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Evaluation of San Diego Gas and Electric Company Wildfire

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Evaluation of San Diego Gas and Electric Company Wildfire Powered By Docstoc
					Evaluation of San Diego Gas and Electric
Company's Wildfire Premium Forecast




                                         Prepared testimony of
                                             Robert Sulpizio




                                                  on behalf of
                         Utility Consumers Action Network
                      California Public Utilities Commission
                                      Application 10-12-005

                                           September 22, 2011




                       1
                                                            Table of Contents

I.         SUMMARY OF CREDENTIALS AND QUALIFICATIONS ....................................................... 2

II.        OVERVIEW........................................................................................................................................ 2

III.          ANALYSIS OF SDG&E’S ASSERTIONS ................................................................................... 4

      A.      SDG&E’S FACTUAL ASSERTIONS ...................................................................................................... 4
      B.        SDG&E’S PROGRAM IS NOT THE MOST “COST EFFECTIVE” WAY TO BUILD COVERAGE AND LIMITS
      FOR THE FUTURE.........................................................................................................................................   5
           1.         The California Insurance Market is Currently Unstable and Could be Costly. 5
           2.         The California Insurance market is not cost-effective...................................... 8
      C.      ASSESSING SDG&E’S EFFORTS TO NEGOTIATE THE BEST POSSIBLE TERMS ..................................... 9
           1.         The Relationship with AEGIS and EIM has Dampened Competition ............. 9
           2.         SDG&E Has Not Considered Offsetting Revenues ....................................... 11
      D.      SDG&E HAS OTHER OPTIONS TO PROTECT ITSELF AGAINST THE PERCEIVED WILDFIRE
      CATASTROPHE RISK...................................................................................................................................11
           1.         SDG&E Has Not Considered Alternative Program Structures ...................... 11
           2.         Alternative Strategies that SDG&E Should Have Explored and Utilized...... 12

IV.           CONCLUSION ...............................................................................................................................18




                                                                                      1
                    CALIFORNIA PUBLIC UTILITIES COMMISSION
                            APPLICATION NO. 10-12-005
                    PREPARED TESTIMONY OF ROBERT SULPIZIO
                                   on behalf of
                      UTILITY CONSUMERS ACTION NETWORK




I. SUMMARY OF CREDENTIALS AND QUALIFICATIONS

         My qualifications as an insurance expert are based upon the experience and
expertise that I have gained in the 49 years I have spent as an underwriter, broker and
consultant to corporate clients. The industries involved include public utilities, financial
services, consumer products and durable goods manufacturing, construction, retail and
pharmaceutical among others.
          My CV and expert testimony experience is attached to this Report as Appendix A.
In brief, I served for three years as a property and casualty underwriter for the Travelers
Insurance Company. The following 46 years were spent as a broker with Clifton
&Company, which was merged into Alexander &Alexander, Marsh& McLennan, Aon
Group , Willis Group Holdings and as an independent risk management consultant.


II. OVERVIEW

          In his Prepared Direct Testimony of December, 2010, SDG&E’s Risk Manager,
Maury De Bont, addressed the overall insurance costs for the Sempra Energy (Sempra)
companies. He stated that the total amount of insurance premiums assigned to SDG&E
will increase by $42 million from 2009 to 2012. Among the primary factors affecting the
increase, according to Mr. De Bont, is an amount of $35.8 million for “Wildfire Property
Damage Reinsurance” to enhance coverage limits, including escalation.1
       Based upon my examination of the facts available to me, I conclude that the
Company’s forecasted “Wildfire Property Damage Reinsurance” premium expense of
$35.8 million cannot be justified. In summary, I have pointed out that SDG&E did not


1
    Prepared Direct Testimony of Maury B. De Bont, December, 20110
                                                   2
demonstrate that the Company’s exclusive reliance upon the commercial insurance
market is the most “cost effective”way to address the wildfire liability risk. SDG&E
failed to thoroughly explore the possibility that alternative program structures,
incorporating alternative risk transfer (ART) techniques would have enabled the
Company to build capacity more cost effectively while lending greater long term stability
to their risk transfer program. 1
     The Company focused its examination of alternatives to the commercial insurance
market on their ability to obtain an additional $600 million in wildfire liability coverage.
SDG&E’s Risk Manager, Maury De Bont stated: “Our goal since the 2009-10 policy
year, when wildfire liability insurance limits dropped by two thirds to $400 million, has
been to get back to the 2008-09 policy limit of nearly $1.2 billion as risk transfer
mechanisms (insurance and other alternative risk transfer options) became commercially
and reasonably available.”2 However, the Company failed to examine the possibility of
building wildfire liability capacity more cost effectively by restructuring the first $400
million of the placement using a variety of alternatives to the commercial insurance
market.
     Secondly, SDG&E failed to thoroughly explore alternative sources of risk funding
that would have proved to be more cost effective than the “Wildfire Property Damage
Reinsurance Program. There is no indication that SDG&E gave any consideration to
contingent capital options as an alternative method of financing a potential catastrophic
loss. The cost of a contingent capital product is far lower than insurance and, at the time
of loss, funds become available immediately.
     The Commission should be very concerned that SDG&E has exploited the current
ratemaking process to be inordinately dependent upon the commercial insurance market
and risk transfer, rather than pursuing more prudent levels of risk assumption or
alternative financing as its sole risk management tool. This is a disturbing example of a
risk manager buying as much insurance as the market will provide because they are
confident that the regulatory authorities will readily approve those expenditures. Instead,

1
  I raised this approach with SDG&E in the Z-Factor application case (A. 09-08-019) and gave a concrete
example of how SDG&E could pursue alternative program structures. The company appears to have
simply ignored or inadequately explored this option.
2
  Prepared Direct Testimony of Maury B. De Bont, December, 2010 Page MBD-8
                                                   3
the Commission should require SDG&E to apply the same practices used by non-
regulated enterprises to hedge their cost of risk effectively.




