Rethinking Risk

On a planet inhabited by more than 7 billion people, injury and loss arising from environmental factors and human behavior are inevitable. Surveys conducted by some of the world’s leading insurance industry organizations offer lists of the risks with the greatest impact, ranging from business interruption, market developments and damage to reputation, to cyber incidents, third-party liability and natural catastrophes. What is becoming clear is that these top risks increasingly are interconnected and have significant ramifications when viewed through the lens of risk management and insurance. This report explores these interconnections in greater depth, along with some of the legal consequences they can engender.

Complexities and connections Risk is dynamic. Global risks are increasingly complex, and change is accelerating. For example, what happens in one location can have severe, near-immediate implications on the other side of the globe. Advances in transportation and communication have in essence made the world smaller. It is easier today to conduct business across the globe than in the past, a development that has fueled both opportunity and exposure. Even seemingly isolated domestic events, depending on their nature, can have widespread impact. When loss occurs, recovery efforts – whether through insurance claims or litigation against a responsible party - can become quite complicated. Enforcing contract terms and conditions with suppliers and business partners can be daunting, especially when they cross international borders. The expectation of quick resolution of disputes is often adjusted downward once parties see clearly the challenge of pursuing or defending international litigation. Consider, for example, the following incidents and their outcomes: March 11, 2011: A magnitude 9.0 earthquake strikes Japan, triggering a massive tsunami. This catastrophe, one of the strongest quakes ever recorded, claimed more than 15,000 lives and caused economic losses of at least $300 billion. In addition to causing a meltdown at the Fukushima Daiichi

Many of the world’s most pressing risks, according to various polls of business leaders, are beyond the power of organizations to control. It is difficult, if not impossible, to predict – much less avoid – natural perils such as earthquakes, floods and wildfires. The effects of such perils are carefully analyzed and inform sophisticated catastrophe models, but the insurance industry and scientists still struggle to determine exactly where and when such events will occur. Likewise, human activity is inherently challenging to forecast. Fortunately, some elements of the risks cited as the most worrisome can be mitigated through insurance and risk management. Strategy-minded organizations therefore should take steps to control what risks they can. A fundamental method of controlling risk and mitigating loss from human or natural causes is provided by the global insurance industry. Through an array of products and services, the industry offers individuals and organizations tools to analyze, reduce and transfer risk. Underpinning these products are legal contracts designed to respond to policyholders’ needs while creating parameters for the insurer’s business commitments. Claims are paid in accordance with the terms and conditions agreed in the insurance policy. Insurers and policyholders, however, must adapt to changes in the business environment and to evolving risks.

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nuclear power plant, the event prompted the closure of nuclear plants across Japan, removing a major source of the nation’s energy. The tsunami also was responsible for supply chain disruption in Europe and North America, for industries including automotive and electronics. Whether large or small in scale, property business interruption and contingent business interruption are common exposures for businesses. The opportunity for a single event to disrupt operations and prevent goods from being sold is a function of the interconnectedness of businesses today. Even relatively small businesses can have multinational exposures to property losses, notes Robert Fisher, a partner in Clyde & Co’s Atlanta office. As an example, a regional U.S. manufacturer and distributor faced a class-action lawsuit involving materials produced in China. The company was named as an additional insured in a policy obtained by its Chinese supplier. Clyde & Co was retained to advise the insurer in China as well as provide coverage opinions under U.S. and Chinese law. In another case, Clyde & Co assisted a client in subrogating a contingent business interruption claim in the United States that arose from a fire at a supplier plant in the United Kingdom, preventing the insured’s high-value products from being sold and fulfilling U.S. purchase orders. The ability of a law firm to provide expertise and seamless service around the world enables better client outcomes on all types of claims, Fisher says. August 12, 2015: Human error in storing volatile chemicals causes a series of enormous explosions at a warehouse complex in Tianjin, China. The blasts killed at least 173, injured hundreds, displaced thousands of people and caused extensive damage to cargo awaiting shipment. Destroyed in the explosions were more than 10,000 automobiles and more than 7,500 shipping containers. The Tianjin event is estimated to result in the largest man-made insurance loss in Asia and one of the largest in history, at $2.5 billion to $3.5 billion, according to Swiss Re. One of the outcomes of the Tianjin event was increased awareness of risk accumulation and the need to understand proximity to other perils.

