Risk ... insurance and the management of risk

Dear Colleagues

Recently there have been two huge events ... the near collapse of the global financial industry and the BP oil spill in the Gulf of Mexico. Both these events raise question about risk and how risk should be managed ... and how the cost of calamity should be funded.

In the case of the financial industry, various key decision makers decided that, because of systemic risk and too big to fail, government should be the funder of last resort. This is a little surprising since the people who made the initial decisions that government should step in were also the same people that had advocated for a very long time that the banking sector and capital markets work best when there is no government engagement.

In terms of risk management ... the private sector banking and finance sector essentially left the whole of the risk with the government ... making no provision whatsoever to be in a position to pull funds from some risk insurance pool in the event of some unanticipated event ... like the sub-prime mortgage melt-down!

In the case of the BP oil spill the assumption was that something like this was not going to happen ... and as far as one can discern there is nothing in either BP or in the oil industry that positions the industry to handle an accident of this sort. The accident should not have come as much of a surprise ... it happens quite frequently around the world, but usually where pollution does not matter (to the companies) very much because there is little publicity and local damage is, in practice, quite routine!

BP and others in the oil industry try to operate safely ... but at the same time they try to operate profitably. The oil industry has a very strong cash flow in normal times ... but they do not have a funded provision for catastrophe set aside. My guess is that there will not be enough BP liquidity to pay claims on a timely basis and in amounts that will make victims whole ... whatever that might be. My guess is that BP will turn out to have a legal structure that makes it very difficult for victims to be compensated. I expect that BP will pay its stockholders a dividend in the near future ... even while the Gulf disaster continues to escalate. They will do this to try to mitigate the stock price losses investors have suffered ... but it is the wrong thing to do. BP may be able to argue it has quite limited legal obligations ... but it has huge responsibilities to the public and especially to those who live in the Gulf coast states.

If risk was being managed comprehensively, BP would have provisions funded that would make it possible for all claims to be paid with little impact on the profit performance of ongoing operations ... but that is not how modern financial managers operate. BP has no special reserves set up and funded to handle the risks that are inherent in its operations ... and because of this the costs are going to come out of its ongoing operations. This is wrong ... but it is the practice of the oil industry ... and all modern industry, that does little to manage risk in a manner that safeguards society.

Transocean ... the owner of the rig has apparently been paid by its insurance carriers for the loss of the rig, and it is reported that they will have a gain in their financial performance as a result of the disaster. To the extent that they had nothing to do with the disaster that would be fine ... but it is not clear yet that this is the case.

Where Halliburton will come out in terms of responsibility is not clear either.

And then there is the question of what responsibility Government at Federal, State and Local level has in all of this. Most oil industry spokesmen seem to be of the view that the least amount of Government is the best ... but at the same time, the private sector industry is not able to organize the pollution mitigation activities that have been needed after the accident without heavy collaboration with government entities. Government entities in the main are inadequately funded ... and are therefore, not surprisingly, ill prepared to handle a serious catastrophe.

The financial services industry prides itself on being innovative. It would be nice to see innovation that makes it possible for the huge systemic and "too big to fail" risks being managed in a responsible way ... but I am not holding my breath. The way really big risk is reduced is having really big provisions and fully funded. Nobody in the capital markets really wants to see this, because the biggest tool in financial engineering is leverage ... and fully funding a risk provision reduces leverage!

At the moment I am not at all optimistic that either the oil industry or the various government entities will be able to deliver meaningful compensation to those who have lost livelihoods as a result of the BP oil spill ... not to compensate for the loss of the productive commons ... the wetlands and natural resources of the region.

I am sure that if the lost value to the economy of the region was quantified it would turn out to be many times the market capitalization of BP! I would like to see this exercise carried out sooner rather than later ... and if this turns out to be so, I would like to hear a robust dialog about how BP and the oil industry as a whole should be held to account.

Maybe I have some facts wrong ... but I don't think so!

Peter Burgess