Fostering Proactive Decision Making with Catastrophe Risk Analysis

By Dr. Akshay Gupta

cover imageIn recent years, natural catastrophes have caused severe property and business interruption losses to organizations worldwide. One of the key lessons from last year’s 9.0-magnitude earthquake in Japan and the major flooding in Thailand was the vulnerability of international supply chains to natural disasters, especially for industries such as high-tech manufacturing and automotive. As organizations continue to globalize, their physical locations and supply chain networks are at risk from multiple hazards — increasing the overall potential for property and business interruption losses.

Corporate risk managers faced with developing risk transfer or mitigation programs for such exposures need to recognize the risks and address them in a comprehensive and objective manner. They have found value in sophisticated tools — including state-of-the-art hazard models and site-specific, engineering-based catastrophe risk assessments — that help them quantify and mitigate losses associated with catastrophic events. These tools can help stakeholders make informed decisions regarding mitigating risk financially (namely, through insurance purchasing), mitigating risk physically (through retrofit investments or addition of redundancies, for example), or appropriate tradeoffs between the two.

Stakeholders can expect detailed evaluations available today to deliver in-depth assessments of an organization’s process flow and supply chain risk. The evaluations can also offer the quantitative insight needed to develop efficient emergency response plans or introduce optimal redundancies in supply chains, both of which increase a company’s resilience. Risk managers who pursue these comprehensive and quantitative approaches to assessing catastrophe risk are poised to make decisions that are not only protective (for insurance decisions) but also preventive (for business purposes such as those outlined below).

Why Analyze Cat Risk?
Catastrophe risk analyses — whether conducted using commercial models or company-specific evaluations — offer enormous value to risk managers because they provide the quantitative framework for informed and proactive decision making. Here are some of the potential benefits:

Identification of catastrophe risk concentrations and optimal mitigation strategies
Catastrophe risk analyses can offer a clear picture of the key drivers of a company’s catastrophe risk — including perils, locations, and business operation vulnerabilities in both processes and supply chains. Analyses assist in the identification of areas in which a company may be overexposed to catastrophe losses, the recognition of which can prompt informed mitigation strategies. For example, an organization could obtain the cost-benefit evaluation for different mitigation options; doing so would allow it to optimize mitigation expenditures and/or focus on those areas most critical from an operation, personnel, or reputation perspective. Catastrophe risk analyses also provide a convenient tool with which a business can simulate hypothetical scenarios to assess its operation’s robustness in specific situations.

Emergency response planning and alternative risk transfer options
Quantitative catastrophe risk analysis can provide an assessment of the potential impact of a catastrophic event as that event is forming — for example, a hurricane a few days from making landfall. Knowledge of the potential effects of such events allows companies to formulate emergency response and business continuity plans. Doing so can result in significant savings, competitive advantages, and an improvement in an organization’s reputation in the market as well as among its personnel. In instances in which adequate insurance capacity is not available or affordable, alternative risk transfer options can also be evaluated. Insurance companies and countries routinely consider these techniques when looking to transfer their risk to the financial markets.

Allocation of insurance costs and coverage among business units
Catastrophe risk analysis allows a company to assess the contributions of individual locations to the company’s overall catastrophe risk. By clearly delineating the likelihood of various critical losses at the location level, results provide a sound basis for allocating the costs of risk mitigation to individual business units.

Understanding the impact of facility acquisition, sale, or development options
A catastrophe risk analysis can quantify the potential marginal effect of the acquisition or sale of facilities to or from a given portfolio, allowing a risk manager to measure the effects of various alternatives on an organization’s risk profile. Catastrophe risk analysis can also be used to assess the risk associated with different development options. For example, an organization could compare the potential impact of acquiring a coastal facility exposed (albeit rarely) to tsunamis versus the effect of acquiring an inland facility close to an active seismic fault.

As an organization’s exposure becomes more complex both in terms of types of assets (high-value manufacturing locations, wind farms, offshore assets) and operations (just-in-time models, supply chains that span the globe), the value of comprehensive catastrophe risk analyses will continue to increase. A risk manager, his or her broker, or the underwriter can initiate such analyses. In each case, the result is a clearer quantitative understanding of the catastrophe risk, which helps all stakeholders. For an analysis to achieve maximum benefits, however, the organization must exhibit a strong commitment to obtain and provide relevant data throughout the analysis, as the next section outlines.

Best Practices
A catastrophe risk analysis is, in simplest terms, a tool. Like any other tool, it must be used correctly to achieve optimal results. The biggest challenges are associated with data quality and uncertainty. Regarding the first challenge, the organization should implement a plan for collecting and improving the data quality of its assets and operations over time (for example, when assets are being purchased or divested or new suppliers are brought on). Typically, the data is available across various departments. Collecting this data may be complicated and may require a strong internal directive as well as allocation of resources and personnel committed to the task.

With respect to the uncertainty inherent in the risk analysis process, bear in mind that as sample size grows smaller (such as when an organization, broker, or underwriter is looking at a subset of a large portfolio or a few individual locations), the uncertainty around the risk increases. Ultimately, an organization’s risk manager can effectively reduce uncertainty through a company-specific risk analysis that includes detailed risk assessments to account for any characteristics unique to a location, the perils being considered, and the organization’s process and operational network. Uncertainty can also be addressed through sensitivity analyses, which test the effect of various scenarios on the organization’s assets and operations.

Quantifying Supply Chain Risk
A supply chain is in essence a collection of operational points, or nodes, that are linked based on functional and revenue stream relationships. Simple examples of nodes include a production facility, a supplier, or a distribution center. When all nodes in a network are identified and appropriately characterized (as in a supply chain), quantifying the physical damage potential associated with each one is relatively straightforward.

Traditional methods for quantifying overall supply chain risk have considerable limitations because they are based on worst-case scenarios, establishing either 0 or 100 percent disruption one node at a time and propagating the impact through the entire supply chain. This does not include the likelihood or frequency of shutdown, nor does it consider the partial shutdown of a single node or the simultaneous disruption of multiple nodes.

Given that the nodes of a supply chain network may be located anywhere in the world, quantifying the risk to supply chains is a complex endeavor. However, this risk can be effectively quantified. Site-specific, engineering-based assessments combine a detailed network analysis with catastrophe risk models. As a result, partial damage and downtime states for all nodes can be simultaneously and explicitly considered. Furthermore, the level of disruption at each location from multiple perils can be accounted for, as can the redundancy, reserves, and resiliency associated with each node. This provides a more realistic and reliable estimate of potential downtime and loss. Cost-benefit evaluations of introducing redundancies for particular nodes or increasing reserves for specific components can also assist in optimizing the supply chain from the perspective of catastrophe risk mitigation.

Safety in Sound Risk Management
Losses from natural catastrophes have steadily mounted in the past three decades as businesses continue to operate on an ever more global scale. In such a complex and competitive market, sound risk management necessitates sophisticated catastrophe risk assessment techniques, including analyses for the business purposes outlined above.

Organization-specific, engineering-based risk analysis can assist risk managers, brokers, and underwriters in quantifying, understanding, and mitigating the physical and monetary losses associated with catastrophic events. Armed with comprehensive, quantitative risk results, today’s risk managers can be far better prepared to assess their exposures and make the most appropriate risk management decisions for their organizations.

Akshay Gupta, PhD, PE, is vice president and director of Catastrophe Risk Engineering at AIR Worldwide, which provides risk modeling software and consulting services.