Sandy Will Reopen a 'Black Box' of Insurance Claims

Sandy Will Reopen a 'Black Box' of Insurance Claims
Thai residents wade through floodwaters in the Bang Phlat district of Bangkok on Nov. 1, 2011
Photograph by Sakchai Lalit/AP

Each year Lloyd’s of London, the company that invented what we now know as insurance, publishes what it calls “Realistic Disaster Scenarios,” a detailed list of hypothetical nightmares—terrorist attacks, earthquakes, midair airline collisions.

Insurers run them through their own books as a stress test, to see what losses could look like. As in years past, in 2012 Lloyd’s included a “North-East Windstorm Event,” a hurricane that makes landfall in New York City, generating losses in the surrounding states as well. It would affect 11 airports, including Atlantic City International, LaGuardia, and Newark Liberty International. And it would exact just under $50 billion in residential losses and around $30 billion in commercial losses.

So Sandy, basically.

A brief note in the “North-East Windstorm Event” reads as follows: “Lloyd’s recognises the difficulties involved in modelling losses from Contingent Business Interruption (CBI) covers. Managing Agents should therefore exclude CBI losses from this event.” Translation: Neither of us really knows how this risk works. So let’s just put a bookmark here and we’ll come back to it.

A business interruption cover, usually thrown in as part of a property policy, protects cash flow lost to a catastrophe. Rather than compensate for the loss of a plant, for example, it compensates for the business lost when the plant is destroyed. Contingent business interruption insurance extends that protection to suppliers. If you make a car, for example, it’s possible you may be covered for production time lost when the plant that builds your dashboard goes down.

This all seems prudent. It’s also very difficult to model, and insurers are taking a bath on it. When commercial insurance premiums are low, as they have been for roughly the last five years, insurers throw in extra coverage to win business. When their investments are doing poorly, as they have been since 2008, the cash flow of new business becomes even more important. And so contingent business interruption clauses expanded down the supply chain.

Insurers facing competition, says Philip Reardon, will cover “not only suppliers, but suppliers of suppliers.” Reardon, who runs property risk consulting for Aon, which brokers reinsurance (insurance coverage for insurers), has seen contract language that covers any supplier in a business’s chain. “Some insurers didn’t know what they were offering,” he says. In an interview with Bloomberg News last year, Jochen Koerner of insurance broker Marsh & McLennan described contingent business interruption covers as “a massive black box.”

Insurers got to peek inside last year, which reinsurer Swiss Re reports was the worst year for global insured property losses since it began keeping industrywide records in 1970. Three events drove those losses—the earthquakes in Japan and New Zealand, and floods in Thailand. The losses in Japan and Thailand, both manufacturing hubs, showed insurers and reinsurers how exposed they were to contingent business interruption. In an interview with Bloomberg Businessweek last year, an executive at Munich Re, a reinsurer, recalled how she had discovered the day after the earthquake in Japan that a manufacturer in Louisiana had run out of chips. “It was a bit of a wake-up call from reinsurers to understand how far their web of insurance was cast,” Aon’s Reardon says.

That was last year. Insurers, confronted with a new risk, tend to react first by reducing their coverage, then working to understand it well enough to put a price on it. But contingent business interruption is hard to price. “You’re almost fighting a losing battle,” says Ed Hochberg, who runs the analytics group at Towers Watson, a risk management consulting firm. There’s not enough data to model behaviors in wide-flung supply chains, he explains, and catastrophe models have enough trouble modeling losses over an extended time period, much less in locations far from where the flood comes in. “It is a little surprising how little our clients know where their products come from,” says Reardon.

“The flooding [in Thailand],” Swiss Re wrote in a study (PDF), “has highlighted the insurance industry’s need for a fuller understanding of its exposure to supply chain risk, via more detailed information from clients and aggregation risk management with appropriate limits and premiums.” The translation: Insurers, learn what you can, and limit coverage wherever possible. Hochberg and Reardon confirm that this is exactly what has been happening in the market.

Business interruption was a “focal point” in this spring’s contract renewals with reinsurers, says Hochberg. Reardon points out that insurers are discovering more single-source suppliers among their clients than they’d expected. Insurers have been attempting to include specific sub-limits for the exposure, and include only named suppliers—that is, not indiscriminately out through the supply chain, but to specific companies the insurer feels comfortable with. But these steps are difficult in a soft market, where insurers are competing with each other to please their corporate customers.

This may change with Sandy. Massive catastrophes, which insurers euphemistically call “industry loss events,” can turn a market in an insurer’s favor. (Though the industry waited in vain for a better market after last year’s losses.) And both Reardon and Hochberg suggested several Sandy-related events that could trigger contingent business interruption losses. The hurricane flooded airports, which supply a service to airlines, which in turn supply a service to companies. It dug up rail lines or covered them in sand. It flooded power stations. Insurance contract renewal negotiations will follow this catastrophe, too, and insurers will have discovered even more suppliers they’ll now fear.

This fear sets up a conflict between businesses and insurers. It’s cheaper for businesses to thin out their supply chains and keep as little inventory on hand as possible. But this passes on a cost that insurers are increasingly unwilling to pay. And as supply chains spread to save money—to places like the industrial areas around the Chao Phraya River in Thailand, site of last year’s flooding—they make the risk even more complicated, and even less attractive to insurers.

If you run a business, you should get comfortable with risks and conditions all the way down your supply chain. You may find in the near future, if you haven’t already, that your insurer is not willing to do it for you. “Insurers are definitely focusing a lot more attention on this,” says Hochberg, “and Sandy’s going to do nothing but increase that level of focus.”

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