October 28th, 2008

Protect Your Enterprise from Casualty Catastrophes

Posted at 2:00 PM ET

Emil Metropoulos, Senior Vice President
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When mega-catastrophes occur, we tend to think about large-scale property damage. Until recently, hurricanes, earthquakes, and terror dominated the conversation. A new type of catastrophe has emerged, however, with the potential to cause more economic damage and perhaps even higher insured losses. Casualty catastrophes involving product and professional liability can spread quickly, destroy considerable amounts of shareholder wealth, and take years to resolve completely. In the past, carriers were unable to address this form of risk sufficiently, and balance sheets have remained imperiled.

The threat of a casualty catastrophe stems from the daily relationships that characterize most businesses. Joint ventures, partnerships, and supply chain linkages have resulted in a complex web of risk integration. A single incident, such as a product recall, could leave many companies (and their carriers) exposed to litigation, settlements, and judgments—even if they seem to have had little influence on the root cause. Recent examples have been neither small nor infrequent. The past decade alone has brought us the laddering of initial public offerings (IPOs), the decimation of Enron and Arthur Anderson, and the current credit crisis.
 
Despite the frequency and magnitude of these events, (re)insurers have been able to do little to protect their capital. Casualty catastrophes are virtually impossible to anticipate, and exposure spreads quickly. Models have struggled to keep pace with the intricacy of trading relationships, and sufficient, accurate data has been unavailable. As a result, carriers have had to manage risks individually, despite an increase in the interdependency of exposures. This has led to a gap in catastrophic clash covers, leaving (re)insurers to try to anticipate integrated risks that are unknown and unknowable. Fortunately, modeling advances and enterprise risk management (ERM) techniques are enabling risk-bearers to manage their casualty catastrophe exposures and allocate capital appropriately.
 
ERM involves a straightforward framework: risk identification, measurement, management, and monitoring. Catastrophic scenario identification will have to entail both hindsight and foresight. (Re)insurance companies should understand the fundamental drivers of their complex and volatile exposures—and use this comprehension to make realistic projections regarding possible casualty risk and disaster scenarios. Prudent ERM practices suggest that firms move beyond the merely required and advance their knowledge of risks that peers or regulators may not recognize yet. With this approach, carriers can ascertain the possible effects of a particular casualty disaster scenario and take specific action—such as increasing retentions, managing limits exposed, transferring risk, or electing not to cover a particular peril (or insured).
 
ERM is particularly important to the effective coverage of casualty catastrophe risks. Assuming a new risk may have implications beyond diversification. In fact, the marginal increase in risk could be magnified based on the insured’s preexisting business relationships. Beyond evaluating the effects of an added insured or peril, the carrier should understand the extent to which it could be assuming exposure to related companies.
 
Guy Carpenter’s Casualty Cat model, developed jointly with Arium, Ltd, helps (re)insurers identify and measure casualty catastrophe exposures and serves as a tool to facilitate risk management decision-making. Carriers can use Casualty Cat’s risk accumulation profiles and disaster scenario inventory to understand how exposure can spread from a root cause across lines of business, industries, and borders. With this information, (re)insurers can determine starting points for risk management planning and execution. Casualty Cat reveals previously hidden aggregate portfolio risks and empowers carriers to manage risk, preserve capital, and generate returns for shareholders.
 
Risk is an enterprise-wide concern, but casualty catastrophes have eluded the ERM grasp, largely because of a dearth of modeling capabilities and data. The advent of casualty catastrophe modeling technology, though, means that carriers can protect their balance sheets and make informed capital management decisions. Finally, casualty catastrophe risk is running out of places to hide.

Guy Carpenter & Company, LLC provides this text for general information only.

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