The Value and Limitations Of Business Interruption Insurance

ForTechnology Companies –

And A Few Ideas On How To Improve It

Urs Nussbaum, Swiss Re

Marsh 2005 Technology Conference

Page 2

Purpose

"Not everything that is faced can be changed, but nothing can be changed until it is faced."  --  James Baldwin

Critical review of present practices

Provide ideas to develop alternatives

Win a few people to pursue the discussion after the conference

Empower all stakeholders to take a leap of faith

"Not everything that is faced can be changed, but nothing can be changed until it is faced."  --  James Baldwin

Page 3

Select General Thoughts On The Nature Of Insurance

Historic Dimension

– Insurance laws hardly change (x finite)

– Products essentially the same

– Broadening/tightening of coverage cycle-driven

World around insurance has changed

– Tangible to intangible (services, Intellectual Property)

– Analogue to digital

– Specialization and value chain focus, outsourcing

– Significant progress in financial risk management (hedges)

– Capital markets as a potent and capable risk taker for all kinds of risks

-> How could insurance survive?

Page 4

Select General Thoughts On The Nature Of Insurance

High level of abstraction – some level of self-adjustment

– Not specific to industries and consumers

– Broad definitions and descriptions (event, insured interest/activities)

– Contains hidden options – previously inexistent events

Semi-finished product – continuously applied

– Risk manager/broker: exposure evaluation & effectiveness of protection

– Underwriter: exposure evaluation and pricing

– Loss adjuster/lawyer: claims settlement process

Page 5

Summary of Pros and Cons Of Insurance

Pros For Insured– Broad coverage incl. hidden risks – “luxury” option

– No basis risk between actual loss and payout

Cons For Insured– Needs specifying and applying to individual circumstances

– Ex-post loss quantification

– Continuous negotiation process

– (No liquid market no price transparency)

Pros For Insurer– Ability to sell “same” service to variety of different

consumers

– Low product cost

Cons For Insurer– Hidden options

– Settlement value determined by third party

– Moral risk management needed

Page 6

Implications For Business Interruption

Exposure Assessment

– Information about business process

– Values

– Limits

Loss Settlement Issues

– Extra Expense/Increased Cost of doing business -> Interest alignment & moral risk management, collaboration Insured with Insurer (overtime, repair, use of other facilities)

– Overcompensation -> exclude: variable expenses, making up for lost production

– Basis of comparison: 12 months before

Page 7

Summary Of Issues

Uncertainty and imprecision remain even ex-post

Judgement and interpretation inherent in implied service/process

Implied Joint Venture between Insured and Insurer (exposure evaluation and loss settlement). Note, interests are not always aligned

Continuous process of negotiation necessitates third party, carries risks of disagreement

Slow, expensive and possibly leads to mutual disappointment

Page 8

Features Of A Solution

Address the disadvantages of the status quo

Specific industry and individual business needs must be reflected in the structure and in the policy to a higher level

Continued negotiation and resulting unpredictability and high level of judgement must be replaced with pre-determined processes/agreements

Post-event loss quantification must be replaced with pre-determined payments under defined conditions to the extent possible

Recoverable must be booked and paid quickly

Page 9

Comparable Product ELPRO

Example Contingent Price Option for power utilities

Payment In case of production shortfall due to occurrence of NERC/FERC triggers

Min(Max (Shortfall- Deductible,O) * Max(Price-Strike,0), or Limit

Effect Reimbursement for production shortfall under market price and production cost calculation/projections

Sample Peak Prices US PJM West

0

100

200

300

400

500

600

700

800

6.1 6.15 6.29 7.13 7.27 8.10 8.24

Date

$ / M

Wh

Unplanned Outage

Strike Price

Page 10

Application of the ELPRO Model

Trigger events

Defined list of acceptable “named perils” including non-physical damage reflecting risk retention level and industry-specific issues

Loss payments (per time unit)

Determination of fixed operating cost, deductible based on risk retention level and available accounting information

Determination of profit component beyond fixed cost (a) capital market projections (stock market index or ratio) or (b) historic profitability based on available accounting information

Loss settlement

Upon verification of trigger event

Specificity,

Pre-determined events

Pre-determined amounts

Faster, cheaper settlement

Page 11

Example Of Alternative Structure Semiconductor Company

Trigger Event (replace FERC/NERC definitions)

– Fire and other key hazard risk, additionally, key supplier credit default and/or information system breakdown at specified locations under consideration of present characteristics

Loss Payment (Replace electricity volume and market price risk)

– Fixed cost – deductible

– Gross profit pegged to historic performance but determined by Philadelphia Semiconductor Index

– Strike Price: Index exceeds defined value (e.g. Phlx > 399)

– Payment: $x for each point that Phlx > 399, per day

Assumption: Correlation between Phlx and BI value

Page 12

Summary of Pros and Cons Of Alternative Structure Exposure and accounting information provide proxy.

Accuracy of pre-loss estimate not significantly inferior to post-loss estimate. Reliability will vary with industry

Tech world is too intangible and too unpredictable to quantify the “true” BI loss

Loss settlement process faster and cheaper

Insurance recovery can be booked fast

Service performance generally more predictable

Basis risk - Danger of under/overcompensation

Underwriting process may take longer

Adverse selection, unprofitable business may find undue attraction

Regulatory muster

Page 13

Open Questions

Regulation/Accounting (insurance vs derivative, SOX)

Quantifying and getting comfortable with the basis risk (Ability to evaluate/model the scenarios)

Internal

Market demand

Page 14

Questions For Discussion

Value of certainty of BI payments

Ability to book insurance recovery quickly

Comfort level with basis risk – ability to (reliably) quantify BI ex-ante

Regulatory comfort level

Value of extending BI cover beyond physical damage

Value of “hidden options”