Evaluation of Insurance on Generation Forced Outages

John N. Jiang, Member, IEEE, Hanjie Chen, Student Member, IEEE, and Martin L. Baughman, Fellow, IEEE
of selected negotiated variables in the insurance contract. Additionally, several examples illustrate how the model can be used in this context. Insurance on GFO is not a standard financial product and usually not tradable. Typically the insurer (seller of insurance) receives a certain premium at the beginning of the contract period, but later pays the insured (buyer of insurance) a certain amount of money if there is a financial loss associated with the GFO. Two conditions need to be met for the insured to receive the payment: 1) occurrence of a generator forced outage during the coverage period, and 2) market prices above the strike price specified in the insurance contract during the period of the forced outage. The insurer may require a certain deductible outage capacity and a cap on the total payment. If the time value of money is ignored, then as per [9], the expected value of the insurance receipt can be represented by the following equation,
N M j = E min[C, MAX Qt K q ( L) ,0 h MAX ( pt K p ,0)] k t =1 j =1

Abstract Hedging against financial losses of Generation Forced Outages (GFO) with insurance can be an attractive hedge against one of the risks associated with generating unit operation. It is difficult, however, to provide a satisfactory valuation of such insurance contracts with classical financial pricing methods. This is because the distribution of the receipt of GFO insurance is exceedingly asymmetric due to the discrete nature of the outages and the unique characteristics of the electricity market that makes possible the presence of price spikes. This valuation problem is dealt with herein by decomposing the original asymmetric receipt distribution into two approximating normal distributions. Then, using the approximating distributions, a generalized method of evaluating insurance on GFO is presented. Using the technique, a procedure for determining an optimal insurance structure is illustrated. Index TermsDistribution Approximation, Financial Risks, Generation Forced Outages, Price Jumps, Insurance Valuation.

(1)

I. INTRODUCTION

n competitive power markets, financial losses associated with GFO can be significant. The losses include not only the costs of repairs, but also the costs of replacement power during the GFO. The costs of replacement can be very significant. For example, if a 200MW unit is forced out of service for 2 weeks and the average spot market price is $50/MWh during the outage period, then the expected total replacement cost of power will be 3.36 million dollars. Before deregulation, these costs could be recovered by charging customers an extra ex post statutory rate. However, in todays competitive environment such costs have to be borne by either power producers or consumers, unless somehow the risks are hedged. New products are now becoming available to hedge against such losses. Reference [3] discussed the importance of forced outage protection with insurance as well as the benefits with several real case studies in new era. Reference [9] proposed a general structure for insurance on GFO and used a Markov process model for electricity prices. Whereas [9] examined the value of the insurance from the perspective of a risk neutral insurer, in this paper the insurance problem is viewed from the perspective of a risk averse insured seeking to optimize values

where, E is the expected value operator; C is the payment cap (maximum payment from the insurer); Qt j is the outage capacity of generator j in period t;

Q is the accumulated capacity outage of insured units;

j j =1 i

This work was supported in part by the Fuel & Energy Risk Management Division of an electric power company. The authors are with the Department of Electrical and Computer Engineering at The University of Texas at Austin. The Authors would like to thank Dr. L. Hughston of Kings College London and Dr. C. Singh of Texas A&M University for their constructive comments on theory and technology of probability decomposition and approximation.

Kq is the amount of deductible capacity (which might be specified as a function of system load or temperature). The insurer will not pay if the total outage capacity is less than this deductible capacity; pt is the spot market price during period t; Kp is the strike price. The insurer will not pay if the spot market price is below this strike price Kp; N is the contract period of insurance, e.g. number of days; M is the number of generators under insurance coverage; h is the number of hours of the day (usually h = 16 if the peak hour power generation is of interest); and k is the insurance premium; Those seeking to hedge the financial risks of outages will be risk averse, however. That is, they will be willing to pay more than the expected value of the loss created by outages to avoid the possibility (even if it may occur with low probability) of incurring a very large loss. The value of the insurance to such a risk averse decision maker will depend upon his/her degree of risk averseness and the probability distribution of the losses. That distribution depends on two types of variables: non-negotiable variables and negotiated variables. 1. Non-negotiable Variables 1

1-4244-0493-2/06/$20.00 2006 IEEE.