III.       ANALYSIS OF SDG&E’S ASSERTIONS


A. SDG&E’s Factual Assertions


          During the 2009/2010 insurance renewal period, SDG&E’s Risk Management
Department found that there was far less wildfire liability and general liability insurance
available and the cost of the insurance dramatically increased.3 Prior to SDG&E’s 2009
renewal, wildfire liability was “routinely” covered as part of the Company’s general
liability coverage. However, the claims filed against California utilities as a result of the
2007 California wildfires have split the market into wildfire liability and general
liability.4
        SDG&E’s Risk Manager, Maury De Bont cited five factors that caused the
      Company to increase their 2009-2010 wildfire and general liability premiums:
      1. Insurer focus on what they perceived to be strict liability for wildfires imposed on
          utilities by the inverse condemnation doctrine in California;
      2. SDG&E experienced liability claims related to three fires and other non-wildfire
          liability losses and an element of “pay back” for the anticipated claims costs was
          included in renewal premiums;
      3. Underwriters perceived an increased exposure to wildfire claims and were
          concerned about the adverse impact of climate change on the fire season;
      4. An increase in wildfire reinsurance premiums that was passed along by insurers to
          SDG&E and;
      5. “Overall market conditions” which were negatively impacted by “global
          catastrophic losses” and “financial conditions of the world economy.” According


3
    Prepared Direct Testimony of Maury B. De Bont, December, 2010 Page MBD-5
4
    Prepared Direct Testimony of Maury B. De Bont, December, 2010 Page MBD-5
                                                  4
         to Mr. De Bont, underwriters increased premiums to offset reduced investment
         income.5
         SDG&E was only able to purchase a third of the wildfire liability coverage limit
(down from $1.2 billion to $399 million) Additionally, the limit purchased for liability
risks other than wildfire dropped by 1/3 from $1.2 billion to $800 million. 6Moreover, the
total wildfire and general liability premiums allocated to SDG&E and SoCal Gas nearly
quadrupled over the prior year from $13.5 million to $55.2 million while they were
compelled to retain substantially more risk. 7SDG&E was forced to accept a significant
increase in it’s deductible as well as assume a 50% share of all wildfire losses within the
first $60 million of insurance coverage.8
         As stated above, SDG&E’s goal since the 2009-10 policy year has been to get
back to the 2008-09 policy year limit of nearly $1.2 billion as “risk transfer mechanisms”
(insurance and alternative risk transfer options) became “commercially and reasonably
available.”9 According to SDG&E’s Risk Manager, Maury De Bont, “The insurance
program put in place, providing SDG&E a combined $1 billion in wildfire protection,
allows SDG&E to build coverage and limits in the most cost effective manner for the
future.”10


B. SDG&E’s Program is Not the Most “Cost Effective” Way to Build
Coverage and Limits for the Future.

1. The California Insurance Market is Currently Unstable and Could be
Costly

    Mr. De Bont has asserted that: “Historically, commercial insurance has been the most
cost effective way to address the (wildfire liability) risk exposure.”11 However, his
assertion is inaccurate. First, it is directly contradicted by the Joint Amended Application

5
  Prepared Testimony of Maury B. De Bont, December 2010, Pages MBD- 6 &7
6
  Prepared Testimony of Maury B. De Bont, December 2010, Page MBD-8
7
  Prepared Direct Testimony of Maury B. De Bont, December 2010, Page MBD-8
8
  Prepared Direct Testimony of Maury B. De Bont, December 2010, Page MBD-8
9
  Prepared Direct Testimony of Maury B. De Bont, December 2010, Page MBD-8
10
   Prepared Direct Testimony of Maury B. De Bont, December 2010, Page MBD-8
11
   Prepared Direct Testimony of Maury B. De Bont, December 2010, Page MBD-8
                                                5
of Southern California Edison Company, Pacific Gas &Electric Company et al. filed
August 31, 2009. The utilities have stated therein that the Amended Application was
prompted by the Utilities’ “…inability to obtain sufficient insurance at a reasonable cost
for third-party claims arising from catastrophic wildfires, as well as uncertainty
surrounding the Utilities’ ability to continue purchasing current levels of insurance in the
future.”12 The Utilities also state: “… the fact that insurance is available now is no
guarantee that insurance will be available in the future. Because of insurer’s heightened
perception of wildfire risk, this market is unstable and insurance availability can change
quickly.”13
       Second, as I have previously observed, the market for high layers of excess
liability insurance is extremely fragmented and has traditionally been populated by a
large number of opportunistic underwriters. To that point, SDG&E’s $600 million
wildfire property damage program is underwritten by 39 insurers. As the utilities have
acknowledged, it is an unstable market that is subject to rapid change. The fact that
property reinsurers were willing to put up $600 million in capacity for a liability program
is evidence of the enormous amount of excess capacity that currently exists in the
insurance market. According to the Wall Street Journal, in an article dated May 11, 2011,
the insurance industry had $74 billion of excess capital at the beginning of the year.14 The
arrangement is typical of the behavior of insurers in a soft market feeding their hunger for
premium income and it is thus susceptible to the inevitable cyclical changes in the
marketplace. It is analogous to the eagerness with which bankers embraced mortgage -
backed securities prior to 2008. The prospective instability of the program is significantly
increased by the fact that the participants are property reinsurers who are using a
technicality to write what is effectively a liability contract and are thus exposing their
surplus to a risk that exceeds their charter.
       There is also reason to believe that the European sovereign debt crisis will
negatively impact the stability and the long- term viability of the $600 million wildfire


