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Catastrophe Events and Business Interruption Insurance

In the event of a devastating catastrophe (“cat”) be it an earthquake, hurricane, flood, or tornado, the first and foremost priority is to ensure the safety all the people involved. Once this has been established, business owners can then begin a mental accounting of the potential losses and the sometimes demanding process of business recovery.

The economic effect of any cat is most likely to be more widespread than what the physical damage initially indicates, whilst building, equipment or stock damage may be straightforward to ascertain and value, economic losses due to revenue shortfall from to business interruption (“BI”), costs for business loss mitigation, and extra expenses for restoring  financial data and other important records can set a company back for months, if not permanently, especially in the absence of a comprehensive disaster recovery plan and appropriate business interruption loss insurance. Cat losses can compound the business recovery efforts, as whilst the business owner may have considered the losses from a particular peril, a cat loss may present additional uncontemplated post loss operating conditions.

The recent earthquakes in Japan and Ecuador will clearly have a vast impact on business in the surrounding areas and present businesses with considerable challenges to recovery, due to what is known as wide area damage. Wide area damage presents considerable obstacles to business recovery and can include prevention of access, loss of critical services (water, gas and electricity), damage to transportation infrastructure, damage to suppliers and customer base, and shortage of repair resources (labour and materials). These conditions escalate the business losses that otherwise would have occurred. For example, in Japan, companies which did not suffer direct damage as a result of the earthquake have been impacted due to the cat’s impact on surrounding access and distribution networks, key services or logistic providers.

The recent damage reports suggest significant wide area damage in Japan and Ecuador. Damages are estimated to exceed USD 10 billion as a result of the Japanese earthquakes and USD 2 Billion for losses in Ecuador. Toyota, Honda and Nissan have suspended production in many facilities across Japan due to damage to production plans and the supply of parts. Ecuador’s ports have been hard hit by the earthquake which is likely to cause delays to exports of bananas, flowers, cocoa beans and fish. There will be an inevitable negative effect on tourism for both countries as a result of the earthquakes. These losses also have the potential to impact business earnings outside the area physically affected, as customers and supplies depend on output and services of the directly affected companies.

Business Interruption CBI and Wide Area Damage

Basic BI Insurance policies cover the Insured for losses arising from interruption to their business as a result of damage to Insured property. These basic BI Insurance policies are not typically broad enough to provide sufficient cover in the event of wide area damage, and it is beneficial to obtain BI coverage that includes policy extensions which broaden the coverage beyond that of financial loss due to damage to the insured’s property, say to include cover for losses resulting from: Service Interruption (interruption of utility services); Acts of Civil Authority; Ingress/Egress (Denial of Access); Loss of Attraction and Contingent Business Interruption (“CBI”) (i.e. damage to suppliers or customers). These coverage extensions can have specified or unspecified sub-limits and separate indemnity periods, and waiting periods / deductibles.

An extremely important extension for cat events is CBI which extends the cover for financial loss to indemnify BI losses that flow from damage to Insured property to suppliers/customers. There are no fundamental conceptual differences between BI and CBI loss quantification, but the peril and property damaged at the supplier or customer must be the type of peril and damage insured by the policy.

CBI is particularly relevant topic considering the current Japanese earthquakes where the entire geographical region has been damaged, which is known to specialise in automotive and semiconductor component production. For example, some of Toyota’s production facilities were damaged and have halted production, interrupting the usage of components which were sourced externally. Further, some of Toyota’s suppliers were also damaged which will potentially lead to a shortage of supply for the assembly plants.  Production of cars has been reduced which will result in downstream BI losses to overseas markets where motor vehicles are distributed and sold. CATs can affect an entire industry and suppliers/customers globally due to the strain put on the global supply chain as increased integration in manufacturing processes has led to greater interdependencies between different global business partners.

The development of global supply chains around the world has created many challenges due to their vulnerability. Current production trends are to have minimal stockholding, to reduce the cost of inventories. Conversely, this creates vulnerability as no buffer stocks are held to mitigate a disruption in production. Moreover, high levels of automation can create a vulnerability of failure of automatic processes and an inability to easily achieve production through alternative means.

Conclusion

Whilst it is essential that business owners have prepared and tested their business continuity plans, business insurance coverage is required to compensate the business owners for the financial losses that occur. Business owners need to consider their insurance requirements carefully, particularly when operating in areas prone to catastrophes. Consideration should be given to the likely consequences of the cat event and how the business will be affected when choosing the appropriate policy and extensions. The businesses survival may depend on the considerations and the decisions that are ultimately made.

By Flemming Jensen.  Published in Insurance Day – May 2016. 

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