Non-negotiable variables might also be called exogenous variables. These variables are objective input variables, i.e., outside the control of either the insurer or the insured. Electricity spot prices, generating unit forced outages, system load levels, and temperatures are all variables that are essential to the valuation of the insurance but, at least for the purpose of this analysis, assumed to be out of the control of either party of the contract. This, of course, means that there can be no manipulation of the outage timing or magnitude by the insured.1 As such, non-negotiable variables are random and represent the uncertain reality. 2. Negotiated Variables Negotiated variables are those variables set through negotiation. For example, strike price, deductible capacity, payment cap and insurance premium are typical negotiated variables. The primary assumption of this paper is that the insured will seek optimal values of negotiated variables, i.e., values that maximize its utility, providing an optimal tradeoff between receipt and risks. The remainder of this paper is organized as follows: Section II details the methodology, Section III presents a numerical examples and sensitivity analyses, and Section IV concludes the paper. II. METHODOLOGY This section describes the proposed valuation methodology for insurance on GFO. The steps in performing the valuation are illustrated in the flow chart of Fig. 1. There are four modules of calculation. The various modules and algorithms are discussed further below. 1. Module 1: Insurance Modeling This module includes a mathematical description of the insurance structure and receipt (typically a 2-party agreement), a model of the investors (in this case, the insureds) utility function, models of the non-negotiable input variables (e.g. spot prices, forced outage rates, etc.), and identifies the negotiated variables (strike price, deductible capacity, payment cap, etc.). 2. Module 2: Simulation of Receipt Distribution In general, due to the complexities of the random processes involved, receipt distributions cannot be calculated analytically. Consequently, the value of the receipt is obtained through numerical methods. Since the non-negotiable variables are usually modeled as random variables, they can be either directly calculated with given stochastic processes preprogrammed into the module, or they might be input from other modeling packages. If preferred, for example, [2] put forward some structural models of spot market prices that might be interfaced with this simulation module to generate spot prices. In simulating the negotiated variables, the values keep changing with each iteration of the loop until the optimal values
The more complicated situation in which it is assumed that the outages are not independent of the insurance contract or the resulting electricity prices is discussed further in the concluding section.
1

are reached. The output of this calculation/simulation module is the probability distribution of the receipt.
Insurance Modeling: Insurance structure Exogenous input variables: outage rates, spot price, etc Investors' utility function Identify/Initiate negotiated variables Simulation of Insurance Receipt Distribution: Calculate the receipt distribution with Monte Carlo Simulation. Decomposition of Receipt Distribution: Calculate two approximating normal distributions and the associated weights. Calculation of Investor's Utility

Update Negotiated Variables

Last Iteration? No Yes Exit

Fig. 1. Flow chart of the proposed model

Module 3: Decomposition of Receipt Distribution Module 3 searches for two normal distributions that, when weighted appropriately, best approximate the original asymmetric receipt distribution calculated in module 2. The output of this module is a vector of values ={1,1,2,2,} that correspond to the parameters of the approximating distributions and the weighting factor. The calculation of the investors utility will be made based on . The theoretical support for probability decomposition technology stems from the basic ideas of information geometry and estimation theory. Reference [4] summarize most of the previous work and give the following formula for searching the closest approximation of a given probability density function by minimizing the distance between two probability density functions, (2) inf 1 ( x) 2 ( x, )dx

3.

where 1 ( x) is the square root of primary probability density function and 2 ( x, ) is the square root of the approximating probability density function(s). is the vector of corresponding parameters. A more detailed discussion of Equation 2 can be found in [4]. In this paper, the approximating distribution consists of a mixture of two normal density functions: 2 ( x, ) = 2 ( x, 1 , 1 , 1 , 2 , 2 ) (3) ( x )2 ( x )2 1 2 2 2 1 1 2 1 2 2 = e + (1 ) e 2 2 12 2 2 Fig. 2 illustrates an original distribution and the two approximating normal distributions.

