Not all sources of risk are the
same. Evaluating seismic risks poses highly complex challenges for engineers. The implications of seismic risks often appear
financially daunting. Recent developments in
the engineering and financial disciplines suggest promising insights for risk management. The key to capitalizing on these advancements is
the integration of both perspectives.
These photos
illustrate a range of earthquake damage to buildings from broken windows to structural
collapse. Repair costs, casualties and
indirect costs, including temporary relocation and loss of income, are related to the
physical damage and can be sizable. The potential public relations impact of earthquake
damage often is neglected, but can also have a long-term effect on a business or
community’s economic outlook. Applications for admissions to a major Silicon Valley
University, for example, dropped by 15% the year after the 1989 Loma Prieta Earthquake,
and didn't full recover for a decade. As the strength of earthquake shaking increases,
damage escalates. There comes a point where losses exceed the capability to manage in an
orderly and controlled manner. The capability
to manage losses effectively defines a threshold beyond which losses are catastrophic.
What means does
an owner have to manage losses?
Facilities owners and managers can optimize
their capability to manage loss by making informed decisions among several key
investments. The first source of recovery
funding is out-of-pocket expenses. This is usually supplemented by some sort of government
disaster assistance. Traditionally owners often buy insurance from companies who spread
their risks to secondary re-insurers.
One
concern with conventional insurance is the risk that the insurance agencies will become
insolvent after a major disaster, and be unable to pay their claims. Another problem with
insurance, and government relief as well, is that funding is contingent upon the direct
losses and usually does not cover loss of business or other indirect costs, which can be
significant. Claims processing can be
adversarial, time consuming, and expensive.
Recently, re-insurers have been using capital markets and
“catastrophe bonds” to reduce their risk of losses from localized natural
disasters. A catastrophe bond is similar to a
regular bond except that in the event of a natural disaster of specified size and location
some or all of the principal is forgiven. Sophisticated owners and communities can
access the capital markets directly, taking advantage of instruments that can be designed
to fit their specific needs. For example, cat
bond forgiveness can be triggered by an event regardless of losses, to avoid the
settlement time and costs associated with conventional insurance. Since the seller of the bond holds the funds there
is no danger of insolvency on the part of an insurer.
How can I
establish a risk and loss management program?
Keys to implementing an effective risk management program are knowing one’s
expected losses, both direct and indirect, and the combination of insurance, bonds and
mitigation that will most effectively minimize these losses. Programs currently in use
today typically focus on the large reinsurance and lending industries and are therefore
generalized. The consequence of this is that uncertainties in loss estimation are very
high. New technology is being developed to make loss estimation more reliable and tailored
to an owner or community’s specific needs.
The horizontal line in figure below defines the boundary between manageable and
catastrophic loss. Adding financial capacity through risk transfer or self insurance
increases manageable losses. Losses that cannot be managed are considered catastrophic. An
owner must be able to accept some risk that an earthquake will occur that is large enough
to exceed its ability to manage. If the quality of an existing inventory is such that the
risk of catastrophic loss is intolerably high, mitigation—retrofitting or replacing
existing buildings—can be effectively used to increase the size of the earthquake
(thereby reducing the likelihood) that would cause catastrophic losses.
Evaluating
a business or community’s susceptibility to losses over the long term and taking
advantage of state-of-the-art engineering and financial technology, creates opportunities
to more efficiently protect building inventories and insure economic sustainability.
