Insurance costs and economic costs of wildfire

The wildfires in Fort McMurray, Alberta, Canada earlier this spring brought great destruction and displaced approximately 88,000 people. It is comforting that no deaths have been reported, especially considering the speed and extent to which it spread. The fire was just very recently, 5th of July, deemed to be under control.

As a 2014 Willis Wire blog reported, wildfires are highly un-predictable and difficult events to control because of wind, humidity and a high abundance of fuel. Fire and smoke spreads quickly causing significant destruction. For an extensive overview I recommend a report published by Lloyd’s – “Wildfire – A burning issue for insurers?”

Costliest insurance event in Canadian history

Standard property and business interruption insurance will provide coverage for the property, possessions and additional costs incurred in association with the fire. Bank of Montreal (BMO) analyst Tom MacKinnon has, in interviews with CBC News, estimated the insurance loss of the event to be up to CAD 9 billion, the costliest in Canada’s history.

But what’s the real cost?

Within the insurance industry we distinguish between insurance costs and economic costs. The latter is the total, “real,” cost of an event, whereas insurance costs are just those paid by policies.

The exact economic cost is harder to predict. One has to account for many ambiguous factors such as cost of rebuild, interruptions, loss of labor and the overall loss to the economy. One thing is sure, though, it is highly likely that economic cost will be in excess of the insured costs.

Business interruption, often a non-damage event

Losses from business interruption can often fall in the economic cost category. This means that a company’s balance sheet could be exposed to massive negative volatility given the uninsurable nature of business interruption where no damage has occurred to insured property. Such exposure must be carefully considered. Organizations trying to maximize return on capital rarely appreciated capital commitments in the form of reserves.

To tie this back to the wildfire discussion, there is evidence that the event has had significant impact on businesses that did not experience any physical damage. It has been reported that Shell and Suncor, two energy companies, were forced to shut down operations close to Fort McMurray. Total lost output was estimated to be as much as 500,000 barrels per day. Reuters reported that Suncor could face losses close to CAD 1 billion due to these interruptions. The non-damage aspects of the business interruption, an uninsured risk, will evidently have direct negative financial impacts and hit earnings of these companies.

Alternatives?

Companies considering prudent risk management should be looking to finance and reserve for potential losses arising from non-damage business interruption.

It is my firm belief that the insurance market, particularly the alternative risk transfer (ART) market, has answers to help manage negative consequence of non-damage business interruption.

Captive

First, for a risk manager or CFO, surprises such as the negative impact of a non-damage business interruption event on earnings is never welcomed. Companies considering prudent risk management should be looking to finance and reserve for potential losses arising from non-damage business interruption: be this following wildfire or any other non-damage event with the potential of seriously disrupting operations.

A captive solution can efficiently be used to set up a structure where non-damage business interruption cover is offered to business units. This permits insurance cover to be in place, reserves accounted for and earmarked on the balance sheet. The solution also facilitates for a buildup of historical data, a first step toward a future risk off-load.

Parametric and index solutions

Second, parametric and index solutions are solutions in which payout(s), a cash infusion, is related to a specific trigger(s).  For example a company would estimate its loss from non-damage interruption and get a guaranteed payout, from a third party, should a specific trigger be pulled. Stepped payouts with multiple triggers are common. Triggers and indices are based on third-party data to help reduce moral hazard.

Defining the right trigger(s) is key in the structuring process. Payouts are swift (1 to 2 weeks), allowing cash to quickly be put to use to make up for lost revenue and to initiate or step-up mitigation projects.

Returning to the wildfires, a parametric solutions example could involve drawing up a radius around a facility, and payout would be triggered when this boundary is breached. The solution could be combined and optimized to include other triggers such as duration of fire, hectares burnt or area evacuated.

Tailor-made solutions, a step away from tradition

Traditionally many losses, such as business interruption without physical damage, have not been insurable. Companies have historically had to take a direct hit to their balance sheet following such events. Today, the industry can actively structure solutions, such as those described, to help companies deal with these types of risk. If enterprise risk management or a risk mapping process identify non-damage interruption risks, the smoke is clearing and it may be worth exploring potential solutions with your advisers.

 

About Jens Peters

Jens Peters is a Consultant in the Alternative Risk Transfer Solutions practice. Based in New York, he is responsib…
Categories: Natural Catastrophe, Reinsurance | Tags: ,

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