Consider hypothetical commercial property construction and development company “X,” which has several high-profile commercial office projects around the world. In this scenario, the company was found to have massively underestimated both development costs (due in part to negligent risk management advice received from the insurer’s environmental audit team) and projected occupancy rental returns at two important commercial office sites in a major city (e.g., London, New York, Dubai, or Shanghai).
Company X failed to make provisions for inaccurate cost estimates and expected returns on its balance sheet, creating a financial “black hole” that the company’s auditors missed. Company X made misleading representations to property investment funds. It raised capital from banks using an overly optimistic analysis of expected financial returns based on the advice of real estate intermediaries. This has led to a directors and officers (D&O) class action against company X by its U.S. shareholders, and the company has had to file for bankruptcy.
While the situation has already become precarious, this is only the first link in the causal chain of exposure, and the contagion spreads quickly. Businesses that provide services to company X — such as quantity surveying, prospectus marketing, legal advisory, accounting, and software design — could become entangled in litigation. Their insurers could have to pay claims later as a result, because their insureds are proven by litigators to have had a role to play in the chain of responsibility, however remote, for company X’s collapse.
The attorneys and accountants advising the commercial property construction and development company on its transactions could become defendants, as well, not to mention the consulting firms that helped set the strategy underlying the failed projects and the investment bankers involved in underwriting them. Even the software development firm is at risk, as it may have misrepresented the nature of the payments made via the accounting software. The insurers providing cover for the project could have errors and omissions (E&O) exposure in relation to the negligent insurance and environmental risk management advice provided.
Thus, one event, centered on a single company’s actions, could have profound consequences for several carriers and reinsurers. In addition to direct risk for the carrier providing E&O cover for the project, insurers writing D&O policies for the companies involved (however tangentially) could wind up paying substantial claims. Eventually, this exposure flows up to reinsurers, resulting in considerable financial damage along the way.
Using the network diagram generated by Casualty Cat, a roadmap of risk highlights the implications of the property developer’s black hole. Company “X” is in the center of the map (in this case represented by NAICS code 23332), with direct exposures radiating from it by industry (e.g., NAICS code 52393 - Investment Advice). But, the exposure chain extends beyond these one-degree relationships. Some industries either derive their exposure from other industries, or through a combination of direct and indirect exposure.
As a result of the interconnected nature of business relationships across industries, many companies that ostensibly have little to do with commercial property development could be sued, putting their insurers at risk. The direct relationship of “one cause, one effect” clearly cannot be the benchmark for risk management. This hypothetical case shows that the actions of one company could subject countless others to litigation. For (re)insurers, the consequences can be costly.
A Platform for Action
While Casualty Cat makes the domino effect from the original trigger seem intuitive, the threats derived from the cause are not readily discernable on their own. A carrier would have to devise a scenario, trace the implications through a vast network, and hope that nothing is missed. A scenario could be overlooked, or an implication may not be captured. As this relatively straightforward example shows, complexity arises quickly. Think about the level of effort needed to anticipate the effects of the subprime mortgage crisis or the initial public offering (IPO) laddering situation back in 2000. Without the capabilities of a robust model, there is plenty of room for error.
Since no event occurs in a vacuum, a single incident can gain momentum rapidly and take months - even years - to run its course. Even the seemingly unrelated could be contaminated. Casualty Cat discovers the hidden links that could lead to unexpected claims well into the future, allowing carriers to take preventive measures now. Using Casualty Cat to determine the potential extent of the risks to a casualty carrier’s portfolio, it is possible to construct and implement a thorough risk management plan. If a casualty catastrophe does strike, the protection afforded by the Casualty Cat-supported plan should prevent balance sheet damage and, in the extreme, threats to solvency. Of course, the carrier will be able to improve capital management as a result of more informed decision-making and the implementation of underwriting risk controls.
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