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In the wake of hurricanes, even insurers must reassess their risk exposures.
Russ Banham, CFO Magazine
December 1, 2005
Many large corporations in the states of Louisiana, Mississippi, Florida, and Texas had prepared for the devastating hurricane season of 2005, assuring the continual flow of business through well-oiled disaster-recovery plans. But it's the season's aftermath that could take them by surprise: substantial increases in insurance-premium rates.
Property-insurance policies come up for renewal in January, and the word is out from insurers and brokers that companies with properties in disaster-prone areas should expect an average 45 percent rate hike over what they paid in premiums last year. Companies with major manufacturing facilities on the Gulf Coast, such as oil and gas concerns, are looking at much higher increases. "Some corporations may not be able to even get insurance, or at least affordably priced insurance," says Karen Horvath, vice president of Oldwick, New Jersey–based A.M. Best Co., which rates insurer financial strength and debt.
The higher prices reflect the $40 billion to $50 billion in property losses absorbed by the insurance and reinsurance markets from hurricanes Katrina, Rita, and Wilma. Corporate buyers of property insurance in disaster-prone regions are left with few options: absorb more risk on the balance sheet, find alternative risk-transfer mechanisms such as captives, cede it to investors in a catastrophe bond (see "Ultimate Coverage," at the end of this article), or simply plunk down more dollars in premiums paid to insurers.
Companies in this situation might take a page from the experts in risk management: insurance companies. Faced with their own property risks and business-interruption exposures, many insurers are — ironically — buying less insurance (or in their special case, reinsurance). Insurance companies are self-insuring, and applying balance-sheet management and disaster preparedness/recovery plans to reduce their exposure to hurricanes, earthquakes, and other natural disasters. So if it's good for the goose, is it good for the gander? To find out, we spoke to CFOs and a top risk manager at four major insurers: FM Global, GE Insurance Solutions, Fireman's Fund Insurance, and Wausau Insurance.
A $75 Million Bet
FM Global, one of the world's largest commercial-property insurers, manages its property risk in three ways: loss prevention and control, business-continuity planning, and self-insurance. "We make sure our facilities — and we've got 55 offices around the world, 5 of which we own — are of the highest quality when it comes to risk," says Jeff Burchill, senior vice president and CFO of the Johnston, Rhode Island–based company. "Our philosophy is that insurance alone isn't enough; you have to do all you can to prevent loss."
FM Global, with revenues of $4 billion last year, absorbs the first $75 million in property and business-interruption losses caused by a hurricane or earthquake, on a per-occurrence basis. "Above this risk retention, we buy excess of loss treaty reinsurance, which is layered among various top-rated reinsurers," notes Burchill. "As far as I can recall, I don't think we've ever had a claim reach into the reinsurance, which is a testament to the physical integrity of our facilities and the expertise of our loss-prevention engineers."
Of the company's 4,700 employees, 1,500 are loss-prevention engineers, identifying potential hazards to client properties, as well as FM's own. "We have such faith in our standards and people that we're willing to bet $75 million on them," Burchill boasts.
FM Global's go-it-alone approach is typical of many insurance companies, and shared by other large companies as well. BP Amoco, for example, has a long-standing policy not to insure incidents worth less than $500 million, absorbing risks below this amount on its balance sheet. As Stephen Cross, CEO of Aon Captive Services Group, which manages corporate insurance captives, puts it: "Why transfer risk to insurance companies that have weaker balance sheets than you do?"
But Cross also cites the downside to absorbing natural-disaster risk. "It's fine to 'go bare' — without insurance — until something bad happens," he explains. "And when something bad happens and shareholders learn you could have bought insurance to cover it, you open yourself up to recriminations. The only way to defend yourself in an action like that is to prove you've adequately and appropriately analyzed the risk against the cost of bearing it internally or shedding it to an [insurer]."
Science vs. Instinct
The determination of how much risk to absorb on the balance sheet and how much to transfer to insurance or capital- markets instruments is part science, part instinct. At GE Insurance Solutions, a reinsurance and commercial-insurance subsidiary of General Electric Co., all risks — strategic, operational, and financial — are identified, assessed, and quantified as part of the company's enterprise risk management program.
"We look at the volatility associated with natural disasters, including our own facilities and our parent's facilities," says Marc Meiches, CFO of the Kansas City, Missouri-based insurer, which earned $8.2 billion in net premiums last year. "We look at the concentrations of our people in one facility and the risks that can be exposed to a natural disaster, and then make a determination of how much risk we are willing to retain. Typically, we take a large deductible and reinsure the rest."
