Summary of Meeting Paper

The 1996 Annual Meeting of the Society for Risk Analysis-Europe

Integrated Risk Management. T.A.W. Geyer and M.I. Morris, Four Elements Limited, 8 Cavendish Square, London, UK

INTRODUCTION

Accidents like the Exxon Valdez oil spill in Alaska, the toxic release at Bhopal, India, and loss of the Piper Alpha oil platform in the UK North Sea do not happen very often. However, when such accidents do occur, their impact can critically impair a company's financial health. When combined with negative publicity and increased levels of regulatory scrutiny, even the management of major corporations become defensive. In addition, with the increasing trend towards "right sizing" organisations, many operators do not have the management resources to carefully monitor and control their total liability or financial exposure. Decentralisation of responsibilities for environment risk management, insurance, and legal counsel often precludes corporations from getting a composite view of accidents which could severely cripple their business. Plant managers face many of the same concerns when assessing their liabilities and insurance needs.

To reduce the likelihood of being faced with unanticipated, unrecoverable losses of any magnitude, many companies in industries ranging from petroleum to finance are taking a proactive approach to managing their liabilities, utilising integrated (financial) risk assessment.

Integrated Financial Risk Assessment creates a complete picture of a company's total liability by translating the impact of accidents into financial terms. This basis facilitates the comparison of various consequences, and incorporates the total costs of incidents to obtain a true financial liability of the undesired event. A financial basis naturally lends itself to the cost-benefit analysis of alternative approaches and/or potential mitigation options. The approach devises cost effective strategies to eliminate and reduce risks and, Ultimately, to protect companies from liability.

The oral presentation of this paper will describe the technique of integrated risk management, and give case study examples of its application.

DIEFFERENT TYPES OF RISKS

Fatalities and Injuries. A number of accidents have occurred in recent years which have resulted in large numbers of casualties. These are vivid reminders that material failure, human error and management shortcomings can affect even the most developed of technologies. The most significant example is probably the toxic release at Bhopal noted in the introduction where many thousands of Fatalities resulted from the accidental release of methyl-iso-cyanate.

Environmental damage, regulatory fines, and clean-up costs. Adverse events can occur which result in no casualties, but nonetheless have significant financial impact. The most well known example here is probably the Exxon Valdez oil spill. This event has cost Exxon billions of dollars, primarily due to the clean up cost and regulatory fines.

Lost Production. The Piper Alpha platform was a key platform through which a number of other platforms pumped hydrocarbons to shore, and thus m addition to the loss of life and assets, there was a significant production loss (or deferred production) due to the loss of this platform.

Asset Loss (replacement costs). An example in this class of risk is Statoil's Sleipner concrete gravity based offshore platform The base of this platform sank to the bottom of the fjord during the final stages of the commissioning tests.

Property damage. An ethylene explosion at a Philips plant in the US required the complete redesign and rebuilding of the plant at a cost in excess of $1 billion.

Loss of market share. ARCO Chemical Company in the US were one of a limited number of producers of MTBE, a petrol additive. An explosion at one of their plants led to a period during which they could not produce, and by the time production had resumed, significant market share had been lost to other manufacturers and importers.

Product boycott. The Brent Spar incident, particularly the response of consumers in Germany, demonstrates the potential financial impact of product boycott.

All the above risks can be evaluated in terms of an adverse financial impact on the operator. Not only do accidents require financial resources, they can also result in increased insurance premiums, make raising capital more difficult, and decrease share values.

THE IMPORTANCE OF RISK MANAGEMENT

It is widely accepted that there is no such thing as zero risk. In a wide variety of industries, many years of design evolution and operational experience have failed to eliminate all risks, and there remains a residue which must be consciously managed and controlled.

Integrated risk management refers to the assessment of a wide variety of risks on a common basis. It involves the bringing together of a range of disciplines (e.g., major hazard assessment, environmental impact, site remediation, economic appraisal), and also the consideration the whole spectrum (life cycle) of an operator's operations (e.g., from R&D, through raw material delivery, processing/manufacture to product delivery and use).

THE APPROACH

Integrated Financial Risk Assessment comprises three main stages: developing a risk profile, evaluating risk control alternatives, and reviewing risk finance options.

