When the Lights Go Out.

Power outages are leading to mounting claims for insurers.

With the California energy crisis making front-page news, more insurers and self-insurers are realizing that they re not immune to the consequences of electric power reliability problems. And experts say the worst is yet to come as demand swells throughout the summer. The prospect of more frequent power outages reveals challenges, as well as opportunities, for insurers.

Power shortages and price shocks seen over the past year stem from a complex mix of factors, including power-plant fuel cost increases, a cold winter in the West, pre-planned power plant downtime, underachievement of energy-efficiency objectives, growing electricity demand, rising pollution-control costs, and a less-than-successful attempt at utility deregulation in California. Even under normal conditions, power outages cost billions of dollars annually throughout the United States--including an untold level of insurance losses--and can interfere with insurance operations, especially given the growing importance of computers and networks within the industry.

Power outages can be triggered by natural or human-induced events or by interruptions within the utility system. Outages can precipitate a variety of insurance claims, including business interruption, property damage, machinery breakdown, relocation or additional living expenses, roadway accidents caused by disrupted traffic lighting and losses by utilities for unserved energy. Insurance claims for "data losses"--due to such things as power surges--are a new and growing issue. Businesses are increasingly vulnerable to interruptions in the distribution chain, especially where just-in-time inventory management is used, and to increasing reliance on information technology. Compounding the problem, some natural hazards that trigger outages may themselves be on the rise.

One byproduct of utility deregulation could be a change in judicial attitudes regarding power interruptions from one of "absence of blame" for public utilities toward "duty of care" for customers in a competitive market. Meanwhile, as vulnerabilities increase, insurance customers are likely to demand more and new types of coverage. Insurability questions also may arise.

Given that the past is typically the basis of insurers' view of the future, insurance companies have a limited basis upon which to change their practices in the face of the worsening national power reliability situation.

Electrical equipment failures are of particular concern for insurers. Hartford Steam Boiler, which insures boilers and machinery, has observed a consistent trend toward higher losses involving electrical equipment during the summer. These include both property losses and business-interruption losses and presumably reflect the combined effects of more operating hours for cooling systems and a higher probability of power interruptions in the summer.

Data on losses specifically attributed to power interruptions are difficult to come by. Insurance regulations and ratemaking rules do not require the reporting of data at this level of detail. Property Claim Services, a division of Insurance Services Office Inc., cannot isolate major power outages in the catastrophe data it compiles, because PCS includes only the events that result in more than 1,000 claims and a total insured loss of $25 million. As a result, power-related losses are at best mixed with others, and individual events with large cumulative costs, such as lightning strikes, are not counted at all. But insurers can play an important role in collecting useful data as is evidenced by the formation of a special committee within the Industrial Machinery Insurance Association to examine the causes of increasing losses due to failures of large, oil-cooled transformers.

While business interruptions can be triggered by a range of events, electric power interruptions are responsible 70% of the time, according to one source. Losses from power outages can include direct interruption of operations, impeded ability of customers to access the business, disruption to employees or owners at home, supply-chain disruptions and damages to equipment caused by "spikes" when power is restored. Insurance losses from business interruptions are particularly awkward for insurers because the losses can continue to develop over long periods following the initiating event, and outages can result in losses hundreds of miles away.

Some of the outage-related losses are covered by conventional business-interruption policies. Certain types of losses are commonly excluded, e.g. those caused by planned outages--or "blackouts." Ironically, utility customers rarely receive notice of such outages. Even if losses are not insured, a number of large customers (New York City, San Francisco, Chicago, Boeing) have successfully sued utilities for outages. Utilities also carry certain forms of insurance to protect against lost sales during outages. For example, Duke Energy is a member of Nuclear Electric Insurance Ltd., which provides property and businesses-interruption insurance for their nuclear facilities, for losses up to several million dollars per week.

Under the broader heading of business interruption, specific "service disruption" endorsements are required to ensure that policies will cover losses associated with power outages. While small businesses rarely purchase such insurance with coverages extending to events occurring away from the customer's premises, the practice is said to be common among large companies, according to a report by the U.S. Department of Energy. Personal lines insurers are not immune. They saw considerable claims for perished food following the 1998 Northeastern ice storm.

Contingent business-interruption insurance covers loss of earnings of an insured because of a loss to another business that is one of the insured's suppliers or customers, as does "contingent extra expense" coverage in cases where production continuity is maintained but operating costs temporarily increase as a result.

In 2000, there was a legal test of the premise that computer data lost during power disruptions would be insured under business-interruption policies ("Policies Must Be Specific," Best's Review, October 2000).The case in question involved Ingram Micro Inc., which claimed that a 20-minute power disruption resulted in $4 million in lost profits. Insurers argued that this did not constitute "physical damage" as specified in the policy, but the courts ruled in favor of Ingram Micro.

