7-1

Importance of Severity in Ranking Exposures

• The first rule of risk management—don't risk more than you can afford to lose—suggests that it is the size of a potential loss that dictates what ought to be done about a particular exposure.

• At least it suggests that the size of a potential loss is the factor that dictates which exposures about which something must be done.

7-2

Importance of Severity in Ranking Exposures

Actually, there are two reasons that potential severity must be measured.

• Some notion of severity is necessary for classifying risks. Whether an exposure will be classed as critical, important, or unimportant depends on the potential severity of loss.

• Severity must also be measured to determine the amount of insurance that should be purchased when the decision is made to transfer the risk.

7-3

Importance of Severity in Ranking Exposures

A lack of precision in determining the amounts of insurance to be purchased can result in unnecessary costs, and in the case of inadequate coverage, sometimes unbearable costs.

• If the amount of insurance is too low, the firm must bear the uninsured loss itself.

• If the amount of insurance purchased is higher than required, there is also an unnecessary cost.

7-4

Importance of Severity in Ranking Exposures

Different degrees of precision are required for the purpose of

(1) classifying risk, and

(2) determining the amount of insurance to be purchased.

7-5

The Prouty Measures of Severity

• Maximum Possible Loss (MPL): the worst loss that could occur, given the worst possible combination of circumstances.

• Probable Maximum Loss (PML): the loss that is likely, given the most likely combination of circumstances.

7-6

Signficance of the MPL and PML

Distinction between the MPL and the PML is derived from the art of the underwriter.

• Underwriter is concerned with the probable maximum loss.

• Given the underwriter’s spread of risk and the numerous properties in his or her risk portfolio, this is a reasonable strategy.

7-7

Signficance of the MPL and PML

• Focusing on the Probable Maximum Loss may also be a reasonable strategy for the risk manager with a large number of properties.

• For the risk manager with a single structure, or a limited number of properties, however, the important measure of severity is the Maximum Possible Loss.

7-8

The Loss Unit Concept

• The loss unit is the total of all financial losses that can result from a single event, taking into consideration the various exposures.

• World Trade Center bombing produced a $600 million loss, but the Loss Unit—the total loss from all sources—could have been billions.

7-9

A Priority Ranking Based on Severity

One technique used by scientists and engineers in the U.S. space program was criticality analysis.

• Criticality analysis attempts to distinguish the truly important things from the overwhelming mass of unimportant things.

• Given the wide range of losses that can occur, from the minute to the catastrophic, it seems logical that exposures be ranked according to their criticality.

7-10

Priority Ranking Based on Severity

• Some risks, because of the severity of the possible loss, will demand attention prior to others, and in most instances there will be a number of exposures that are equally demanding.

• Given the survival objective, any risk that involves a potential loss that would threaten survival must be classed as a critical risk.

• All exposures that could produce a financial catastrophe rank in the same category, and there is no distinction among risks in this class.

7-11

Priority Ranking Based On Severity

• Critical risks include all exposures to loss in which the possible losses are of a magnitude that would result in bankruptcy.

• Important risks include those exposures in which the possible losses would not result in bankruptcy, but would require the firm to borrow in order to continue operations.

• Unimportant risks include those exposures in which the possible losses could be met out of the existing assets or current income of the firm without imposing undue financial strain.

7-12

Loss Severity - Real Property

• Book values—based on historical costs and fictitious depreciation rates—have little to do with the actual loss that the organization would suffer if the asset were damaged or destroyed.

• From the risk manager's perspective, there are two possible measures of value for real property:

• Actual cash value • Replacement cost

7-13

Measuring Real Property Values

There are three approaches that are generally used to estimate building replacement costs

• Estimates or bids by building contractors and appraisers

• Construction cost indexes,

• Average square foot costs.

7-14

Contractors and Appraisers

When owner hires a builder to reconstruct a damaged building or to make repairs, the amount actually paid is the replacement cost of the damaged or destroyed property.

• Contractors can estimate the cost of rebuilding before a structure is damaged.

• Professional appraisers perform the same cost calculations as would a contractor developing a bid for construction of the building.

7-15

Internal Appraisals

Many appraisal charts are available which are of assistance in computing the present replacement cost, given the original construction cost.

When the appraisal is performed internally, one of two approaches is generally used:

• a construction cost index or

• a square foot cost method.

7-16

Construction Cost Index

Table 07-1: Construction Cost Index

1926 = 100.0

**** *****

1983 = 1176.7

1984 = 1224.4

1985 = 1249.6

**** *****

1995 = 1571.5

7-17

Construction Cost Index

Original cost of the structure is multiplied by the index value for the current year.

