Cash in the new post-crisis world and Climate change: testing the resilience of corporates’ creditworthiness to natural catastrophes: Difference between pages

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  | label2 =Miroslav Petkov
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  |  data2 =[http://www.standardandpoors.com/en_EU/web/guest/home Standard & Poor’s], London 
The Association of Corporate Treasurers
 
 
 
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|  data3 =[http://www.standardandpoors.com/en_EU/web/guest/home Standard & Poor’s], London
 


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==Introduction==
==Introduction==
After more than six years from the start of the financial crisis we have been through a credit and banking crisis, a sovereign debt crisis, the euro crisis and a major process of re-regulation of financial services. While the peaks of turbulence are past, the consequences are still very much with us. And it is not all bad. When times were hard, the benefits of running a well-managed professional treasury department became even more apparent. Efficient cash management and prudent investing became more important than ever.
While recent history shows that natural catastrophes may have not been a major rating factor on corporate credit quality in the past, their effect in the future may increase considerably if, as scientific evidence suggests, we experience more frequent and more extreme climatic events. If such extreme events were to occur, companies’ existing insurance and overall disaster risk management measures could, in the opinion of Standard & Poor’s Ratings Services, become considerably less effective. Therefore, we see improvements in companies’ disclosures about their exposure to natural catastrophes becoming more relevant to our ratings analysis.
Larger companies are in the privileged position that bank or bond funding is once again readily available even if more generally the banks’ capacities for making new loans have undoubtedly become restricted. Private equity owned companies have always been acutely aware of the need for cash generation and tight controls on cash management. That lesson has been learned across the board. Companies revised their cash forecasts, partly to see what levers could be pulled to save cash, and partly because these forecasts needed updating to reflect the continuing downturn in the economy. Reducing gearing was the order of the day, new acquisitions were reined back, working capital was thrown into the spotlight to be managed more tightly and cash was allowed to build up to provide future financial flexibility. The lessons learned from the financial crisis will have a long lasting benefit in the fields of cash management, forecasting and investing.
 
Understanding the working capital cycle and taking control of it became a priority; in many companies this had been a neglected area. Making full use of the available accounts receivable and accounts payable technologies, getting on top of reconciliations, reducing admin and errors, tightening Days Sales Outstanding, claiming supplier discounts and improving cash flow and its forecasting will all be a permanent legacy of those critical times.
 
The economic cost of natural catastrophes has risen significantly over the past 10 years (see Figure 1 below). However, through a combination of existing preventive measures, most of the companies we rate have managed to mitigate the impact of such events on their corporate credit profiles. Nevertheless, with scientists predicting an increase in extreme climatic events, firms’ vulnerability to natural catastrophes is in our view likely to be sorely tested.
 
===Overview===
* Generally, companies have so far managed to mitigate the effects of natural catastrophes through liquidity management, insurance protection, natural disaster risk management, and post-event recovery measures.
* However, the more frequent and more extreme climatic events many scientists predict could adversely affect companies’ credit profiles in the future.
* Greater disclosure of firms’ exposure to extreme natural catastrophes should, in our opinion, encourage them to bolster their resilience to these events and thereby aid transparency.
 
 
 
 
[[File:Natural_loses_caused_by_natural_catastrophes.jpg|700px|center]]
 
 
==Catastrophes seldom trigger rating actions – yet==
Although natural catastrophes can result in companies experiencing property losses and production and market disruptions, such events are not frequently a factor behind our negative rating actions. Since 2005, we have identified natural catastrophes (tropical storms, floods, droughts, and earthquakes) as the main or material contributing factor for at least 60 negative rating actions (comprising downgrades and outlook revisions). This compares with around 6,300 corporate credit downgrades on companies in total over that period. In addition, we revised our outlook on less than five companies to stable from positive as a result of natural catastrophes. Overall, we find that companies’ liquidity management, insurance protection, natural disaster risk management, and post-event recovery measures were adequate in mitigating the impact of natural catastrophes on their rating profiles during the period.


