Managing catastrophic risk: getting beyond the insurance crisis; The incidence of catastrophic risk has increased markedly, and insurance rates have risen with it. Some companies are re-examining the issue of self-insurance or even doing without and using their equity base to cover potential risks.

It probably won't come as a surprise to the average reader of the day's headlines, but statistically, the world is getting riskier--and insurance scarcer. "I think there is a crisis," says Robert Muir-Wood, chief research officer of Risk Management Solutions (RMS), one of the leading risk modeling firms.

Eighteen of the 20 costliest catastrophes since 1970 have occurred after 1990, and 10 of them after 2000. Risk modeling firms have raised their estimate for the frequency of hurricanes, and the more intense storms are increasing more than less intense storms. RMS's estimate of the loss from a 100-year storm has risen almost 50 percent, Muir-Wood says, from $70 billion to $105 billion. One reason: economic demand surge, that is, the rise in prices for materials and labor that people need to make repairs

There are also brand new sources of risk to consider. Ten of the world's 15 most deadly terrorist attacks came after 1993, and avian flu has focused new attention on the risk of a pandemic.

Not only are catastrophes happening more often, they're causing more economic damage when they do. The U.S. population continues to move to areas prone to disaster, so there are more people and assets at risk. "The five fastest-growing states are five wildfire states in the American Northwest," says James C. Schwab, senior research associate at the American Planning Association. Over half of the U.S. population lives in coastal regions, and the population density of the hurricane-prone Southeast has grown much faster than that of the nation as a whole.

Moreover, new business models that place more reliance on global supply chains suggests more economic vulnerability to catastrophes than ever before. According to the U.S. Department of State, most U.S. terrorism targets are businesses. "My concern would be that the loss of critical skill sets anywhere in the world could paralyze us from an economic and social standpoint," says Gary Lynch, global leader of Risk Intelligence Strategies and Resiliency Solutions in insurance broker Marsh Inc.'s Risk Consulting practice.

The loss of skilled engineers, capital markets decision-makers, cleared personnel in the defense industry, even the highly trained operators of cranes in container shipping ports could cripple a company and bring a supply chain, or in some cases even a whole region, to an economic halt, Lynch suggests.

Much of the new risk is not insurable. There is, for example, no insurance against a pandemic (although workers compensation could cover some of the damage). Even for traditionally insurable property and casualty risks, insurers and reinsurers are cutting capacity and raising rates.

In hurricane territory, especially Florida and the Gulf Coast, companies confront astronomical premiums for minuscule coverage amounts "In 2005, we had $1.2 billion in coverage with a $60 million deductible and paid $4.5 million in premium," says Bill Wheatley, treasurer of Florida's Memorial Healthcare System. "In 2006, we could only get $100 million in coverage, for a $100 million deductible, and were quoted $12.5 million in premium."

Memorial opted to go without coverage in 2006. It wasn't alone. Jerry McAloon, senior vice president of Aon Natural Resources, says, "As we went into the 2006 season, there was simply nowhere the capacity available at any price, as had been available in previous years, and the capacity that was available was at many multiples of what it had cost in prior years. So, most companies simply had no choice but to do without."

That sounds like bad news, but in fact it might be good news for shareholders. The new environment is forcing companies to re-think their approach to risk management. "We saw our premiums jump exponentially for property and windstorm, and retentions thrown at us that took our breath away," says John Phelps, director of risk management for Blue Cross and Blue Shield of South Florida Inc. "One of the things we learned from that was that we need to reduce our reliance on insurance as a solution."

In fact, there's a strong case to be made that, at least for larger public corporations, going without catastrophe insurance may be the best approach from a shareholder value perspective. "It's important to start out by recognizing that the corporate firm, in and of itself, is an incredibly effective risk management mechanism," says Clifford Smith, a professor of business administration and finance and economics at the Simon Graduate School of Business, University of Rochester. "Corporations can take on risks that individuals have a harder time managing." Smaller entities are also finding ways to manage risks effectively without insurance.