August 31, 2016: Global supply chains are disrupted when financially struggling Korean shipping giant Hanjin Shipping files for bankruptcy protection. Hanjin, one of the world’s largest container ship operators, fell victim to the worldwide economic slowdown after the 2008 financial crisis as well as sharply lower shipping rates. Hanjin felt the impact of lower rates on routes between Asia and Northern Europe and Asia and North America, which represented a large percentage of its revenue. Meanwhile, in September 2016, an estimated $14 billion of cargo was stranded aboard Hanjin vessels which were prevented from entering ports due to the risk or threat of arrest by Hanjin creditors, and the port operators’ fears that the shipping company would be unable to pay docking fees. The delays in shipping are expected to have downstream effects on the revenue and profits of many retailers as they scrambled to arrange alternative logistics. About 95% of the world’s manufactured goods are transported in containers, making disruptions such as the Hanjin bankruptcy a major risk for manufacturers, distributors and merchants. February 18, 2008: The U.S. Department of Agriculture announces one of the largest-ever recalls of ground beef, totaling 143 million pounds, by a California meat company. Widely distributed among restaurants, grocers and even federally subsidized school lunch programs, the recall created logistical challenges for customers of the meat company, and the USDA acknowledged that much of the product subject to the recall had already been consumed. The recall was prompted after a clandestinely filmed video of employees abusing ill cows raised questions about food safety. The incident brought further scrutiny to food producers, raised awareness of product liability risks and ushered in more stringent regulations. In 2007, there were 21 recalls of beef suspected of contamination with the pathogen E. coli. Although the USDA classified the health hazards from the 2008 recall as remote, the California meat company ultimately went into bankruptcy. Product liability risks extend well beyond the food and beverage industries. Manufacturers in virtually all industries face exposure to product liability claims. For example, 14 automobile manufacturers have been forced

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to replace tens of millions of defective airbags made by supplier Takata. The National Highway Traffic Safety Administration has called it the largest and most complex safety recall in U.S. history. Product liability litigation is usually complex and expensive for all parties. A particular burden on defendants is pre-trial discovery in meeting plaintiffs’ requests for documentation. February 2015: One of the largest-ever data breaches is discovered at a major U.S. health care insurance company. The incident exposed more than 80 million patient and employee records, including those of customers living outside the United States. The malware identified in the cyber attack was associated with malicious programs originating in China. In addition to incurring costs for forensic investigations and breach notification, the insurer also faces numerous lawsuits alleging, among other, things, failure to adequately protect its data systems, failure to timely notify customers of the data breach and economic losses including paying for services that should have included protecting personally identifiable information. A judge in February 2016 dismissed certain of the claims but allowed many to proceed. The size of the consolidated class and the theories of liability could well influence future data breach litigation. Adding to the company’s reputational impairment were opportunistic “phishing” attempts to direct affected customers to fraudulent websites after the breach. Costs related to the breach reportedly are expected to total tens of billions of dollars. An evolution of cyber risk that Clyde & Co partners have observed, especially in the past year, is the rise of cyber crime and increasing sophistication of social engineering using technology. For example, some cyber criminals are hacking e-mail and voice-mail systems to fraudulently direct the transmission of funds outside the victimized organization. Traditional crime insurance policies generally exclude voluntary parting of funds, yet the evolution of sophisticated cyber extortion schemes is creating a new source of economic loss, which is what crime insurance is intended to cover. Similarly, business interruption can be as severe from a cyber incident as from a natural disaster, yet a cyber incident typically does not result in a physical loss. Property business interruption policies are designed with a direct or contingent physical loss as the coverage trigger,

yet cyber business interruption is now a serious exposure for a growing number of organizations. As a result, the insurance industry has an opportunity to innovate its products and services to reflect this evolving nature of risk. Working with a law firm that understands the evolution of risk can help insurers to develop new products that capitalize on emerging needs and avoid taking risks where insurers do not intend to do so. The above examples illustrate the web of uncertainty woven by unexpected events. The strands can be much longer and more intricate extending out from the location where the event occurs. From an insurance perspective, property and liability losses can take some time to develop, especially where supply chain disruption and consequential business interruption are involved. Resulting regulatory investigations and penalties as well as third-party litigation further complicate the risk exposure for affected businesses.

2015 Distaster Losses 13% of overall disaster losses were manmade, representing $12 billion vs. $80 billion in natural disasters Source: Swiss Re

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A closer look at a given loss event, of human or natural origin, often reveals a greater impact than appears at first glance. The top risks, when examined, have significant correlations; often a single event can have impact in multiple areas of business and society. Complexity of risk is greater today and so is the speed at which risks can occur. For example, in 1918, an influenza pandemic took nearly a year to spread around the world. Less than a century later, tropical viruses such as Ebola and Zika can travel to virtually any population center on Earth in under 24 hours. Between advances in air travel and the trend in urbanization, a pandemic in the present day could affect a large number of people in a short time. One of the consequences of global pandemic would be the inability of businesses to operate, either from lack of customers, employees healthy enough to work, or both. A public health emergency also could shut down transportation or prompt officials to issue quarantines. A business can face financial loss frommultiple risks, and potentially more than one at once, with knock-on effects for a long time afterward. Consider these scenarios and the opportunity for insuring them: –– Business interruption can be caused by macroeconomic or market developments or changes in legislation/regulation and result in damage to reputation or brand. Property business interruption policies generally are triggered by specific perils that result in physical damage, though not every disruption occurs due to physical loss. –– Cyber incidents can disrupt business operations, damage reputation and brand value and influence changes in legislation or regulation. Downtime from a cyber event can severely limit a business’s ability to serve customers and generate revenue, especially for those that rely on e-commerce. At the same time, the event may cause both first-party loss and third-party liability. –– Changes in market conditions can significantly alter a business’s growth strategy; for example, the sharp drop in oil prices has led some major petroleum firms to abandon costly exploration projects. Redeployment of assets can change the organization’s risk profile and, along with it, the need to reconsider its insurance and risk management approaches.