12
   Joint Amended Application of Southern California Edison Company, Pacific Gas & Electric Company et
al A.09-08-020 (Filed August 31, 2009) Page 2
13
   Joint Amended Application of Southern California Edison Company, Pacific Gas & Electric Company et
al A. 09-08-020 (Filed August 31, 2009) Page 3
14
   Wall Street Journal, “Ahead of the Tape” by Kelly Evans, May 31, 2011
                                                  6
property damage placement. SDG&E’s broker commented that they approached more
than 80 markets throughout Europe, as well as Bermuda, London, the U.S., Australia and
Japan in order to complete the placment.15In an article appearing in the Insurance Risk
Management Institute’s (IRMI) online feature “IRMI.com”, consultant Donald J. Riggin
observed: In the run up to Europe’s financial crisis, many of Europe’s largest insurance
groups bought billions of Euros worth of bonds issued by seemingly stable Euro zone
banks and governments. As the market for insurance was, and remains, very soft (lots of
competition producing very low premiums), these insurers saw these low risk high return
bonds as a way to offset underwriting losses precipitated by the soft market.” Mr. Riggin
goes on to suggest that this is a potentially serious problem that could reveal itself when
the European Union’s “Solvency II Directive” takes effect. Solvency II is the new set of
regulations designed to ensure that EU insurers and reinsurers hold capital and surplus
commensurate with their risks. He comments: “If Euro zone insurers are marking these
bonds to market (posting their value at market rather than book), assuming they haven’t
defaulted by then, while, at the same time, being required to meet the SCR (Solvency
Capital Requirement) minimum capital and surplus requirements under Solvency II as
well, ….. something’s gotta give.”16
           I am personally familiar with the fleeting nature of what can best be described as
“innocent capacity” (underwriters who participate in risks with which they are not
familiar because of the attraction of significant premium income). In the late 1980’s
Scandinavian marine and energy underwriters were awash in excess capital because of
the North Sea oil boom and eagerly underwrote property insurance for utility risks,
including those with significant California Earthquake exposures. When this market was
beset by large losses, including those from the Loma Prieta earthquake, they quickly
abandoned the utility market. There is every reason to suspect that the wildfire property
reinsurance program will experience this same phenomenon. As the utilities themselves




15
     Sempra Energy Excess Liability Marketing Report, June 26, 2010 to June 26, 2011, Page 7
16
     “Is a Perfect Storm Coming for Europe’s Insurers?” by Donald J. Riggin, IRMI. Com, August, 2011
                                                     7
have stated in their Joint Amended application, “…this market is unstable and insurance
availability can change quickly.”17
       The wildfire property damage reinsurance program offers scant evidence of being
a stable and “cost effective” answer to SDG&E’s long term catastrophe liability needs.
Therefore, I find no basis to support Mr. De Bont’s assertion that the insurance program
“… allows SDG&E to build coverage and limits in the most cost effective manner for the
future.”18



2. The California Insurance market is not cost-effective

         There is simply no basis upon which to support Mr. De Bont’s assertion that the
Wildfire Property Damage program is the most “cost effective” as an accurate
comparison with potential alternatives is impossible. As Marsh USA acknowledges in
their Marketing Report, the $600 million Wildfire Property Damage Aggregate Excess of
Loss arrangement is “ narrow in scope.” Marsh has described the program as a “named
peril” policy for property damage to homes and commercial buildings caused by a
wildfire emanating from the right-of-way of SDG&E. The broker asserts that “…this
insurance would have covered approximately 80% of the losses caused by the October,
2007 wildfires.19
         Mr. De Bont has failed to acknowledge the “narrow scope” of the new excess
program when comparing its cost to that of the underlying $400 million wildfire liability
program. Specifically, the new program excludes bodily injury and “will only recognize
the erosion of the underlying $400 million limit by losses that would be covered by the
property damage liability program.”20Additionally, since this is a “named perils” property
damage contract rather than third party liability coverage, there would be no coverage
afforded for defense costs.




17
   Joint Amended Application of Southern California Edison Company, Pacific Gas &Electric Company et
al A. 09-08-020 (Filed August 31, 2009) Page 3
18
   Prepared Direct Testimony of Maury B. De Bont, December, 2010, Page MBD-8
19
   Sempra Energy Excess Liability Marketing Report, June 26, 2010 to June 26, 2011. Page7
20
   Sempra Energy Excess Liability Marketing Report, June 26, 2010 to June 26, 2011, Page 7
                                                 8
           Moreover, according to SDG&E, the Company accrued [Begin Confidential]
''''''''''''''' '''''''' ''''''''''''''''' [End Confidential] in defense costs in connection with the 2007
wildfires. 21This is a significant financial risk that is not addressed by the wildfire
property damage program.