An Example of Decomposition
1.8% 1.6% Original Distribution 1.4% 1.2% Approximating Distribution 1 Approximating Distribution 2 Approximated Distribution

1.0% 0.8% 0.6% 0.4% 0.2% 0.0%

Payoff

* The approximating distribution is so close to the original distribution and almost indistinct.

Fig.2. Illustration of distribution decomposition

Though closed form solutions to the decomposition problem can sometimes be found [1, 5, 7, 8], in general a closed form solution does not exist. To make the model more general, a numerical method based upon Maximum Likelihood Estimation (MLE) was chosen for decomposing the original receipt distribution into a mixture of two normal distributions. This is done by solving the following problem to calculate the elements of = {1,1,2,2,}, where is the weight and L i is the probability of pi. Here the MLE is equivalent to non-liner least square error estimation):
( pi 2 ) 2 ( p )2 i 21 1 2 22 2 1 (4) + min Li e e 2 2 2 i =1 2 2 1 The solution is the input to Module 4. 4. Module 4: Calculation of Investors Utility Since the insurance receipt distribution calculated in Module 2 is a function of the vector of negotiated variables such as strike price, deductible capacity, payment cap, etc., the approximating distributions are also a function of these same variables. If we let denote this vector of negotiated variables, the optimal choice can be calculated by solving the following problem: (5) max U ( ( )) J 2

In Fig. 3, the x, y-axes are the risk measures used for the two approximating distributions of the insurance receipt (namely the standard deviations 1 and 2) and the z-axis is the expected receipt (E[rp]). The concave surface is the efficient frontier that is the most efficient trade-off between mean and variances: each point on the efficient frontier represents the investment that yields the largest expected return for a given variance level. The convex surfaces represent the iso-utility surfaces of the investor. The optimal structure of investment is the tangent point between the iso-utility surface and the efficient frontier. 5. Iteration Utility maximization is the result of the iteration process represented by the loop of Fig. 1. In this process, the computer searches for the set of negotiated variables that maximize the utility to the investor. III. APPLICATION: CASE STUDY EXAMPLE The determination of the optimal set of negotiated variables in a simplified example insurance contract illustrates the methodology. A. The Case Study Example 1) Insurance Structure The insurance of interest is to cover the replacement cost associated with GFO for four months (120 days). The insured has seven generating units and the insurance is to be provided on these units. The unit of outage period is taken to be a day. It is further assumed there is no price cap (maximum payment). For this example the insurance premium k will be assumed to be equal to the expected value of insurance receipt as calculated in Equation 1. This means that the premium for the insurance contract exactly matches the expected value of the payout by the insurer no matter what the value of the negotiated variables are. This removes the insurance premium from the list of negotiated variables, leaving just two negotiated variablesdeductible capacity and strike pricesimplifying the presentation and discussion of results. 2) Modeling the Non-Negotiable Variables For simplification in this example there are only two non-negotiable variables: forced outage and spot market price of electricity. Model of Generation Forced Outage Process: The outage process qt is usually modeled as a continuous time discrete state Markov process. The process is further simplified here as an independent on-off (two-state) Markov chain. Both the outage process and the repair process of generation units follow Poisson distributions. These processes are usually described by a 2 2 transition matrix Tq. q t q t 01 (6) T = 00 q q t t 10 11 s.t. 0 t ij 1, t ij = 1, i, j = 0,1 The entries in matrix Tq represent the steady state conditional transient probabilities from one state to another. For example,
q t10 is the transition probability from state-1 (outage state) to

Probability

Solving this optimization problem is equivalent to searching for the tangent point of the efficient frontier and the iso-utility surface of the investor shown in Fig. 3.

