Tag Archives: accurate ratable business interruption values

San Andreas — The Real Horror Story

For the past two weeks, the disaster movie “San Andreas” has topped the box office, taking in more than $200 million worldwide. The film stars Dwayne “The Rock” Johnson, who plays a helicopter rescue pilot who, after a series of cataclysmic earthquakes on the San Andreas fault in California, uses his piloting skills to save members of his family. It’s an action-packed plot sure to keep audiences on the edge of their seats.

As insurance professionals who specialize in quantifying catastrophic loss, we can’t help but think of the true disaster that awaits California and other regions in the U.S. when “the big one” actually does occur.

The real horror starts with the fact that 90% of California residents DO NOT maintain earthquake insurance. The “big one” is likely to produce economic losses in either the San Francisco or Los Angeles metropolitan areas in excess of $400 billion. With so little of this potential damage insured, thousands of families will become homeless, and countless businesses will be affected – many permanently. The cost burden for the cleanup, rescue, care and rebuilding will likely be borne by the U.S. taxpayer. The images of the carnage will make the human desperation we saw in both Hurricane Katrina and Superstorm Sandy pale by comparison.

The reasons given for such low take-up of earthquake insurance generally fall into two categories: (1) Earthquake risk is too volatile, too difficult to insure and, as a result, (2) is too expensive for most homeowners.

Is California earthquake risk too volatile to insure?

No.

The earthquake faults in California, including the Hayward, the Calaveras and the San Andreas faults. are the most studied and understood fault systems in the world. The U.S. Geological Survey (USGS) publishes updated frequency and severity likelihood every six years for the entire U.S. This means that estimation of potential earthquake losses, while not fully certain, can be reasonably achieved in the same manner that we can currently estimate potential losses from perils such as tornados and hurricanes. In fact, the catastrophe (CAT) models agree that it’s likely that on a dollar-for-dollar exposure basis, losses from Florida hurricanes that make landfall are more severe and more frequent over time than California earthquakes, yet nearly 100% of Florida homeowners actually maintain windstorm insurance. If hurricane risk in Florida isn’t too volatile for insurers to cover, then earthquake risk in California should follow that same path.

Isnt earthquake coverage expensive?

Again, the answer is a resounding no.

The California Earthquake Authority (CEA), the largest writer of earthquake insurance in the U.S., has a premium calculator that quotes mobile homes, condos, renters and homeowners insurance. For example, a $500,000 single-family home in Orange County, CA, can be insured for about $800 a year, or roughly the same price as a traditional fire insurance policy. To protect a $500,000 home, an $800 investment is hardly considered expensive.

The real question should be: Are California homeowners getting good value? CEA policies carry very high deductibles — typically in the 10% to 15% range — and the price is “expensive” when the high deductibles are considered. As one actuary once explained it to us, “With that kind of deductible, I’ll likely never use the coverage, so like everyone else I’ll cross my fingers and hope the ‘big one’ doesn’t happen in my lifetime.”

It’s this lack of value that’s the single biggest impediment preventing millions of California homeowners from purchasing earthquake insurance. It’s also an area that has much room for improvement.

How can we as an industry raise the value proposition of earthquake coverage? Consider the following:

  1. The industry can make better use of technology, especially the CAT models. California is earthquake country, but it’s also a massive state. This map shows that the high-risk areas mostly follow the San Andreas fault and the branches off that fault. There are many lower-risk areas in California, and the CAT models can be used to distinguish the high risk from the low risk. Low risk exposures should demand lower premiums. Even high-risk exposures can be controlled by using the CAT models to manage aggregates and identify the low-risk exposure within the high-risk pools. We expect that CAT models will help us get back to Insurance 101 by helping the industry to better understand exposure to loss, segment risks, correct pricing, manage aggregates and create profitable pools of exposure.
  2. The industry can bundle earthquake risks with other risks to reduce volatility. Earthquake-only writers (and flood as well) are essentially “all in” on one type of risk, to steal a common poker term. Those writers will fluctuate year to year; there will be years with little or no losses, then years with substantial losses. That volatility affects retained losses and also affects reinsurance prices. Having one source of premium means constantly conducting business on the edge of insolvency. Bundling earthquake risks geographically and with other perils reduces volatility. The Pacific Northwest, Alaska, Hawaii and even areas in the Midwest and the Carolinas are all known to be seismically active. In fact, Oklahoma and Texas are now the new hotbed regions of earthquake activity. Demand in those areas exist, so why not package that risk? Reducing volatility will reduce prices and help stabilize the market. We estimate that in parts of California, volatility is the cause of as much as 50% of the CEA premium.

