Archive for December 2010
There are dozens of different types of insurance, from insurance that you have to take out by law (such as car insurance), to policies that it’s a good idea to have (such as contents insurance) to those that are ‘nice to have’ rather than necessities.
Figures from the Association of British Insurers show that, during the recession, one in four people cancelled their home insurance. While it’s a good idea to make sure you’re not paying for insurance you don’t need, you should always think about what would happen if disaster were to strike before cancelling any insurance policies.
How does insurance work?
When you take out an insurance policy, you pay a premium to the insurance company. If you never make a claim, you never get any of the money back; instead it’s pooled with the premiums of others who have taken out insurance with a particular firm.
That may not sound like a good deal, but the idea behind insurance is that everyone pays into a pot of money, knowing that only some of them will ever need to make a claim. If you have to make a claim (perhaps because your washing machine has flooded your kitchen and damaged your floor), the money comes from the pool of your and other policyholders’ premiums.
How are premiums calculated?
Insurers are professional risk takers, which means they know the probability of different types of risk happening so they can calculate the premiums needed to create a fund large enough to cover likely loss payments.
Clearly, only a proportion of policyholders will make a claim in any one period. So, an insurer will take two important factors into account when calculating the premium it will charge. Firstly, how likely it is in general terms that someone will need to claim and secondly, whether the person who wants to take out the policy is a bigger or smaller risk than the ‘average’ policyholder.
Take three examples. In motor insurance, a young person with ahigh-powered car, or a driver with a long history of accidents will pay a higher premium than a mature and experienced driver with a car with a smaller engine who has not had an accident before.
Similarly, the owner of a fish and chip shop will pay a higher premium for his or her fire insurance than, say, the owner of an office. The risk is greater, so the premium is higher.
Someone who is young, fit and in a risk-free job will find it easier to buy life insurance and will pay lower premiums than someone who has a heart condition or is in a risky occupation.
The level of premium is also affected by the insurance company’s desire to target a particular section of the market. So, if an insurer wants to encourage younger drivers to buy insurance from it, it may decide to undercut the premiums charged by some of its rivals.
Two kinds of insurance
There are two different kinds of insurance - life insurance and general insurance.
General insurance pays out:
If a car has an accident or is stolen
If a house catches fire or is burgled
If a holiday has to be cancelled
Most life policies, on the other hand, pay out when an event happens, such as when someone dies.
Anyone can buy life insurance but, the amount you pay in premiums will depend on your age, your health, and the type of work you do. The younger and healthier you are, the cheaper the premiums for life insurance. But if you work in a risky job, you’ll normally have to pay more for life insurance.
Most types of insurance are annual policies. That means that the amount you pay can change every year and, if you’ve made a claim in the previous year or your circumstances have changed, it could affect your premiums.
However, some types of insurance, such as life insurance and insurance that pays part of your income if you cannot work because you’re seriously ill, are long-term contracts. That means you don’t get renewed quotes every year as the premium is set when you first sign up.
If you have a joint mortgage with your husband, wife or partner, you can take out life insurance that will pay out if they die before the mortgage is paid off. However, you can’t take out insurance on someone unless you’d be financially worse off if they died.
What is the excess?
With many general insurance policies, you have to pay the first part of any claim – called the excess – if something goes wrong. The level of the excess can vary widely. For a travel insurance policy, it may be £25 – £50 while for a car insurance policy it could be £100 or more.
Sometimes insurers will impose a large excess if you’ve already claimed for something and you’re likely to do so again, such as for flood damage or subsidence(which is when a building develops cracks because the foundations have moved).
General principles
Other principles apply to all kinds of insurance:
Insurance can provide compensation only for the actual value of property. It cannot cover the loss of sentimental value, for example.
There must be a large number of similar risks so that the likelihood of a claim can be spread among other policyholders. It must be possible for insurers to calculate the chance of loss so that a premium can be set which matches the risk.
Losses must not be deliberate and not inevitable. Clearly, you could not buy fire insurance for a house which was already burning nor life insurance for someone on his or her deathbed.
Lastly, there are some risks which have financial implications so vast that they can be dealt with only by the state. These risks (mainly those arising from war or the major escape of nuclear or radioactive material) are normally not insurable.
Tailor your policy to your electronic gadgets (mobile phones, iPhones, laptops, iPods, sat navs, cameras, blue tooth headsets, camcorders and more) with prices starting from as little as £1.49 per month!
Teak Investments – An Intransparent Market
Teak is a prime tropical hardwood and requires 20 to 25 years to grow in a commercial forestry plantation. The plant origins from Asia but today teak plantations can be found in various tropical climates such as Central and South America, Asia and Africa. Teak investments in a plantation are said to be one of the most attractive investment opportunities in the long term, avoiding deforestation of natural prime forest and producing investor returns in excess of 10% and thus are claimed to beat the stockmarket.
