loading icon

Calculating the Effects of a Natural Disaster

The Allianz Risk Barometer 2022 reported that natural catastrophes are now the third-highest global business risk, while climate change has moved into the sixth position. These rankings represent 25% and 17% increases from last year.[i] Furthermore, the increasing complexity of business structures means that it is often difficult to predict the risks to which they may be exposed and how to calculate any ensuing loss.

In this article, we will discuss the concept of business interruption calculations as they relate to catastrophic events.

The Financial Impact of Catastrophic Events

Since business’ operations can be impacted by factors other than its individual physical damage, the approach to estimating losses from natural catastrophes can differ from normal property damage claims.

For example, the individual physical damage to an Insured’s premises may be relatively minimal compared to the financial impact of the natural catastrophe on the Insured’s business. Additionally, the business may also need to deal with some or all of the following issues:

  • Severely damaged infrastructure in the surrounding area
  • An interruption in the delivery of supplies
  • Customers who may not be able to purchase goods or services from the Insured due to the suspension of their operation
  • A shortage in turnover due to suspension of production
  • Additional costs incurred for loss mitigation
  • The cost to restore financial data and other vital records

Contingent Business Interruption Loss Arising from a Catastrophic Event

As increased integration in manufacturing processes results in greater interdependencies among upstream and downstream business partners, catastrophes can affect an entire industry, including its suppliers and customers.

Additionally, businesses now tend to have minimal inventories to reduce inventory costs. In a natural disaster, this approach may mean they have insufficient resources to mitigate disruptions in operations. Furthermore, over-reliance on automation can create a susceptibility to disruption in the event of an automation failure that makes it difficult to achieve production through alternate methods.

Because usual business interruption insurance policies cover the Insured for losses arising from the interruption of their operations due to physical damage to the Insured’s property, they may not provide sufficient coverage in the event of a natural disaster. Thus, it can be beneficial for a business to obtain coverage that includes policy extensions.

One important policy extension for catastrophic events is Contingent Business Interruption (CBI), which extends the cover for financial loss as a result of interruptions to suppliers’ or customers’ operations/production.  There are no conceptual differences between business interruption and contingent business interruption loss calculations.  However, the type of peril and property damaged at the supplier or customer must be insured and listed by the policy. Difficulties could potentially arise in correlating the business interruption losses to specific suppliers and customers when it impacts multiple parties.

Other Circumstance Clause in Wide Area Damage

Catastrophic events, such as earthquakes, typhoons, and floods, may not only lead to damage to the Insured’s property but also give rise to wide-area damage. In this instance, we need to understand how the incident triggers the policy.

For example, Restaurants A and B are both in an area that suffered massive devastation due to an earthquake. They each have a policy that states a “loss resulting from interruption of or interference with the Business carried on by the Insured at the Premises [is] consequent upon DAMAGE to Property used by the Insured at the Premises for the purpose of the Business.” This means that coverage is only triggered by damage to the property operated by the Insured and not by a specific peril or damage to any surrounding areas. Please also assume that neither restaurant has coverage extensions such as loss of attraction or denial of access.

Restaurant A sustained physical damage following the catastrophe, which resulted in a reduction in turnover for six months. Restaurant B sustained no physical property damage, but it also experienced a similar level of reduction in turnover for six months due to the downturn in the local economy.

The policy language means that Restaurant B is not eligible to make a business interruption loss claim for a reduction in turnover. However, since Restaurant A sustained a loss due to physical damage, it seems they are eligible for a business interruption loss claim.

Since Restaurant B did not suffer damage but did experience a downtown, it would indicate that Restaurant A has losses that also occurred for the same reason. It is therefore important to segregate the loss due to the physical damage sustained by Restaurant A, as a result of the earthquake.

In this case, the other circumstance clause plays a key role in the “but for” analysis in the projection of standard turnover. Thus, to properly estimate the loss of restaurant A, we should make certain adjustments to its standard turnover.

Conclusion

We have witnessed shortages in human and material resources in relation to recent catastrophic weather events, and both can lead to an extended restoration period.  Thus, comprehensive business recovery plans are extremely important.

The recovery plans should include ensuring the safety of staff and customers along with the restoration of properties such as buildings and plants.  To mitigate the loss during the restoration period, the business may find alternative means of production by incurring additional costs. The preservation of documentation and restoring of financial data are also important, as these will be required to estimate the losses after the incident.

Moreover, businesses need proper coverage in their policy, particularly when operating in vulnerable areas impacted by catastrophes. In these areas, the survival of a business may ultimately depend on the recovery plan in place and the type of insurance policy it has.

[i] https://www.agcs.allianz.com/content/dam/onemarketing/agcs/agcs/reports/Allianz-Risk-Barometer-2022.pdf

Leave a Reply

By disabling cookies some features on the website (such as the IRB calculator) will not be available, do you still want to reject cookies?

Yes No