Hollywood has produced yet another action-packed film. But to add a touch of realism, Hollywood screenwriters should consider making the leading actor, The Rock, a true hero – an “insurance super hero” who sells affordable earthquake insurance.

Checklist to Prepare for Business Interruption

Business interruption (BI) losses are among the most confusing types of claims in the insurance industry. As claim specialists, we are often asked for a “checklist” filled with action items for when a loss occurs. A “checklist” isn’t practical because there are too many variables and “if/then” scenarios to map out. When you have a significant property damage and business interruption claim, only experience can guide the way to a fair recovery.

However, there are actions that can be taken ahead of a loss to ensure you are prepared. The following seven items represent such a “checklist.” It will not only help with your next loss but can have an immediate benefit to your risk management program.

1. Prepare accurate ratable business interruption values

The annual ritual of preparing the business interruption worksheet is often treated as an administrative nuisance.  It should be looked at as an opportunity to accurately account for the insurable risk for which you pay your premium and to accumulate annual values for future trending.

The worksheet provided by the insurance company is woefully inadequate to explain the nuances of most businesses. Go beyond the worksheet and explain your business more completely to underwriters. For an effective BI values methodology, solicit help from the specialists, such as an experienced forensic accountant. The results will be appreciated by underwriters and should translate into more appropriate coverage and possibly a more favorable rate. Once a system is in place, accuracy, consistency and efficiency should be improved.

2.    Analyze exposure scenarios and calculate MFL and PML

Once the ratable BI values are calculated, policyholders should explore realistic loss scenarios. The BI value is an annual number that does not factor in real-life responses that would generally mitigate a claim. To get to the actual exposure to risk, companies should determine the maximum foreseeable loss (MFL) and probable maximum loss (PML) measurements. The MFL measures a “worst case scenario” in which all of the loss-control protections fail. The PML is the more realistic loss scenario, in which mitigation systems work and contingency plans are executed properly. In both cases, the property damage and business interruption effects would be calculated as if they had occurred.

Loss scenarios should be postulated in detail, e.g. by location and by occurrence, considering all factors. These numbers should not be measured by simply applying a daily “BI rate” to an engineered loss period. It is more realistic to prepare as if presenting a claim, exploring all “what if” possibilities. Insurers may offer some assistance in this process, but remember, their version will be from their perspective. As with any claim, you should always prepare your own scenarios and your own calculations according to your understanding of your operations. An independent forensic accountant will have prepared claims just like your scenarios and would be able to accurately value the losses.

3.   Analyze contingent risks

Concurrent with the MFL and PML analysis, you should work to understand contingent risks to your business. Knowing what your suppliers’ and customers’ exposures are is important. Policyholders should involve leaders in operations, procurement and sales to help identify contingent exposures. If you have a sole supplier, your contingent exposure may be greater than anticipated and should be examined.

It is important to understand how your current policy language would respond to the contingent loss scenarios you’ve identified. For example, if suppliers in your policy are referred to as direct supplier,” make sure you understand how this would be interpreted in a claim. If “direct” means only those suppliers with whom you have a direct contract, and an indirect supplier, i.e. a second-tier supplier, has a loss that affects you, would you be covered? These scenarios should be discussed with your broker and underwriter to ensure your policy will respond as expected.