Fig.3. Illustration of optimal astructure of insurance

state-0 (non-outage state). 3

The state process can be expressed as shown below:

1 0 qt = 0 1 if if if if q t 1 = 1dN t = 0 q t 1 = 1dN t = 1 q t 1 = 0dM t = 0 q t 1 = 0dM t = 1

(7)

Prob(dN t = 1) = q dt , Prob(dM t = 1) = q dt

The variables q and q represent failure rate and repair rate of generator, respectively. The unconditional probabilities of generators in outage state (known as forced outage rate r) and in non-outage state thus can be derived: (8) r = Prob(q t = 1) = , Prob(q t = 0) = + + For simplification, the following notation is defined to represent a two-state (on-off) Markov chain for unit i: i i i i (9) qti {i , i , T i (t 00 , t 01 , t10 , t11 )} Since there are seven generating units in the example, there are seven outage processes qti, i=1, 2,...7. It is also assumed that the outage processes are independent and if qt=1, the capacity loss equals to the nameplate capacity of the generation. Model of the Electricity Spot Market Price: Spot price model adopted in the example follows a mixed distribution described by Equation 10,
N (a1 + b1 Lt , 1 ) Lt < L* p pt ( Lt , q ) ~ N (a1 + b1 Lt , 1 ) qt = 0 * N (a + b L , ) q p = 1 Lt L t 2 2 t 2
p t

threshold value L*. However, when load is above L*, price varies differently depending on the jump status: if there is no price jump, price still varies with low volatility; if there is price jump, price varies with a higher volatility. 3) Modeling of the Negotiated Variables Since, in this example, the insurance premium is assumed to be equal to the expected receipt of the insurance and there is no payment cap, there are only two negotiated variables: deductible capacity (Kq), strike price (Kp). The goal of the evaluation is to find the optimal values of deductible capacity and strike price at which the utility of the insured is maximized. 4) Modeling the Insureds Utility Function The utility function defined in this paper is a function of negotiated variables ={1,1,2,2,} and it is assumed to have the following form:
U ( ) = ( 1

12 2 ) + (1 )( 2 2 ) k 1 2

(11.a)

where ={1,1,2,2,} is as defined above. k is the cost of the insurance. In the base case study of this paper, k is set to be the expected value of the insurance to simplify the discussion. Equation 11.a is actually a variation of the mean-variance utility function in financial Industry. The parameters of 1 and 2 quantify the risk averseness of the insured and are both restricted to be greater than zero. Exploration of modeling risk averseness (i.e., modeling 1 and 2) is out of the scope of this paper. This paper simply assumes the following about 1 and 2.

dLt = k L ( L Lt )dt + L dWt L

p p p p and, qtp { p , p , T p (t00 , t01 , t10 , t11 )}

1 = e
(10)

1 k 1

(11.b)
2

where pt is the spot market price; Lt is a continuous time continuous state random driver of price process, e.g., a mean-reverting process representing system load; L* is the threshold between low price volatility region and high price volatility region; qtp is a standard Markov Chain for the price jumps. The notation of its parameterization is illustrated in Equation 9. p and p are jump-up rate and falling back rate, respectively; ai, bi (i=1,2) are the parameters representing average price level (simplified as a linear function of load level in this example). i (i=1, 2) is the volatility of the spot price movement. i is the index of the price region: i=1 stands for low price volatility region and i=2 stands for high price volatility region, i.e. 1<2. L is the mean level of system load; L is the volatility of system load; kL is the reverting rate of load process; dWtL is an independent Wiener processes of load. The price distribution described by Equation 10 is normally distributed with a small volatility when load is less than a

where is a linear scalar for risk averseness. Thus the change of risk averseness can be easily realized by changing . Such treatment is to simplify the sensitivity analysis presented shortly in the following sub-section C. (i-k)/i is the ratio between expected excess return and standard deviation. This ratio is known as the Sharpe Ratio [6]. It measures the reward per unit of risk. Introduction of the Sharpe Ratio in 1 and 2 is to incorporate the change of risk averseness investors display for investments with the same expected excess return but very different level of risks. For example, the averseness to an investment of $100 expected return with $1 volatility could be very different from that of the same $100 expected return but $90 volatility. 5) Summary: Parameters of the Example Table I summarizes the values of all parameters used in the example. Some of these values are based on statistical analysis of historical observations in the ERCOT market of Texas. Some values are given. B. The Results 1) The Results of Simulation of Insurance Receipt The insurance receipt is estimated using Monte Carlo simulation in Module 1. Fig. 4 shows three original receipt distributions for three different sets of the negotiated variables.

