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.

7-1
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.

7-2
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.

7-3
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.

7-4
 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.

7-5
 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.

7-6
 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.

7-7
 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.

7-8
 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.

7-9
 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.

7-10
 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.
7-11
 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

7-12
 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.

7-13
 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.

7-14
 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.

7-15
 Construction Cost Index

Table 07-1: Construction Cost Index

1926 = 100.0
**** *****
1983 = 1176.7
1984 = 1224.4
1985 = 1249.6
**** *****
1995 = 1571.5
7-16
 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

7-17
 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 Index Value
New base-year index value

7-18
 Changing the Base Year

Building was built in 1985

1985 Index Value = 1249.6
1995 Index Value = 1571.5

1571.5
= 140.2
1249.6

1985 cost X 140.2 = 1995 replacement cost

7-19
 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.
7-20
 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. 7-21
 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.
7-22
 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

7-23
 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.
7-24
 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

7-25
 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.

7-26
 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.
7-27
 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.

7-28
 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."

7-29
 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.
7-30
 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.

7-31
 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.
7-32
 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.

7-33
 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.

7-34
 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.

7-35
 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.

7-36
 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.

7-37
 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.

7-38
 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.

7-39
 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.
7-40
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.
7-41
 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.
7-42
 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."

7-43
 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.
7-44
 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.
7-45
 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.

7-46
 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.

7-47
 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."

7-48
 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.

7-49
 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.
7-50
 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.
7-51
 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.

7-52
 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.

7-53
 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.
7-54
 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.
7-55
 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.
7-56
 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.

7-57
 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.
7-58
 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.

7-59
 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.

7-60
 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.

7-61
 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?"

7-62