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W. Jean Kwon, Ph.D., CPCUSchool of Risk Management, St. John’s University

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Risk Management and Insurance: Perspectives in a Global Economy

15. Risk Management for Catastrophes

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Study Points

Risk analysis

Risk control

Risk financing

http://www.wmo.ch/pages/prog/dpm/images/collage.gif

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Risk Analysis

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Risk Analysis

Analysis of potentially catastrophic events largely identical to those for non-catastrophic event, except:

• Devotion of greater time and effort to exploring the susceptibility of the entity’s physical structure to damage.

• Common reliance more heavily on modeling

• Scenario planning can play a significant role.

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Susceptibility to Damage

Design features and construction quality• The tradeoff between cost and quality• Causes of damage

• Natural• Human-made (e.g., terrorists or disgruntled employees)

Age of structures• The Great Hanshin (Kobe) Earthquake in Japan in 1995

Infrastructure• Transportation and communication facilities of the affected area• Critical to a prompt and orderly recovery• Hurricane Katrina in New Orleans in 2005 in the U.S.

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http://katrina.house.gov/

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Catastrophe Modeling

The use of computer-assisted mathematical techniques to estimate possible losses associated with catastrophic events• Use of site and specific property characteristics (the so-called

“exposure data”)

Primarily for natural catastrophes such as hurricanes, earthquakes, storms, floods• Some for terrorism (e.g., AIR modeling)

Widely used by insurers, reinsurers and intermediaries• Figure 15.1 for a natural catastrophe model

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Natural Catastrophe Risk Modeling (Figure 15.1)

Description of the model in pages 376-377.

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Scenario Planning

Analysts generate simulation games that are used by management to consider and develop plans to deal with alternative futures

Scenarios bring forth decisions by the ultimately responsible persons.• Subsumes elements that are difficult and often impossible to

formalize, let alone quantify

Cause decision-makers to realize that they consciously or unconsciously likely have a preconceived notion of what the “official future” will hold.• Insight 15.1• Figure 15.2

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Closed Strategic Management Loop

ConstructMultiple

Scenarios

DeviseStrategic

Plan Based on Scenarios

ImplementStrategies

Monitor theEnvironment and

Strategic Implementation

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Terrorism Risk Analysis

Protection priority• High priority• Medium priority• Low priority

Hazard and vulnerability assessment• Defining threats• Identifying likely threat event profile and tactics• Assignment of a threat rating

Go also to FEMA for additional information.

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Risk Control

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Loss Prevention

Land use restrictions

Building codes

Disaster planning• The U.S. – A Failure of Initiative, a report about government

preparedness against disasters – Hurricane Katrina and New Orleans

• Insight 15.3 (Home Depot’s reactions to the hurricane)

• The E.U. – The Environmental Integration Manual

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Loss Reduction

Crisis management• The process of identifying those situations that constitute a crisis,

having an organized response to the crisis and ultimately resolving the crisis

The process• Engage appropriate employees to consider the range of crises• Develop responses for each identified crisis, including a master plan• Assign clear recovery responsibilities to individuals• Speak with one voice and through one high-level person• Keep employees, customers, other stakeholders and the public well

informed by honestly and openly sharing the nature of the difficulty and what the organization is doing about it

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Loss Reduction – Corporate Viewpoint

The importance of effective crisis management – “sustainable risk management”

Corporate catastrophes and shareholder value

Reputation crises and shareholder value

Mass fatality events and shareholder value

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Loss Reduction

Insight 15.4 (Tylenol case)

Insight 15.5 (Boycott)

Insight 15.6 (Reputation loss)

Figure 15.4 (Reaction of Share Prices to Mass Fatality Events)

http://img218.imageshack.us/img218/9641/71374286xv4.jpg

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Share Price and Reputation Crisis (Figure 15.3)

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Share Price and Mass Fatality Event (Figure 15.4)

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Risk Financing

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Retention

Recommended when• Insurance is unavailable or unaffordable• Property owners have the capability of financing losses internally

Retention is often used along with other risk financing options.• For example, excess insurance on top of large retention

The problems with retention are vividly demonstrated when a catastrophe occurs.• Especially in developing countries

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Insurance

Risk financing capacity for catastrophic loss exposures remains a major concern for the insurance industry internationally

Insurance policies often exclude coverage for many catastrophic events.• Nuclear-related events• Flood damages• Earth movement• Terrorist act

• Countrywide variations exist.

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Insurance – Catastrophe Reinsurance

Often a risk-financing and loss-sharing arrangement between insurance firms

Several reinsurers that specialize in catastrophe reinsurance• The Caribbean• The London market

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Insurance – Private Risk Pools

A wide array of uses by insurance companies• Residual markets for nonstandard drivers in automobile insurance or

employers in workers’ compensation

A case of catastrophic loss exposure – nuclear activity• The World Nuclear Association• OECD’s Paris Convention on Third Party Liability in the Field of

Nuclear Energy of 1960 (amended in 2004)

• The Price-Anderson Act in 1957 (U.S.)• Insight 15.7

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Nuclear Insurance Coverage (Insight 15.7)

Facility form (liability) policy

Secondary financial protection policy

Master worker policy

Suppliers and transporters policy

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Insurance – Government Risk Pools (CEA)

$1.0

$3.0

$2.0

$1.0

$1.5

$2.0Assessment against insurers

Reinsurance

Line of credit

Reinsurance

Additional commitments from insurers

Insurers' Initial Capital Contributions

CEA (www.earthquakeauthority.com)

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Insurance – Terrorism Risk

Australia – Australian Reinsurance Pool Austria – Terrorpool Austria France – GAREAT Germany – Extremus Israel – The Property and Tax Compensation Fund The Netherlands – NHT Spain – CCS South Africa – SASRIA The U.K. – Pool Re The U.S. – Terrorism Risk and Insurance Act

Table 15.1

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Catastrophe Risk Securitization – Cat Bonds

InstitutionalInvestors

CatastropheRisk

SPV(Reinsurer + Bond Issuer)

Premium Coverage Investment Principal + Return

Insurer (Reinsurer)

Premium Coverage

Investment Bank(Bond Underwriting + Rating)

Escrow Account(Bond Investment)

Not in the book.

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Discussion Questions

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Discussion Question 1

Older facilities often are more susceptible to damage than newer ones. Explain why this is so and make a case for why the government should not require that the owners of such older facilities to upgrade them to contemporary structural standards?

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Discussion Question 2

Loss mitigation is a fundamental factor in better managing the physical environment risk. What aspects of loss mitigation do you believe offer the most promise for the future?

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Discussion Question 3

Develop at least two “alternative futures” for how risk management might change for operators of nuclear power plants.

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Discussion Question 4

If sound crisis management is as important as suggested in this chapter, why do major corporations seem to accord it so little attention?

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Discussion Question 5

We have described terrorism risk pools in selected countries.

• Find the reasons why some governments listed in the table acted upon creation of a terrorism insurance scheme before September 11, 2001.

• Do you find any other governments offering similar programs? (Hint: Examine Brazil, Finland, Hong Kong and Japan for possible programs.)