THE VIEW OF RAM ENGINEERS

THE VIEW OF TECHNICIANS

THE VIEW OF SALESMEN

VIEWS

THE VIEW OF INSURANCE EXPERTS

THE VIEW OF TOP MANAGEMENT

There is only one way to address and solve all above mentioned questions. What is urgently needed is a transformation of the RAM curve into three financial distribution curves. The overall objective is to calculate the financial expectation value of each contract, separately. Furthermore, accounting practices must be tightly linked to these curves; they may not "live a separate life" but must be totally harmonized. In doing so, a fully risk adjusted accounting system can be built which enables one to coherently create effective insentive systems.

The three contracts show the following specifications:

Contract 1:**** Sales Price: 90 Mio $****Guarantee: 94 %****Penalty /1% / Refaund /1%: 2 Mio $ / 0.5 Mio $

Contract 2:**** Sales Price: 90 Mio $****Guarantee: 90 %****Penalty /1% / Refaund /1%: 3.5 Mio $ / 1 Mio $

Contract 1:**** Sales Price: 90 Mio $****Guarantee: 92.6 %****Penalty /1% / Refaund /1%: 0.5 Mio $ / -

According to contract 1, the buyer and the seller have agreed upon a guaranteed level of energy availability at the end of the year of 94%. Furthermore, a penalty of 2 Mio $ per 1% of lower energy availability will be charged and must be paid by the seller. In the case of producing more than 94% energy availability, a refund of 0.5 Mio $ will be transferred back from the buyer to the seller.

The other two contracts can be interpreted in analogy. Contract 3 is insofar special as there are no refunds paid at all and both the expectation of the energy availability and the guaranteed corresponding figure is the same.

In this example, the sales price will not be investigated because it does not influence the yearly cash flow volatility with respect to our underlying RAM distribution.

We assume that at the end of the year all three plants produce the same amount of energy. Let us further assume that the observed energy availability is by random 90%. Remember, that the three plants are exactly the same as far as their structure and their failure-, and repair rates are concerned, thus the underlying drivers in form of our RAM distribution curve is exactly the same, too. The only difference is that the applied financial contracts between the buyer and the seller have other specifications. According to contract 1 a penalty of 4% à 2 Mio $ = 8 Mio $ has to be paid at the end of the year. Do we have to punish the seller of contract 1?

The NOT risk adjusted journal entry would be: Penalty Costs / Cash 8 Mio $.

By random, the guaranteed (set in advance) and the observed (at the end of the year) energy availability of the plant 2 (contract 2) are alike. No cash will flow out of the organization. What about the salesman of contract 2? Is he really in a neutral position? In such situations, a not risk adjusted accounting would not apply any journal entries. Within a fully risk adjusted accounting system, we do have to generate 2 journal entries, one of them is profit & loss effective, the other is not.

After starting another three background runs the financial distribution curves can be plotted. Only now we are really in a position to decide on fully risk adjusted journal entries. The consequent separation between unexpected (random) and expected (non random) contributions is the key. The basis for each and every profit & loss effective journal entry has to be the expectation value of the corresponding financial variable.

For contract 1, we have 2'931'239 $ which is to be interpreted as a negative result, thus is unfavorable. Contract 2 generates 2'463'062 $ which is favorable, and contract 3 holds 177'512 $ unfavorable. All random deviations from these expectation values have to be managed by means of one risk pool clearly declared in the balance sheet. The random contributions are never subject to be booked into the income statement. Thus, the involved accounts for the journal entries are balance sheet accounts, solely.

Only through these practices, it will be guaranteed that the risks can be managed there, where they have to be: in the balance sheet. As a consequence, not the profit and loss will be subject to tremendous fluctuations, but the balance sheet. Within the balance sheet, we do have to indicate a special risk pool on both the asset side and the liability side, where all unexpected contributions will be accounted for. Contract 1,2, and 3 contribute as follows: -5'068'761 $, -2'463'062 $, -1'122'488 $, respectively. The total unexpected amount of the cash flow volatility is summed up to -8'654'311 $. This figure is to be interpreted as a risk pool shrinkage. One of the key points is the fact that the risk pool is never influenced by either negative or positive shifts. The expectation of the change of the risk pool is at all times 0.