There are indications that business-interruption losses are on the rise, due to both increased vulnerability and changes in the frequency and intensity of the triggering events (often weather-related). However, much prior work has focused on aggregate impacts or on other segments, rather than on impacts at the level of individual firms. In 1993, the Disaster Research Center initiated a series of surveys attempting to fill this void, with more than 5,000 businesses surveyed in the course of a series of studies. In surveys of Memphis and Los Angeles/Santa Monica it was found that 25% to 30% of the businesses carried business-interruption insurance and that about 15% of the total number of businesses had a backup electric generator. The studies generally found that the level of preparedness was low, and that the overall emphasis of risk-management efforts was more on life safety than business continuity. They also found that larger firms were more prepared than smaller ones, as were facility owners opposed to l essors. However of particular concern, the large retail and service-sector segments were found to be particularly unprepared.

Triggering Events

The following accounts illustrate the diversity of power-disruption events affecting insurers:

* Hurricane Andrew left 3 million homes and businesses without power, downing 21,100 utility poles.

* The Disaster Research Center Study found that damage and disruption to utility and transportation "lifelines" contributes significantly to disaster-related losses. During the 1993 floods in the Midwest, for example, power stations were flooded, resulting in power outages affecting 35,000 households. While 15% of the businesses experienced physical damage, 33% were without power. More than 40% of the businesses were forced to close for some period of time.

* In 1992, the Chicago River flooded into an underground tunnel system below the Chicago Loop. All businesses in the area were unable to operate due to the loss of electrical power.

* Loss of electrical power was a significant contributor to the dollar losses experienced following the Northridge earthquake, according to a report by the International Institute for Applied Systems Analysis. More than 2 million customers were without power. Nearly 80% of Los Angeles' businesses reported experiencing some degree of business interruption, of which 68% was nonstructural. Business-interruption losses amounted to $6.5 billion. About $1.5 billion, or 11% of the total insured loss was business interruption, according to the Institute for Business and Home Safety. Physical damages to lifelines--power, gas, water systems--were estimated at $2 billion.

* Citing rapid growth in personal computer usage, power failures and surges account for more than 45% of computer data losses.

* Hartford Steam Boiler Inspection & Insurance Co. sees an average of $15 million in claims each year from voltage spikes created when power is restored.

Natural Causes

Natural disasters play an important role in electric power disruptions, particularly lightning, geomagnetic storms, floods, earthquakes, ice storms and windstorms.

Following Hurricane Andrew in 1992, about 20% ($8 billion) of the total insured and uninsured losses were related to business interruption. And analyses of a potential magnitude-6.8 earthquake along the Newport/Inglewood Fault Zone in Southern California have pegged business-interruption losses at 41% of the total $80 billion nationwide economic loss, according to a report prepared by the School of Urban and Regional Planning at the University of Southern California.

Swiss Re reports $5 billion to $6 billion in lightning-related damages annually, including "loss of electronic equipment due to power surges and problems with electric power grids." St. Paul Insurance Co. reported paying an average of $332 million in lightning-related claims annually between 1992 and 1996. One report from the Department of Energy states that of the lightning-related losses experienced at its own facilities, 80% were due to voltage surges.

Insurance risks posed by geomagnetic storms include electronic equipment failure, spacecraft and satellite damages, aviation accidents, telecommunications breakdown, corrosion in oil and gas pipelines, disturbances in railway signaling systems and damage to transformers in utility grids. Events with major effects on utilities occurred in 1940, 1958, 1972, 1982 and 1989. According to a study by Swiss Reinsurance Co., the 1989 event caused a nine-hour power cut in Quebec, affecting 6 million customers.

Extreme Weather on Rise

A recent article in Science magazine and a major study by the United Nations' Intergovernmental Panel on Climate Change have reviewed the current and projected dimensions of extreme events. Leading researchers in the field noted that the frequency and intensity of many such events have been increasing and are expected to continue to increase. Included are average summertime peak temperatures, extreme temperature episodes and heat waves, extreme precipitation events and more intense and more frequent El Nino events. Notably, climatologists predict a significantly increasing incidence of heat waves and lightning strikes if average temperatures increase. Whether such trends are due to human-induced global climate changes or to natural variability in the climate system, the potential implications for electric system reliability are significant.

Risk-Management Strategies

Insurance loss-prevention techniques range from financial instruments (e.g., through insurance premium structure, deductibles, reinsurance, residual market mechanisms or alternative risk-transfer mechanisms) to engineered risk management (e.g., backup power systems) to continuity planning to keep businesses running.

Following are three examples of innovative insurance products designed to address power outages, while managing the risk (exposure) assumed by the insurer:

* In 1999, Chubb introduced a bundled machinery-breakdown and service-interruption product (ESP Select) with limits up to $200 million. Data loss is included in the coverage.

* Great Bay Power Corp., a Portsmouth, N.H.-based energy company, bought a "double-trigger" insurance policy from the former Cigna Property Casualty (now part of Ace Ltd. in Bermuda) .The insurance kicks in when there is both an unscheduled outage at the Seabrook nuclear plant causing it to shut down and a hike in the spot price of electricity above a strike point.

* FirstEnergy Corp.--an Akron, Ohio-based holding company--bought a double-trigger insurance policy from Ace USA Power Products. The insurance triggers when a power outage resulting in more than 600 MWh of lost power and a spot market price exceeding $74 per MWh occur in tandem. In the summer of 1999, both triggers were pulled, but the loss fell below the company's $25 million deductible.