2 = e

2 (1 ) k

Symbol h i t 00
i t10
i t 01

TABLE I PARAMETERS OF MODELS Definition Equation 1 Equation 9 for outage processes Equation 9 for outage processes Equation 9 for outage processes Equation Equation Equation Equation Equation Equation Equation Equation Equation Equation 9 for outage processes 10 for price processes 10 for price processes 10 for price processes 10 for price processes 10 for price processes 10 for price processes 10 for price processes 10 for price processes 10 for price process

Value 16 hours 0.94 0.54 0.06

p p t 01 , t11

Equation 10 for price process Equation 11.b for price process

0.44
8.25 10 6

Deductible Capacity Kq (MW)

i t11 a1 b1 a2 b2 L* L kL L p p t 00 , t10

0.46 4.05 ($) 0.80 ($/GW) 1105.60 ($) 226.70($/GW) 49.20(GW) 46.36 (GW) 0.20 4.95 (GW) 0.56

generation capacity of 2,065MW under coverage. For illustration purposes only three capacity values and four strike prices are shown. 3) Utility Maximization In module 3 the corresponding utilities of the insured are calculated according to Equation 11 for each entry in Table II. (Reader should note that the value of utility is a relative measure of investors preference; so its absolute value is meaningless.) In Table III, the maximum utility under optimal values of the negotiated variables is highlighted in enlarged bold font.
TABLE III UTILITIES OF EACH BASE CASE SCENARIO (105) Strike Price Kp ($)
$0 413 MW 516 MW 620 MW $24 $30 $35

-5.18 -4.32 -3.23

-8.43 -5.87 -3.33

-9.13 -6.12 -4.28

-9.92 -7.84 -4.43

1 2 # of sim.

Calculated based on Equation 11.b Module 2 6 10 4

GFO of all units are independent. The Capacities are 290MW, 290MW, 445MW, 140MW, 140MW, 340MW and 420MW respectively.
3.2% 2.8% 2.4%

Low Expected Receipt Distribution [Kp = $24; Kq = 516MW] Medium Expected Receipt Distribution [Kp = $24; Kq = 413MW] High Expected Receipt Distribution [Kp = $0; Kq = 413MW]

Probability

2.0% 1.6% 1.2% 0.8%

4) Asset Valuation and Optimal Choice In this example, the optimal deductible capacity is 620MW (30% of total capacity) and the optimal strike price is $0. The expected value of the insurance, calculated using Equation 1, is $1.3 million. Fig.s 5A and 5B show the distribution of the insurance receipt, the two approximating normal distributions, and a comparison of the original distribution and the approximation, for the instance of optimal negotiated variables.
Decomposition of Distribution of Optimal Insurance Receipt 2.50%
Original Distribution Approximating Distribution 1 Approximating Distribution 2

0.4% 0.0% 40 160 280 400 520 640 760 880 1,000 1,120

2.00% Probability

Insurance Receipt ( $10,000)

1.50% 1.00% 0.50%

1 = $7.0 105 ,1 = $3.8 105 2 = $16.6 105 ,1 = $9.5 105 = 0.4

Fig. 4. Illustration of simulation distributions 2) The Results of Decomposition Table II gives the decomposition results for each set of negotiated variables.
TABLE II THE DECOMPOSITION RESULTS Strike Price Kp ($)
413 MW $0 (26.0, 10.4) (49.2, 22.0) 0.4 (13.7, 5.3) (26.8, 14.3) 0.3 (7.0, 3.8) (16.6, 9.5) 0.4 $24 (8.2, 3.6) (23.3, 15.8) 0.2 (4.2, 1.8) (14.8, 10.1) 0.3 (2.2, 1.4) (9.6, 6.5) 0.4 $30 (5.3, 2.9) (20.4, 14.9) 0.2 (2.4, 1.7) (12.5, 9.4) 0.3 (1.1, 0.8) (6.4, 5.9) 0.3
5

