Catastrophic Risk: Analysis and Management / Edition 1 available in Hardcover
Catastrophic Risk: Analysis and Management / Edition 1
- ISBN-10:
- 0470012366
- ISBN-13:
- 9780470012369
- Pub. Date:
- 04/29/2005
- Publisher:
- Wiley
Catastrophic Risk: Analysis and Management / Edition 1
Hardcover
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$125.00Overview
The first comprehensive volume to address this topic from a financial perspective, this book is a guide to the worst financial risks threatening companies and industries today. Author Eric Banks begins with a consideration of 'catastrophe' and its mplications, looks at the state of actuarial and financial modelling of catastrophe risks, and discusses the creation of a risk management framework that will enable the efficient and secure management of exposure. Catastrophic Risk is essential reading if you're a corporate treasurer, CFO, or insurance/financial risk manager responsible for corporate risk management. Order your copy today.
Product Details
| ISBN-13: | 9780470012369 |
|---|---|
| Publisher: | Wiley |
| Publication date: | 04/29/2005 |
| Series: | The Wiley Finance Series , #320 |
| Pages: | 194 |
| Product dimensions: | 6.97(w) x 9.78(h) x 0.76(d) |
About the Author
Read an Excerpt
Catastrophic Risk
By Erik Banks
John Wiley & Sons
ISBN: 0-470-01236-6Chapter One
Catastrophe and Risk1.1 INTRODUCTION
Risk, which we define as the uncertainty surrounding the outcome of an event, is an integral and inevitable part of business. Companies and governments operating in the complex economic environment of the 21st century must contend with a broad range of risks. Some do so in an ad hoc or reactive fashion, responding to risks as they appear, while others are proactive, planning in advance the risks that they wish to assume and how they can best manage them. Since it has become clear over the past few years that risk can be financially damaging when neglected, anecdotal and empirical evidence suggests that institutions increasingly opt for formalized processes to manage uncertainties that can lead to losses.
Risk can be classified in a number of ways and, though we do not intend to present a detailed taxonomy of risk, a brief overview is useful in order to frame our discussion. To begin, risk can be divided broadly into financial risk and operating risk. Financial risk is the risk of loss arising from the movement of a market or performance of a counterparty, and can be segregated into market risk (the risk of loss due to movement in market references, such as interest rates, stock prices, or currency rates), liquidity risk (the risk of loss due to an inability to obtain unsecured funding or sell assets in order to make payments), and credit risk (the risk of loss due to non-performance by a counterparty on its contractual obligations). A rise in funding costs, an inability to sell financial assets at carrying value, or the default by a counterparty on a loan are examples of financial risks. Operating risk, in contrast, is the risk of loss arising from events that impact non-financial business inputs, outputs, and processes. Lack of electricity needed to power assembly lines, collapse of a computer network, disruptions in the sourcing of raw materials, or misdirection of payments or orders are examples of operating risks.
Risk can also be classified in pure or speculative form. Pure risk is any exposure that results either in a loss or in no loss, but can never generate a gain; speculative risk is an exposure that can result in a gain, a loss, or no loss. In general, operating risks are often pure risks (e.g., if an assembly line fails to function as expected a loss results, and if it functions as it should no loss occurs), while financial risks are often speculative risks (e.g., if interest rates rise the cost of funding rises and a loss occurs, if interest rates decline the cost of funding declines and a saving, or 'gain,' results).
Risk can also be classified by frequency and severity. Though the specter of risk is present in virtually all business activities, the frequency of occurrence can vary widely. Some exposures can create losses (or gains) every day, week, or month. For instance, currency rates move every day, and a firm with unhedged foreign exchange risk that revalues its operations to daily closing rates will experience a loss (or gain) each business day. In general, however, these frequent losses (or gains) are likely to be relatively modest in size, as the foreign exchange market can only move by a certain amount on a given business day. The same is true for many other financial risks, which are collectively considered to be high frequency/low severity risks - that is, a loss or gain may occur every day, but the absolute size is almost certain to be quite small.