The Case for Going Bare

Smith co-authored a study of energy giant BP plc's risk management approach, published in 1993 in the Journal of Applied Corporate Finance. The study is timely now because BP, despite its recent, well-publicized catastrophes in Alaska and Texas, has reviewed its approach and decided to stick with self-insurance.

Essentially, BP has turned traditional thinking about insurance inside-out, and decided to purchase insurance against small losses, but to self-insure against large, catastrophic ones. The textbook approach to insurance is just the opposite--to self-insure against small losses but purchase insurance against big ones. In the current insurance climate, BP's unorthodox approach merits serious consideration by other companies.

Perhaps unorthodox is the wrong word. There isn't much orthodoxy about purchasing insurance, and reasons for buying insurance are often not defined in financially orthodox cost-of-capital or shareholder value terms. Managers may buy insurance for cosmetic, rather than economic reasons.

"There are many and varied reasons for buying insurance, even for large corporations," says Aon's McAloon. "If you're buying to protect earnings, you might buy differently than if you're looking to protect cash flows. Sometimes you buy it not because the financial statements need it but because you have obligations, mortgages or project financing where it's a requirement. Sometimes, even for the largest companies, it's psychological--the CEO doesn't want to look at a TV camera and say, 'We didn't insure.'"

Whatever the reason, there's good reason to believe that insurance against small losses can be a better deal for shareholders than insurance against catastrophes. Small losses often stem from commonplace events, such as accidents, fires and equipment breakdowns. They happen frequently, and independently of each other, so the law of large numbers comes into play, and the insurer can reliably predict annual losses and set a premium that will cover them.

With that, the market for this kind of insurance is competitive, with low barriers to entry and low rates. Companies that buy insurance against small losses can benefit from insurer advice on preventing losses, and on insurer expertise in settling claims. They can also be reasonably confident that insurers will pay rather than dispute a claim. In short, they get their money's worth.

That's not the case with catastrophic losses. They don't happen often enough for the law of large numbers to work. What's more, the catastrophe claims are highly correlated and hard to predict. Insurers don't have the same depth of actuarial records for catastrophic risks as they do for, say, fires, so they have turned to statistical modeling to predict losses. But in several recent catastrophes, the models were wrong.

Models Missed the Mark

Gary Kaplan, chief underwriting officer for Zurich North America Commercial, says of the 2004-2005 hurricane season, "we found that some aspects of the model were pretty far off." Models underestimated how much prices for materials and labor would rise after the storm. They also underestimated the damage to building contents. Forecasts "were not as accurate as we thought" about how various types of buildings would hold up in storms.

Model-makers such as RMS and insurers like Zurich have certainly adjusted their models to include what they have learned. Nonetheless, skepticism about models lingers. Phelps of Blue Cross and Blue Shield of Florida says, "Modeling with short-term history produces results with minimal credibility. Over 20 years, it becomes more accurate, and over a hundred years, it becomes very accurate. But how do you price today for next year's risk when you have modeling that has questionable credibility in the short term?"

Uncertainty about risk magnifies the risk. Because insurers charge for taking risks, they charge more to take unpredictable risks than they charge to take fairly predictable ones. They can charge much more than they need to cover risks.

During the decade ending in 1989, Smith and his co-author wrote, BP paid over a billion dollars in premiums and collected only $250 million in claims. Insurers are, of course, happier to collect premiums than to pay claims. In one large liability claim, it took BP years and an estimated $1 million in legal costs and management time to collect only 70 percent of the claim.

Sometimes, members of the Lloyds syndicate have sued under-writers for malpractice in order to avoid paying claims. Bruce Jeffries, managing director of Aon Natural Resources, says, "Every single large claim has had lots of very important discussions." In the case of refineries shut down by Hurricane Katrina, insurance companies have argued they ought not to have to pay damages because the shutdowns helped drive up gas prices, and the companies made more money than they would have been if there had been no storm.

Smith conjectures that large claims are so infrequent that insurers risk little reputation capital from disputing them. Of course, in some cases, a large claim may push an insurer into insolvency, at best limiting the ability of the policyholder to recover.