Original cost in 1926 = $1 million

1995 Index Value = 1571.5

$1,000,000 X 1571.5 = $15,715,000

7-18

Changing Base Year of Index

To compute the replacement cost value of a structure built in some year other than the base year, we convert the base year of the cost index to the year in which the building was built.

Index value for indexed year

New base-year index value= New Index Value

7-19

Changing the Base Year

Building was built in 1985

1985 Index Value = 1249.6

1995 Index Value = 1571.5

1571.5

1249.6= 140.2

1985 cost X 140.2 = 1995 replacement cost

7-20

Construction Cost Indexes

• The appraisal firm Marshall and Swift, publishes construction cost indexes in its publication, the Stevens Valuation Quarterly.

• Although a construction cost index is an effective means of determining current replacement costs, data on the original cost of the structure must be available.

• In this case, a different approach must be used, such as the square foot cost method.

7-21

Square foot Construction Costs

In the U.S., cost data are accumulated by professional appraisal companies, who offer the services of their engineers and architects to property owners who desire a specific appraisal of their property.

• Stevens Valuation Quarterly is perhaps the best known of these databases.

• Valuation Quarterly is a loose-leaf manual with quarterly supplements that lists construction costs for a wide variety of building types and other structures.

7-22

Valuation Quarterly Spot Cost Method

• The square foot costs in the Steven’s Valuation Quarterly vary by occupancy and type of construction.

• Occupancy classifications reflect the differences in construction among occupancy classes (for example, churches versus hotels, and hotels versus hospitals).

• For each occupancy, the square foot replacement costs are presented for five major types of construction.

7-23

Construction Classifications

1. Class A Fire Resistive Buildings

2. Class B Fire Resistive Buildings

3. Class C Masonry Buildings

4. Class S Buildings

5. Frame (Class D) Buildings

7-24

Size and Shape Modifiers

• A square structure will enclose the maximum area per lineal meter of perimeter.

• In addition, straight walls are less expensive to construct than are corners and angles.

• As a result, the square foot construction cost of a structure varies not only with the dimensions of the structure, but with its shape.

• Appraisers recognize the influence of size and shape through the use of "modifiers" which reflect the influence of these factors on average square foot cost.

7-25

Measuring Personal Property Exposures

Personal property is a generic term that refers to the contrents and other movable property owned by the organization. It generally consists of

• machinery and equipment

• furnishings

• raw materials and inventories

7-26

Machinery, Equipment, Furnishings

• Machinery, equipment, and furnishings, like buildings, may be valued on an actual cash value or on a replacement cost basis.

• For personal property, actual cash value is approximately equivalent to market value, and one can determine the market value of the property from suppliers of the type of property involved.

7-27

Machinery, Equipment, and Furnishings

• Replacement cost indices are available which indicate the current replacement cost for property of different ages, given the original cost of the property.

• Indexing is simpler and less time consuming than attempting to determine market values for a large amount of equipment, but it is workable only if the original cost of the equipment is available.

7-28

Replacement Cost to Actual Cash Value

• Actual cash value can be computed by deducting depreciation from replacement cost.

• Although this will always involve an element of judgment, the Stevens Valuation Quarterly provides a useful table of depreciation rates for various types of contents.

7-29

Inventory and Raw Materials

Usually, the only depreciation applicable to inventory or raw material is obsolescence, as might be the case with outdated stock.

• Conventions used by accountants—"first in-first out" or "last in-first out"—reflect a distortion in values.

• Properly measured, the inventory or raw materials should be valued at replacement cost; "next in-already here."

7-30

Tenant’s Improvements and Betterments

• Tenant’s Improvements and Betterments are alterations or additions made to real property at the expense of a tenant.

• The tenant of a structure may spend a substantial sum in modifying and improving a structure owned by someone else.

• Usually these improvements become a part of the building, and will belong to the building owner, depending on the terms of the lease.

7-31

TIB Example

Brown constructs building at $1,000,000 cost.

White installs $200,000 in improvements.

• Investment by White increases the value of Brown's building to $1,200,000.

• This is the value of Brown’s interest in the structure and the amount he would lose in the event the structure is destroyed.

7-32

TIB Example

• White has an interest in the intangible "use value" of the improvements.

• If the building is destroyed, White will suffer the loss of use of the improvements.

• The exact amount of White’s loss will depend on when the improvements are destroyed and the period of use anticipated and guaranteed by the lease at the time of installation.

7-33

TIB Example

• If destruction occurs shortly after installation, White will lose the full $200,000 in use value that is lost.

