Management of Catastrophic Risks

By: Tara Ard

Kevin Cook

Marcus Gadson

Brad Kreuzinger

Terri Menser

Payal Patel

Kristin Sims

Harris Weinstein

Catastrophic RiskA brief overview…

Landslides/ Mudslides

• Mountains

• Hilly areas

• Rain

Liquefaction

Floods

Tsunami

Blizzards, Snowstorms, Hail

Where Does Hail Happen

Tornadoes

Hurricanes

Thunderstorms

Wildfires, Building Fires

Terrorism• Incredible variation in potential methods

usable.– Bombing, Dirty Bomb, Biological, Nuclear

• Hard to predict.

• University of Alabama research– “Our research won’t predict that an attack

targeting civilians at a public market will take place tomorrow at 9:30 a.m.”

Likely Terrorism Targets

Biggest Types of Losses Following a Catastrophic Event

Background

• There is a trend of increasing losses from natural catastrophic events since the early 1980’s– Increasing number of natural disasters– Increasing density of population

Landslides

• Landslides currently are the only uninsurable natural disaster by private insurance companies

• In recent years, it is estimated landslides have caused $1-2 billion worth of damage

• Largest losses from landslides:– Structural and property damage– Casualties

Floods• According to the National Flood Insurance

Program, floods are America's most frequent and costly natural disaster

• Losses from floods include:– Human mortality– Damage to personal property from flood water– Damage to real property (structural damage)

• Includes inside walls, and the resulting mildew, mold, and fungus

– Under FEMA, Damage due to mudflow• Flowing mud that inundates the home

– Under commercial policies, business interruption

Blizzards and Snowstorms

• Largest losses:– Economic losses

• Property damage

• Infrastructure damage

• Loss of business activity

– Insurance claims• Automobile

– Livestock

Tornadoes

• According to the Insurance Information Institute, tornadoes have accounted for over a quarter of all catastrophe losses from 1987 through 2006.

• Biggest losses:– Property

• wind damage

• Water damage

– Human casualties• Lack of warning

Hurricanes

• Hurricane Katrina of 2005 is the most destructive and costly hurricane in U.S. history

• Largest Losses:– Property and infrastructure damage

• Flood damage

• Wind damage

– Loss of lives

Fire

• Biggest types of losses:– Personal property– Commercial property– Forest and wildlife– Human casualties

Terrorism

• Biggest losses:– Human casualties– Disruption of business operations– Personal, real, and commercial property

Earthquakes

• Largest types of losses:– Property losses– Damage from flooding– Public infrastructure

Most Costly Catastrophic Events in 2008

Most Costly Insured Catastrophe Losses in 2008

 Catastrophe  When  Where  Insured Losses

 Hurricane Ike  September  US, Caribbean  $20 billion

 Hurricane Gustav  August  US, Caribbean  $4 billion

 Tornadoes, rainfall, hail

 May  US  $1.325 billion

 Winter storm Emma

 February  Europe  $1.321 billion

 Snow storms, ice  January  China  $1.3 billion

 Thunderstorms, hail

 May  US  $1.1 billion

What is Involved in Managing Catastrophic Risk?

• 5 basic steps to useful risk management program, regardless of peril:– 1) Understanding current level of

exposure– 2) Assessing acceptability of risk– 3) Evaluating alternative risk mitigation– 4)Selecting an approach– 5) Implementing the approach

Managing Catastrophic Risk• While earthquakes are often considered the

most terrifying of natural disasters, windstorms, including hurricanes and tornadoes, actually produce greater annual losses than those of earthquakes.

Managing Catastrophic Risk

• New building codes – International Building Code– Wind Borne Debris Codes– Florida Building Code

• Computational fluid dynamics programs– Wind flow patterns can be modeled

around proposed and existing buildings

Managing Catastrophic Risk

• Terrorist Risk Management Program– Phase I: Threat identification and initial site

assessment

– Phase II: Detailed risk assessment• Determine the impact of a particular terrorist event

(ie: blast and explosion analysis, progressive collapse analysis, chemical, biological, and radiological threat assessment)

– Phase III: Risk management• Protection of facility and occupants

• Emergency planning and disaster recovery

• Reduction of financial risk

Managing Catastrophic Risk

• Reduction of financial risk– Diversifying– Pooling– Charging premiums

Why Insuring Against Risks is Complicated?

