The FAS Focus. Edition 12 November Welcome to the 12 th edition of FAS Focus.

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1 The FAS Focus Edition 12 November 2017 Welcome to the 12 th edition of FAS Focus. This issue features an article on wide area damage, jointly written by Andy King (Head of FAS UK) and Mark Thompson (Global Head of FAS). This topic is very current. With the various typhoons that hit the United States, South America and Asia in the last few months causing widespread damage, claim parties will need to have a look at policies from a wide area damage perspective. Andy and Mark discuss some differences between US and UK policy wordings. Our second article is written by David Gibson (Sydney), and discusses the impact of price spikes in the electricity market. Although David looks at the Australian market, the issues raised are universal and can make a big difference to the final claim settlement, so it s worth taking note. FAS Global is growing and we are pleased to announce further senior additions to the FAS teams in various parts of the world. Welcome to Josephine Suppiah (Partner), Aruna Chandrapalan (Senior Manager) and Richard Keegan (Corporate Risks Director) in London Terri Adams has been promoted from Senior Manager to Director. Jessica de Maudave (Manager) joins us in Brisbane and Chris Gooch (Manager) is joining us in Sydney. In addition, Jake Carter, previously in the Sydney and Brisbane offices has moved to Auckland to head up FAS Global New Zealand. We hope this issue of FAS Focus provides some useful insight and that you enjoy reading it. Feedback on the content is, as always, welcome and we at FAS would be delighted to hear from you to discuss your thoughts on the topics considered. Adrienne Kouwenhoven Partner, Head of Asia T E akouwenhoven@fas-sg.com

Principles of wide area damage With many islands and areas seriously damaged by the various hurricanes that have passed through the Caribbean and Florida coastline, as well as the various typhoons in

2 Principles of wide area damage With many islands and areas seriously damaged by the various hurricanes that have passed through the Caribbean and Florida coastline, as well as the various typhoons in Hong Kong and Japan, the question of wide area damage in Business Interruption ( BI ) claims will once again be raised. We therefore thought it timely to revisit the principles of wide area damage. The below reflects our experience when quantifying business interruption losses in a range of wide area damage scenarios during the earthquakes in China, Japan and New Zealand and the widespread flooding in Bangkok and the UK during recent years. UK policy wording: but for the incident A BI policy typically provides cover for interruption or interference in consequence of loss, destruction or damage to property used by the insured at the premises for the purpose of the business. In most UK policy wordings the link to material damage is repeated by the word incident : the amount payable by way of gross profit is the sum produced by applying the rate of gross profit to the amount by which the turnover during the period of indemnity shall fall short of the standard turnover in consequence of the incident. In such wordings Incident is defined as Loss of, or destruction of, or damage to property used by the Insured at the Premises for the purpose of the Business. Incident thus has a very specific meaning and does not encompass other damage within the surrounding area. But for the incident, can essentially be read as but for the Insureds damage. This is important in relation to the Other Circumstances Clause. Effect of the other circumstances clause The purpose of the Other Circumstances Clause is to make adjustments to the anticipated but for the damage trading results, or Standard Turnover, so that the insured receives the correct indemnity. The wording is set out in full below with my highlights: to which such adjustments shall be made as may be necessary to provide for the trend of the Business and for variations in or other circumstances affecting the Business either before or after the incident which would have affected the Business had the incident not occurred so that the figures thus adjusted shall represent as nearly as may be practicable the results which but for the incident would have been obtained during the relative period after the incident The defined term incident is repeatedly used, and it appears to be the intention of the Other Circumstances Clause and the rest of the wording of the policy to deal with losses resulting solely from damage to property at the designated premises. This essentially means that, when considering the anticipated performance of a business, the Other Circumstances Clause can be used to adjust downward (or upward in some circumstances) the standard or expected turnover to reflect trends (i.e. a downturn in business) which are themselves the result of the event that caused the damage to the premises. For example, in a widespread flood scenario, we have to take into account the new world order after the flooding, and calculate the expected turnover the Insured would have achieved but for the damage, i.e. if it had been the only business on a hill and its surroundings were flooded. In many instances, the worse the wide area damage, the lower the anticipated sales and the lower the BI loss, as often business decreases substantially when roads are blocked, and supply chains are affected as a large number of businesses sustained damage. That said, there may be instances where a business, had its insured assets not been damaged, may have been able to take advantage of other competing businesses in the vicinity suffering damage, thereby legitimately anticipating a higher level of turnover than would have been generated prior to the event. An example of this may be a hotel which could have enjoyed full occupancy due to its competitor hotels in the neighbourhood being out of business. 2

