March 2010

THE BROADER IMPACT OF CAT EVENTS

Chris Ehlers, CPA, Matson, Driscoll & Damico

Introduction

While every catastrophe ("CAT event") leaves a wake of destruction in its path, there are times when the financial impact is more widespread than the physical damage would indicate. Consider the following:

September 11, 2001 - World Trade Center Terrorist Attack

The images of this day are ones we will never forget. Countless men and women demonstrated great personal courage as they fought to save the thousands of people trapped inside the World Trade Center buildings as they burned and eventually collapsed.

Of the damage done in New York alone, it is estimated that both insured and uninsured property losses amounted to approximately US$34 billion. ⁱ

December 26, 2004 - Asian Tsunami

The impact of this disaster is difficult to digest. Almost 230,000 people in 11 countries lost their lives. Countless fishing communities found their villages decimated and their livelihoods virtually destroyed.

However, because most of the losses occurred in areas where there was little or no commercial property insurance, the impact on the insurance industry was reasonably minimal. In fact, the vast majority of commercially insured losses came from the tourism industry and amounted to approximately US$2.5-$4 billion. ⁱⁱ

August 29, 2005 - Hurricane Katrina

The eye of Hurricane Katrina passed within 10-15 miles of the city of New Orleans and cut a wide swath of property damage from Texas to Central Florida and on up into Canada.

An article published in 2006 estimated that damages were in excess of US$200 billion, making Katrina one of the most expensive hurricanes to ever hit the United States. ⁱⁱⁱ

February 7, 2009 - Victorian Bushfires

The afternoon of February 7, 2009 was a day of unprecedented weather, with the combination of heat and winds proving catastrophic as temperatures reached 46.4 C (115.5 F) and wind gusts were close to 100 km/hour (66 mph).^iv Over the course of the day, 13 different fires started, burning 450,000 hectares (1.1 million acres) and causing 173 fatalities, making it the biggest bushfire tragedy in Australian history.

According to the Insurance Council of Australia, the general insurance industry received approximately 9105 claims as a result of the fires with an estimated insurable cost of AU$1.12 billion. ^v

Considering the Impact of a CAT Event

In all of the above examples, the economic effects on the impacted areas are well known and documented. However, beyond the direct physical loss, these disasters also had an enormous impact on the surrounding business communities. Hence, one must also consider the economic implications when people leave an affected area and are either unwilling or unable to return or visit.

The 2004 Asian Tsunami and Hurricane Katrina both impacted communities that relied heavily on tourism to sustain their local economies. In the instance of the Victorian Bushfires and the World Trade Center Terrorist Attack, local merchants all provided services to the communities that were ultimately devastated.

Thus, when residents left these areas, tourists no longer wanted to visit and past patrons were either unwilling or unable to return to the impacted region, the local businesses - some with little or no damage to their actual structures - suffered greatly.

Business Interruption - Typical Language

Section 2 cover - Consequential Loss of Profits Insurance Industrial under the Special Risk ("ISR") policy - includes the following language:

In the event of any building or any other property or any part thereof used by the Insured at the Premises for the purpose of the Business being physically lost, destroyed or damaged by any cause or event not hereinafter excluded (loss, destruction, or damage so caused hereinafter termed "Damage" ^vi) and the Business carried out by the Insured being in consequence thereof interrupted or interfered with, the Insurer(s) will, subject to the provisions of this Policy including the limitation on the Insurer(s) liability, pay to the Insured the amount of loss resulting from such interruption or interference in accordance with the applicable Basis of Settlement. ^vii

From the accounting perspective, the key word in the above definition as it relates to a CAT event is the term "Damage". However, as is sometimes the case, this definition is not as black and white as it might originally seem to be and requires the instruction and guidance of the carrier or its representative.

Several policies include other triggers outside of the word "Damage". Some of these include: Service Interruption; Acts of Civil Authority; Ingress/Egress (Denial of Access); Loss of Attraction and Contingent Business Interruption, at times with a limited or reduced sub-limit, waiting period or deductible.

Where the Forensic Accountant Comes Into the Picture

When a BI claim arises as a result of physical damage in conjunction with a CAT event, a forensic accountant's role is to measure the actual loss sustained by the insured had the physical damage not occurred in accordance with the policy. The determination of coverage is ultimately left to the discretion of the underwriter.

As described in the preceding examples, some businesses suffered insured Damage as a result of the CAT event, thus triggering the coverage under the business interruption policies. However, even after repairs were complete and the businesses were once again operational, the reduction in turnover due to the wider effect of the CAT event prohibited them from returning to their expected normal turnover. In these cases, it is important to ascertain whether or not the CAT event played a role in causing the continued reduction.

For example, in the aftermath of the Asian Tsunami, insurers used tourist arrival data to help determine the downturn directly attributable to a reduction in tourism as many people cancelled holidays in the immediate months that followed. This data is used to help determine revenue projections based on expected occupancy and revenue rates for each insured had no loss occurred.

It is also important to consider the impact that a loss at one location following a CAT event had on other branches or outlets covered under the same policy. Because a CAT event frequently causes customers to temporarily relocate to surrounding areas, the customer may still transact with the insured but at a different location.

Assuming that the policy coverage's structure allows for it, the forensic accountant should - in order to fully examine the overall impact on the insured's bottom line - identify and quantify any increase or make-up in business at these alternate locations.

A further issue that can occur is determining whether or not it is economical to expedite the repair of physical damage. Following a disaster, a hotel might pay premiums to repair sleeping rooms as quickly as possible; however, if the ensuing demand to occupy them is low, it is not necessarily in the insured's best interest to pay the premium repair rate.

Conclusion

There are a vast number of coverage issues to consider following a catastrophic event. When a forensic accountant is involved from the outset, he or she can assist with "but for" scenarios that range from, "Should the insured utilise its staff for temporary repairs?" to "Will the insured need to enter into a contract with a competitor to secure supply to meet its customers' needs?" By helping to quantify the various elements described above, the forensic accountant can be a crucial part of the team that ultimately helps get the insured back up and running as quickly and efficiently as possible.

About the Author

Chris Ehlers, CPA is a Director of Matson, Driscoll & Damico's office in Sydney, Australia. Originally a part of the firm's Houston office, Chris gained significant experience in the oil and gas, chemical/petrochemical and power generation industries. He also has in-depth catastrophe knowledge following the 2004 Hurricanes, Hurricanes Katrina and Rita in 2005 and, most recently, Hurricane Ike in 2008.

He has conducted various seminars and training sessions on business interruption measurement issues to claims managers, underwriters, loss adjusters and lawyers.

Chris can be reached at +61 2 9220 1706, +61 423 590 806 or via email at cehlers@mdd.com.