Understanding Catastrophes

Cost of Hurricane Katrina

Recent natural and man-made catastrophes are mandating that business recalibrate risk. This is because ‘worst cases’ are being exceeded all around us.

Japan’s earthquake has reverberations both in buildings in Tokyo and auto plants in Kentucky. The recent Thai flooding upset supply chains around the world in many industries. Australia’s floods and fire stagnated its economy. The oil industry takes a step backward following a mammoth platform disaster. The future of the nuclear industry, seen a short time ago as an answer to the scarcity of fossil fuels, its itself now in question. The auto industry, as if its just-in-time supply chain worries weren’t enough, must also grapple with product recall disasters that damage the reputation of its leading brands.

This recalibration comes none too soon, because many and perhaps most leaders in government and industry do not appreciate the likelihood that a catastrophe will hit them in the near future.

Catastrophes are not Rare

Natural catastrophes are often described as ‘1 in X year events’ — for catastrophic winds the convention for an intolerably strong event is 1 in 100 years; for floods it is 1 in 200…and for earthquakes 1 in 500 years. But ‘1 in 500 year’ earthquake suggests that the event has a 0.2% probability of happening within the next year.

This may be helpful to insurance companies as they allocate risk on the annual insurance policies they write, but it is extremely misleading for corporate and government leaders because these figures suggest that catastrophes are rare events – they are nothing of the sort.

A much more relevant way to describe the risk to an organization with exposure to natural catastrophes would be:

‘There is a 30% chance that you will be hit by at least one catastrophic flood, windstorm, or earthquake in the next 20 years.’

That’s the way the math works, and it certainly feels more like the way the world works. As additional perils are considered, both natural and man-made, the chance that an organization will be hit by a catastrophe approaches a certainty.

Extreme Reversals of Fortune

To test this point for the corporate world, we evaluated extreme reversals of fortune of 600 of the world’s largest companies during the last 20 years. We found that these ‘corporate catastrophes’ are disturbingly frequent. A major company will, on average, suffer a sudden and steep reversal in its fortunes that is not systemic to the broader market once in seven years.

The reasons behind these falls range widely – from failed international expansions, to rumours of plant contamination, to declines in gate receipts due to the 9/11 attacks, major oil spills, nationalizations, etc.

Only 5% of the companies we examined came through the 20 years without a single market capitalization crisis. Liquidity usually suffers in these events, as credit windows close while the company tries to regain the confidence of its stakeholders. Many chief executives hold reserves on their balance sheets to help survive these events. This is very expensive insurance in that it prevents this cushion from being deployed to grow the business, but at least these companies recognize the fundamental certainty of catastrophes.

Many other leaders do not recognize the risk. They seem to buy into the ‘1 in 200 year’ approach, and this view is consistent with high leverage levels. The ongoing financial crisis is an obvious example of organizations that got the odds of extreme reversals tragically wrong.

Have we Learnt our Lessons?

So natural and corporate catastrophes are the most uncommon of common events. They are exceptional, but only in their severity – they happen frequently enough that we ought to be well prepared for them. One of the main shocks of Japan’s tsunami and nuclear nightmare is that they were as well-prepared as any society for a massive earthquake, but their worst case was not nearly bad enough. Will we learn from this continuing disaster?

It is tempting to think that California could handle any earthquake thrown at them, but we only have to look at the Hurricane Katrina experience to understand that we should be humble about our abilities. New York would not brush off a major hurricane; indeed the city ‘dodged a bullet’ with a hurricane last summer and could not handle winter’s snowfall a year ago. We have also found that most major companies are very confident in their emergency preparation capabilities, but in light of recent events, this confidence is not credible.

Steps to Prepare for Catastrophic Risk

A first step in being prepared is to recognize that it is near-certain that major organizations will suffer a catastrophe of some kind. Once our mindset changes, getting ready for an emergency takes on the urgency it deserves. But there is one step that is prerequisite to strong preparation for catastrophe.

Every major organization – whether public or private – needs a focal point for assessing and preparing for catastrophic risk. I have heard many times that ‘the CEO is the chief risk officer’, but this no more true than saying the CEO should be the chief financial or the chief operating officer. Understanding and preparing for catastrophic risk is a critical and complex task that demands distinctive leadership. Florida needs a chief risk officer. California needs a chief risk officer. Every major corporation needs a chief risk officer.

This position has as its main challenge the synthesis and communication of risks that reside in organization silos, each of which has its own language and culture. Finance people talk of risk and assess risk in certain ways, insurance people in others, operating people in others. It is the rare company that demands that a single language of risks be spoken at board level. Until this first step happens, the journey toward understanding and adequately preparing for the worst case cannot begin.

About Phil Ellis

Phil is Global Head of Strategic Risk Consulting for Willis' Risk & Analytics. He works with large and complex …
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