Developing the Risk Profile

The first stage of the risk management process is the identification of how things can go wrong. This is the hazard identification stage of the risk assessment. In industries involved in the manufacture, handling or transport of hazardous materials, the risk arises mainly as a result of loss of containment accidents. For transport operations, events of interest are derailment and collisions of trains, groundings and collision of ships, extreme weather conditions, road traffic accidents, etc.

The next stage of the process is to establish how often such events can be expected to occur. This involves estimating the frequency of the hazardous incidents and requires data such as the failure rates of valves, pipes and vessels, transport accident frequencies, etc. This stage involves assessment of not only the frequency of the initial incident, such as the release of a flammable material, or the derailment of a train but also establishing the frequency of the ultimate outcome. This will be determined by the success or failure of the various mitigation systems and emergency response actions. For example, in the event of a loss of containment accident, the consequences will be influenced by whether the release ignites, whether the spill is on land or water, whether isolation valves act to limit the duration of the release etc. In the case of a derailed train, the consequences will be increased in the event of a secondary collision, or whether there is a subsequent fire. This stage of the analysis develops a variety of different scenarios (each associated with a particular level of damage, severity of explosion, size of material spills, etc.).

The final stage is then to quantify the total cost of the accident scenarios. This involves estimating the environmental damage, and the likely clean-up costs, scrutinising legal case precedents as regards the level of regulatory fines associated with accidents, estimating the loss of production costs and asset replacement costs, etc.

Finally, the frequency and financial consequence information is combined to produce overall measures of risk to support the decision making process. This may be frequency loss curves, mean recurrence frequency data, annual average liability, maximum liability, etc. One advantage of this kind of approach is that the risk profile can be easily understood by both technical and financial managers.

Risk Control Evaluation

The next step involves identifying potential risk control measures. The previous stages win have identified the dominant contributors and these become the focus of management attention they are the areas where potentially most benefit will be gained. Risk control options may include improvements in the areas of:

The risk model allows the impact of such control options to be assessed and a measure of the risk reduction to be obtained. Together with the cost of implementing the risk control measures, their cost effectiveness can be established.

Risk Finance Options

Given a detailed knowledge of the risks, and having implemented cost effective risk control measures, a number of options are available to finance the residual risk. Firstly a company can decide to accept the risk and do nothing further. Alternatively, self insurance may be decided upon, taking advantage of the tax benefits, or transference of the risk either through insurance with a third party or, for example, by purchasing a material rather than manufacturing it. The risk profile will show where insurance is most needed.

Risk Management Guidelines - Criteria

It is also possible to define risk guidelines or criteria, primarily determining the maximum level of risk which the company is prepared to tolerate. Risk criteria provide the anchor points in a decision making framework, which ensure that risk related decision making is both consistent and repeatable. Criteria can be set in terms of the absolute losses, or in terms of the asset value of the company, or in terms of loss of annual profits, etc.

BENEFITS OF INTEGRATED RISK MANAGEMENT

Quantification of risks in itself beings a number of benefits, including identifying the dominant contributors to the risk upon which management attention can be focused, providing a basis for evaluating remedial measures which reduce the frequency and/or consequences and for evaluating the cost effectiveness of such measures, and allowing judgements to be made as to the acceptability of the risk.

However, the benefit of the integrated risk management approach is that it measures all liabilities on a common financial basis. This is important as rarely will a risk control measure only address one risk, and one may draw incorrect conclusions about the cost effectiveness of a measure if its total effect is not studied.

For example, consider a railway operator who is evaluating a measure which reduces the frequency of derailment. A safety only assessment may conclude that the measure is not worth implementing, as very few derailments result in fatalities. However, if the same measure reduces the likelihood of freight train derailment, and the potential spillage of hazardous cargoes (with the associated environmental damage and clean-up costs), and account is also taken of the asset replacement cost of damaged rolling stock and the lost revenue due to the time for which the lines cannot be used are taken into account, the measure may well be judged cost effective.

Summary

Integrated Financial Risk Management addresses the following questions:

Application areas include:

Ultimately this type of approach should lead to increase profits through optimisation of resource usage. It should also lead to increased financial stability through reducing the frequency of unexpected losses, and devising appropriate insurance strategies.