Other exposures create losses (or gains) much less frequently, perhaps every few years or decades. For example, an energy company operating a natural gas-fired generator is exposed to the risk of mechanical failure, which might cause the generator to cease producing power. Given the design of the equipment such a shut down is not expected to occur, but if it does happen the financial consequences from interrupted business revenues may be significant. Similarly, a violent tornado may strike an agricultural area and destroy an agricultural cooperative's crops; the tornado is not expected to occur very often, but if it does, the crop damage may be substantial. Or, a very large systemic liquidity crisis may occur in the banking sector as a result of a unique confluence of micro- and macro-economic events; again, although the event is not expected to happen very frequently, it may cause substantial economic damage. These types of natural or man-made events, often termed catastrophic, or disaster, risks, are considered to be low frequency/high severity risks - they do not occur very often, but they have the potential of creating very large losses. The focus of our discussion in this book is on such catastrophic risks.
The basic classification of risk by type, result, and frequency/severity is summarized in Figure 1.1.
Catastrophe risk is a broad topic that must be viewed holistically, as it can impact many facets of society - human, social, political, cultural, scientific, and economic. The very breadth of its impact means a specialist focus on the individual components is generally necessary. In fact, this book is centered specifically on the financial/economic impact of catastrophic risks, and how exposures can be analyzed and managed in order to minimize losses. While the management of all financial and operating risks is critical to continued prosperity in the private and public sectors, we shall not address the high frequency/low severity exposures that affect daily business activities; these are beyond our purview and are treated in many other works. Neither shall we attempt to address the social, cultural, or scientific issues of catastrophes, or those surrounding crisis management and disaster recovery. Again, these are vital issues, but well beyond our scope. In the balance of this chapter we consider the nature of catastrophe and its potential scope of impact; we also introduce the concept of catastrophe risk in the conventional risk management framework, and provide an overview of the structure of the text.
1.2 THE NATURE OF CATASTROPHE
1.2.1 A definition
Catastrophe does not lend itself to a simple, universal definition. While we have mentioned that a catastrophic event is a low frequency/high severity risk, it may be sudden or prolonged, and natural or man-made; it may affect valuable financial/physical assets in a densely populated city, or it may impact a desolate and unpopulated region; and, it may be measured by arbitrary guidelines or very precise metrics. Despite room for interpretation we shall develop certain definitions and concepts that provide us with the necessary tools to evaluate catastrophe and catastrophe risk (with some caution to the reader that other alternatives and extensions may be perfectly acceptable).
For our purposes we define a catastrophe as a low probability natural or man-made event that creates shocks to existing social, economic, and/or environmental frameworks, and has the potential of producing very significant human and/or financial losses. Though a catastrophe is traditionally viewed as a single large event that causes sudden change - such as an earthquake or terrorist attack - we can expand the definition to include instances where a gradual accumulation of many small incidents, perhaps precipitated by the same catalyst, leads to the same scale of damage/losses; such events may not actually be recognized as catastrophes until a long period of time has passed and many losses have accumulated.
Although the potential for large losses exists, a catastrophic event does not always lead to losses. While we are primarily concerned with events that might produce losses and considering what can be done to mitigate or minimize them, we would be remiss in excluding events that occur without creating losses. Accordingly, a large earthquake striking in an unpopulated region of the Aleutian Islands and a similar earthquake striking in the densely populated city-center of Kobe are both catastrophic events.
The catastrophe is the event itself, and not the specific human or financial outcome of the event; this is important because each new event, whether or not it creates social/economic damage, becomes part of the historical data record that is so vital in developing an analytic framework. Naturally, from a pure risk management perspective we are primarily interested in situations that have the potential of creating real event losses.
1.2.2 Frequency
Many types of financial and operating risks appear on a regular basis - so regularly, in fact, that their impact can be estimated with a high degree of accuracy through standardized tools. Automobile accidents, household fires, stock price declines, standard medical procedures, and other non-catastrophic risk events occur every day, and the severity of each individual event is generally quite small. They can be quantified through statistical frameworks and actuarial processes, allowing exposed parties to make cost/benefit decisions with a high degree of confidence.