• If, on the other hand, the improvements are destroyed after five years and White’s lease still has five years to run, White will have lost one-half the expected use value.

7-34

Valuable Papers and Records

• Most effective approach to measuring the potential severity of the valuable papers and records exposure is to calculate cost of reconstructing the information, using a reasonable internal labor rate.

• Attempt to measure the value by this method may indicate that it would not be possible to reconstruct the records.

7-35

Tax Treatment of Property Insurance Recoveries

• A business is allowed a deduction for the book value of property that is destroyed by an accident, such as a fire or windstorm.

• If the book value of the asset is the same as the insurance recovery, the deduction for the damaged property offsets the insurance proceeds.

• The problem arises when the insurance proceeds exceed the book value of the asset.

7-36

Tax Recovery Example

• XYZ owns a building which it has insured for its replacement cost value of $10 million.

• The book value of the asset—its original cost less accumulated depreciation—is $5 million.

• In case of loss, XYZ’s deduction for the building is limited to its depreciated basis of $5 million.

• The insurance recovery of $10 million therefore exceeds the deductible basis by $5 million, and XYZ realizes a taxable gain.

7-37

Section 1033(a) of Internal Revenue Code

• This type of loss and recovery is termed an involuntary conversion and is subject special tax treatment under Internal Revenue Code Section 1033(a).

• Taxpayer is given the option of recognizing the gain (and paying taxes on the gain), or deferring taxation of the gain.

7-38

Section 1033(a) of Internal Revenue Code

• XYZ can elect to recognize the $5 million in taxable gain, pay the appropriate tax, and enter the new building built with the insurance proceeds in its books with a $10 million basis.

• XYZ may elect to defer taxation of the gain by entering the new $10 million building in the books at the same basis as the building that was destroyed.

7-39

Measuring Indirect Loss Exposures

• Indirect or consequential losses have traditionally been divided into two categories: "time element" and "other."

• Time element coverages, as the designation implies, are those indirect loss coverages in which the amount of loss is usually a function of time.

7-40

Time Element Exposures

• These exposures involve loss resulting from the inability to use an asset, and the reduction in income or the additional expenses occasioned by that loss of use.

• The common forms of time element insurance coverages are Business Interruption and Extra Expense, Contingent Business Interruption and Contingent Extra Expense, and Leasehold Interest insurance.

7-41

Measuring Business Interruption Exposures

• For business interruption, the measure of loss for most organizations is the expenses that would continue during a period of shutdown, plus the profits that would be lost during that period.

• When operations are suspended, income that would have been earned ceases.

• Some expenses may contrinue.

• The measure of business interruption loss is the expenses that continue and the profit that is lost during the period of interruption.

7-42

Period of Interruption

• Loss sustained is usually measured in terms of the period that will be required for restoration, commencing with the date of the loss and continuing until the damaged property is restored to usable condition.

• It may be possible for an organization to continue its operations at another location, or perhaps on a reduced basis at the location where the damage occurs.

7-43

Manufacturing Versus Mercantile

• When a mercantile establishment is interrupted, it loses sales, and the most appropriate measure of loss is the reduction in sales, less the cost of the goods sold and the expenses that do not continue during the interruption.

• When a manufacturer is interrupted, it loses production. The distinction between "sales" and "production."

7-44

Manufacturing Versus Mercantile

• The manufacturer of Christmas tree ornaments might produce throughout the year, but sell its production in September thru November.

• An interruption during the months of March, April, and May would not result in a reduction in sales during that period, precisely because no sales were being made.

• However, the lost production would be translated into reduced sales during the following September, October, and November.

7-45

Measuring Business Income Loss

• Determining the potential severity of a business interruption loss is basically a prediction.

• More specifically, it is a prediction of the future income and expenses of the firm, and the period that would be required for restoration.

• The logical approach is to assume the worst possible contingency—a total loss—and compute the potential loss in terms of the time that would be required to restore the premises in the event of such a loss.

7-46

Measuring Business Income Loss

• The Stevens Valuation Quarterly includes estimates of the time required for construction of buildings of various types of construction for specified occupancies.

• Once the period of interruption has been determined, it is necessary to predict the maximum loss that could be sustained during that period.

• This will vary with the seasonality of the business, and also with the trend in earnings.

7-47

Measuring Business Income Loss

• A highly seasonal business could lose a substantial portion of its income during a short period of interruption.

• Since expenses that do not continue are not payable under the business interruption forms, to the extent that such expenses can be identified, they should be deleted.

7-48

Employee Expense

• One of the major considerations in estimating a potential business interruption loss is the need to continue payroll of employees during a period of interruption.

• Sometimes, employees must be retained for the resumption of operations.

