Running the risk

There has been no shortage of shocks to the financial community recently and in an increasingly risky world, management of risk is likely to become even more important going forward. As businesses become increasingly global, complex supply chains and interdependence create new risk management challenges. Financial institutions and investors are faced with risks that previously were not material, but now represent a potentially substantial concern regarding client financial stability.

Natural hazard exposure is such an extreme risk, which can result in severe property loss and business interruption. Earthquakes, as the recent devastating occurrence in Chengdu, China, and similar incidents, including hurricanes, tornadoes and floods can impact the movement of goods to market and consequently cash flow. Such a strong link between what happens elsewhere and the financial health of creditors requires changes in diligence regarding risk assessment.

To properly manage natural hazard risk, three essential steps are necessary: risk assessment, evaluating risk mitigation options and implementing best mitigation programs. A risk assessment is crucial to optimizing an overall corporate risk strategy. Understanding the risk in terms of both severity and frequency and reviewing this against your risk tolerance goals is key. Information generated from a risk assessment is then used to determine the most effective short and long-term risk reduction strategies, and to support financial decisions on financing and transferring risk in the traditional and alternative markets.

Once it is determined which locations are at risk and to what extent, the available options are either to reduce or transfer the risk. One must evaluate the remedies based upon cost effectiveness and ability to achieve the desired goals. For example, insurance and transfer to capital markets via cat bonds provide financial relief, but do not mitigate the inability to serve clients. If the goal is to maintain client service levels and minimize downtime, the mitigation strategy must involve a reduction in vulnerability to those aspects that cause the business interruption. This may involve strengthening the buildings, equipment anchoring and other engineered solutions. This phase often requires close coordination of work with other disciplines, such as structural engineering, mechanical and electrical, required to implement the recommended facility upgrade measures. In other instances, this phase may involve preparation or enhancement of a disaster preparedness and recovery plan and training a client’s staff in implementing the plan; or it may involve other aspects of facility planning such as development of risk-averse design criteria for new construction.

Implementing the chosen mitigation plan for significant, possibly franchise-threatening events is crucial to a successful risk management program. Planning is as important as assessing and transferring the risk in the first place. Statistically, the vast majority of businesses that fail after a major catastrophe event are those without emergency plans in place. Success is highly dependent upon how well the organization has planned to handle these occurrences in the minutes, hours, weeks and months that follow the initial event.

Fortunately, the technology exists today to quantify and manage natural hazard risk for both property and business interruption losses. Natural hazard catastrophe models are available for most of the developed world that can quantify the frequency and the severity of hazard risk and probabilistically estimate potential loss for individual property sites and entire portfolios of risk.

ABS Consulting authored a research study quantifying earthquake risk in Japan for eight industry groups. The findings were remarkable, in that one of the industry groups was exposed to a potential loss of two years worth of pre-tax earning, while several others were vulnerable to over one year of pre-tax earnings loss. A substantial aspect of the loss was tied to business interruption.

The research study is downloadable from the ABS Consulting Web site at www.absconsulting.com/news/2008/JapanEarthquakeResearch.pdf.