The same does not necessarily apply to catastrophes. Most catastrophes occur very infrequently, and they may be quite severe. For instance, although some 700 significant natural disasters occur in an average year, this figure is quite small given the number of vulnerable areas around the world; one of these 700 events may only appear in a given location once every ten, hundred, or five hundred years - and sometimes even longer. The tools and rich history of past events that are used to evaluate frequently occurring risks are not available to help in the quantification process. These differences, as we shall note later, make financial modeling, decision-making, and ongoing management more challenging. Despite this relative lack of frequency, some types of catastrophes recur, meaning that they can be anticipated - though not predicted. In the short term catastrophes are non-routine, often appearing as random events; in the very long term, however, certain classes are routine.
The probability that a particular type of catastrophe will occur is generally expressed as an annual occurrence frequency, e.g., there may be a 0.01% probability of an 8.0 magnitude earthquake occurring in City XYZ in a given year. This can be depicted in graph form, as in Figure 1.2, where frequency is conveyed as a probability of occurrence and severity as a metric of loss or damage (e.g., dollar losses, magnitude, intensity). Events that occur very frequently and have low severity outcomes dominate the left-hand portion of the curve; those that appear infrequently and have higher severity outcomes comprise the right-hand portion of the curve; the two relationships are depicted in Figure 1.3.
An associated frequency measure is the recurrence interval (or return period), or the average time within which an event equal to, or greater than, a designated severity occurs; this is simply the time-independent inverse of the occurrence frequency, i.e., the recurrence interval of the 8.0 earthquake in City XYZ is 100 years (1/100 years = 0.01%). Occurrence frequency and return period are typically held constant from year to year in analytic frameworks, apart from any condition changes owing to man-made influences. A related concept is the non-encounter probability, or the probability that no event greater than, or equal to, a given magnitude will occur over a particular period, i.e., there is a 99.9% annual non-encounter probability of an 8.0+ earthquake striking in City XYZ. All three measures of frequency are widely used in catastrophe risk management, and we shall revisit them throughout the book.
Knowing that catastrophes occur infrequently is an important consideration when evaluating the potential for losses, as a large magnitude event that occurs only rarely must be managed differently from a small magnitude event appearing regularly. It is not sufficient, of course, to say that catastrophes occur infrequently; within this broad classification we can divide frequency even further, into non-repetitive, irregular, regular, and seasonal events (further granularity is possible, but this categorization is detailed enough for our purposes).
Non-repetitive catastrophe: a disaster that occurs only once in a particular area and can never be repeated in the same location to yield the same results. Examples include the collapse of a dam (which forever changes the channel, floodplain, and discharge dynamics above and below the dam), a massive landslide from a mountain slope (which permanently alters the landscape and potential for a repeat event), or a terrorist bombing (which obliterates a landmark structure in a particular location permanently). It is important to note that non-repetitive catastrophes can recur, but always in different locations and/or under different circumstances (e.g., another dam can collapse, another building can be bombed); the time and location of future events remain unknown.
Irregular catastrophe: a disaster that does not appear with any degree of statistical regularity, but which can occur repeatedly in a general location or marketplace, though time and specific location are generally unknown. Examples of irregular catastrophe include a tsunami generated by an earthquake, or a very large stock market collapse.
Regular catastrophe: a disaster that is characterized by the regular, if sometimes very long and gradual, accumulation of forces that lead to the triggering of an event. Though the pattern of buildup occurs on a regular basis and can be accommodated within a statistical framework, the precise timing of event occurrence remains unknown. Examples of regular catastrophe include an earthquake on a known fault line or a volcanic eruption from an active volcano.
Seasonal catastrophe: a disaster that has the potential of occurring on a regular basis in a general location during a given time period; while this helps limit the time and space of occurrence, the precise location, severity, and moment of occurrence remain unknown. Examples include hurricanes, extra-tropical cyclones, floods, and droughts, all of which can occur in particular areas during specific seasons.
Catastrophes that feature a dimension of repetition, such as regular or seasonal events, can be described by statistical distributions, which allows for better estimates of severity and frequency. Those that are non-repetitive or irregular are more challenging to quantify. We shall consider this point at greater length in Chapter 4. Figure 1.4 summarizes the classifications noted above.