C. Assessing SDG&E’s Efforts to Negotiate the Best Possible Terms

1. The Relationship with AEGIS and EIM has Dampened Competition

       The incestuous relationship that exists between AEGIS and EIM and its members
who participate in the management of the Company, discourages effective competition.
In response to the question: “what’s different about AEGIS?”, its Chairman and CEO
point to the fact that the Company’s members have the opportunity to participate in the
management and operations of the insurer. According to AEGIS’ 2010 Annual Report,
more than 60 members participate in the Company’s Board of Directors, Risk
Management Advisory Committee and other advisory groups.22
           Mr. De Bont’s service on AEGIS’ Risk Management Advisory Committee creates
a potential conflict between supporting the interests of SDG&E’s shareholders and
ratepayers and assuring the profitability of the insurance company.
           Even AEGIS’ management acknowledges the existence of more competitive
terms being available in the current soft market. In their 2010 Annual Report they state
the following: “Today, we are in a “soft” competitive insurance market where there is
more capital chasing insurance opportunities than ever before. On renewal, you may find
a cheaper price, maybe even following or coming close to our broad coverage forms.
Why not take it?” In response, they answer that AEGIS offers better long term control
over the cost of risk and that “ insuring with AEGIS is not a transaction, it’s a
relationship.”23 Yet, these assertions have not been borne out by SDG&E’s renewal
results.


21
   UCAN-SDG&E-DR-26, Question 12
22
   AEGIS 2010 Annual Report, Page 6
23
   AEGIS 2010 Annual Report, Page 2
                                                       9
        First, as to AEGIS’ assertion that it offers better long term control over the cost of
risk, SDG&E’s insurance costs have continued to escalate despite the absence of any
wildfire related losses since 2007 and a significant improvement in utility industry market
conditions. The final premium charged by AEGIS for SDG&E’s primary layer of
coverage rose by $636,000, or 5%, from $12,400,091 to $13, 036, 416 in 2010. The
increase was attributed to the loss of the AEGIS “continuity credit.”24 This is despite the
fact that AEGIS described 2010 as a “remarkably good year”, with total surplus having
grown by $139 million, or 16%, to $1.001 billion and the Company’s combined ratio
(losses and expenses as a percentage of total premium) amounting to 95%; the lowest
since 1987.25The loss of the continuity credit eliminated what even the insurer
acknowledges is “an important tangible benefit of membership in AEGIS.”26
        Second, AEGIS has failed to reveal any quantifiable benefits accruing from the
long term “relationship” with the Company. According to SDG&E’s broker, “AEGIS
resisted any suggestion of lower prices and they also could not reduce the quota share
arrangement.”27
     The utility company members of AEGIS who serve as part of the insurer’s
management are serving two masters. It is impossible to conceive of how effective
negotiations can be conducted in these circumstances. AEGIS, as well as the other
industry mutual, EIM, have benefited greatly from the regulatory environment in which
the utility industry operates. As long as insurance premiums can be passed along to the
ratepayers as an “ordinary cost of doing business”28 with little or no scrutiny and the
incestuous relationship between AEGIS’ management and its members exists, there is no
incentive on the part of the insurer to conduct serious negotiations and compete with the
marketplace.




24
   Sempra Energy Excess Liability Marketing Report, June 26, 2010 to June 26, 2011
25
   AEGIS 2010 Annual Report, Page 2
26
   AEGIS 2010 Annual Report, Page 4
27
   Sempra Energy Excess Liability Marketing Report, June 26, 2010 to June 26, 2011, Page 3
28
   Joint Amended Application of Southern California Edison Company, Pacific Gas &Electric Company et
al, A.09-08-020 (Filed August 31, 2009) Page 4
                                                 10
2.      SDG&E Did Not Consider Offsetting Revenues

          SDG&E should have received a premium reduction to reflect the positive impact
of the Cox Communications settlement agreement upon the net amount of the 2007
wildfire losses. Through 2010, insurance payments to SDG&E for the 2007 wildfire
claims amounted to almost $1.1 billion while the settlement agreement with Cox
Communications provided that SDG&E would receive approximately $444 million.
29
     Therefore, the net loss sustained by insurers will be $656 million, a reduction of 40%,
upon receipt of the final settlement proceeds.
          According to Mr. De Bont, insurer pay back “…continues to play a role in
underwriters’ resistance to lowering pricing.” 30 It is not appropriate for insurers to have
disregarded the fact that the Cox settlement will reduce their net loss by 40%. Yet there is
no evidence that SDG&E made any attempt to argue this point in its renewal
negotiations.




D. SDG&E Has Other Options to Protect Itself Against the Perceived
Wildfire Catastrophe Risk

1.      SDG&E Has Not Considered Alternative Program Structures

        According to SDG&E, the Company determined that their new $600 million
wildfire property damage program was the most “cost effective” during telephone
conversations conducted with their broker over the course of renewal negotiations.
During the course of those telephone conversations, the Company has stated that they
determined that the timing and costs associated with certain alternative risk transfer
(ART) techniques (e.g. catastrophe bonds, self insuring and establishing a self insurance
reserve) made them “infeasible” and “not cost competitive” with the commercial
insurance and reinsurance market.31 However, SDG&E has chosen to ignore UCAN’s
repeated question of whether it may be possible to build capacity more cost effectively

29
   UCAN-SDG&E-DR-26, Question 13
30
   UCAN-SDG&E-DR-26, Question 7
31
   UCAN-SDG&E-DR-26, Question 8
                                               11
by restructuring the first $400 million of the wildfire liability placement while also
lending greater stability to the overall program, recognizing that, by their own admission,
it is uncertain that they will be able to purchase comparable levels of insurance in the
future. Until they answer that question with a documented response, the Commission
should not assume that their alternative is reasonable.