0.00% -20 -10 0 10 20 30 40

Insurance Receipt ( $10,000)

Fig.5A. Original optimal distribution vs. approximations

Original Distribution vs. Approximation

516 MW

620 MW

$35 (3.8, 2.6) (16.6, 13.9) 0.2 (1.3, 1.0) (7.6, 8.5) 0.2 (0.8, 0.9) (5.9, 5.4) 0.4

Deductible Capacity Kq (MW)

1.20% 1.00% Probability 0.80% 0.60% 0.40% 0.20% 0.00% -20 -10 0 10 20 30

Original Distribution Approximation Distribution

K p = 0, K q = 620 MW Premium = $ 1,3 10 6

The Unit of the values in parenthesis is in $10

The first pair of values in each cell of Table II, (1, 1), corresponds to the parameters of the first component normal distribution. The values (2, 2) in the middle are the parameters of the second component normal distribution. The value at the bottom is , the weight of the first normal distribution (the weight for the second normal distribution is (1-)). Across the columns the strike price (Kp) ranges from $0 to $35/MWh while in the rows the deductible capacity (Kq) ranges from 413MW to 620MW or 20% to 30% of total

40

Insurance Receipt ( $10,000)

Fig.5B. Original optimal distribution vs. approximations

C. Sensitivity Analyses This section presents the sensitivity study of the optimal insurance choice to system load level, risk preference of the insured, and the insurance premium. 1) Sensitivity to System Load Level Load is the primary driver of spot price movement. It directly 5

changes the receipt of the insurance. If the system load level is high, it means average market prices will be high and price volatility may be high. The optimal insurance choice of the insured may change if risk changes. Table IV shows the sensitivity of the optimal insurance choice to the changes of average load level represented by L in Equation 10. Three scenarios are analyzed: high average load where L is 10% above the base case, low average load where L is 10% below the base case, and medium average load which is the same as the base case shown above. These three scenarios are indicated by low, mid and high respectively in Table IV. The maximum utility in each scenario is highlighted in enlarged bold font. The corresponding pair of deductible capacity and strike price represents the optimal structure.
TABLE IV SENSITIVITY OF AVERAGE LOAD LEVEL
Strike Price, Kp Utility 10
Kq (MW) 413 546 620
5

negotiated variables. The insured with higher would purchase more expensive insurance with low strike price and vice versa. 3) Maximum Premium to the Insured The maximum premium the insured would be willing to pay is the threshold price that makes him indifferent between insuring and not insuring in terms of utility value. Lets denote the utility of not insuring with U 0 and the utility of purchasing insurance with the threshold price be U(k). Then, the threshold price, k, should equalize the two utility values as, (12) U 0 = U ( k ) With Equation 11.a, we can easily get, 2 2 (13) k = ( 1 1 ) + (1 )( 2 2 ) U 0 1 2 where the definition of 1, 12, 1, , 2, 22, 2 remain unchanged. U 0 is a function of many factors including the load obligation of the insured, its trading strategy, production cost and market liquidity of spot selling, etc. To illustrate the how to calculate of the maximum price an insured would be willing to pay, we assume the following for simplicity: Assumption on Financial Situation of the Insured The production cost of the insured is $30/MWh; the insured has 80% of load obligation under which he has to serve the load equaling 80% of his total capacity (1652 MW in the given case study). There is no restriction in buying and selling in the spot market: the insured is allowed to fulfill its load obligation through market purchasing if the market price is lower than the production cost. The insured is also allowed to sell his remaining available capacity to the market if the market price is higher than the production cost and load served. Assumption on the Spot Market The spot market price is an exogenous random process as described by Equation 10. In terms of market liquidity, we further assume the maximum amount of electricity the insured can sell to the market each day is only up to 15% of his total generation due to liquidity limitation of the spot sell. Based on new parameters of firms financial position and the parameters shown in Table I, the overall loss distribution of not insuring is calculated through Monte Carlo simulation and decomposed into two approximating normal distributions. The utility of not insuring can then be obtained ( U 0 = 3.5 105 ). The maximum price the insured is willing to pay for insurance contracts with alternative values of the negotiable variables can be calculated with Equation 13. Table VI lists the maximum price and the expected payoff of each insurance option. Two columns appear under each strike price in Table VI. The number in the left hand box of each entry is the maximum price the insured is willing to pay based upon the utility value of the insurance. The number in the right hand box of each entry is the expected payoff of the insurance contract (which, in this example, is also the premium). For example, for the entry of Kq=413MW and Kp=0, the maximum price the insured would be willing to pay is $4.2 million while the expected payoff of the contract is $4.0 million. The expected payoff is calculated based upon the approximating distributions

