A Major Blow

Article, Post MagazineNovember 2008

Insurance / Property

When supplies of valuable commodities like oil are threatened by events such as hurricanes, price spikes can follow. So how does this affect the quantification of business interruption losses? Justin Crick, Partner at RGL's London office, explains.

The recent passage of hurricanes Gustav and Ike through the oil producing areas in the Gulf of Mexico led to an increase in the price of oil due to supply concerns about the potential for significant damage. This is not a new phenomenon and goes right to the heart of economic pricing theory, which asserts that as supply reduces - or is perceived to reduce - and demand remains the same, there will be a price increase.

One of the many factors that could lead to a reduction in supply may be an insured event, such as damage to an oil rig following a hurricane. However, price spikes are not restricted to the oil and gas industry and other recent and well-documented examples include: semi-conductor prices, after the 1999 Taiwan earthquake; European-wide electricity prices, following the turning off of many French nuclear reactors in 2003 due to the hot weather; the price of gold, after power cuts in South Africa in 2008; and coal price, following the floods earlier this year.

Deep impact

If the increase in the commodity price is due to an insured event, it may have a significant impact on the financial loss suffered by the insured party. Frequently, multinational insureds will have numerous sites throughout the world. And in large scale events, such as hurricane Katrina, the insured party is likely to have both unaffected and affected sites. While the affected site will have no production, the unaffected site will benefit from a higher selling price. In this way it can be argued that the benefit - that is the additional gross profit - which the undamaged site achieved as a direct result of damage to the insured's other site, should be deducted to calculate the loss had the damage not occurred.

Furthermore, the price that should be applied to the lost production also needs to be considered. For example, whether the price used should be the market price over the interruption period or the price that would have applied, had the damage not occurred.

By way of illustration, consider an insured with two plants, each with equal capacity. One of the plants is damaged by an insured event and the other is not. Due to the current supply and demand constraints, the price of a commodity increases by 10% on news of the damage. The loss, without consideration of the impact on the price at the damaged plant, is quantified as shown in table one.

However, if the impact on the price on actual sales at the unaffected plant and the price on lost sales are considered, the impact could be computed as shown in table two.

In this basic example a 10% increase in the selling price leads to a $1.6m (£1m) reduction of the business interruption loss - or 22% - of the calculated loss that did not account for the increase in the price.

The above example very much simplifies the issues as it assumes that the increase in the commodity price is easy to identify, which is not the case in reality. Factors that could complicate this include, but are not limited to: the price was on a upward trend prior to the incident or there were a number of factors that have caused the price to go up during the interruption period in any event; or there was damage to other installations with differing owners and, therefore - but for the damage to the insured's installation - the price would still have increased due to the reduced supply market wide. This issue is particularly common in catastrophe situations.

The big issue

These two issues make the quantification of BI losses involving commodities a complex and often emotive issue. Once the adjustment team has highlighted there is a price spike issue, it may be necessary for insurers to instruct a pricing expert to consider the impact. Furthermore, if and how the policy deals with this issue also requires careful consideration.

Any discussion on the impact of commodity prices and BI losses would be incomplete without mentioning the recent volatility. Often in BI reviews the emphasis is on turnover and accompanying sales trends. However, depending on whether the insured is a buyer or seller of commodities, recent dramatic changes in commodity prices turn the focus of attention on to the calculation of the rate of gross profit that is to be applied to any sales loss.

The impact of commodity prices, which can be both positive and negative, demands careful consideration in all aspects of BI claims. The ramifications of various movements - both before and after the interruption period - also need to be accounted for to ensure that a like-for-like comparison is made.

Table 1: Calulation of Loss

Calculation of Loss

 

Loss of production / sales (units)

Price per unit (during the interruption
period) (US$ per unit)

Less: cost per unit

Gross profit per unit 

10,000

880

(150)

730 

Total loss (US$) 

 7,300,000

 

Table 2: Calculation of possible credit

Calculation of Possible Credit

 

Lost production

Production at unaffected plant

10,000

10,000

Total (units)

Price but for the incident

Actual price during the interruption period 

20,000

800

880

 Increase due to the incident

80

Possible credit (US$)

1,600,000

 

As appeared in Post Magazine, November 2008.

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