Like other prudent companies, GE Insurance rests its faith on its contingency plan in the event of disaster. "Frankly, we're more concerned about the business-interruption risk after a hurricane than the property risk," says chief risk officer Samira Barakat, who works closely with Meiches in overseeing the enterprise risk management program. "Our goal is to have people back working the day after a disaster strikes." In July, GE Insurance tested its contingency plan following the bombings in the London subway system, which shut down the company's European disbursement and treasury operations. "Within four hours, we were back up paying bills," says Meiches. "We're very serious about business interruption, which is why we are willing to absorb more of this risk on our balance sheet and use reinsurance to absorb the truly catastrophic risks."
Fireman's Fund Insurance Co. has a similar approach to its natural-disaster risks. "We have staff who are experts when it comes to modeling our exposure to property loss," says Jill Paterson, executive vice president and CFO of the Novato, California-based multiline insurer, with $5 billion in 2004 revenues. "They use computer models that make a determination of probability to get a clearer picture of potential losses, based on the type of structure and the characteristics and intensity of a hurricane. We then push this data down to our underwriters' desks to compare these potential loss scenarios with our surplus and with the reinsurance prices available in the marketplace." (Owned by the large European financial-services company Allianz, Fireman's Fund purchases reinsurance to protect itself from catastrophic risk, a portion of which is purchased from its parent company.)
Wausau Insurance Cos. similarly absorbs more risk than the average corporation. "We typically take a significant risk retention and then cede off layers above that to reinsurers," says Scott Names, CFO of the Wausau, Wisconsin-based commercial- property and liability insurer, with $1 billion in 2004 revenues. "It varies by line, but our practice is to take higher retentions where we feel they are appropriate, and then reinsure the rest."
The cost of reinsurance on the open market plays a role in how much risk these insurers are willing to retain on their balance sheets. "In some cycles, reinsurance is very cost-effective; if we can protect our balance sheet at minimal cost, we will," says Names. "On the other hand, if the reinsurance market is hardening up and prices are outside what we feel is appropriate, we'll retain more risk internally."
Can noninsurance companies also skip over conventional insurance and go directly to the reinsurance market? "They would need to form a captive insurance company in order to cede risks to reinsurers," explains Paterson of Fireman's Fund. "Certainly, if they have a very good risk-management department, they should [consider] forming a captive."
In the end, all of the insurers we spoke with keep a constant weather eye on property risk. FM Global's vigilance, for example, gives it the confidence to bear $75 million of natural-disaster risk on its balance sheet. "If we see a deficiency in one of our properties from a risk standpoint, we attend to it immediately," says CFO Burchill.
Hence, the company's bold self-insurance strategy. Says Burchill: "It may sound strange coming from an insurance company, but we firmly believe that the majority of all losses are preventable."
Russ Banham is a contributing editor of CFO.
Tapping the capital markets for disaster protection.
Catastrophe bonds, a rarely used vehicle for managing disaster risks, have attracted more interest in the wake of 2005's hurricane season. To date, only three companies — Tokyo Disneyland, the French utility EDF, and Vivendi's Universal Studios in Los Angeles — have issued them. The bonds are issued via special-purpose vehicles (SPVs) — legal entities that hold the capital raised from investors, either to pay them off when the bond matures or to pay off the companies if the bond is triggered by a natural disaster, such as wind speed above a certain threshold or an earthquake intensity exceeding a specific number on the Richter scale. (Vivendi's $175 million bond, for example, is linked to earthquakes at various locations around Universal Studios.)
The strategy has appeal for these companies because of their concern over the ability of insurers and reinsurers to pay up in the event of a truly catastrophic disaster, such as an earthquake toppling much of Los Angeles. Payment is not an issue with a catastrophe bond, because the money is held by the SPV.
Swiss Re Capital Markets, which co-underwrote two out of the three transactions, says that since the hurricanes, it has been in talks with a few other companies about the strategy. There is a limit, however, to this application. "Many companies cannot meet the minimum financial thresholds to make the bond viable," says Judy Klugman, a Swiss Re managing director in New York.
"To do a capital-markets transaction, you need a minimal notional amount being transferred, which typically is in excess of $100 million," she says. "There aren't that many companies with manufacturing plants worth that much in a disaster-prone area, other than energy companies with expensive facilities onshore and offshore [in the] Gulf of Mexico, which are actively looking at this as an alternative. They see the capital markets as a great complement to traditional insurance." — R.B.