–– Natural catastrophes, e.g. windstorm, flood, earthquake, can cause widespread loss of life, property damage, business interruption and alter the economic landscape, locally and beyond. For example, an event such as Hurricane Katrina was not only a massive insured loss event but led to long-term population migration, affecting businesses in terms of both labor and customers. For businesses in catastrophe-prone locations, reopening quickly can mean the difference between surviving and closing permanently. –– Disputes over intellectual property and/or regulatory intervention can change the trajectory of a business. Companies in multiple industries have been forced to revise their business plans as a result of litigation from suppliers or actions brought by foreign regulatory authorities. U.S.-based technology companies, for example, have discovered that European Union antitrust regulations canmake the E.U. a costly place to do business. The risks that business leaders cite as those most likely to induce insomnia are seldom confined to single locations. Risk, like the insurance industry itself, is global. Coping with rising volatility and interconnectivity of risk calls for a fundamentally different approach, one that relies on understanding the big picture as well as minute details. That calls for specialist expertise with worldwide perspective.

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Managing interconnected risks If there is a common thread in the tapestry of global risks, it is uncertainty. The great challenge in managing risk is how to create certainty where little to none exists. For most organizations, risk transfer through insurance plays a critical role, particularly for high-severity exposures. Insurance and reinsurance provide important solutions in protecting value, for both the private and public sectors. The insurance industry’s response to emerging risks has resulted in innovative products that can substantially increase the resiliency of businesses to unexpected financial loss. Fundamental to effective risk management and risk transfer, however, are a clear understanding of known risks and careful planning to cope with the unknown. Advances in risk analytics are helping the insurance industry and businesses to assess and quantify exposures as never before. Yet, the question of whether a claim is covered comes down to the terms and conditions of the insurance contract itself. Thoughtful drafting of policy wordings is crucial to balance the needs of insureds with the financial obligations of their insurers. Further complicating the challenge of managing risks that have global impact is that the nature of such risks spans many markets and jurisdictions, and often requires the participation of multiple insurance companies. Knowledge of international laws and regulations is therefore crucial to managing and underwriting global risks. Failure to grasp and comply with local and national regulations can be costly and create gaps in risk management and insurance programs. It is difficult to envision the current global risk environment reversing course. Economies will not become less interconnected. Global risks and regulations will not reduce in complexity. Doing business and underwriting risks internationally is highly unlikely to become simpler or easier. Acknowledging these dynamics, organizations more than ever must consider expert partners – in risk advisory services, insurance and legal matters. Local perspectives, while offering value, are intrinsically limited. Specialist expertise, providing global perspectives, is far more valuable to businesses and insurers in helping them to achieve their goals.

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Appendix

Below is a table of the top risks from sources including Allianz Global Corporate & Specialty’s 2016 Risk Barometer, theWorld Economic Forum (Zurich and Marsh, principally) and the biennial Aon Global Risk Management Survey (2015 was most recent). These annual lists provide insight into what’s most worrying to risk observers. The global risk environment is too complex to consider risks singly.

Allianz Global & Corporate Solutions Aon

World Economic Forum (top 10 by impact)

Business interruption

Damage to reputation/brand

Failure of climate-change mitigation and adaptation

Market developments

Economic slowdown/slow recovery Weapons of mass destruction

Cyber incidents

Regulatory/legislative changes

Water crises

Natural catastrophes

Increasing competition

Large-scale involuntary migration

Changes in legislation and regulation Failure to attract/retain top talent

Energy price shock

Macroeconomic developments

Failure to innovate/meet customer needs

Biodiversity loss and ecosystem collapse

Loss of reputation/brand value

Business interruption

Fiscal crises

Fire, explosion

Third-party liability

Spread of infectious diseases

Political risks

Computer crime/hacking/ viruses/ malicious codes

Asset bubble

Theft/fraud/corruption

Property damage

Profound social instability

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Clyde & Co LLP is a limited liability partnership registered in England andWales. Authorised and regulated by the Solicitors Regulation Authority. © Clyde & Co LLP 2017

Clyde & Co LLP

www.clydeco.com

J361311 - January 2017

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