United States BI wordings: but for the event The coverage in US policies is worded differently for business interruption, which has consequences for the way wide area damage claims are dealt with.

3 United States BI wordings: but for the event The coverage in US policies is worded differently for business interruption, which has consequences for the way wide area damage claims are dealt with. US BI wordings cover BI losses caused by direct physical loss of or damage to property. The coverages vary but in general US wordings pay for the actual loss of business income and extra expense you sustain due to the necessary suspension of your operations. Operations are defined as your business activities occurring at the described premises. The Loss Determination Clause does require an estimate to be made of what the results of the business would have been, but with no specific formula. This has led to a specific windfall profit exclusion clause within the Loss Determination Clause, such as: The Loss will be determined based on: 1. The Net Income of the business before the direct physical loss or damage occurred; 2. The likely Net Income of the business if no physical loss or damage had occurred, but not including any Net Income that would have been earned due to increase in the volume of business, due to favourable business conditions caused by the impact of the covered cause of loss on customers of other businesses; 3. The operating expenses including any payroll expenses necessary to resume operations with the same quality of service that existed just before the damage occurred; and 4. Other relevant sources of information including financial records and accounting procedures, invoices and other vouchers and deeds, liens or contracts. The specific exclusion of windfall profits under the US wording has implications. If windfall profits caused by the impact of the covered cause of loss are excluded, then it may be iniquitous for windfall losses caused by the impact of the covered cause of loss to be imposed on the claim by insurers. Of course, this depends on insurers intentions and actual policy wording. We have seen instances in the past, such as during the Sichuan Earthquake, where US policy wordings stipulated the impact of the covered cause, and as a result, business interruption calculations had to be based on a but for the event scenario, i.e. what would the business have earned but for the earthquake. This meant that our expected scenario essentially reflected a world preearthquake, rather than the new world postearthquake. Put differently, it disregarded any adjustments due to wide area damage. Concluding remarks Of course, the above provides a general overview and any final approach will be determined by the specific circumstances of each case, applicable policy wording and instructions from insurers. Mark Thompson Head of MCL Asia Pacific, Head of FAS Global T E mark.thompson@fas-au.com Andrew King Head of FAS Global (UK) T E andrew.king@fas-uk.com 3

The impact of price spikes in wholesale electricity markets When we switch on the lights at home, the electricity that runs through our lightbulb is at the end of a long journey.

