Calculate the real cost of catastrophe

  • Kevin Ingram CFO, FM Global

To protect against threats to corporate value, many companies rely too heavily on insurance coverage

If we have one job as CFOs, it's protecting the value of our companies. One of the most insidious threats to corporate value is sudden disruption from events like fire, hurricane, flood, earthquake or cyber attack—disruption that is ostensibly insured. The problem is, there's always a portion of that kind of loss that's uninsured. We tend to be vaguely aware of this risk, but rarely do we put numbers to it.

Consider a flood. What's insured is the physical damage to your deluged property and the revenue lost while your business is suspended or curtailed. Eventually, the insurance coverage expires and what is never covered are the customers you've lost, the growth you've forfeited and the penalty you've paid (and will continue to pay) as investors lose confidence in you. These losses can destroy enterprise value, if not enterprises themselves.

Hidden Loss

In the classic flood example, there was a pair of rival manufacturers. One had the foresight to build on high ground and one did not. The former wound up grabbing market share and momentum from the latter.

Another company recently suffered a similar loss in value after a cyber attack. While immediate disruption and data loss may have been covered by insurance, the company was forced to adjust its guidance downward. That caused investors to panic and the company's stock to plummet, erasing 20 percent of the enterprise's value. Unfortunately, the loss of value was not insured.

In both examples, the damaged companies relied too heavily on the coverage provided by their insurance. Although the insurance covered some of the damage, it did not make the organizations whole. It would have been more cost-effective for those companies to invest upfront in loss prevention and business continuity efforts.

Formerly Nebulous Risks

Although these losses in value should not surprise CFOs, the conversation around uninsured loss has largely been under the radar and definitely in the abstract. I believe that illustrating this phenomenon and quantifying the risk of uninsured loss can help CFOs make better strategic decisions—before learning the hard way.

You're probably familiar with the classic iceberg image, which depicts insurable loss above the waterline, and uninsurable, long-term losses hidden in the murky depths. For the first time, my team is putting hard numbers to these hidden losses that lurk beneath the surface.

To quantify the risk of lost enterprise value in a disruption, we developed the total financial loss model. In quantifying risk, this model effectively calculates the true value of resilience.

Let's say you're building a new factory to support your fastest-growing business segment. You already have a year's worth of orders to fill, and you invest in construction, machinery, networking, security and a workforce. This investment and the new business it's expected to generate raise the total valuation of the company to US$4.3 billion. The best available evidence indicates that a serious fire would cost the company US$220 million in property damage and lost revenue from business disruption. Therefore, you buy the requisite insurance coverage based on that projection.

Now comes your risk manager requesting an additional US$1.5 million from your already overstretched budget for automatic fire sprinklers. In this real-life example, she was turned down. "We have already exceeded our budget," she was told. "Isn't this why we bought insurance in the first place?"

Modeling the Total Loss

The risk manager in the above example ran the numbers through the total financial loss model. In addition to the US$220 million in insured loss that a serious fire would cost, the model projected these uninsured losses:

  • Customer loss: A protracted business disruption would prompt longtime customers to turn to other vendors, resulting in a projected loss in enterprise value of US$200 million.
  • Lost growth: A major disruption would curtail the company's growth, at least over the short-to-medium term, and that lost growth is growth that it would never get back. Even if the company were to rebound to its prior growth rate, it will have missed forever the compounding effect of the lost growth. Projected loss in enterprise value: US$335 million.
  • Lost investor confidence: A major disruption is proof of elevated risk, and that elevated risk rattles investors, thereby driving up the company's cost of capital. Add in the missed growth targets and the loss in equity could be US$90 million.

The total projected uninsured loss, then, is US$200 million plus US$335 million plus US$90 million = US$625 million.

The risk manager went back to her CFO with the numbers and explained, "A serious fire could cost us US$220 million in insured loss plus US$625 million in uninsured loss—the latter of which is more than 14 percent of the company's value." In this clear light, spending US$1.5 million for sprinklers to protect US$625 million in value was a great investment. The risk manager won the case and the company installed the sprinklers.

Simply put, the total financial loss model takes a loss scenario and quantifies that risk in a completely different way, using a discounted cash-flow approach to calculate the loss in enterprise value that could occur as a result of reduced future cash streams and a related cost of capital increase.

Seeing the Impact

The total financial loss model can be programmed into a spreadsheet to provide easy-to-read graphical output. CFOs, risk managers and other users can modify assumptions, including timescales and game out various scenarios. My team employs our proprietary loss expectancy or maximum foreseeable loss figures, financial data from S&P Global's Capital IQ research and an independent consultant's data on loss events' effect on cost of capital.

The takeaway is that it's indisputably cost-effective for an organization to invest in property risk improvement, starting with properties that are most at risk of a loss and most important to its profits. We see many companies adopting this approach, yet too often it's after a painful disaster that changes their perspective. Business continuity improvement is the other half of the solution.

As a CFO on the lookout for opportunities to grow your company's value, it's too easy to overlook the threats, natural or man-made, and to assume that the insurance policy you bought is enough to cover it. It just isn’t.

Investing in resilience is one of the best decisions you can make. It protects you, your shareholders, your debtholders and your employees. And it covers your No. 1 obligation: protecting the overall value of your company.

As originally published in CFO.


Related content and resources:

Predictive Analytics: Take the guesswork out of risk management

How Analytics Is Helping to Curb Insurance Losses

Data, Analytics and ROI

Resilience by the Numbers