Physical Environment for Risk
and Insurance
Identification
Measurement
Financing
Types of Risk
• Fundamental risk: exposure to loss that may
affect many people or property interests at
the same time
• Particular risk: exposure to loss that is
usually limited to a single entity or small
group
Characteristics of fundamental
risks
• Broad Impact
– hurricane, flood etc. affect a number of people
• Catastrophic Potential
– natural catastrophe
– technical catastrophe (human origin)
• Localized
– cost of losses might not be shared among
people from other regions
Important fundamental risks
• Earthquakes
– caused by moving tectonic plates
– plate boundaries (called faults) are at a greater
risk
– coastal regions typically have faults
– Pacific Rim is very prone
– Ring of Fire: Alaska, Japan, China, Philippines,
Indonesia
Worst case scenario ($b)
property
Business Deaths
Injuries
San
125-170
Francisco
30-35
3-8000
8-18000 175-225
Los
130-180
Angeles
30-40
2-5000
8-12000 180-250
Tokyo
900-1200 350-550 40-60000 80100000
Total
15002100
Storms
•
•
•
•
•
•
Beaufort Scale
0 Calm
0-1(mph)
8 Gale
39-46
10 Storm
55-63
12 Hurricane 73+
Other types: Tornado has a funnel with
wind speed of 200 miles or more
Other risks
• Floods
• Environmental risks
– Nuclear risks
– Chernobyl death toll will be 100,000+
• Global warming
– Since 1800, global temperature has risen by at
least 0.5C
– Produced mainly by excessive CO2
Factors defining loss potential
• Key factors:
– distribution of people and property
– Concentration of people and property create the
critical mass necessary for a catastrophic loss
– Nature of peril and frequency/severity
– Susceptibility of property to damage
Distribution of people & property
• Concentration
• Scale economies produce large
concentration
– 747 carries many people cheaply
– giant oil tankers make transport cheaper
– large ocean oil platform make extraction of oil
feasible
• Economic reasons for concentration
Reasons for concentration
• Personal reasons
– coastal climate is better
– usually warmer and sunnier
• Cultural reasons
– strong family ties
– absence of social security by government
Trends
• Frequency of catastrophes on the rise for
both man-made and natural
• Property damage severity is also on the rise
• Why?
• Possible culprits: global warming, more
development, less care for risk
Management of physical
environment risk
• Risk assessment
– modeling: need to understand geology,
meteorology, structural engineering etc.
• Loss mitigation
–
–
–
–
land use restriction (Acapulco problem)
building codes
retrofitting existing property
disaster planning
Risk financing
• Retention
• Insurance
– reinsurance
– private risk pools: Marsh & McLennan has
created ACE Ltd. And XL Insurance Ltd. To
create risk pools not available in the traditional
markets
– Government risk pools
Modern approaches
• CatRe options
– an insurer or reinsurer exposed to catastrophic
risk can by these options as a hedge
– seller’s money acts as capital for insurer
– spreads the risk
• Event bonds
– California Earthquake Authority has a number
of these bonds on issue
Political risks
Methods of global interaction
• Exporting
– Simple export can face many foreign risks
• Joint ventures
– foreign direct investment is the next phase
– with capital abroad, more risks
• Wholly owned subsidiaries
– highest form of risk
Political risk
• Definition: Any governmental action that
diminishes the value of the firm operating
within the political boundaries or influence
of that government
• Example: Manuel Noriega shut off water
and electricity after US firms were
forbidden to pay taxes in Panama
Classification
• Confiscation, expropriation and
nationalization
• Contract repudiation and frustration
• Unfair regulatory environment
• Currency inconvertibility
• War risk
• How do we measure them?
Country Rating by S&P
India
Indonesia
Italy
Japan
Mexico
Nigeria
Peru
Singapore
BB+
BBB
AA
AAA
BB
NR
NR
AAA
Providers of country risk assessment
Bank of America World Information Services
Business Environment Risk Intelligence (BERI) S.A.
Control Risks Information Services (CRIS)
Economist Intelligence Unit (EIU)
Euromoney
Institutional Investor
Standard and Poor's Rating Group
Political Risk Services: International Country Risk Guide (ICRG)
Political Risk Services: Coplin-O'Leary Rating System
Moody's Investor Services
How to manage political risks
•
•
•
•
Develop channels of communication
Implement good pre-departure training
Localize firms
Structure contracts so that they can be
renegotiated
• Assist with local projects and local issues
Integration strategies
•
•
•
•
Establish joint venture with local firms
Transfer pricing is done fairly
Establish open financial reporting
Example: Hong Kong firms have strong
links to China well before hand over,
allowed Chinese princelings to hold
extensive equity in Hong Kong companies
MIGA
• Multilateral Investment Guarantee Agency
was established in 1985
• MIGA acts as a primary insurer for war risk,
nationalization risk, currency
inconvertibility risk and contract risk
• MIGA now has 107 member countries
• It is formally associated with the World
Bank but financially independent
Government agencies
• US:
– Overseas Private Insurance Corporation
– Foreign Credit Insurance Association
• Europe
– Export Credits Gurantee Department was
introduced early 1919
– Trevarbeit is a private but German government
backed company
Private providers
• US: AIG, CIGNA, Chubb
• Europe: Lloyd’s of London