Commodity boom threat to resource companies balance sheets

Assessing risk without considering the counter-cyclical nature of commodities and insurance cycles can place resource companies' balance sheets at risk -paradoxically at a time when commodities prices are most firm.

Greg Wattam of Alexander Forbes Risk & Insurance Services says during boom times, resource companies typically rely on the value of their assets to enable them to cover losses internally without resorting to their insurer to settle claims.

"At these times companies in the resource sector tend to reduce the value of their insurance cover as commodity prices increase.

"But this is very risky strategy should the cycle turn. And history has shown us that cycles do turn very quickly."

Wattam advises risk managers in resources companies to train themselves to read the signals that anticipate commodity and insurance cycles.

"Only by factoring commodities and insurance trends into risk policy, can companies in the resources sector develop a truly effective risk philosophy.

"During a hard insurance market cycle insured organisations often incur the bulk of their losses on-balance-sheet without settling claims with their insurer. Our experience has demonstrated that where insurance market cycles soften, the insured see an opportunity to reduce the retention levels of their self-insurance", says Wattam.

"If a company has also cut back on its physical risk management programme or maintenance expenditure, its exposure is increased even further. Under these conditions a company's insurance portfolio would be 'out of sync' with both commodity and insurance market cycles.

"Risk managers and insurance advisors must be ever-vigilant in reading the signs to anticipate the internal and external current and future trends that will have an impact on an organisations risk philosophy".

A risk philosophy reflecting these often counter-cyclical insurance and commodity cycles allows the development of a risk policy which views the achievement of a companys strategic objectives within a dynamic and cyclical market environment.

The corporate risk managers' role, particularly in resources companies, is to inform the development of an appropriate risk philosophy including an awareness of the relative positioning of commodity and insurance cycles. While offsetting insurance costs to balance sheets does pose a risk, being aware of the relative development of commodities and insurance cycles can make the critical difference between a risky and a sound insurance policy.

But, cautions Wattam, "As quickly as shareholder approval and a company's ratings can appreciate from the proper management of risk, they can also evaporate without ongoing revision of an organisation's risk philosophy and the effects of internal or external influences".

Normally companies model a series of potential large losses to determine the impact they may have on the balance sheet during the course of the insurance period. This helps risk managers identify what needs insuring through an external insurer and what the company can cover itself. This approach works well when organisations are able to sustain losses from their balance sheets without having any material impact on their earnings per share (EPS). It does not, however, make sense when commodity prices fall - which is usually exactly when the insurance cycle hardens.

As such, corporate risk managers who accurately account for commodity and insurance cycle trends in their risk assessments can create critical competitive advantage for companies in the resources sector.