The Physical Environment for Risk

1
The Physical Environment for Risk Insurance

• Catastrophes, Disasters, and Dealing with Risk

2
Introduction

• Fundamental risk
• Exposure to loss that may affect many people and
  property interests at the same time
• Natural and man-made disasters
• Particular risk
• Exposure to loss usually limited to a
  single-entity or small group
• Fire or explosion in a factory

3
Fundamental Risk

• Characteristics
• Broad impact
• Potential for catastrophe
• Localized
• Public sector involvement

4
Disasters A Comparison

• Natural
• Flood
• Storms
• Earthquakes (seaquakes tsunamis)
• Drought
• Forest fire
• Hail, avalanches etc.

• Man-Made
• Major fires, explosions
• Aviation/space
• Shipping
• Road/railroad
• Mining accidents
• Building/bridge collapse
• Other disasters

5
Loss Potential

• Factors Influencing Loss Potential
• Distribution of people and property
• Concentration trends (economic, personal,
  cultural reasons)
• Proximity to catastrophic perils
• Loss frequency
• Loss severity
• Susceptibility to damage
• Design features (construction quality, age of
  building infrastructure)

6
Natural Disasters

• Human suffering economic losses are increasing
  annually
• Trend towards higher losses per event
• Why? Scientists say its global warming
• So, cant predict timing, severity, size

7
Natural Disasters Human Level

• 3 levels of social responsibility
• Global
• State (community)
• Individual
• All are linked
• Collective loss-sharing occurs at state level
  redistributes burdens of losses

8
Natural Disasters Insurer Level

• Transfer losses from victims
• Wide base of global insurers, reinsurers, and
  investors
• Loss sharing risk transfer
• Shares risk before the disaster occurs

9
Managing the Physical Environment Risk

• Risk assessment
• Identification of exposure
• Analysis to determine potential impact
• What are the assets subject to loss? (Human,
  tangible intangible)
• What perils can cause harm?
• What are potential consequences?

10
Managing the Physical Environment Risk

• Loss mitigation
• Financial loss? Property, product, productivity
• Income loss? Employee injuries etc.
• Risk (loss) prevention
• Cost/benefit analysis
• Avoid, prevent, reduce, control hazards, transfer
  via insurance contract

11
Managing the Physical Environment Risk

• Risk financing
• Retention internal funding of losses
• Companies retain when losses are predictable
  (frequency and severity are probable numbers)
• What is risk-bearing capacity of firm?

12
Environmental Liability

• Surprise environmental liabilities could be a
  significant competitive disadvantage (or
  investment)
• Improvements via risk management (addressing the
  environmental potential problem areas) or.
• Exxon Valdez oil spill market cap. Dropped 5
  immediately

13
Environmental Liabilities

• Companies can invest to improve environmental
  risk management or
• Simply wait for regulators to impose their will
• Study cos. with number of lawsuits earn lower
  ROE ROA, therefore,
• Companies MUST risk manage or lose
  competitiveness market value

14
Environmental Liability

• Capital markets have addressed the need to
  address environmental fitness
• Capital markets will reward those companies who
  have managed their environmental risk effectively

15
Environmental Risk Management

• Insurance industry must communicate what info. it
  requires to u/w protect
• Relevant info what underwriters need
• Info. standards uniqueness still requires
  standards and consistency
• Comparable info. from all risks to promote
  future gains
• Environmental benchmarks respond and create new
  appropriate products

16
Risk Assessment

• Underwriting
• Who, what, where, when
• Risk characteristics
• Underwriter either
• Accepts risk
• Rejects risk
• Changes risk characteristics

17
Loss Mitigation

• Insurers can be proactive in promoting
• Land-use restrictions
• Building codes
• Retrofitting existing property
• Disaster planning
• Might reduce potential social costs of disasters

18
Loss Mitigation

• Countries can be held responsible for inadequate
  building regulations
• Insurers play a role but.countries must do their
  part, too
• blame or responsibility assists in bringing
  problems to the world

19
Loss Sharing

• Global pattern of natural disasters is uneven and
  unpredictable
• Insurance cover is also uneven and unpredictable
• Asia 13 insured but highest loss
• North America 65 insured 50 losses
• Europe in between
• 90 premium volume from industrialized countries
  with 20 of world population

20
Loss Sharing

• Wealthy countries give little aid to poor
  countries after disasters occur
• What if?
• A formal subsidy program existed to transfer risk
  from rich to poor if natural disasters occurred

