Physical Environment for Risk and Insurance

Identification

Measurement

Financing

Types of Risk

• Fundamental risk: exposure to loss that may affect many people or property interests at the same time

• Particular risk: exposure to loss that is usually limited to a single entity or small group

Characteristics of fundamental risks

• Broad Impact– hurricane, flood etc. affect a number of people

• Catastrophic Potential– natural catastrophe– technical catastrophe (human origin)

• Localized– cost of losses might not be shared among

people from other regions

Important fundamental risks

• Earthquakes– caused by moving tectonic plates– plate boundaries (called faults) are at a greater

risk– coastal regions typically have faults– Pacific Rim is very prone– Ring of Fire: Alaska, Japan, China, Philippines,

Indonesia

Worst case scenario ($b)

property Business Deaths Injuries Total

SanFrancisco

125-170 30-35 3-8000 8-18000 175-225

LosAngeles

130-180 30-40 2-5000 8-12000 180-250

Tokyo 900-1200 350-550 40-60000 80-100000

1500-2100

Storms

• Beaufort Scale

• 0 Calm 0-1(mph)

• 8 Gale 39-46

• 10 Storm 55-63

• 12 Hurricane 73+

• Other types: Tornado has a funnel with wind speed of 200 miles or more

Other risks

• Floods

• Environmental risks– Nuclear risks– Chernobyl death toll will be 100,000+

• Global warming– Since 1800, global temperature has risen by at

least 0.5C

– Produced mainly by excessive CO2

Factors defining loss potential

• Key factors: – distribution of people and property– Concentration of people and property create the

critical mass necessary for a catastrophic loss– Nature of peril and frequency/severity– Susceptibility of property to damage

Distribution of people & property

• Concentration

• Scale economies produce large concentration– 747 carries many people cheaply– giant oil tankers make transport cheaper– large ocean oil platform make extraction of oil

feasible

• Economic reasons for concentration

Reasons for concentration

• Personal reasons– coastal climate is better– usually warmer and sunnier

• Cultural reasons– strong family ties– absence of social security by government

Trends

• Frequency of catastrophes on the rise for both man-made and natural

• Property damage severity is also on the rise

• Why?

• Possible culprits: global warming, more development, less care for risk

Management of physical environment risk

• Risk assessment– modeling: need to understand geology,

meteorology, structural engineering etc.

• Loss mitigation– land use restriction (Acapulco problem)– building codes– retrofitting existing property– disaster planning

Risk financing

• Retention

• Insurance– reinsurance– private risk pools: Marsh & McLennan has

created ACE Ltd. And XL Insurance Ltd. To create risk pools not available in the traditional markets

– Government risk pools

Modern approaches

• CatRe options– an insurer or reinsurer exposed to catastrophic

risk can by these options as a hedge– seller’s money acts as capital for insurer– spreads the risk

• Event bonds– California Earthquake Authority has a number

of these bonds on issue

Political risks

Methods of global interaction

• Exporting– Simple export can face many foreign risks

• Joint ventures– foreign direct investment is the next phase– with capital abroad, more risks

• Wholly owned subsidiaries– highest form of risk

Political risk

• Definition: Any governmental action that diminishes the value of the firm operating within the political boundaries or influence of that government

• Example: Manuel Noriega shut off water and electricity after US firms were forbidden to pay taxes in Panama

Classification

• Confiscation, expropriation and nationalization

• Contract repudiation and frustration

• Unfair regulatory environment

• Currency inconvertibility

• War risk

• How do we measure them?

India BB+Indonesia BBBItaly AAJapan AAA Mexico BB Nigeria NRPeru NRSingapore AAA

Country Rating by S&P

Bank of America World Information Services Business Environment Risk Intelligence (BERI) S.A. Control Risks Information Services (CRIS) Economist Intelligence Unit (EIU) Euromoney Institutional Investor Standard and Poor's Rating Group Political Risk Services: International Country Risk Guide (ICRG) Political Risk Services: Coplin-O'Leary Rating System Moody's Investor Services

Providers of country risk assessment

How to manage political risks

• Develop channels of communication

• Implement good pre-departure training

• Localize firms

• Structure contracts so that they can be renegotiated

• Assist with local projects and local issues

Integration strategies

• Establish joint venture with local firms

• Transfer pricing is done fairly

• Establish open financial reporting

• Example: Hong Kong firms have strong links to China well before hand over, allowed Chinese princelings to hold extensive equity in Hong Kong companies

MIGA

• Multilateral Investment Guarantee Agency was established in 1985

• MIGA acts as a primary insurer for war risk, nationalization risk, currency inconvertibility risk and contract risk

• MIGA now has 107 member countries

• It is formally associated with the World Bank but financially independent

Government agencies

• US: – Overseas Private Insurance Corporation– Foreign Credit Insurance Association

• Europe– Export Credits Gurantee Department was

introduced early 1919– Trevarbeit is a private but German government

backed company

Private providers

• US: AIG, CIGNA, Chubb

• Europe: Lloyd’s of London