reinsurance is largely thought of as risk transfer for event risk," says Roland Pike, executive VP at Carvill America, a privately owned reinsurance intermediary in Norwalk, Conn. "There are, as we've found Out with the September 11 event, some events that are too big even for the reinsurance industry to absorb. So there has to be a continuing search for new ways, whether it's through the government or through capital markets, to create more capacity for the transfer of these mega-risks."

The markets themselves are creating value for commodified risk transfer methods. "There has been some evolution in the past few years from the vaguely defined balance sheet to earnings-per-share protection, which is very difficult to write," says McCarthy. "These customers are developing a better understanding of what their risk exposures are and they're looking for tailored coverage based on external factors that insurers can underwrite to impact their exposure. It's thinking of the risk exposures on an enterprisewide basis but also defining coverage that's very specific to that enterprise. The one-size-fits-all approach to protect the balance sheet is hard to underwrite and hard to get the needed capacity. Also, it's a difficult internal sale because of all the constituencies the risk manager would have to deal with."

Effects of Enron

Enron's departure will be felt by the markets they were involved in, especially some of the newer ones. But there also is much to be said about the new opportunities the company brought to life. "They were one of the creators in a lot of new markets that were aimed at developing novel ways of hedging risks," says Paul Vandermarck, managing director at Risk Management Solutions, Newark, Calif.

"At the heart of it, they had very smart ideas about helping organizations of all different types manage risks that they hadn't been able to manage before," he says. "The weather market still exists today. There are a significant number of investment banks, energy trading companies, and reinsurance companies that are all active participants in this market globally. It's a market that will survive Enron and it will add value in a lot of different ways."

"To some extent, some of these markets are the legacy that they leave behind," Vandermarck continues. "In a way, there are markets that wouldn't exist if they hadn't been the one to make the investments they did, and if they hadn't experimented and hadn't been creative about it."

Efforts are in the works to make accounting of these types of risk transfer methods more mainstream. While politicians debate accounting reforms, the National Association of Insurance Commissioners (NAIC) is working on a proposal for new regulations for these vehicles, says Steve Broadie, assistant VP of financial legislation and regulation at the National Association of Independent Insurers (NAII), in Des Plaines, Ill.

"There are efforts through the insurance securitization working group through the NAIC to give what would essentially be underwriting accounting treatment for the use of insurance-linked derivatives to hedge different types of insurance risks," he says. "That project is fairly far along and there may be a compromise in the works. The basic idea is that it would give something that is similar to underwriting account treatments for the use of derivatives if counter-parties meet certain standards."

Transferring energy risks through these vehicles will continue to be valuable, says McCarthy. "The utilities have made good use of a lot of risk management pools to manage their side of the business. I do think end users are going to take advantage of some of those tools, as well. That's a growth area. The general hardening of the market on the insurance side is going to have customers taking a look at more creative ways to tailor coverage. As it gets more expensive, they need to think through what their retentions really should be."

While long-term implications of Enron's demise are hard to predict, the likelihood of continued use of the methods they pioneered is strong, says a source at Standard & Poor's, New York. "People dealing with the energy and weather derivatives are still committed to that particular strategic direction. In the short run, there may be some pulling back. In the long term, though, to the extent that these things made economic sense and provide people with an economic way to hedge exposure, someone else will take up the banner."

Lori Widmer may be reached at lwidmer@lrp.com.