2. Alternative Strategies that SDG&E Should Have Explored and Utilized

           SDG&E has previously indicated that there is a roughly 60%/40% split between
the $13 million total non-wildfire and wildfire premium for the primary AEGIS layer.32
Accordingly, SDG&E is presently paying AEGIS a rate of approximately 28% ($5
million p/o $17.5 million limit for the wildfire coverage. This is, in turn, in excess of a $4
million self-insured retention (reduced from $5 million) for both towers of the program.
           In regard to the wildfire liability tower, I offer a model loss stabilization plan that
presents a viable alternative to the wildfire liability coverage currently being provided by
AEGIS and EIM at substantially lower cost..The objective of the loss stabilization plan is
to provide a 5-year fully funded solution with limited risk transfer to a reinsurer; although
in an amount sufficient to allow the program to come to fruition and achieve its goal of
cost stabilization over the long term.
In brief, the loss stabilization plan would have operated as follows:
          A reinsurer would underwrite 50% to 90% of the proposed program;
          The reinsurer agrees to an initial rate for the first year - e.g. 10%
          Each year, the rate is adjusted based upon a 5 year rolling average of claims;
          There is a maximum upward or downward adjustment – e.g. the change in rate is
           limited to a maximum increase of say 25% and 20% respectively;
          In year two, the rate is established as 4 lots of 10% of the policy limit plus losses
           (plus agreed expenses);
          In years three, four and five and subsequent years the rate is computed using the
           same basic formula until a 5 year rolling average is achieved;
          There is an agreed minimum rate below which the premium would not fall;


32
     Prepared Rebuttal Testimony of Maury De Bont, 3-19-10, Page MD 11
                                                  12
        A maximum of 2 or 3 annual aggregate limits would be agreed over 5 years;
        SDG&E would participate as a coinsurer , so it would benefit from losses being
         reduced and be only partially compensated for losses increasing.
         When I presented a simple model approach to SDG&E in 2009, Mr. De Bont
dismissed the possibility of pooling with other California utilities as an option because it
“….simply could not provide the limits needed.”33 Once again, Mr. De Bont has insisted
upon using as his basis for the assessment of alternatives the ability of those alternatives
to provide $600 million in capacity in excess of the existing $400 million wildfire
liability program, while totally ignoring the possibility of building a more cost effective
and stable foundation for a catastrophe program in combination with the purchase of
commercial market capacity at higher excess levels where the cost of that capacity would
be less expensive.
         As I have previously observed, other industries and professional groups have
responded to the shortcomings of the traditional insurance market by employing a variety
of alternative risk financing techniques; one of which is a group captive.
In an article published in the widely read insurance industry publication “Rough Notes”
Magazine, Michael J. Moody offered the following commentary: “The captive insurance
movement continues to grow despite a precedent setting soft insurance market. As figures
from various captive domiciles attest, captive formations over the past four or five years
are on a pace to challenge hard market formations. There are several reasons for this
continued increase. Captives are beginning to become part of some organizations’ overall
strategic risk financing programs and many buyers are just fed up with being at the mercy
of the insurance industry.”34
         SDG&E’s insurance broker, Marsh, recently had this to say about group captives:
“Over the past 20 years, participants in group captive facilities have more than doubled.
Companies that join group captives are seeking the advantages of cost savings, insulation
from the market cycles, greater ability to manage risk, plus they have the opportunity to
share in investment income and underwriting profits.” In response to the question: “Who


33
  Prepared Direct Testimony of Maury B. De Bont, December 2010, Page MBD-9
34
  “New Impetus for Group Captives” by Michael J. Moody, MBA, ARM, “Rough Notes” Magazine,
February, 2011
                                              13
should participate in a group captive?” Marsh offered the following: “ Ideal candidates
are financially solid, best-in-class companies with an entrepreneurial background where
the top executives want to achieve greater control over risks and basic insurance costs.”35
This description fits SDG&E to a T.
        SDG&E dismissed the pursuit of catastrophe bonds as an alternative because they
allege that their estimated cost was “….far greater than commercial and reinsurance
costs. Also, they indicate that the maximum available limit would be in the $100 million
to $200 million range, presumably, as compared to the new $600 million wildfire
property reinsurance program. 36 However, there is no indication that any thought was
given to the possibility of utilizing the capacity provided by a catastrophe bond(s) to
replace a substantial portion of the commercial insurance capacity supporting the $400
million wildfire liability placement. In fact, when asked about the exploration of
alternatives in a data request, SDG&E indicated that catastrophe bonds were in the 9.5 %
annual premium range compared to a rate of 7.344% for the final wildfire liability layer
of the $400 million underlying program which provides a limit of $36.5 million excess of
$362.5 million. Therefore, a catastrophe bond(s) may have proved to be less expensive
than all but the uppermost layer of the underlying commercial insurance placement.37
        SDG&E is unique in the cursory attention it has given the potential benefit of
incorporating a catastrophe bond(s) into their risk transfer program. For example, the
California Earthquake Authority (CEA) recently announced that they sold $150 million
in three year catastrophe bonds to investors. The Authority’s CEO said of the transaction:
“This deal is a game changer. While traditional reinsurance remains valuable, the CEA
must diversify and expand claims paying resources.” The CEA’s CFO added: “This deal
establishes a multi-year repeatable method of risk transfer that’s less costly than
traditional reinsurance.”38 It was also noted that investor demand “significantly
exceeded” the $150 million issuance.
        According to reinsurance broker, Aon Benfield, total catastrophe bond volume
outstanding for the second quarter of this year sits at $11.5 billion, down from more than