4 The impact of price spikes in wholesale electricity markets When we switch on the lights at home, the electricity that runs through our lightbulb is at the end of a long journey. That journey begins when a power company sells the electricity it generates to the electricity retailer who supplies your home. This sale from generator to retailer is made possible by the existence of a wholesale electricity market. Transactions between generators and retailers can occur at pre-agreed fixed contract prices. However, some electricity is over a spot market, in which prices change on a half hourly or hourly basis to balance supply and demand. The National Electricity Market (NEM), which operates across all of Eastern Australia, is an example of such a market. Spot prices can vary considerably in this market. Whilst spot prices on the NEM typically average less than $100 per Megawatt Hour (MWh) 1 of generation, prices have been recorded at levels in excess of $10,000/MWh. The complexities of these markets present unique challenges in assessing the Business Interruption loss of a power station. These include: 1. Considering how lost generation can impact spot prices; 2. Looking at the impact of lost generation on the Insured s overall generation portfolio; and 3. Anomalies caused by price caps. Impact of lost generation on spot prices As with all markets, electricity markets operate on the principle of supply and demand. When demand exceeds supply, the price of electricity will increase, and when demand is lower than supply, the price will decline. When a generating unit experiences an outage, total supply in the spot market reduces. This can cause an increase in the spot price. In some cases, where the outage is relatively small, or the market is oversupplied, there may be a negligible impact on the spot price. However, in other cases the impact on price can be significant, such as when a large unit experiences an outage during a period of high demand. There are many factors which influence spot prices, such as time of day, season, weather, the performance of competitors and broader economic conditions. For this reason, we will often engage an economist who specialises in electricity markets to determine the impact of an outage on the price of electricity. An increase in spot prices due to an insured outage has two implications for a Business Interruption claim. First, the expected revenue of that unit needs to be adjusted to reflect the price it would have achieved had the lost output been available. Second, if the Insured operates other generating units, then the benefit of a higher price on those units should also be considered. Generation portfolios and make-up The impact of lost generation on spot prices can also mean that the decision to use spare capacity to make up lost generation is not always a straightforward one. Large power generation companies typically operate a portfolio of multiple generating units. For these Insureds, it is often possible to make up some or all of their lost generation by using spare capacity across the remainder of the portfolio, typically at an increased cost. However, at times when the spot price is particularly sensitive to changes in supply, it can actually be more beneficial for an Insured not to make up some of its lost generation. An example of this is shown below. In this example, total revenue actually increased despite a loss of output, due to the increase in the spot price caused by the lost generation. There would therefore be no benefit to the Insured in making up its lost generation. 1 Megawatt Hours measure the volume of electricity generated. As the name suggests it represents the amount of electricity a unit will generate if it operates with output of one Megawatt for a period of one hour. A Megawatt measures the instantaneous output of a power station. 4

Anomalies caused by price caps A feature of power generation policies we often see is a cap on the maximum revenue per MWh payable under the policy.

5 Anomalies caused by price caps A feature of power generation policies we often see is a cap on the maximum revenue per MWh payable under the policy. This price cap is usually a fixed number such as $100/MWh. The application of this cap can cause two anomalies. First, as noted above, the loss of generation can sometimes result in a benefit to the Insured, due to the price spikes in spot prices at certain peak times. Typically, this benefit would be offset against losses in other trading intervals. It is not always clear how this benefit should be treated when a price cap is in place. For example, we reviewed a claim where the Insured benefited by around $1.5 million from increased spot prices caused by the incident. The majority of this increase was due to increases in spot prices which were already above the price cap. 2 However, the application of a price cap (before taking into account the benefit above) reduced the claim by around $2 million. It would seem inconsistent to deduct the benefit from the claim when similar losses had been excluded due to the application of the price cap. Second, if the price cap is lower than the cost of generation at some of the Insured s generating units, then it could become uneconomic to make up any lost generation at that unit. For example, say the spot price was $150/ MWh and the Insured could make up lost generation at $120/MWh at another unit. The Insured (and Insurers) would be $30/MWh better off if it made up the lost generation at $120/MWh. However, if a price cap of $100/MWh was in place then it would actually be more expensive to Insurers if the Insured chose to make up lost generation at $120/MWh. Concluding thoughts This article only touches upon some of the issues which arise due to the complexity of the wholesale electricity market. The impact of lost generation on spot prices can have a significant impact on the quantification of Business Interruption losses. For these reasons it is important to engage a team of experts who can model the impact of outages on spot prices, understand the impact on loss mitigation and address the anomalies which arise in these claims. David Gibson Director, FAS Global (Australia) T E david.gibson@fas-au.com 2 For example, say the price cap was $100/MWh. The price benefit was the result of spot prices increasing from $120/MWh to $130/MWh. 5

MCL Global. Major & Complex Loss. Global Capabilities. cunninghamlindsey.com

MCL Global. Major & Complex Loss. Global Capabilities. cunninghamlindsey.com Major & Complex Loss Global Capabilities cunninghamlindsey.com MCL Global - Global Capabilities Strength in numbers The insurance market is facing some fundamental changes in the claims it faces and the