September 18th, 2008

The Casualty Catastrophe Domino Effect

Posted at 6:10 PM ET

David Lewin, Head of International Casualty

Sometimes, a single incident can trigger a chain reaction. Before you realize what has happened, economic damage has mounted, and claims are being filed. Particularly surprising is that the companies being affected were not really involved in the initial event. This risk, “casualty catastrophe,” has become increasingly frequent and severe in recent years, yet casualty writers remain exposed. The threat is difficult to detect, as it arises from the connections among businesses rather than a specific peril. Consequently, casualty catastrophe has been almost impossible to analyze and mitigate. New modeling techniques, though, may help (re)insurers manage their capital more effectively.

Today, business is conducted through relationships that are becoming increasingly complex. Supply chains intersect routinely, bringing global implications to bear even on local companies. Partnerships, joint ventures, investment activity, suppliers, clients—the ultimate transaction may occur at the point of sale, but many other relationships make it possible. Each of these relationships, enabling the commercial process, also creates a framework for the proliferation of risk. When a liability-related incident occurs, a causal chain follows that can affect each company even tangentially related to the one at the root cause. Risk spreads quickly.

For casualty carriers, this can be particularly menacing. Professional liability writers tend to protect their portfolios based on the direct risks to their insureds. This method is effective for managing risk among root causes, but it does not address risks further down the causal chain. Claims may arise from companies that do business with the company that triggered the event, and the carrier may not have anticipated them.

Consider a hypothetical commercial property construction and development company with a number of major projects in progress worldwide. The firm was found to have substantially misgauged both costs and projected returns in a major city (such as London, New York, or Dubai). This hypothetical concern did not develop a contingency plan for inaccurate estimates and projections, creating a financial “black hole” … which the company’s external auditors did not identify. As a result of these financial debacles, the firm misrepresented itself to property investment funds, raising capital through an analysis that was not accurate.

Because of this situation, shareholders in the United States have begun a class action lawsuit—subsequently joined by European investors—and the property development firm has filed for bankruptcy. Beneath the surface, though, a web of relationships stands to imperil the many companies with which the property firm interacts. Prospectus marketing, legal advisory, accounting, and consulting firms could become the targets of a cunning plaintiff attorney. The investment bankers who raised capital could fall prey, and the insurer who wrote the errors and omissions (E&O) policy on the misrepresented project may face large claims.

The professional liability carriers that cover each of these companies could be at risk. Judgments and settlements could impair their balance sheets, even though their clients may not have been involved in any wrongdoing. Further, if one carrier’s portfolio includes both the property development firm and one of its trading partners, risk is compounded. A casualty catastrophe emerges from a root cause, and risk-bearers are left to pay, simply because it is almost impossible to protect themselves.

Guy Carpenter’s Casualty Cat product was designed specifically to address the casualty catastrophe threat. Developed jointly with Arium, Ltd, Casualty Cat scours (re)insurer portfolios in search of the direct and derived risks that could turn a seemingly contained event into a disaster. This innovative risk management platform helps carriers identify risks, accumulate their derived impacts and ultimately take action from an informed perspective.

For every risk-bearer, the goal is optimal capital management. Casualty catastrophes, lurking unseen in the corners of nearly every portfolio, always have stood in the way. Improved modeling capabilities, though, have rendered casualty catastrophe risk both detectable and transferable, enabling carriers to use their capital more effectively.

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