Some observers have noted that the frequency of disasters appears to have increased over the past few decades. In fact, there is little scientific evidence to support such a claim: the frequency of disasters such as earthquakes, flooding, tornadoes, extra-tropical cyclones, industrial contamination, or terrorism does not appear to be accelerating, nor is it necessarily expected to. While global warming and changes in the hydrological cycle have alternately increased and decreased certain hazards that have the potential of creating disasters (e.g., spring flooding and winter storms, respectively), and though certain man-made events appear to be on the rise as a result of geopolitical tensions (e.g., large-scale terrorist-related activities), the incidence of disasters has not actually increased. In fact, growing media coverage and larger damages may be contributing to the perception of increased frequency.
1.2.3 Vulnerability
As we explore dimensions of low frequency/high severity risks, we want to consider the element of the topic that is most important to our theme - the management of losses. In particular, we consider the concept of economic vulnerabilities. From a risk management perspective, we are interested in understanding the interaction between catastrophe and vulnerabilities in order to determine the potential for losses of a given size, and ways of minimizing such losses.
A vulnerability exists when humans and/or infrastructure are present and 'at risk' when a catastrophe strikes, or has the potential of striking. Vulnerabilities represent the potential for losses from casualty, damage, destruction, and/or business interruption. When vulnerabilities are present and a catastrophe occurs, some amount of losses will result; when no vulnerabilities exist, no losses can occur. Thus, the unpopulated region of the Aleutians has no vulnerabilities - when the earthquake strikes, no losses will ensue, as human life and infrastructure are not exposed to the risk. But the densely populated center of Kobe is highly vulnerable to loss; when the earthquake hits, as it did in January 1995, the combination of the actual catastrophe and the vulnerability generates losses. The existence of vulnerability can be estimated without precise knowledge of risk levels, but the size of a loss cannot be quantified without also estimating the strength of a particular catastrophic event.
(Continues...)
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Table of Contents
Acknowledgments ixAbout the author xi
PART I IDENTIFICATION AND ANALYSIS OF CATASTROPHIC RISK 1
1 Catastrophe and Risk 3
1.1 Introduction 3
1.2 The nature of catastrophe 5
1.2.1 A definition 5
1.2.2 Frequency 5
1.2.3 Vulnerability 8
1.2.4 Measuring severity 11
1.3 The scope of impact 11
1.4 Catastrophe and the risk management framework 13
1.5 Overview of the book 15
2 Risk Identification I: Perils 17
2.1 Natural catastrophe 18
2.1.1 Geophysical 19
2.1.2 Meteorological/atmospheric 22
2.1.3 Other natural disasters 26
2.2 Man-made catastrophe 29
2.2.1 Terrorism 29
2.2.2 Industrial contamination 31
2.2.3 Technological failure 32
2.2.4 Financial dislocation 33
2.3 Mega-catastrophe and clash loss 34
3 Risk Identification II: Regional Vulnerability 35
3.1 Spatial impact of natural catastrophes 36
3.1.1 Bermuda and the North American Atlantic Coast 36
3.1.2 Florida 36
3.1.3 North American West Coast 37
3.1.4 US Great Plains/Midwest 38
3.1.5 Caribbean 39
3.1.6 Mexico 39
3.1.7 Japan 40
3.1.8 South Asia/Southeast Asia 41
3.1.9 Middle East/Near East 43
3.1.10 Europe 43
3.2 Spatial impact of man-made catastrophes 44
3.2.1 North America 46
3.2.2 Europe 47
3.2.3 Asia/Pacific 47
3.3 Urban vulnerabilities 47
4 Modeling Catastrophic Risk 49
4.1 The development and use of models 49
4.2 The goals of catastrophe modeling 50
4.3 General model construction 51
4.3.1 Phase one: Hazard/peril assessment 52