A variety of technological risk-management tools also are available, and insurers have played varying roles in their deployment. Examples include building codes that improve disaster resilience, promotion of backup power capabilities and wireless earlywarning systems. Insurers can award premium discounts as incentives to insureds to implement such tools.

Insurers have played a role in standardizing risk-management technologies, as is exemplified by the Industrial Machinery Insurers' Association Risk Classification of Electrical Surge Protection Devices.

In some cases, insurers have explored potential risk-reduction benefits associated with energy-efficient and decentralized renewable-energy technologies. There is a cross-cutting "inherent" benefit insofar as these technologies reduce energy demand and thus the needs for backup power. This is exemplified by the temperature-retaining benefits of high-efficiency refrigeration systems containing valuable perishables, such as pharmaceutical supplies. And light-emitting diode, or LED, traffic lights require 95% less power to operate than traditional ones.

Disaster preparedness and post-event recovery are critical to any loss-control strategy, and many insurers provide products and services in this area. Insurer organizations, such as the Institute for Business and Home Safety, have engaged in business-continuity discussions through their participation in Electric Power Research Institute's Disaster Recovery Business Alliance. EPRI's Disaster Planning and Mitigation Technologies has focused on prompt restoration of electrical power as part of the disaster-recovery process.

Solar photovoltaic systems can help avert business interruptions caused by power outages. Photovoltaic-backup power systems were used to power communications systems, street lights and other loads in the aftermath of Hurricane Hugo, Hurricane Andrew and the Northridge earthquake. Highlighting the vulnerabilities of insurance operations to power outages, the American Modern Insurance Group is testing a photovoltaic-powered mobile office for processing claims following disasters.

Novel Partnerships

As society becomes more dependent on electricity and electronic-communications systems, insurers will encounter growing interest in electric reliability issues. Meanwhile, utilities are actively growing their risk-management offices, spurred in part by utility deregulation.

While this trend has to do mostly with diverse market and financial risks as regulated franchises disappear, it also reflects new risks associated with power reliability. Insurers inevitably will seek to cultivate new business opportunities based on providing appropriate loss-prevention services, perhaps in partnerships with the utility industry or other players in the energy sector.

There is considerable scope and precedent for this. As a case in point, fuel-cell vendor Sure Power has bundled a high-reliability fuel-cell system with business-interruption insurance underwritten by American International Group. The system was installed at a data center of the First National Bank of Omaha, Neb.-- the country's largest independent bank and seventh-largest credit-card processor.

In another development, the risk-management unit of Enron recently acquired Integrated Process Technologies, a former subsidiary of Hartford Steam Boiler Insurance & Inspection Services. This brings together a unique mix of talent in risk management and energy management at Enron.

Evan Mills is a staff scientist with the Lawrence Berkeley National Laboratory, Berkeley, Calif. A forthcoming study upon which this article is in part based was sponsored by the Electric Power Research Institute, Palo Alto, Calif.

Severe Weather Impact on Daily Utility Operations
Frequency and intensity of severe weather events are expected to
increase.
Storm Date  Storm Type          Total Customer Outages     Cost
May 1989    Tornadoes                  228,341          $15,189,671
Sept. 1989  Hurricane Hugo             568,445           64,671,150
1990        *All storms                                     753,805
March 1993  Wind, ice and snow         146,436            9,176,203
Oct. 1995   Hurricane Opal             116,271            1,655,350
Jan. 1996   Western N.C. Snow           88,076              872,585
Feb. 1996   Ice storm                  660,000           22,905,627
Sept. 1996  Hurricane Fran             409,935           17,471,826
(*)1990 is used as a typical year without any major storms. Dollar
amounts are the total restoration costs in labor and materials for
all weather-related events throughout the year.
Source: Duke Power Co.

Cause and Effect

Events that result in power interruptions and costs to electricity consumers also affect utilities. In many cases the resulting losses are insured. Some examples follow:

* 1968 and 1999: Losses experienced by public utilities in Canada totaled 14% of total natural disaster losses nationally, according to Emergency Preparedness Canada.

* 1989-1994: Losses involving 75 large oil-cooled transformers resulted in $55 million in insured losses, of which property losses were $20 million and business-interruption losses were $35 million, according to the Industrial Machinery Insurers' Association.

* March 13, 1989: A geomagnetic storm resulted in a nine-hour blackout, affecting 6 million Hydro Quebec customers. The same storm affected power systems in Sweden and England.

* 1998: The North American Ice Storm of 1998 provides a dramatic example of the impacts of ice storms on utilities, according to Canada's Institute for Catastrophic Loss Reduction. According to Emergency Preparedness Canada, electric outages in the affected areas of Canada deprived 16% of the Canadian population of power, and 19% of the work force was unable to get to work. In Canada, 130 transmission towers and 30,000 distribution poles were toppled, and damage to the transmission system was 1 billion. Notably in early 2001, a group of insurers brought a $200 million suit against Canadian utilities for being ill-prepared for the event.