Accounting For Catastrophe

|

By Tom O'Brien

|

Catastropheslow frequency, high-impact events such ashurricanes, earthquakes, tornadoes and terrorist attackscan bringdown buildings, disrupt supply chains, devastate a workforce, andcripple or even put a company out of business.

|

Despite their infrequency, the magnitude of the potential lossesfrom these events obligates corporate risk managers to consider thepossibilities.

|

Historically, the greatest impact to corporations fromcatastrophes has been on property insurance. However, in this newrisk environment, the risk management community has been madepainfully aware that some events can lead to catastrophic lossesfrom workers compensation claims and loss of life.

|

A hard insurance market makes the risk from catastrophes evenmore challenging to manage, forcing corporations to make toughdecisions about how much coverage to buy, whether to increasedeductibles, or assume some or even all of the risk internally.Risk transfer decisions such as these can be made rationally,however, only if they are informed by an understanding of the fullrange of potential losses and their probabilities.

|

Now, tools are available that provide corporate risk managersand chief financial officers with just that kind of information.Catastrophe models, which have been widely used by the insuranceindustry for more than a decade, are also the best way for riskmanagers to understand their catastrophe risk.

|

The combination of computer modeling technology and advancedscientific understanding enables sophisticated loss analyses thatjust cant be matched by traditional probable maximum loss studies.Catastrophe modeling helps risk managers prepare for extreme eventsin the following ways:

|

(1) Provide detailed loss analysis: A detailed,location-specific loss analysis will provide much deeper insightinto property and workforce exposure to extreme events. Byquantifying the range of potential losses, a risk manager is betterable to plan for, mitigate and transfer risk. Results can also beused to negotiate insurance rates at renewal.

|

(2) Identify large loss drivers: Catastrophe modeling will let acorporation know if a small percentage of their propertiescontribute disproportionately to their risk exposure. Considerationcan be given to the installation of loss mitigation devices athigh-risk properties, minimizing the impact of an extreme event onthe property and employees, and potentially reducing insurancepremiums.

|

(3) Understand large loss scenarios: Corporations need to knowwhat their largest losses might be and the chances of those lossesoccurring. In addition to using this information for insurancebuying purposes, it is also good information to have for disasterrecovery planing.

|

(4) Optimize risk transfer: When researching transfer options,it is important to know how different approaches can impact thebottom line. Catastrophe modeling helps corporations evaluatemultiple approaches, including consideration of captives, risk poolformation or other means of alternate risk transfer.

|

When transferring risk through traditional insurance markets,approaching renewals with a catastrophe loss analysis providesconsiderable negotiating leverage with your underwriter.

|

By incorporating the latest scientific research about thefrequency, location and behavior of catastrophic events, whethernatural or man-made, models are able to replicate the range,severity and frequency of potential events.

|

Applying expertise in scientific, engineering and otherdisciplines in the computer modeling process enables dramaticreduction in the uncertainty of catastrophe loss estimation.

|

For the corporate risk manager, a little bit of data will go along way in replacing the subjective, “rule of thumb” approaches toestimating potential losses. Reliability of the resulting estimatesdepends on the sophistication of the model and the quality of theinput data provided by the corporation.

|

To successfully perform modeling for a property portfolio,location information, basic structural details and replacementvalues for each building are required. Additional data is requiredfor workers compensation and life analyses.

|

Looking at how each of these data elements is incorporated intothe study provides a better sense of how catastrophe modelingworks:

|

Location: First the model determines the latitude and longitudefor each property address. Using advanced statistical techniques,the model then simulates a set of possible extreme events andoverlays the location or path of those events to determine thedestructive force on each property.

|

Also considered at this point are the geographical andgeological attributes of property locations to determine what kindof amplifying or dampening effect they could have on thedestructiveness of the event. For example, hurricane exposure isexacerbated by proximity to the coast and soil type has a largebearing on loss potential from an earthquake.

|

Structural characteristics: Mathematic equations known as“damage functions” are developed for each combination ofconstruction type, such as wood, masonry, concrete and steel;occupancy type, such as residential, commercial and industrial; andperil, such as earthquake, extreme wind and terrorism. These“damage functions” are based on engineering studies and historicallosses from actual extreme events. By combining an understanding ofevent severity at a particular location with an understanding of abuildings structural resiliency and responses, realisticassumptions can be made about the range of potential damage, on apercentage basis, that could result from a possible event.

|

Replacement Values: By applying the percentage of structuraldamage to a buildings replacement value, the loss from thatparticular event can be described in dollar terms. But lossassessments are not limited to the structure. Building content andbusiness interruption losses can also be derived from catastrophemodeling.

|

Beyond property: Using property damage as a foundation andincorporating details about the number of employees and shiftrotation for factories, determinations can be made regardinginjuries and fatalities resulting from an extreme event to estimateworkers comp losses. To fully analyze a life portfolio, additionalinformation is needed that includes assumptions regarding employeeswhereabouts outside of the office.

|

One of the primary benefits of the computer modeling process isthe ability to run extreme event analyses repeatedly with a levelof randomness that replicates reality. The models simulatethousands of event scenarios that might happen each year. With notwo years exactly alike, the range of potential losses can bequantified in meaningful terms.

|

As the hard insurance market continues to put a strain oncorporations, risk managers must understand their companys exposureto catastrophic losses; be able to convey that understanding to thebroker, underwriter and supervisor; and determine the ideal mix ofretention, transfer and mitigation of risk. The output of acatastrophe modeling analysis is an invaluable tool in theexecution and communication process.

|

The level of detail and quantification of the variousprobabilities of loss enable the risk manager to develop aproperty, workers comp or life program that truly matches the risktolerance level of their company. Being able to differentiatebetween the events and probability of a tolerable loss and the mostextreme losses allows the risk manager to select the deductible andcoverage limit that is most cost effective.

|

Catastrophe modeling is a decision support tool that enables therisk manager of the 21st century to identify, quantify and manageextreme event risk. Incorporation of modeling into a riskmanagement program helps the risk manager keep ahead of growinginsurance demands and keep the company protected.

|

Tom O'Brien is a risk-modeling consultant for AIR WorldwideCorporation in Boston. AIR is a catastrophe and weather riskmodeling company.


Reproduced from National Underwriter Edition, March 10, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved. Copyright in this article as anindependent work may be held by the author.


Want to continue reading?
Become a Free PropertyCasualty360 Digital Reader

  • All PropertyCasualty360.com news coverage, best practices, and in-depth analysis.
  • Educational webcasts, resources from industry leaders, and informative newsletters.
  • Other award-winning websites including BenefitsPRO.com and ThinkAdvisor.com.
NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.