Professor Dan C. Jones FINA 4355 Fall 2008 Version Professor Dan C. Jones FINA 4355

Professor Dan C. Jones FINA 4355 Risk Management and Insurance: Perspectives in a Global Economy 15. Risk Management for Catastrophes Professor Dan C. Jones FINA 4355

Study Points Risk analysis Risk control Risk financing

Risk Analysis

Risk Analysis The analysis for events that hold a catastrophic potential are largely identical to those for non-catastrophic event, except: Risk managers devote greater time and effort to exploring the susceptibility of the firm’s physical structure to damage. Such corporations commonly rely more heavily on modeling to estimate the probable effects of natural catastrophes on their businesses. Scenario planning can play a significant role.

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.

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

Natural Catastrophe Risk Modeling (Figure 15.1) Description of the model in pages 376-377.

Scenario Planning A strategic planning method in which analysts generate simulation games that are used by management to consider and develop plans to deal with alternative futures Scenarios should bring forth decisions by those who are ultimately responsible for making them. Subsumes elements that are difficult and often impossible to formalize, let alone quantify It is intended to 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

Closed Strategic Management Loop Construct Multiple Scenarios Devise Strategic Plan Based on Scenarios Implement Strategies Monitor the Environment and Strategic Implementation

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.

Risk Control

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

Loss Reduction Crisis management The process 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

Discussion based on Knight and Pretty’s works Loss Reduction 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 Discussion based on Knight and Pretty’s works

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)

Share Price and Reputation Crisis (Figure 15.3)

Share Price and Mass Fatality Event (Figure 15.4)

Risk Financing

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

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.

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

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

Nuclear Insurance Coverage (Insight 15.7) Facility form (liability) policy Secondary financial protection policy Master worker policy Suppliers and transporters policy

Insurance – Government Risk Pools (CEA) $1.0 $3.0 $2.0 $1.5 Assessment against insurers Reinsurance Line of credit Additional commitments from insurers Insurers' Initial Capital Contributions Source: CEA (www.earthquakeauthority.com)

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

Catastrophe Risk Securitization – Cat Bonds Not in the Book! Catastrophe Risk Insurer (Reinsurer) Premium Coverage Institutional Investors SPV (Reinsurer + Bond Issuer) Premium Coverage Investment Principal + Return Investment Bank (Bond Underwriting + Rating) Escrow Account (Bond Investment)

Discussion Questions

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?

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?

Discussion Question 3 Develop at least two “alternative futures” for how risk management might change for operators of nuclear power plants.

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?

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.)