So, all in all, the fact that big companies may have trouble buying insurance against catastrophic damages may be a blessing in disguise. Investors can diversify away the risks of a catastrophic event hitting one stock, so they don't reward management for buying insurance. "Equity in the capital structure is a very effective risk management mechanism," says Smith. "Debt is inherently a less flexible source of capital than equity, and the flexibility of equity is particularly valuable the more uncertainty there is in the environment."

BP understands its own operations better than any insurance company, and therefore has a comparative advantage in self-insuring catastrophic losses using its equity cushion. In 2005, a refinery explosion at BP's Texas City, Texas plant claimed 15 lives, injured 170 and reportedly led to over 1,000 lawsuits, not to mention $21 million in regulatory fines for safety violations. In March 2006, a hole in a corroded BP pipeline in Prudhoe Bay, Alaska caused a 5,000-gallon oil spill and incalculable damage to BP's brand.

Yet, BP hasn't flinched from its go-bare approach to major risks. A spokesman says, "Our approach to insurance remains essentially unchanged from the early '90s, in that we carry major risks ourselves. The size and breadth of the company--particularly in terms of geography and diversity of business streams--provide the hedging capability we believe we need. At the same time, we believe we continue to have a deeper understanding around the 'risks' of our core business--energy--over those outside the industry."

The Case of Memorial Healthcare

Faced with sharply increased premiums and cutbacks in the amount of insurance available to them, smaller companies are also sharpening their understanding of catastrophic risks and devising new approaches. Memorial Healthcare System, based in Southeast Florida, found in 2006 that it could buy less than 10 percent of the coverage previously available--yet that 10 percent would cost almost triple the previous premium. Not only did Memorial decide to go bare in 2006, it began to lay the groundwork for a captive that would allow hospitals to pool risks and finance their steeply higher deductibles.

Memorial is working with RMS, the same modeling agency that works with insurers. The three-tiered program will cover, first, the traditional deductible of 3 percent of the total insured value; then, in tier two, a loan facility of 2 percent of the total insured value; and, finally, a risk pooling arrangement in which each participant would agree to share in the other participants' risks, based on their degree of risk.

Memorial treasurer Wheatley expects to see his system's comparable premiums fall from $12.5 million to $7 or $8 million. "We're creating a mechanism that provides a significant amount of financing and liquidity, up to 7 percent of total insured value, to augment the existing resources of the hospital systems," Wheatley says. "One of the reasons that the premium is less is that we don't have the same expense load and profit requirement that property and casualty companies do. We may be able at our company to price at something very close to the pure risk level."

The model assesses the risk of each hospital participating in the program, and weights premiums accordingly. Diversification will help Memorial and other participants reap savings. So will risk reduction. In the current tight insurance market, companies in Florida and the Gulf region complain that they don't get premium discounts for agreeing to retain more risks, or even for reducing their risks by, for example, taking precautions against hurricanes.

"If you're in a certain ZIP code, it doesn't matter if you're a stick frame built in 1940 or reinforced concrete," says an executive with a Gulf Coast building company. But Wheatley says that Memorial is "hard-shelling" two of its hospital campuses so they'd be able to withstand at least a Category 3 storm, and expects to be able to factor the mitigation into its premium.

Business Resiliency

However, insurance only goes so far. Brian Jemelian, CFO of Yamaha Corp. of America, based in Buena Park, Calif., says, "We do carry business interruption insurance, which covers lost profits as a result of an interruption. What is not covered, however, is lost future business, lost market share or lost dealer shelf-space."

About five years ago, the threat of uninsurable losses led Yamaha to focus on business continuity in the event of a disaster. A business impact analysis assessed the loyalty of every one of Yamaha's customers, and concluded that while some would stick with the company despite the interruption, others would not.

Yamaha established a Corporate Emergency Response Training (CERT) program, a four-day course that 18 percent of its workforce has attended. It secured its computer equipment in a bunkered facility able to handle a severe earthquake. It designated an alternate location to work from in the event of a disaster, established an emergency management team and got divisions and manufacturing facilities on board to develop their own business continuity plans.

