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Insurance and quantitative risk management – a solution for timber investors

Insurance products are now available to help mitigate some timberland investment risks and create a more stable source of returns, argues Christian Röckemann, founding partner of First Forest.

Timber investors are exposed to a variety of risks related to biological growth, markets, natural disasters and country  risks. Insurance products are now available to help mitigate some of these risks and create a more stable source of returns, argues Christian Röckemann, founding partner of First Forest, a timberland investment and risk consulting firm.

Christian Röckemann
Christian Röckemann

Timberland as an asset class literally grows in both volume and value from the day of establishment and continues into perpetuity.

Depending on the product strategy – the main drivers include tree species and desired end product – there are typically two to three cashflows during a single rotation period, derived from intermediate thinning operations and final harvest. It is here you find an important attribute of this asset: based on biological growth habits, the underlying investment horizon of timberland can be from only a few years to over a century.

Timberland investors can benefit from a portfolio approach by leveraging the diversification effect of investing in various tree species, age classes, rotation lengths and locations. This portfolio approach leads to relatively stable returns and predictable cash flows. Recent stochastic analysis even supports the thesis that well-diversified timberland portfolios behave like a “principal protected” asset, assuming sound investment and forest management processes are in place.

Exhibit 1 illustrates typical return levels that timberland investors expect from their long-term, sustainably-managed portfolios in various parts of the world.

Exhibit 1: Typical timberland investment return levels

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Risk and risk mitigation strategies

But as with any investment asset, timberland is not without its risks. Exhibit 2 illustrates the three main risk categories common to timberland investments that both the forest managers and the portfolio managers need to focus on to differing degrees.

Exhibit 2: Risk categories of timberland investments

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Looking at biological growth as a risk category, we differentiate between biotic, abiotic and management risks. The biotic risks – insects like the bark beetle, rotting, fungi – can be minimised by applying best management practices for silvicultural decisions, such as selecting trees that perform best in a given location and regularly monitoring individual tree stands. But it is the abiotic risk class which this article focuses on and where insurance can help to mitigate the potential impacts.

Natural perils such as fires, floods, hurricanes and other natural disasters can have an enormously destructive impact on any individual timberland asset. The fact that natural perils are unpredictable, occur randomly and can be very severe and widespread makes it difficult to apply traditional risk management measurements.

That is when systematic exposure-based risk modelling – or Quantitative Timber Intelligence (QTI) – and portfolio-based risk transfer solutions come into play. QTI offers a new risk mitigation framework for investors and managers of timberland portfolios, combining foresters’ experiences with insurance and portfolio management expertise. Quantitative analysis gives indications about where the “true risks” for the ongoing cashflows are. Risk transfer solutions can then be designed to address these risks.

It is critical to move away from a single-stand insurance perspective towards a holistic portfolio approach where the diversification effect is a key element. And this type of insurance is available with adequate premiums, making risk transfer a relevant strategic option for managers and investors, both from an overall cashflow stability perspective and from a fiduciary standpoint.

From our experience with Timber Management Organizations (TIMOs) and investors, First Forest and Swiss Re have found five factors are driving the demand for risk solutions:

  • Adequate risk coverage at a reasonable price
  • Convenient and “standardised” contracting
  • Reasonable data and monitoring need
  • Strong and reliable risk partner
  • Reference transactions in peer group

By design, portfolio insurance solutions focus on natural hazards: fire, lightning, windstorm, and hail, ice and snow. There is the possibility of covering debris removal and reforestation costs, loss adjustment expenses, firefighting costs and losses emanating from insects and disease too. Adequate risk coverage at reasonable price levels is generated by the portfolio approach, combined with an acceptable level of data requirements and monitoring. The risk cover is provided by large and leading insurance and re-insurance organisations and is available for the main professional investment markets – US, Central and South America, Europe and Oceania.

We believe that the use of larger-scale portfolio insurance will grow. The insurance solutions allow investors and their managers to:

  • Improve the stability of ongoing cash flows of the investment
  • Participate in larger timberland aggregates and benefit from attractive portfolio pricing
  • Improve risk capacity in their own portfolio (for example, US as core) to include attractive assets globally
  • Reduce fiduciary risk as agents to their principals
  • Develop new ways to gain exposure to the asset class (for example, tiered investment solutions providing various risk/return-levels)

Value at Risk and Insurance: an analytical perspective

Exhibit 3: Expected Cash Flows and Insurance effect

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Exhibit 3 illustrates the cashflow effect of insurance at the portfolio level. For the sake of convenience we include only one period in the graph, which in reality is followed by many more.

On the left side you can see the typical expected cashflow distribution and the value at risk with no insurance in place. While the cashflow characteristics for diversified timber investments per se are attractive, and investors face a “positively skewed” distribution of expected cash flows, there is still some risk of missing cashflow targets. Typical investment targets are “4 percent cash-on-cash yield” or “positive cashflow”. Stochastic analysis provides adequate risk indicators like value at risk and enables the management to find and evaluate risk reduction strategies.

A cashflow distribution with insurance cover is illustrated in the right-hand side of exhibit 3. The timberland owner is compensated for losses by natural hazards. In our illustration the distribution is therefore “cut” at the lower end, and bent: a cash flow is available to be distributed. The consequence: insurance has improved the predictability and stability of cashflows from timberland investments.

Transferring risks to reliable and financially-strong risk experts will not be a feasible solution for everyone and pre-conditions to gain risk coverage have been set. To qualify for risk coverage, it is expected that timberland owners/managers are able to deliver:

  • Sound and sustainable forest management practices (including certification such as Forestry Stewardship Council)
  • Clear management responsibilities and sound land title
  • Comprehensive and solid financials with sustainable investment case
  • Reasonable timber price market assumption
  • Minimum diversification of asset base
  • Adequate and comprehensive valuation methodologies for timber

Insurance experts for agriculture and timberland in turn are aware of the specifics of the asset and have to offer crisp policy wording, acceptable data and reporting needs, regional risk assessment and claims handling services.

Quantitative risk analysis and insurance solutions increase the attractiveness of timberland investments and professionalise the asset class for institutional investors; for those moving into the asset class and those expanding their geographical reach.