35
   “Group Captives” Marsh USA, 17 April, 2011
36
   UCAN-SDG&E-DR-26 Question 8
37
   UCAN-SDG&E –DR-26 Question 8
38
   Business Insurance, August 2, 2011
                                                14
$13 billion in the first quarter. The broker also said that it forecasts “substantial issuance
of catastrophe bonds in the second half of 2011” based upon discussions with interested
sponsors.39
        In an article in “Environmental Finance” it was noted that the oil industry, which
has historically relied on self insurance for spill risks because of lack of insurance
capacity and high premium costs is looking at insurance linked securities, such as “cat
bonds”, as an alternative.40
         SDG&E has chosen to severely restrict its options and endure continually
spiraling insurance costs by refusing to seriously explore alternatives that would replace
the participation of AEGIS and EIM in the wildfire liability program. Also, it is entirely
possible that eliminating the wildfire liability exposure from the AEGIS and EIM
programs would open the non-wildfire liability segment of the program to more
competition.
        There is no indication that SDG&E gave any consideration to contingent capital
options as another alternative method of financing a potential catastrophic loss. In fact,
insurance limits are a form of contingent capital, albeit an owned source of risk capital
that remains off balance sheet. Through the purchase of an option contract, a contingent
capital product provides access to risk capital if a “covered” event occurs, e.g. a wildfire
exceeding $400 million. This is not insurance, so the losses are not covered as such.
Because it is an option, it is only exercisable if both counterparties agree that a predefined
triggering event has occurred, i.e. a financial loss exceeding $400 million resulting from a
wildfire.
         The value of a contingent capital transaction is that, at the time of loss, funds
become available immediately. Unlike insurance, it can be used for almost any risk,
insurable or not.
        The costs of a contingent capital product are far lower than insurance. The option
buyer pays a fee to the seller. If the option expires without being exercised, the fee is the
only expense incurred by the buyer.


39
   Property Casualty 360, “Reinsurance Property Risks See Sharp Price Increases” by Mark E. Ruquet, July
6, 2011
40
   “Environmental Finance” 17 August, 2011
                                                  15
          The rating agency, Moody’s, recently published an article concerning an
announcement by the French reinsurer, SCOR, that they had recently triggered their
catastrophe linked contingent capital facility. According to an article by the alternative
risk transfer blog “Artemis”: “The benefits of an instrument such as contingent capital (or
indeed catastrophe bond) are often in the predictability of the triggers, the timeliness of
these instruments coming into play and the speed of payout, when compared to other
sources of reinsurance or retro cover. It makes a lot of sense for re/insurers to utilize
contingent capital arrangements…. As yet another alternative part of their risk transfer
mix.”41
          The question that I urge the Commission to ask SDG&E is if this makes sense for
a reinsurer, why is it not also appropriate for SDG&E to utilize contingent capital,
together with other alternative risk management tools rather than relying exclusively
upon the traditional insurance market? They have failed to support their assertion that
their exclusive dependence upon the insurance market is the most “cost effective” way to
build coverage and limits for the future. The Commission did not get an answer to this
question in the Z-Factor case and the ALJ in that proceeding recommended that
SDG&E’s increased liability insurance premium and deductible expense not be entitled
to Z-Factor treatment. I believe the question is still quite relevant for SDG&E’s
insurance costs on a going-forward basis.
          In an article published by the respected publication IRMI (Insurance Risk
Management Institute) consultant Donald J. Riggin, writing on the subject of contingent
risk capital, offered the following comment:


           “ So how do we convince American business to kick the (insurance) habit? In a
          world of just-in- time inventory supply chains….the vast majority of businesses
          still warehouse enormous amounts of insurance. The notion that we “warehouse”
          insurance is an apt description. How else could we define holding a huge amount
          of a commodity with no secondary market value (we cannot sell it to someone
          else even at a loss), one that we must purchase anew every12 months, and one
          that has little real economic value? Unused excess insurance limits are like crack
          cocaine: once we experience the euphoria, i.e., the sense of security, we find that


41
 www.Artemis.bm “The Alternative Risk Transfer, Catastrophe Bond, Insurance Linked Securities and
Weather Risk Management Blog July 13, 2011
                                                16
        we are indeed addicted…..Perhaps, if we cannot break the habit, we can switch to
        a less expensive drug with fewer side effects.” 42

        While acknowledging that insurance remains an efficient tool for managing risk,
Mr. Riggins concludes with the observation that …intelligent and creative risk managers
generally find that a combination of risk financing and risk transfer techniques produces
the best use of their company’s risk capital. Risk managers should consider contingent
risk capital among the various risk financing options.
        There is a possible reason why SDG&E would not have been willing to consider a
contingent capital option. The option buyer must make the other party whole and this is
usually accomplished through the issuance of preferred stock or some form of
subordinated debt. SDG&E would, no doubt, find the prospect of having to issue new
debt to pay for an insurable loss less than desirable since the Company has enjoyed the
advantage of having insurance premiums passed along to ratepayers as an “ordinary cost
of doing business”, with little or no consideration given the question of whether the
purchase represented a prudent business decision or whether less expensive alternatives
were available. However, in their joint amended application seeking authority to establish
a wildfire expense balancing account, the utilities acknowledge the potential need to
finance wildfire liabilities through the issuance of short -term and long -term debt. They
comment as follows: “ Modest WEBA balances can be financed within the utilities’
existing short-term debt program. In the event of a severe wildfire for which a Utility
incurs substantial liability, however, the affected Utility may need authority to issue new
short-term and long- term debt in order to meet its obligations. The affected Utility may
require such authority more quickly than a traditional application process would permit,
given the potential need to meet large financial obligations rapidly.”43 Therefore, it is
apparent that there is the ability and, in certain circumstances, the willingness to meet risk
capital obligations through the issuance of debt.




