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THE SURGE OF NATURAL DISASTERS: TIME FOR A SEA CHANGE IN RISK MANAGEMENT

As businesses and consumers are acutely aware, insurance costs have increased significantly over the past few years as a result of an unprecedented number of natural catastrophe losses coupled with inflation and higher reinsurance costs.[1]  How can businesses continue to afford risk protection and stay adequately insured in the event of loss?  Particularly as insurers are moving to more restrictive limits that reduce the insured’s ability to claim loss, this lack of capacity has resulted in insureds retaining more risks. 

It is a matter of perspective, however.  For businesses, instead of being stuck with paying higher costs for less coverage, they are coming to the quick realization that not only do they have some control over these costs, it is an opportunity to approach risk protection differently.

Define the risk categories.  The five types of risk frequently referenced are operational, financial, strategic, compliance, and reputational.  Beyond those include market risk, credit risk, liquidity risk, and more recently, cyber risk.

Review your risk profile.  When was the last time your business, whether it be your law firm or a client’s business, took a hard look at its current risk profile?  Have risk exposures been properly identified?  Of those areas of exposure, what is the likelihood or frequency of the risk occurring?   Of all the areas identified, which risks are the highest and most impactful to the organization? 

Review risk mitigation strategies.  Once you have prioritized your organization’s business risks, how do you deal with each one?  Are there ways to avoid the risk?  Is it a risk that can be accepted because its likelihood of occurrence is slim or its impact is (relatively) inconsequential compared to the other risks?  For those risks that cannot be avoided or accepted, can the risk be managed, and how?  What action steps are needed?  Are those actions feasible and within the business’s control?  What is the attendant cost?  What is the time horizon for each action? 

Does the business have a contingency plan in the event of the occurrence of one of these identified risks?  How does your business determine whether the risk is about to occur or has occurred?  Is there a monitoring system in place?   What is that system and how effective is it? For any risk(s) identified, how are those communicated?

Review insurance coverages.  Many businesses do this with the assistance of their broker, but when was the last time your coverage(s) were reviewed, which includes endorsements, exclusions, limits, deductibles, and any changes in terms?  A regular cadence is key—whether yearly or more frequently, and certainly in the event of a change in the business plan, after an unanticipated occurrence, or as new risks emerge—compliance or otherwise.

Review your claim history.  More claims equal higher premiums and make it more difficult to control insurance costs.  It also limits the universe of choices.  What measures are currently in place to prevent claims?  Are those measures effective?  Is there room for improvement? 

Alternatives to Traditional Insurance.  Once you have completed your insurance review and prior to renewal, are there any alternatives to managing the risk other than purchasing/renewing insurance coverage?  Is there any opportunity/appetite for self-insuring all or part of the risk(s)?  What might that look like? What would the cost be compared to traditional coverage?

Some Alternatives:

            Self-insurance.  Self-insurance occurs when a business opts to cover its costs out-of-pocket by setting aside funds to do so instead of paying out premiums to a third party for insurance coverage.[2]  The money may be set aside in a loss fund or savings account, or redeployed in a more sophisticated arrangement such as a captive insurance company.

            Hybrid insurance.  Similar to self-insurance, a hybrid approach allows a business to cover its cost up to a point; an umbrella or excess policy is purchased to protect against catastrophic claims or those beyond a certain dollar amount.[3]   This approach can significantly reduce up-front insurance costs and allow for more control by the business. As with self-insurance, having more “skin in the game” heightens vigilance and helps control costs.

            Captives.  In response to the tough market, captive use has been on the rise.  Figures released by AM Best in August 2023 show that captive surplus has grown by 17% since 2018.[4]  Essentially a form of self-insurance, captives are typically established to meet the unique risk management needs of the company and provide tax-advantaged protection which helps contribute to the company’s bottom line.[5] A captive, once organized, operates in a manner similar to a commercial insurer and is subject to state regulator requirements, including capital and reserving.[6]  There are currently 30 captive domiciles in the U.S. including 29 states and the District of Columbia. 

Some of the risk management benefits derived from a captive include the ability to mitigate the impact of pricing and capacity volatility in commercial markets; obtaining access to reinsurance markets; and the ability to obtain coverage for risks traditionally not available or economically feasible in commercial markets, to name a few.[7]  Particularly because of hard markets like the current one, captives offer companies more flexibility to retain risks and insurance/reinsurance options to manage a difficult insurance market.[8]

            Parametric solutions. The increased frequency of secondary perils, which are severe weather events emanating from primary catastrophes such as hurricanes and include severe storms and flooding, have led to the development of parametric products, which according to AM Best, represent a growing share of the insurance world.[9]