When looking at concrete available teak investment opportunities, the individual investor is faced with a jungle of different providers and ‘Best Buy’ options. Doing a proper comparative analysis is difficult, requires too much time and also there is a lack of data making it very hard to actually understand and evaluate the available options. For the non-expert it is nearly impossible to compare the various teak investment offerings and shortly the investor is lost and faced with the only option to trust in whatever he was told.
IRR
Most teak investments highlight the return potential of such investments and use the Internal Rate of Return (IRR) as best proxy (or sometimes also referred as the Return on Investment ROI). The IRR is a subjective forward-looking estimate, derived from expected cash flows. Showing a stream of cash in and out flows does not necessarily mean the financials are put in stone, in contrast those estimations are heavily dependent on the underlying assumptions. For teak, only a few assumptions already define most of the cash flows:
- Price inflation estimate
- Base selling price assumption per m3 of teakwood
- Commercial timber volume of a tree (in m3)
- Thinning schedule
Inflation is difficult to estimate going forward and in some cases historic data is being used for justification purposes. Just to mention, supply and demand dynamics in the future might be very different from the past while a base selling price should correspond to a realistic achievable price currently observed in the target market.
To estimate expected timber volume, the tree diameter is of especial relevance when buying into an existing plantation. However, even if the diameter appears superb, the trees should be straight and should have enough space to grow to maximize the commercial value.
The thinning schedule defines when commercial thinnings are made to take out the bad trees and leave more space for the good ones to grow further (natural selection). In order to have a commercial value, the wood needs to have a certain age. For estimation purposes, setting the thinning schedule earlier on, positively impacts IRR, since the investment horizon is shorter.
Changing one or two key assumptions in such a model results in significantly different cash flows and IRRs. Thus, more important than looking solely at the outcome (IRR) it is crucial to review the underlying assumptions and potential risks of the investment proposal.
Since all those assumptions are subjective, they can be used to ‘push’ IRR up, showing a more optimistic picture to attract investors than in reality. Thus its important to check that the assumptions are consistent with observations in reality. Without having a proper comparative basis, it will be very difficult for the single investor to challenge and put those assumptions into a context. Teak investments are long term in nature thus require strict discipline in cash management. Compounding effects of incorrect assumptions could have a devastating effect for investors: the company runs short of cash, requires more funding and existing investors could get diluted. Thus from an investor point of view, it is more important to be comfortable with the assumptions rather than the IRR.
Risks
Teak investments have various risks starting with improper site and location analysis, fires can especially damage younger trees while older trees are more resistant to such. Those risks are especially relevant for Greenfield projects after the first years since planting the trees. Passing the first years leads to bigger trees, thus the need for maintenance work reduces and the results are clearly more visible. Thus entering a plantation at a more mature stage should actually show a lower risk when the first years have already passed.
From an investor point of view, as relevant as the technical risks, are the risks of the investment itself:
- Quality of the plantation manager
- Asset being illiquid
- Overpaying at time of acquisition
- Underfunding of the investment
- Legal risks
It is important to obtain confidence that the plantation manager has the capability to undertake the maintenance properly in order to maximize the commercial value of the trees. What helps best here is to look at reference projects and actually check that the underwood has been cut and the branches are pruned.
Private teak investments are illiquid in nature and thus the investor needs to be prepared to be invested during the whole time of the project. One way to mitigate this risk is to be invested at a project involved in plantations of various maturities, thus expecting ongoing cash flows rather than be exposed to one final harvest year. The other option is to sell the investment before harvest, e.g. in year 10, which in theory is attractive to a new investor (shorter investment horizon) but in practice is difficult since the market is intransparent and it is difficult to find a buyer. However, contacting an independent broker such as Investing Alternatively might be advisable.
Price Per Hectare
Price Per Hectare bases on effective costs to be paid for an investment, thus is less affected through a subjective bias than IRR. Teak plantations have similar activities – growing trees – and the cost structure is pretty similar. Thus, Price Per Hectare is an ideal quick ratio to compare investment options across the industry. From an economic point of view, Price Per Hectare should be low when entering an investment. However, Price Per Hectare should always be considered in the context of a risk analysis. There might be valid reasons why it is worthwhile to pay a higher Price Per Hectare if it helps to reduce risk:
- Sustainability certifications such as FSC should allow to sell the timber to more buyers than non-certified timber, thus reducing risk
- Value additions such as a mill can allow to capture more value along the value chain
- Quality of the plantation manager since it affects the risk of improperly maintaining the plantations
Factors like these influence the risk / return equation, thus providing arguments to pay higher price per hectare than a similar opportunity which shows less premium arguments, thus has higher risk.
Conclusion
Some folks in the industry might tell you that financial forecasts are just numbers which all base on estimations and have not much to do with the reality which is growing a tree. From an investor point of view they are wrong. Visiting a plantation and seeing it in good condition is not enough to complete a Due Diligence. You should only invest if the expected return outweighs your risk. Thus this requires an in-depth look at the financial forecast, the entry price, the risks and how the investment relates to other investment proposals.