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By DAVE LENCKUS, who has covered the insurance industry for more than two decades

Scenario: Imagine the Long Beach and Los Angeles ports, which handle approximately 40 percent of the nation's imported container cargo, shutting down for weeks, maybe months.

According to the U.S. Geological Survey, California inevitably faces a storm so monstrous that it's difficult to imagine how cargo ships could dock in the state, how many longshoremen would be at work to unload them anyway and how the goods could be moved out of the state.

The impact of such a calamitous storm is laid out in a USGS report, "The ARkStorm Scenario: California's Other 'Big One,' " released in January.

An ARrkStorm--ARk stands for Atmospheric River 1,000--is an epic system consisting of so-called "atmospheric rivers" that form in the tropics, move up to California and then dump as much as 10 feet of rain over the course of weeks. An ARkStorm devastated the state nearly 150 years ago, beginning in late 1861 and continuing for 45 days into February 1862, according to the USGS. The agency estimates that these storms occur once every 100 or 200 years.

In current day California, the implications would be staggering, because of the state's development since Civil War days.

The report forecasts that flooding 300 miles wide and 20 miles long would drown the Central Valley. Los Angeles County--where the two ports are located--as well as Orange County, the San Francisco Bay area, San Diego and coastal communities also would be flooded, damaging or destroying one-quarter of the homes in the state.

During the storm, winds in some areas would reach hurricane-force speeds of up to 125 miles per hour. Hundreds of landslides would cause further damage to property and roads.

Power, water and sewer services would be interrupted for weeks or months.

The report estimates business interruption costs would reach $325 billion.

California has a flood control system, but an ARkStorm would overwhelm it, says the USGS report, which is based on input from 117 scientists, engineers, public-policy experts, insurance experts, and utility employees.

The agency concludes, however, that loss of life and property damage could be mitigated significantly if the flood control system, designed to handle what had been thought to be 100- to 200-year runoffs, is overhauled.

Analysis: For companies located east of the Golden State that would have to wait an extended period for the delivery of their products and components at an alternate port as a result of an ARkStorm, their business interruption loss would not be insurable.

The interruption would not result from any insured damage to their property. Their suppliers would not have suffered a loss, so there would be no contingent business interruption loss. And even a fledgling business interruption product designed to respond to supply chain losses that are not triggered by physical damage would not help, since no link in the supply chain would have

been broken.

It's what could be described as a phantom business interruption loss.

Even if the USGS's report does not alarm a business, either because it does not depend on Asian imports or it considers the agency unnecessarily overwrought, the risk of phantom business interruption from other perils should be a concern, experts say.

In just the past year, experts point out:

-- The eruption of an Icelandic volcano spewed an ash cloud that compelled European aviation authorities to ground commercial airlines for more than a week last April, and again for a few days in May. The International Air Transport Association estimated that airlines lost at least $200 million every day they were grounded.

-- The months-long oil spill in the Gulf of Mexico seriously harmed tourism along the Gulf Coast, even at resorts on beaches where oil did not wash ashore.

-- In Japan, even suppliers that were not damaged by the March 11 earthquake and tsunami could face problems operating for awhile because of the disaster's impact on personnel, utilities and the infrastructure.

It's been a year of "global weirding" that should underscore the phantom business interruption risk, said Marik Brockman, a Portland, Oregon-based partner with Diamond Advisory Services unit of PricewaterhouseCoopers L.L.P.

The risk always has existed, but the ash cloud's costly effect on airlines showed that phantom business interruption is a bigger problem than executives at many companies had realized, said Brian C. Elowe, Boston-based managing director of the Global Risk Management Group at Marsh Inc.

Several factors have increased that risk over the past generation, experts say.

In particular, global supply chains have become very complex for many businesses, Elowe and Brockman say.

With these "food chains" getting longer, a company can indirectly rely on a supplier affected by a natural disaster on the other side of the world, Brockman said.

In addition, a host of other problems can break that chain, including poor economic conditions and political unrest, said John White, Chicago-based vice president-market management with Allianz Global Corporate & Specialty Americas.

Compounding the problem is businesses' growing dependence on the just-in-time inventory system, which minimizes warehousing costs, but can result in lost sales and revenue very quickly if a breakdown occurs anywhere along the supply chain, said Richard S. Betterley, president of Betterley Risk Consultants Inc. of Sterling, Mass.

Ironically, technological advances, which have allowed businesses to boost worker productivity so greatly over the past couple decades, also play a role, said Pete Fahrenthold, the Houston-based managing director-risk management at United Continental Holdings Inc.

The Icelandic volcano eruption illustrates that, Fahrenthold said. "The eruption occurred along the major transatlantic flight route from the U.S. to Europe. This route was critical because it is the best pathway for commercial airliners to make the flight, and advances in air traffic control have enabled a greater volume of flights through the same airspace. Flights around the cloud would have conflicted with the range capabilities of many of the aircraft in use today."

Even the news media plays a role in the risk, said Tony Clark, Chicago-based vice president-property claims with Allianz. With access to instantaneous coverage of news events around the world, businesses often will have a knee-jerk reaction to an event, such as an unusual wind or snowstorm across Europe that results in a business interruption loss, Clark said.

Events, however, often quickly pass and do not warrant any reaction, he said.

Volcanic ash clouds, earthquake-triggered tsunamis, long-delayed shipments and the next chapter in global weirding notwithstanding, risk managers can mitigate their organizations' phantom business interruption losses, experts say.

"It's a pure disaster recovery play," Betterley said. "The problem is that it's hard to forecast the future. So a good disaster recovery plan gives you the ability to freelance; you have everything lined up and then you can turn on a dime" when disaster strikes.

Managing the supply chain is the first line of defense, Marsh's Elowe said. Companies should identify the two or three suppliers that are most critical to the organization and then examine who their main and sub suppliers are. They then can craft an alternative supply route they can use during an emergency that breaks a link somewhere in the original supply chain, he said.

Because of the difficulty of anticipating potential disasters, there are few good disaster recovery plans in place, "and fewer are executed well," Betterley said.

After all, he said, "Who would contemplate a volcano in Europe?"

A disaster recovery plan "has to be well thought out, but you can't mitigate every single risk," said Robert Glasser, a New York-based managing director at BDO Consulting, a division of BDO USA L.L.P. "No one can mitigate 100 percent."

Plus, if an event creates a phantom business interruption at a company's main operation, as the volcanic ash cloud did with airlines, the cost of mitigating might be too high, he said.

"If you believe a risk has a significant odds of occurring, research the cost of coverage for a shutdown," Glasser said. "Someone else, for a premium, may be willing to take that risk for you" on a manuscripted basis.

(Read about our second emerging risk, solar weather.)

May 1, 2011

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