21
Risk Transfer

• Large claims reinsurance and capital reserves
  are required
• new hedging instruments (catastrophe bonds)
  whereby investors get better returns when cats.
  do not occur
• Governments play huge role in insuring,
  redistributing, and (finally) absorbing costs of
  catastrophic events

22
Risk Financing

• Retention
• Insurance
• Reinsurance
• Private risk pools
• Government risk pools
• Alternative Risk Transfer tools

23
Governments and their roles

• Can act as primary insurer (US National Flood
  Insurance Program)
• Provides insurance at fair premiums
• Incentives on those taking loss/risk reducing
  measures
• Can provide aid and transfer losses to tax paying
  public (private and public infrastructure costs)
• Many countries cannot afford to transfer risk

24
International Communitys Role

• Provide disaster aid via subsidized loans from
  international orgs.
• Little international disaster aid
• Little loss-sharing on global level
• Charity

25
Hurricanes, Earthquakes et al

• Human numbers in 2003 are staggering
• 142 Natural catastrophes
• 238 Man-made catastrophes (shipping and
  transport-related accidents)
• 44,000 killed in earthquakes (60,000 in all
  events)
• 150,000 made homeless

26
Disasters cont

• Severity often tied into old/traditional
  construction (which is lacking)
• Dollar losses
• 58 billion (natural cats. drought, heatwaves,
  forest fires, flood, hail etc.)
• 70 billion (all cats. including power failure
  last August)
• Insured covered only 18.5 billion

27
Disasters our own making?

• Climate change a factor?
• Clear trend towards higher losses
• Insurers try to risk manage via incentives to
  control losses and their own financial burdens

28
Earthquake Insurance

• Covers two principal risk-areas
• Shake sold as an endorsement to a policy and
  covers damages to property contents and may
  also include business interruption, additional
  living expenses, auto damage
• Fire-following sold as an endorsement and may
  also cover business interruption et al

29
Measurement of Earthquake Exposure

• Probable Maximum Loss (PML)
• The threshold dollar value of losses beyond which
  losses caused by a major earthquake are unlikely
• Gross PML is the amount after deductibles but
  before either catastrophic and other reinsurance
  protection
• Net PML is the amount after deductibles and
  catastrophic and other reinsurance protection

30
Measurement of PML

• Insurers with earthquake exposure in BC Quebec
  should
• Use a computer model to estimate PML, or,
• Use default loss-estimate standards
• Insurers have to demonstrate an understanding of
  their models, type of data and assumptions used,
  sensitivity of results to changing assumptions

31
Exposure Management Test

• Gross PML must not exceed (on an ongoing basis)
  the sum of the following resources
• Earthquake reserve required by OSFI
• Amount of retention the company is currently
  using to manage its earthquake exposure
• Documented reinsurance coverage
• Approved capital market financing

32
Earthquake Insurance Risk

• Management
• Board and Management oversight
• Earthquake reinsurance
• Capital market financing
• Parental backing

33
Board Management Oversight

• Documented written policies and procedures for
  managing earthquake risk
• Policies and procedures should be developed by
  senior mgmt and reviewed and approved annually
• Senior mgmt should regularly review the PMLs and
  adequacy of financial resources

34
Board Management Oversight

• Senior mgmt should review probability of
  collection on a claim for reinsurance coverage
• Demonstrate that computer model used has been
  thoroughly researched

35
Earthquake Reinsurance

• Analysis of credit-worthiness of reinsurer used
• Adequacy of reinsurers capital base
• Reinsurers earnings performance over time
• Financial strength of reinsurers shareholders
• Quality of regulatory regime reinsurer is in
• Expertise, reputation, integrity of reinsurers
  management
• Track-record of reimbursement after previous
  catastrophes
• Length of time reinsurer has been in existence

36
Capital Market Financing

• Minimum conditions
• Risk has been or will be laid off to investors
  that meet suitable standards
• Catastrophe-linked financial instruments are
  subordinated to the interests of policyholders
  and other creditors
• Redemption of catastrophe-linked financial
  instruments will require OSFIs approval
• Capital instrument is an appropriate substitute
  for the usual financial resources available to
  meet gross PML

37
Capital Market Financing cont

• Under standby arrangements, capital will be
  forthcoming immediately after a catastrophic
  earthquake with no preconditions that prevent or
  delay the infusion of capital
• Adequate disclosure will be made in the notes to
  the companys financial statements in accordance
  with GAAP

38
Parental Backing

• Formal reinsurance agreements, evidenced by
  written documents between Canadian incorporated
  insurance companies and their foreign parent
  institutions is required
• Other supporting financial arrangements provided
  by parent, such as letters of credit or guarantee
  facilities cannot be used