A parametric product is a type of insurance that covers the probability of a predefined parameter; it is a contractual agreement between the insured and insurer based on a “triggering event.”[10]  The payout depends on the occurrence of that event (e.g., due to a weather event, a cyber/terrorism attach, etc.), regardless of the actual loss.[11]  An independent third party determines the intensity of the event and the impact on the claim.[12]  As a result, no claims adjustment is needed after the event has occurred, unlike a traditional indemnity product.[13]  This results in a more expeditious contract payout, sometimes in a matter of days.[14]  Quick payment is particularly important when it comes to floods, as a delay in restoration can result in old proliferation which can cause health problems over time.[15]

As recently as July, the Caribbean Catastrophe and Risk Insurance Facility (CCRIF) will have made total payouts in the neighborhood of $350 million to the Governments of St. Vincent, Grenada, and Trinidad & Tobago following Hurricane Beryl, which triggered all of the facility’s parametric policies for those countries.[16]

Parametric products serve an important societal need by reducing the protection gap, providing affordable coverage for groups that are either uninsured or under-insured.  Recent examples include small farm owners in several African countries, each of which involved some governmental as well as non-governmental funding.[17]  This is known as community-based catastrophe insurance (CBCI) and can cover a single hazard or range of natural disasters for a given community, including floods, wildfires, and earthquakes.[18]  This innovative approach not only enhances financial resilience by providing affordable coverage, it also creates incentives for risk reduction both at the community and individual level.[19]  Programs like this could become a game changer, where insurance would be paired with risk reduction measures such as hazard mitigation, building code changes, and community resilience planning.[20]  Such innovation could become the norm, but will require the concerted (and collaborative) effort of insurers, regulators, and communities. 

            Use of Artificial Intelligence/Data Analytics.  Effective risk management is increasingly calling for more surgical use of data and predictive models to properly and accurately assess risk.  Having the right data is important, but the ability to analyze it quickly and in real time to make informed decisions is key.  This is true both on the insurance side, as well as in the businesses that are insured.  By analyzing historical data and patterns, predictive analytic platforms such as Salesforce Einstein Analytics and Google Cloud AI enable organizations to predict potential risks and market trends.[21]  Indeed, AI-driven reporting tools can be used to enhance insights and quickly uncover vulnerabilities.[22]  These tools enable insurers to optimize underwriting and claims processes, as well as overall risk management, to the benefit of the insured and insurer, as well as the regulator who oversees effective risk management and the financial solvency of the insurance companies they regulate.[23]

The use of AI to manage risk is particularly helpful when handling and evaluating unstructured data that does not fit neatly into a spreadsheet.  Such data can and indeed, is being utilized to more readily detect fraud; cyber risks; aid in accurate risk classification; enhance customer service; and streamline processes and operations.[24]

Conclusion

            Whether an insurer, a business, or a regulator, there is no denying that we are in the midst of a very tough and challenging insurance market for the foreseeable future.  It is how the storm is weathered that will differentiate successes from failures and will require the willingness and flexibility—by insurers, businesses, and regulators-- to embrace alternative approaches to traditional risk management, with an eye toward decisive action sooner rather than later.

References

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[1] NAIC, Property & Casualty Insurance Industry, 2023 First Half Results.

[2] National Insurance Brokers, “The Pros and Cons of Self-Insuring for Businesses:  Is it Right for You?”

[3] Treadstone Risk Management, “Popular Alternative Insurance Solutions and Structures.”

[4] AM Best Market Segment Report:  Feasibility and Utility Sustain Rated Captives’ Excellent Profitability, August 3, 2023.

[5] NAIC Insurance Topics, “Captive Insurance Companies,” May 9, 2024 update.

[6] Id.

[7] PWC, “Captive Insurance,” at p. 4.

[8] PWC, “Captive Insurance and Risk Management,” p.2.

[9] Best’s News, Special Report: “AM Best Explores Risk Management and Loss Mitigation Opportunities Offered by Parametric Solutions,” Dec. 20, 2023.

[10] Id.

[11] PWC, “From niche to mainstream: closing the protection gap through parametric insurance.”  https://www.pwc.ch/en/insights/fs/cosing-the-gap-with-parametrics-insurance.html

[12] Id.

[13] Id.

[14] Marsh McLennan, “Using Parametric Solutions to Help Close the Flood Protection Gap.”  https://www.marshmclennan.com/insights/publicationsl/using-parametric-solutions-to-help-close-the-flood-protection-gap.html

[15] Id. at p. 5.

[16] Reinsurance News, 11 July 2024.

[17] Id.

[18] Marsh McLennan at p. 5.

[19] Id.

[20] Id. at p. 7.

[21] Forbes, “Mastering Risk:  Unleashing the Power of Data and AI in Strategic Risk Management,” by Sal Rehmetullah, Feb. 29, 2024.

[22] Id. at p. 3.

[23] Id. at p. 4.

[24] Forbes Advisor, “How Businesses are Using Artificial Intelligence in 2024.”