$0 LOW -16.8 -10.8 -7.2

$24

$30

$35

MID HIGH LOW MID HIGH LOW MID HIGH LOW MID HIGH -5.2 12.1 -17.0 -8.4 13.5 -18.2 -9.1 12.0 -16.0 -9.9 12.2 -4.3 7.4 -11.3 -5.9 6.2 -11.3 -6.1 5.2 -10.4 -7.8 5.1 -3.2 3.5 -6.2 -4.4 0.4 -7.0 -3.3 1.5 -6.9 -4.3 1.8
6 6

Insurance Premium for high average load is $4.33 x 10 (10% above the base case) Insurance Premium for high average load is $0.18 x 10 (10% less than the base case)

Table IV shows that the deductible capacity of the optimal insurance decreases as the system load level increases. It means that the insured would be willing to pay a higher premium and seek more protection of GFO when load is high and the market is more volatile. 2) Sensitivity to the Insureds Risk Preferences The risk preference of the insured has a monetary value in any incomplete market where the risk cannot be eliminated. Therefore, the optimal choice of the insured may vary with different risk preferences. Table V shows the results of sensitivity analysis of the optimal insurance choice to the scaling factor of risk aversion parameters, , defined in Equation 11.b. Low , thus low 1 and 2, implies that volatility decreases the utility more in Equation 11.a. The sensitivity analysis consists of three scenarios: the base case plus two cases with lower (higher risk aversity). A medium risk averse case has set to 20% of the base case, and a high risk averse case has set to 2% of the base case. These three scenarios are labeled low, mid and high, respectively, in Table V. The maximum utility in each scenario is highlighted in enlarged bold font. The corresponding pair of deductible capacity and strike price at the column and row headers represents the optimal insurance negotiated variables.
TABLE V SENSITIVITY OF RISK AVERSION LEVEL
Strike Price, Kp Utility 10
Kq (MW) 413 546 620
5

$0 LOW -69.7 -43.7 -17.9

$24

$30

$35

MID HIGH LOW MID HIGH LOW MID HIGH LOW MID HIGH -10.5 -5.2 -84.8 -14.7 -8.4 -77.6 -14.7 -9.1 -73.2 -15.1 -9.9 -7.5 -4.3 -27.8 -7.7 -5.9 -26.4 -7.8 -6.1 -33.0 -9.9 -7.8 -4.4 -3.2 -10.3 -3.9 -3.3 -13.1 -5.0 -4.3 -10.2 -4.9 -4.4

Insurance Premium for medium risk tolerance investor is $6.62 x 106; Insurance Premium for low risk tolerance investor is $0.39 x 106.

The results shown with Table V indicate that risk averseness has an important effect on the optimal selection of the

in Table II. The insured is risk averse, thus willing to pay more than the expected loss for protection.
TABLE VI MAXIMUM PRICE THE INSURED WILLING TO PAY
Strike Price, Kp
Premium $10
6

[4] [5] [6]

$0
Max. Price Premium

$24
Max. Price Premium

$30
Max. Price Premium

$35
Max. Price Premium

Kq (MW) 413 546 620

[7] [8] [9]