1. New Threats

2. Priorities

3. Sunk Costs

4. Expensive

How Are Catastrophic Risks Managed in Other Countries?

• Rich countries’ luxuries

• Post-disaster recovery by government

• Little political incentive

Catastrophic Management in Developing Countries

Catastrophic Management in Developing Countries

• Private funding– Post-disaster borrowing

– International Donations • Lack of immediate cash hinders recovery

– Creates spillover effect

• World Bank has donated 40 billion for natural disaster recovery over the past 30 years

• World Bank Global Initiative

Real Life Example: Haiti

• Most deprived nation of the Western Hemisphere

• No national building code• Limited water and power distributions

hampered relief efforts• Over 250,000 fatalities, many due to lack of

medical care (20,000 a day)• As of March 2010, Red Cross has

raised over 100 million in relief efforts.

The U.S. General Accountability Office

Study of systems in France, Germany, Italy, Spain, Switzerland and the UK undertaken.

Each was found to have developed and employed a combination of public and private approaches to deal with catastrophes but only three impose government-mandated insurance that cover disaster risk.

Accounting standards and tax laws in each of the six countries studied allowed insurance companies to establish tax-deductible reserves for future catastrophic events, although there can be significant differences in the reserving approaches used in each country.

Catastrophic Insurance in select EU Countries

Alternative Risk Transfer• Purpose of Alternative Risk Transfer

(ART) is for Insurance Companies to ensure that they have enough liquidity to pay for claims filed in the event of a catastrophic loss

• Some methods of ART include:– (1) Contingent Surplus Notes (CSNs)

– (2) Exchange Traded Catastrophic Options

– (3) Catastrophe Bonds

– (4) Sidecars

Alternative Risk Transfer• Contingent Surplus Notes (CSN)

– Allows insurance company to pay for a catastrophe over an extended period of time

• (1) Insurance company sets up a trust which buys U.S. Treasuries and sells the notes to investors

• (2) Investors receive interest from bond + additional interest from insurance company for the added risk

• (3) At time of a catastrophe, Insurance company has legal right to substitute its own notes (CSNs) for the U.S. notes – giving Insurance Co. immediate liquidity

– Interest and principal are still paid on the notes, but now the investor has taken on a greater risk of financial default

Alternative Risk Transfer• Exchange Traded Catastrophe Options

– Began on the Chicago Board of Trade in 1992• Discontinued in 1999 because it lacked a viable market

• How it worked:– Speculators sold options to Insurance Companies

who were paid when the specified index of catastrophic losses reached a certain value

• E.g. Insurance Company is paid at the strike price of its contract

– Alternatively, there were put options, where Insurance Companies bought the right to sell shares to investors at the strike price

Alternative Risk Transfer

• Catastrophe Bonds (Cat Bonds)– Risk-linked securities that transfer risk to investors– Floating rate bond structure– Typically returns LIBOR plus a spread to investors– If triggered (catastrophe occurs) the principal paid

to an insurer is forgiven and used to pay claims– Appeal to investors because they are largely

uncorrelated with other assets in a portfolio– Typically rated below investment grade (BB and

B)

Alternative Risk Transfer

• Reinsurance Sidecars (or just Sidecars)– Financial structures that are created for investors to

take the risk and return of a group of policies– Insurer only pays premiums if the investors place

sufficient funds to ensure they can meet claims– Investors’ liability limited to funds they put in– Rose in popularity after Hurricane Katrina

• Raise funds from capital markets investors• Avoid existing reinsurers with past liabilities• Avoid new reinsurers with lengthy and expensive “ramp

up” period

Questions?