42
   “Contingent Risk Capital” by Donald J. Riggins, IRMI June, 2007
43
   Joint Amended Application of Southern California Edison Company, Pacific Gas &Electric Company et
al A. 09-08-020 (Filed August 31, 2009)
                                                 17
IV. CONCLUSION

       For the reasons cited above, I have concluded that the forecasted expense of $35.8
for Wildfire Property Damage Reinsurance cannot be justified on the basis of SDG&E’s
assertion that it allows the Company to build coverage and limits in the most cost
effective manner for the future. Therefore, it is my recommendation that SDG&E be
permitted to collect $ 6.5 million in additional insurance expense for the year 2012 rather
than their forecasted increase of $42.3 million.
           .




                                             18
                                APPENDIX A

                    QUALIFICATIONS OF ROBERT SULPIZIO


Summary
Senior insurance and risk management professional, with extensive experience in
advising Fortune 500 companies. Expertise includes alternatives to traditional risk
transfer, such as captive insurer formations. Broad insurance market experience in the
United States, London, Bermuda and Europe.

Professional Experience

Risk Management Consultant/Litigation Support                          2008 to Present

Independent Consultant to corporations in the areas of risk management and
alternative risk finance and expert witness with expertise in agent/broker standard of
care, insurance industry custom and practice, coverage issues, insurance brokerage
management and systems and procedures.

Extensive deposition experience including the submission of written testimony in U.S.
federal court cases and prepared testimony to California Public Utilities Commission.
Case experience includes: agent/ broker errors and omissions, construction defects,
property, business interruption and excess liability coverage issues.


Westaff, Inc, Walnut Creek, CA                                         2007 to 2008

Westaff, Inc. headquartered in Walnut Creek, California, was a major national supplier of
temporary staffing services. I was retained as a consultant to review the Company’s risk
management program and develop strategies to reduce the Company’s cost of risk.

Initiated review of brokerage and loss control services.
Conducted a captive feasibility study.
Participated with the Company’s Risk Manager and brokers in the marketing and
negotiation of the Company’s Workers’ Compensation and ancillary programs.
Reported to the Company’s Chief Executive Officer and Board of Directors on risk
management issues.


Willis Group Holdings, San Francisco, CA                             2002 to 2005
Client Services Director, Willis Risk Solutions

                                            19
Willis Group Holdings, with headquarters in London and New York and offices in more
than 103 countries, is the world’s third largest insurance brokerage firm.

Initiated and managed relationships with some of Willis’ largest clients, including PG&E
Corporation and Bechtel Group, Inc.
Established Willis’ large account practice, Willis Risk Solutions, in San Francisco office.

Aon Risk Services, Inc. , San Francisco, CA                         1997 to 2002
Managing Director, Strategic Account Management
Aon Risk Services, a subsidiary of Chicago based Aon Corporation, is a leading provider
of risk management and brokerage services.

Managed relationships with Aon’s largest corporate clients, including Bechtel Group,
Inc. and PG&E Corporation. Responsible for the development of service strategies and
the delivery of global resources.
Created large account service unit in San Francisco office and recruited, trained and
supervised professional staff.

Marsh, Inc., San Francisco, CA                                    1985 to 1997
Managing Director
Marsh, Inc. is a subsidiary of New York headquartered Marsh & McLennan Companies,
which is a global professional services firm.

Managed major corporate client relationships, including PG&E Corporation, Clorox,
Levi Strauss, Bechtel Group, Inc., National Semiconductor and Raychem ( now Tyco
Int’l.)
Responsible for Client Management staff in San Francisco office.
Led Sales Management for San Francisco office, including recruitment of staff and
developing and conducting sales training programs.

Reed Stenhouse, Inc., San Francisco, CA                             1984 to1985
Senior Vice President
Reed Stenhouse, headquartered in Canada, was a major international insurance broker
which was acquired by Alexander & Alexander in 1984.

Managed relationship with Bechtel Group, Inc.
Supervised team of ten professionals dedicated to the exclusive service of the Bechtel
account.

Alexander & Alexander, Inc., San Francisco, CA                    1982 to 1984
Senior Vice President
Alexander & Alexander was the world’s second largest insurance brokerage firm, prior to
being acquired by Aon Corporation in 1997.

Managed major client relationships, including Transamerica Corporation, Labatt’s
Breweries and Dillingham Corporation.
                                            20
Led service team of five professionals.

Clifton & Company, San Francisco, CA                                  1968 to 1982
Senior Vice President and Director
Clifton & Company, headquartered in San Francisco, was one of the top 20 insurance
brokerage firms in the United States, with offices throughout the western United States
and in London. Clifton was acquired by Alexander & Alexander in 1982.

Managed Clifton’s major client relationships, including Bayer A.G.(Cutter Laboratories/
Miles Laboratories), Transamerica Corporation, PG&E Corporation and Shaklee
Corporation.
Recruited and trained professional staff.
As a member of the Board of Directors, participated in strategic planning.
Participated in exploration of merger and acquisition opportunities and negotiations for
Clifton’s acquisition by Alexander & Alexander.

Johnson & Anton, Inc .San Francisco, CA                          1965 to 1968
Assistant Vice President
Johnson & Anton,Inc was a prominent San Francisco-based insurance brokerage and
benefits consulting firm.

Placed and serviced Property and Casualty business for commercial accounts including
Quantas Airways, Philippine Airlines, as well as several construction and real estate
development companies.