4.2 2.6 1.6

4.0 2.4 1.3

2.2 1.5 1.0

2.0 1.2 0.7

1.9 1.3 0.8

1.7 0.9 0.5

1.6 0.9 0.7

1.4 0.6 0.4

Table VII shows the probability of insurance receipt exceeding the maximum price. These probabilities are less than 50% because the insured is a risk averse hedger.
TABLE VII PROBABILITY OF INSURANCE RECEIPT EXCEEDING THE MAXIMUM PRICE (BASE CASE) Strike Price Kp ($)
$0 $24 $30 $35

L. P. Hughston, D. C. Brody, Interest Rates and Information Geometry, Proceedings of Royal Society, UK. Vol. 457, 1998, pp. 1343-1363. R. Jarrow, A. Rudd, Approximate Option Valuation For Arbitrary Stochastic Process, Journal of Financial Economics 10 (1982) 347-369. W. F. Sharpe, "Mutual Fund Performance." Journal of Business, January 1966. C. Singh, J. O. Kim, A Frequency and Duration Approach for Generation Reliability Evaluation Using the Method of Stages, IEEE Trans. on P. S. Vol. 8, No. 1, February 1993. C. Singh, J. O. Kim, A Continuous Distribution Approach for Production Costing, IEEE Trans. on P.S. Vol. 9, No. 3, August 1994. C. Stetson, P. Murray, Power Outage Risk, EPRM Publications, October 2000, 45.

Deductible Capacity Kq (MW)

413 MW 516 MW 620 MW

40.0% 38.6% 32.0%

42.3% 35.4% 28.6%

42.0% 34.8% 26.9%

40.8% 33.6% 24.1%

John N. Jiang currently is the director of research of Providian Financial Corporation in San Francisco in charge of quantitative modeling of investment portfolio, asset valuation and securitization and risk management. He has B.S, M.S. in Electrical Engineering and M.S. in Power Economics and Energy Finance Area. He is finalizing his PhD under the supervision of Dr. Martin Baughman in the Department of Electrical and Computer Engineering at The University of Texas at Austin. Hanjie Chen currently is the principal energy risk analyst in the Lower Colorado River Authority in Austin, TX. His research interest is in real option analysis and risk management. He has both B.S and M.S. degrees in electrical engineering. He is now pursuing his PhD in energy finance area at The University of Texas at Austin. Martin L. Baughman, Professor Emeritus in the Department of Electrical and Computer Engineering at The University of Texas at Austin, is also a senior advisor for The Brattle Croup providing consulting services. His research interest is in power system economics and systems planning.

IV. Summary and Conclusions An insurance valuation methodology for GFO is put forth in this paper. It utilizes distribution approximation theory to approximate the very asymmetric distribution of insurance receipts, facilitating the optimal selection of negotiated values of an insurance contract on generation forced outages. In the proposed model, Monte Carlos simulation is used in calculating the receipt distribution of the insurance. The MLE method is used for decomposing the receipt distribution into two normals. The optimal insurance structure is obtained by seeking the point of tangency of the utility surface and the efficient frontier. It is worthwhile to point out that one of the assumptions we made is that the outages of insured generators are independent of market price. In reality, if the market price has a strong correlation with particular generators under coverage, it is possible for these generators to game their outages to seek more payout. In this case, the valuation becomes more complicated. This is known as the adverse selection problem in the insurance industry. Detailed discussion is beyond the scope of this paper. The method proposed provides a simple and clear measure for commonly seen asymmetric receipt distributions. This method is not only useful for experimenters and practitioners to price financial contract but also very important to firms high-level firm wide risk management. The proposed generalized decomposition technique can be applied to other markets where return distribution is asymmetric and classic mean-variance measure is not sufficient. V. REFERENCES
[1] [2] [3] M. M. Alavi-Sereshki, C. Singh, A Generalized Continuous Distribution and Approach For Generating Capacity Reliability Evaluation and Its Application, IEEE Trans. on P.S. Vol. 6, No. 1, February 1991. M. L. Baughman, W. W. Lee, A Monte Carlo Model For Calculating Spot Market Prices of Electricity, IEEE Trans. on P.S, Vol. 7, No. 2, May 1992. D. H. Hartman, Forced Outage Insurance for Electric Utilities, RISK CONSULT publications, 2001.