4.3.2 Phase two: Vulnerability assessment 55
4.3.3 Phase three: Contract assessment 59
4.3.4 A general example 60
4.3.5 Other perils 63
4.4 Challenges 64
4.4.1 Model characteristics and assumptions 65
4.4.2 Model validation 66
4.4.3 Tail risks 67
4.4.4 Data quality and granularity 67
PART II MANAGEMENT OF CATASTROPHIC RISK 69
5 Catastrophe and the Risk Management Framework 71
5.1 Active risk management 71
5.1.1 Enterprise value, liquidity, and solvency 72
5.1.2 Loss control, loss financing, and risk reduction 74
5.2 Risk monitoring 81
5.3 Private and public sector efforts 82
5.4 Sources of capital 83
5.4.1 Insurers/reinsurers 83
5.4.2 Investment funds 84
5.4.3 Financial institutions 85
5.5 Toward active risk management 85
6 Catastrophe Insurance and Reinsurance 87
6.1 Insurable risk and insurance 87
6.1.1 Full insurance 88
6.1.2 Partial insurance 88
6.1.3 Captives 89
6.2 Catastrophe insurance 89
6.3 Reinsurance 92
6.3.1 Facultative and treaty reinsurance 92
6.3.2 Proportional and excess of loss agreements 93
6.4 Catastrophe reinsurance 95
6.5 Market cycles 98
6.6 Internal risk management 101
6.7 Challenges 103
6.7.1 Pricing difficulties 103
6.7.2 Earnings and capital volatility 104
6.7.3 Concentrations 106
6.7.4 Limits to insurability/uninsurable risks 106
6.7.5 Lack of insurance/reinsurance penetration 107
6.7.6 Capacity constraints 107
6.7.7 Contagion effects and systemic concerns 108
7 Catastrophe Bonds and Contingent Capital 111
7.1 Overview of securitization 111
7.2 Catastrophe bonds 112
7.2.1 Standard structures 112
7.2.2 Innovations 120
7.2.3 Market focus and direction 123
7.3 Contingent capital 124
7.3.1 Standard structures 125
7.3.2 Contingent debt 126
7.3.3 Contingent equity 128
7.4 Challenges 131
7.4.1 Structural flaws 132
7.4.2 Regulatory differences 132
8 Catastrophe Derivatives 135
8.1 Overview of derivatives 135
8.1.1 Exchange-traded derivatives 136
8.1.2 OTC derivatives 137
8.2 Exchange-traded catastrophe derivatives 139
8.3 OTC Catastrophe derivatives 140
8.3.1 Catastrophe reinsurance swaps 140
8.3.2 Pure catastrophe swaps 142
8.3.3 Synthetic OTC structures 142
8.4 Challenges 144
8.4.1 Index construction and basis risks 144
8.4.2 Lack of contract transparency 144
8.4.3 One-way markets 145
8.4.4 Pricing difficulties 145
8.4.5 Regulatory barriers 145
9 Public Sector Management and Financing 147
9.1 Forms of public sector involvement 147
9.1.1 Ex ante loss control measures 147
9.1.2 Insurance/reinsurance 148
9.1.3 Ex post crisis management 156
9.1.4 Financing and subsidies 157
9.1.5 Financial regulation 158
9.2 Challenges 159
9.2.1 Voluntary versus mandatory measures 159
9.2.2 Public and private sector responsibilities 160
9.2.3 Lack of market access and capacity 161
10 Outlook and Conclusions 163
10.1 Loss control 163
10.1.1 Loss control implementation 163
10.1.2 Enforcing urban planning 163
10.2 Quantification 164
10.2.1 Modeling requirements 164
10.2.2 Transparency 164
10.2.3 Complexity of terrorism 165
10.3 Loss financing 165
10.3.1 Vulnerabilities and risk capacity 165
10.3.2 Discriminatory funding and insurance 166
10.4 Government participation 166
10.4.1 Optimal government role 166
10.4.2 Limited government resources 167
10.4.3 Adverse incentives 167
10.4.4 Market deregulation 168
10.5 General management 168
10.5.1 Sub-optimal management 168
10.5.2 Sustainability of solutions 169
10.5.3 Preparing for the mega-catastrophe 169
10.5.4 Amalgamated solutions 169
10.5.5 Learning from past events 170
Bibliography 171
Index 175
What People are Saying About This
"...useful to have at hand...Risk, of whatever nature, remains something that needs to be addressed at all times." (Accounting Technician, August 2005)
“It is a beautifully clear book…enlightening… one which turns a complex and potentially off-putting subject into a remarkably interesting one.” (Strategic Risk, June 2007)