Once the values and scenarios are updated, you will be better able to make informed decisions about your insurance coverage, limits and terms.

4.    Business interruption vs. extra expense

Another common discovery from performing an exposure analysis is which type of time element coverage is the best risk transfer solution. Considering each location, if the risk is a lost of sales, BI would cover the lost earnings. If sales are not the risk or they can be sustained at an extra expense, extra expense coverage would be more appropriate. If sales are at risk but can be mitigated to the degree contingency measures are enacted at an additional expense, it’s a combination loss exposure.

It’s of value to risk managers to know what the exposure truly is because, if an exposure can be covered by extra expense coverage, it may eliminate or reduce the need for BI insurance. For example, if you are a distributor with multiple warehouses whose inventory is insured at selling price, what’s at risk? If you have alternative space or can quickly secure temporary space, the likelihood of experiencing a sales loss that exceeds the sales value of your lost inventory is remote. How much BI coverage should you buy vs. extra expense? Exploring your loss scenarios and subsequent contingency plans would allow you to better quantify your risks and select the option best suited to your needs. Extra expense is a more “tangible” risk than BI, making it easier for underwriters to rate, and it generally will cost less.

5.   Gross earnings, gross profit and business income

The names are different, but the intent is the same – to protect earnings lost because of damage or loss of use of insured property. The history of each of these forms would take a separate paper to detail, but, in a nutshell, gross earnings is a form commonly used in the U.S. with a basis in manufacturing risks, while gross profit is used throughout the world and has its basis in mercantile operations. Business income is the term used for the current ISO forms. Today, all forms have been modified to accommodate almost any business — however, there are some situations where one form may be preferable. The terminology and the mechanics of calculating business interruption loss varies among the forms, but the answer should be the same, regardless.

The exception to this has to do with the period of indemnity — the gross profit form is usually limited to a specific time, while gross earnings will continue until repairs are (or should be) completed with “due diligence and dispatch”; there is the ability to add an extended period to recover sales. It is important to make sure the form you have would cover your potential loss period. For example, if you have a manufacturing company with specialized production equipment that have long lead times to replace — longer than the period that a gross profit form would cover — you should probably have a gross earnings form. If you do not see a scenario that would exceed the gross profit period and you cannot accurately predict an extended period required to add to gross earnings, the gross profit might be a better option. If there isn’t any scenario that would create a loss that exceeds the gross profit period of indemnity and you are comfortable that you can cover that time to recover sales, than either form would work. There are new options that allow you to pick which form you would like to use up until the closure of a claim — these forms eliminate the need to determine which form is right for your business. Just make sure you have a form that will cover your worst-case scenario.

6.   Professional fees coverage

Most policies now include professional fees coverage. Insurers recognize the need for dedicated claim preparation experts and are willing to pay for it as part of the claim. Often, this coverage is subject to limits that can be negotiated. If you are not familiar with this coverage or do not have it, you should discuss with underwriters. For the most part, this coverage can be included at some level just by asking. The benefits of having specialized claim preparation experts available as a resource for a claim can make the difference between a successful claim and a headache.

7.  Organize your claim team

In addition to forensic accountants, a claim may include forensic engineers, attorneys and others. It is a good idea to know those you want to use before needing their services. Meet with the various providers beforehand and select those that fit best for your organization. Typically, paperwork associated with hiring someone can be completed before needing their assistance (i.e. non-disclosure, purchasing, W-9, etc.) so that if something happens they can begin work immediately. Additionally, there may be an opportunity for the provider to help with reporting issues on business interruption values.

While no business wants to suffer a loss of earnings, the more prepared you are the better the results will be. The steps shown above may take years to fully develop and should be evaluated annually to account for changes to your business.

If these recommendations are incorporated into your insurance program, there’s no need for a claim checklist. Your risk management team will be prepared for any worst-case situations with the best-case solutions.