Article sent in by CINCS, LLC, New York, USA

Forest for the Trees….

Forests as a more attractive investment

Forests and tree crop enterprises have a tremendous economic value. They have reliable
revenues, and even environmental revenue streams, such as water and biofuels. Forests also
serve as carbon sinks, which, in a carbon-constrained global economy, gives owners a further
opportunity to monetize their investment.

Several uncertainties block investors from realizing these potential revenue streams. The
insurance industry views forests as a high-risk asset class for several reasons: First of all, bio-
sinks like forests and soils are unusual because the sequestered carbon can be lost through
natural or man-made events. The natural hazards include fire, wind damage, pest infestation,
and drought. Human actions take their toll through illegal logging, arson, poor soil management,
project risk, and enterprise disruption.

Insurers believe that these risks don’t lend themselves to reliable risk modeling, and this
uncertainty increases in an era of climate instability, when shifting weather patterns and impacts
can dramatically hurt forest assets.

A number of market participants – CINCS among them – believe that insurers overestimate the
risks, and that recent regulatory and monitoring developments dramatically improve the
investment prospects of forest assets.

The Best Standard

Launched in 2007, the latest version of the Voluntary Carbon Standard (VCS) sets well
designed and valuable guidelines for validating, measuring, and monitoring carbon offset
projects. The VCS Standard for Agriculture, Forestry and Other Land Use (AFOLU) governs
forests.

This framework rightly assumes that the longevity of trees can be a problem for relying on
forests as carbon sinks. The carbon is stored only as long as the trees are standing. AFOLU
addresses these “permanence” issues in a simple, blunt way: Because of the risks to the
permanence of the carbon sink, each forest must set aside a buffer of unused acreage held in
reserve.

The size of the buffer grows or shrinks with the risk of loss, as well as with carbon market
requirements. The VCS requires a 30% risk-adjusted buffer. The Chicago Climate Exchange
and CCAR also require buffers. The required buffer size can be reduced over time as the
project matures and the risk of non-permanence diminishes.

From a risk perspective, buffers as a form of self-insurance, or reserving, serve the function
they’re designed for, but at a considerable cost – forested land that could otherwise be
monetized goes unused. Some profit is diminished. A more economical form of insurance would
sweeten the investment prospects. This situation creates an ideal opportunity for applying some
time-tested insurance methods to forests.

What Insurers Need

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In entering another product area, insurers pay keen attention to how well the asset meets the
conditions of insurability. The conditions are:

Randomness – any specific occurrence of the risk must be truly random and unpredictable.

Assessability – the overall behavior of the risk must be amenable to analysis and law-like
behavior in some sense.

Mutuality – the risk pool of insureds must be large enough to spread the risk around
sufficiently

Affordability – the premiums for insuring the risk must be economically feasible for the
potential insureds.

In fact, forest insurance could satisfy all these conditions. No hard barrier exists for forests.
1.) The conditions of randomness and assessibility depend on gathering information. Since a
large body of forestry expertise is readily available, these conditions can be met.
2.) With a large number of investors, the risk pool could be spread over a large area –
perhaps even globally – which would more than satisfy the requirements for mutuality and
affordability.

Business As Usual
How would this work for reinsurers and primary insurance companies? The business would look
very familiar. They would assess and price risk. With the abundant data on natural / plantation
forestry, they would model risk frequency and severity and other hazards (illegal logging etc.).
They would pay close attention to the values of the timber, carbon and ecosystem services.

With this information, insurers would choose a risk structure and thus design insurance
products. They would set premiums by excess options (retaining risk or ceding it to others).
They would spell out the loss assessment procedures, and itemize the obligations of forest
owners and insurers in very detailed contracts. In other words, business as usual for the
insurance industry. In addition, they would create model data for carbon buffer requirements in
accordance with the VCS. They would spell out roles for local insurance companies and
premium subsidies.

In order for this market to function properly, monitoring would necessarily play a large role. The
forests must be patrolled on the ground and from the air. The insurers will closely monitor
seasonal conditions, and crucial measures like the fire danger index. What’s more, satellite
monitoring, now quite sophisticated, can watch hot spots, illegal activity, new access roads, and
holes in the forest.

Governments and NGOs are already undertaking close monitoring as part of their goal of
preserving carbon sinks and protecting biodiversity. It’s not a huge stretch to make commercial
use of this valuable data.
Better measurement would result in more knowledge about high quality forest areas, which
would in turn command a premium from investors. This would create a very positive shift away
from growth models using “lowest site class,” in which the most marginal investment becomes
the de facto standard.

CINCS, LLC 561 Broadway, Suite 6A New York, NY 10012 cincs.com +1.212.925.8106
Once this market is established, a number of ancillary products will no doubt appear to facilitate
the work of insurers and investors. As in other branches of the property and casualty business,
modelers with particular expertise will offer easier ways for insurers to manage these buffer
insurance products.

The likeliest client for this insurance might be large state agency and quasi-governmental
authority. It would resemble the forestry equivalent of the California Earthquake Authority, for
example, or the pooled terrorism insurance vehicles that existed in the U.K. in the 1970s and
1980s. These state agencies would have large portfolios of widely dispersed forest assets. The
reinsurers are going to want a large, sophisticated wellcapitalized client, not individual projects.
This authority would then sell coverage to the individual forest projects.

Risk and Reward

Forest risk coverage presents a tremendous opportunity for the insurance industry and the
businesses that serve them. The existence of a sound insurance market for CDM forest projects
would be a tremendous benefit.

The broad social goal is to bring as much forest as possible under professional management by
experienced foresters. This would include natural forests, reafforestation and afforestation
projects, as well as plantations, tree crops and even biofuel feed stocks.

It would eliminate much of the uncertainty that often hobbles forestry projects. It would promote
the growth of professional foresters managing larger areas, which would maximize all the
agendas of almost every stakeholder.

The presence of insurers will add a considerable economic push to better forest governance.
The governments whose boundaries encompass large forests will have a powerful partner in the
insurance industry, one with a strong stake in having forests managed in the best way possible.
What’s more, these investments can sequester carbon and improve the ability of forests to
serve as “the lungs of the planet.” The stakes are high.

Brian Thomas is a strategic writer with extensive knowledge of financial services, the capital
markets and the insurance industry. He publishes a blog about climate change adaptation called
Carbon Based (http://carbon-based-ghg.blogspot.com/).

CINCS, LLC 561 Broadway, Suite 6A New York, NY 10012 cincs.com +1.212.925.8106