Travelers Insurance Companies                                        1962 to 1965
Property/Casualty Underwriter

Underwrote and serviced large commercial accounts, including pharmaceutical and
manufacturing Product Liability risks, Casualty retrospective rating programs and
construction risks, including owner and contractor-controlled wrap-ups.

Education
University of California, Berkeley
B.A., Political Science, 1961

University of California, Hastings College of the Law




                                           21
                               APPENDIX B
UCAN DR26-7
7.     On Page MBD 6, Mr. DeBont cites insurer “pay-back” as a factor in the increase
       in 2009-2010 wildfire and general liability premiums. Please indicate whether
       payback was a continuing factor in establishing SDG&E’s wildfire and general
       liability premiums in 2010-2011. Please also provide copies of all workpapers,
       presentations and correspondence relating to the development of the 2010-2011
       renewal premiums.

SDG&E Response:


Please refer to the 2010-2011 Excess Liability Marketing Report provided in response to
Question 1 above, which indicates that the effects of the 2007 San Diego County
wildfires continued to have an impact on liability insurance premiums. As described in
my testimony “Pay-back” was one of five factors affecting the 2009-2010 policy year
insurance premium costs, and continues to play a role in underwriters’ resistance to
lowering pricing. SDG&E was made aware of this during telephone conversations
conducted with SDG&E’s insurance broker over the course of the liability insurance
renewal process. Please refer to the responses provided in response to Q1 above for a
copy of all workpapers, presentations and correspondence pertaining to the 2010-2011
renewal.


UCAN DR26-8
8.     On Page MBD -8, Mr. DeBont states: “The insurance program put into place,
       providing SDG&E a combined $1 billion in wildfire protection, allows SDG&E
       to build coverage and limits in the most cost effective manner for the future.”
       Please describe the process by which SDG&E established that the new program
       was the “most cost effective”. Please provide copies of all analyses, workpapers,
       correspondence, presentations etc. which compare SDG&E's program with other
       considered but "less cost-effective" programs.

SDG&E Response:




                                            22
Please see the attached 2010-2011 Excess Liability Marketing Report provided in
response to Question 1 above, which provides a comprehensive description of the process
by which SDG&E established the wildfire insurance program.


Our determinations in establishing that the new program was “most cost effective” were
arrived at during telephone conversations conducted with SDG&E’s insurance broker
over the course of the liability insurance renewal process. During these telephone
conversations, SDG&E discussed other alternative risk transfer (ART) techniques as
catastrophe bonds, pooling wildfire liability with other investor owned utilities,
reinsurance, and captive insurance. We determined that the timing and costs associated
with certain ART mechanisms (e.g. catastrophe bonds, self-insuring and establishing a
self-insurance reserve) made them infeasible and not cost competitive with the
commercial insurance and reinsurance market. By example, the reinsurance market had
ample limits/capacity to provide compared to other alternatives. We found the maximum
available limit for catastrophe bonds were in the $100 million to $200 million range
excess of $400 million commercial insurance program. The reinsurance wildfire property
damage program produced an overall rate for the $600 million placement of 5.343%,
which is 27.25% less than the 7.344% rate for the final wildfire liability layer in the
commercial $400 million underlying program. The reinsurance wildfire property damage
program structure, as explained in DR-3 above, also achieved a $567,000 savings in
insurer taxes. Catastrophe bonds were in the 9.5% annual premium range, far greater
than commercial and reinsurance costs. Also, establishing a self-insurance reserve for
wildfire risk exposure did not, and continues to not make sense. This is because the
wildfire risk constitutes such a huge catastrophic loss event, SDG&E could not set aside
enough funds, even with contributions from other I.O.U.s, to pay for the type of wildfire
losses sustained in 2007. The amount of total wildfire insurance currently purchased
($1.025 billion) is still not enough to cover the entire potential wildfire risk exposure, so
the Company does “self-insure” potential loss above insurance, but does not set aside any
funds.




                                              23
There are no other analyses, workpapers, correspondence, presentations that identify
other “less cost-effective” programs.


UCAN DR26-12
12.             Please state the total paid and reserved 2007 wildfire claims to the present date
                broken down on an annual basis.


SDG&E Response:


                The 2007 San Diego County wildfires include, specifically, the Witch,
Guejito, and Rice fires.



The following information has been identified as CONFIDENTIAL PROTECTED
INFORMATION PURSUANT TO THE SIGNED NDA IN THIS PROCEEDING
 [Begin Confidential]




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''''''''''''' ''''''''' '''''''' '''''''''''' ''''''''''''''''''' '''''''''''''''''''' '''''''''''''''''''''''''''' ''''''''' ''''''' ''''' ''''''''''''''''''''' ''''''''' ''''''''''''
'''''''''''''''''' '''''''''''' '''''''''''' '''' '''''''''' ''''''''' ''''''' '''''''''''' '''' ''''''''''' ''''''''''''


[End Confidential]
UCAN DR26-13
13.             Please provide the status of the Cox Communications litigation. Also, describe
                what impact has the litigation had, or will have, on SDG&E’s wildfire claims
                costs.

SDG&E Response:
                                                                                                 24
In December 2010, SDG&E and Cox reached an agreement settling SDG&E's cross
complaints against Cox in the wildfire litigation. The settlement agreement provided that
SDG&E would receive approximately $444 million, which it will use for wildfire related
expenditures, and SDG&E will defend and indemnify Cox against all compensatory
damage claims and related costs arising out of the wildfires. SDG&E received
$144,154,780 in 2010 and the balance of the Cox settlement payments in 2011.




                                           25

				
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