Although Yamaha hasn't suffered a severe business interruption, Jemelian says it has already reaped benefits from the plan. "My biggest surprise was the boost in morale that came from the CERT program," he says. "Folks were sending emails to the president saying how thankful they were. It was truly a demonstration that employees do come first."

Process improvements have resulted from the company centralizing what used to be 40 databases into one content management system accessible on the Web, from imaging records and from putting cash management functions online.

Toyota Motor Sales USA has a similar program, and Business Continuity Manager Janet Mebust, CBCP, says that "for every dollar we spend, we're saving seven dollars in recovery costs." In Hurricane Katrina, when a credit corporation office in Baton Rouge lost phone service, Toyota flew in satellite phones. When the team relocated to Houston and had trouble finding hotel space because of the flood of New Orleans residents who had been evacuated there, Toyota learned a lesson. As Hurricane Rita later veered toward Houston, the Houston employees made hotel reservations in Dallas a few days before the storm hit, so they could continue to operate at their sister office there.

Marsh's Lynch recommends that companies look at risk holistically, but focus on how the company really creates value, rather than on the specific nature of the threat. A manufacturer of flooring operates in a competitive environment, with many manufacturers. "The manufacturing process isn't what they're concerned with, because they can outsource to competitors if manufacturing fails," he says. "It's the relationships with buyers they really want to protect."

Often, companies are not aware of the risks that could shut them down. "In the U.S.," Lynch says, "50 percent of our energy is generated by fossil fuel, but 66 percent of the fossil fuel is shipped by railroad. So, the utilities are dependent on railroads, and I question their level of supply chain diligence."

Some companies have recognized that their own business continuity depends on the business continuity of suppliers. One firm with long lead times and sole-source suppliers in the area hit by Hurricane Katrina weathered the storm well because it had proactively worked with suppliers to help them develop business continuity programs, and had even sent its own team out to help the suppliers recover after the storm.

According to Lynch, the head of supply chain at the company said, "We're not in the business of funding their business continuity, but we are in the business to survive. If we don't think beyond contracts and litigation, we'll fail." In other cases, risks to suppliers have led companies to consider acquiring the suppliers, or withdrawing altogether from the businesses that depend on them.

Howard Kunreuther, professor of Decision Sciences and Business and Public Policy Co-Director, Risk Management and Decision Processes Center at the Wharton School, University of Pennsylvania, says, "Insurers are reluctant to provide the kind of coverage they have in the past, unless they have to, for example, when the state requires them to in order to do other business."

One of the most dramatic ways for companies to adapt to this fact is to simply rely on the equity base to self-insure; for large and well-capitalized firms, this may be the most financially rational strategy. For those whose debt covenants mandate insurance, and for small businesses, self-insurance may not be an option. But Robert Hartwig, chief economist of the Insurance Information Institute, thinks that it's a stretch to call the current environment of high prices and limited capacity a "crisis."

From 1991-2002, U.S. property and casualty insurers weren't even able to earn their cost of capital. But they began to do so in 2003, and in 2006, net income for property and casualty insurers was a record-shattering $57 billion. "As the price goes up, there are new entrants willing to take the risk, but only when the return is sufficient. In the wake of Katrina, $10 billion was raised by startup companies writing policies or the reinsurance behind them. They put up money at very considerable risk in 2006, and it turned out for them, because nothing happened," Hartwig says.

Perhaps what lies beyond the insurance crisis may be a combination of increased supply and reduced demand for insurance, as companies respond to the current environment by various forms of self-reliance and risk mitigation. As demand and risk fall, so could rates. The worm may yet turn--the insurance business is, after all, cyclical.

Gregory J. Millman ([e-mail]) is a freelance writer in New Jersey and a frequent contributor to Financial Executive.

RELATED ARTICLE: takeaways

* Not only are catastrophes happening more often, they're causing more economic damage when they do. This has created predictable concerns for insurers, and for their customers.

* Huge increases in premiums and deductibles, especially in the areas hit hard by the 2005 hurricanes, have spurred quite a few companies to "go bare," or operate without insurance.

* One of the most dramatic ways for a company to adapt to the cost and scarcity of catastrophic risk insurance is to simply rely on its equity base to self-insure. BP plc is a good case in point.