• In other cases, the workers could be easily replaced, and do not therefore represent a "necessary continuing expense."

7-49

Loss of Earnings After Restoration

• Consideration should also be given to the possibility that earnings may not return to their previous level immediately upon physical restoration of the premises.

• Loss of earnings may continue beyond the time when restoration is complete because of the loss of customers.

7-50

Expenses of Continuing Operations

• Expenses to continue operations following damage to facilities may include the expense of temporary premises and equipment, moving, extra labor, advertising, printing, travel for employees, and so on.

• Amount of these extra expenses is estimated from available information and projected for the anticipated period that will be required to resume normal operations.

7-51

Contingent Business Interruption

1. Contributing Property - when the firm depends on one or a few manufacturers or suppliers for most of the materials or services to conduct business.

2. Recipient property - when the firm depends upon one or a few businesses to purchase the bulk of its products.

3. Leader property - when the firm depends upon a neighboring business to help attract customers to its place of business.

7-52

Contingent Extra Expense Insurance

• Similar to contingent business interruption in the sense that it is property of some other firm, rather than the firm’s own property, whose destruction would cause the loss.

• A contingent extra expense exposure exists, for example, in instances where a manufacturer has a low-cost source of raw materials. Shutdown of the supplier’s plant would force the insured to obtain these materials elsewhere at a higher cost.

7-53

The Leasehold Interest Exposure

• Leasehold interest refers to the value that exists when an individual or organization enjoys a favorable lease, which might be terminated if the premises leased were destroyed.

• A lessee may suffer financial loss when the rent specified in the lease is below the current market, and the lease provides for cancellation in the event of damage to the premises.

7-54

Leasehold Interest Example

• ABC has leased property for $1,000 a month under a contract that does not provide for escalation of the rent, but which contains a provision for the cancellation of the lease in the event of fire damage to the premises.

• Increases in rents since the inception of the lease make it impossible to secure similar quarters at less than $2,000 a month, and that the current lease has six years to run.

7-55

Leasehold Interest Example

• This situation creates a leasehold interest of $1,000 a month for the 72 month period remaining in the lease.

• Because the amount of the leasehold interest exposure is a function of time, and because the loss, if one occurs, will be sustained over a period of time, measuring the leasehold interest exposure involves discounting to calculate the present value of the loss.

7-56

Leasehold Interest Example

• The value of the leasehold interest exposure is a lump sum, equal to the discounted present value of the difference between the bargain rate in the lease and the cost of equivalent facilities in the market.

• The net leasehold interest will vary over time, reducing with the number of months left to run in the lease. The magnitude of the exposure diminishes over time.

7-57

Leasehold Interest Example

• In our example of a firm with a lease that has six years to run, with a guaranteed rent of $1,000 when prevailing rents for similar facilities are $2,000.

• The leasehold interest is $1,000 a month. The net leasehold interest is the present value of $1,000, discounted at some rate of interest for 72 months.

7-58

Leasehold Interest Example

Reference to a present value table indicates that the present value of $1 a month for 72 months at 6% is indicated to be $60.6425.

Leasehold Interest Per Month $1,000

X Net Leasehold Interest Factor 60.6425

Total Leasehold Interest $60,642.50

$60,642.50 invested at 6% will provide $1,000 per month for 72 months.

7-59

Measuring Criminal Loss Exposures

For many years, there was no satisfactory way to measure the potential for theft by employees.

• Eventually, the Surety Association of America amd the American Institute of Certified Public Accountants devised a series of "Dishonesty Exposure Indices" which may be used to roughly estimate the fidelity exposure.

• There are separate formulas for public bodies, banks, and mercantile or manufacturing firms.

7-60

Dishonesty Exposure Index

• Based on certain financial measures from financial statements, a Dishonesty Exposure Index is computed

• Reference to a Table based on these indices indicates the minimum level of fidelity coverage that is recommended.

• Indicated fidelity limits are minimums, and higher limits of coverage should be considered.

7-61

Measuring Legal Liability Exposures

Regrettably, there is little that we can say about the process of measuring potential severity in the case of legal liability.

• It is an exposure for which there is virtually no maximum.

• Reference to the daily newspapers provides a stark reminder of the fact that the size of damage awards has grown significantly.

7-62

Measuring Legal Liability Exposures

• Ford Pinto award of $1.28 million

• The Dalkon Shield, losses in billions of dollars

• Manville Corporation bankruptcy

• 1984 accident at Union Carbide's plant in India, which killed more than 2,000 people

• Many authorities believe that given the current state of our tort system, there is not currently an answer to the question "how much liability insurance is enough?"