Predicting the Unpredictable

Article, PostSeptember 2011

Insurance / Property

Tony Levitt discusses the factors that need to be considered when quantifying losses in the current economic climate.

The office of National Statistics recently released lacklustre gross domestic product growth figures for the three months to June 2011. The growth rate was reported at 0.2%, which is down from 0.5% in the previous quarter.

What is clear from the figures is that the state of the economy is changeable and difficult to predict. So much so, that one-off events such as a royal wedding and an extra bank holiday can significantly impact underlying growth.

Uncertainty, whether in a downtown or upturn, can have an effect on the quantification of business interruption claims. The traditional forensic accounting method – of using the past to predict the future – may not be possible in such a market. The impact on an individual company will depend on its operations but the unpredictable economic situation makes forecasting, but for the insured event, particularly difficult.

The uncertainty principle, a cornerstone of quantum mechanics, published in the 1920s by the German scientist Werner Heisenberg, signalled the end of scientific determinism – the assumption that everything in the universe could be predicted, if the correct set of scientific laws existed.

Parallels can be drawn with insurance claims and the need to forecast revenues. Some level of uncertainty is an inevitable consequence of any discipline where prediction of the future is needed. This is the foundation of claims, where it is necessary to project future income but for an insured event.

The current financial climate poses a number of challenges, particularly following the global financial crises in 2008. Many countries are still in a desperate financial situation - whether as a result of the recession, government debt, or currency issues – and are taking a long time to recover.

Effects of the recession

The UK manufacturing sector continues to feel the effects of the recession, having contracted unexpectedly in July 2011, and it is only emerging markets such as India and China which seem to be buoyant. However, even those economies have been affected and many factories in China have closed due to the shrinking market for sales in the West.

The energy market, including petrochemicals and base metals, was severely affected by the global financial collapses, with substantial and sudden drops in volumes and prices. However there could be an upturn in an industry in a specific geographic location. For example, Australia is currently experiencing a recovery in commodities. So a claim needs to be looked at in the context of its industry and geographic market conditions.

The activity in these markets confirms their unpredictability and the difficulty in forecasting. The starting point for a projection of sales will often be an analysis of pre-incident trading levels. Recent experience has shown that this is not always a reliable indicator of future performance.

The forecast of future revenue and profits of companies in the UK will also vary between industries and within certain sectors. For example when projecting the revenue of an airline, the approach may be different for a traditional airline compared to its budget counterpart. Similarly, a budget hotel chain might be experiencing better results than a luxury hotel chain.

Companies react to the challenging economic climate in different ways. Some will become aggressive, seeking to maintain sales by cutting their prices, offering discounts or changing their mix of products, while others will focus in maintaining profitability even at the expense of declining sales.

A UK company will be affected by the lack of growth in the UK economy but this could be limited if the company exports its sales or services – particularly to countries that are in better economic shape than the UK. Linked to this is the financial position of a company, and whether it is able, irrespective of a loss, to continue trading successfully in difficult circumstances. The availability of assets that can easily be turned into cash could be key to its survival. A loss will invariably put more pressure on its finances, and may be blamed for its failure.

Sales and revenue

When projecting sales following a loss, it is important to ensure the loss reflects not only the direct effects of the incident but also any factors that would have arisen in any event. If a motor manufacturer in the UK sustained a loss in the summer of 2011, it would have to account for, as an example, the Japanese earthquake in March, and whether this affected the supply of key components required.

Projecting revenue following a loss can be tricky, even in a stable economic environment. In the current climate, with diminishing projections for growth, the task becomes more difficult and will impact the quantification of insurance claims.

It is vital to look not only at the economic position, and the industry in which the insured operates, but also the company itself: where it operates; who its customers are; its financial position before the loss occurred; and any relevant external factors. Without this, it is predicting the unpredictable.

 

As appeared in Post, September 2011.

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