==Forecasting==
Spare cash generated may be invested in suitable instruments or may be used to payback debt. Either way, stage one in the process is to revisit the cash forecasts and plans in order to be realistic in the new environment. Old assumptions may not apply. If we have all learned one thing from the credit crisis, it is that you need to plan for the unexpected shock. All forecasts will need to be stress tested with some extreme assumptions.


==Managing==
Whether wanting to reduce debt or to use cash for investing, managing cash flows cannot be neglected. Companies are taking action to chase up debtors (or help debtors and themselves in “supply chain finance” initiatives) and collect the cash. They are looking to make more effective use of any pockets of cash around their group companies. Where small floats are left in subsidiary accounts, these are being reduced. Cash pooling systems are being tightened up with more frequent repatriation of balances, or simply by bringing more companies into the system. For a large group, it is truly amazing what cash can be generated as if from nowhere.
The crisis has reminded companies not to take access to funding for granted. If banks are somewhat less inclined to have fully committed credit facilities sitting unused then treasurers have no choice but to pre-fund their needs; this can mean having both borrowings and cash on the balance sheet at the same time. Treasurers and their boards now regard a certain amount of inefficiency in pre funding or over funding, along with the cost of carry, as a cost that has to be borne. In the overall scale of things, it is often thought a cost worth bearing.


==Segmenting==
[[File:Figure2_rating_actions_by_peril.jpg|700px|center]]
Phase three is segmenting the funds, and here the new emphasis is on flexibility and therefore keeping investments more liquid or invested for shorter periods. Now might be the best time to make opportunistic acquisitions so that a company does not want to be locked into long-term and inflexible deposits. Added to this, a shorter maturity presents less risk that the counterparty will get into financial trouble during the investment’s life.
The counter argument is that given how low interest rates have been then perhaps it is reasonable to seek a yield pick-up through investing further down the maturity curve. Interestingly, this is not something that has been happening to any great extent. The logic is that flexibility and reducing credit risk trumps any small yield pick-up. This demonstrates that for non-financial companies holding cash and generating income from it is not an end in itself, but rather the cash is there to be used more profitably in the business.
Low interest rates are a feature that has prevailed far longer than first expected. To combat recession and encourage economic recovery the authorities in the major economies have provided monetary stimulus using quantitative easing as the key tool to inject cash into the financial system. Central banks have, in a manner of speaking, been printing money in order to purchase government bonds and thus depressing rates, even out to the longer-term maturities. At the short-term end interest rates have, for brief periods, even gone negative, meaning that the banks in effect charge a fee for holding customer deposits safe. When rates are low to start with, banks that are rated relatively safe can be swamped with deposits that they cannot profitably use for on-lending, so instead must discourage via negative rates.
Perversely, the very banks that are low risk and attractive to treasurers will very often not wish to gross up their balance sheets through taking deposits. The new Basel III leverage ratio can be a limiting factor on grossing up for some banks, even pushing those banks to consider imposing limits on cash left in operational accounts.


==Investment policy==
An investment policy encapsulates how a company’s risk appetite translates into practical objectives and rules. Counterparty credit risk is no longer purely theoretical – it is a very real risk. If, pre-crisis, a company was prepared to mark a limit for a single A-rated bank, it is probably still happy to do business with such a counterparty. What has changed is that companies may have reduced the limits per bank so as to force a greater degree of diversification of investments, or have introduced a new rule such as ‘no more than 10% of funds with any one name’, subject to exceptions for modest amounts. But companies operate in the real world and the choice of well-rated banks open to them has diminished. Maybe companies have to accept dealing with lower rated institutions? Reducing risk through diversification is an alternative and the use of money market funds for easy diversification continues to be popular.
The counterparty limit set for a bank (which covers all forms of credit exposure, not just liquid funds investments) will usually be derived from an approach that starts with the credit ratings of the banks, supplemented by other information. Limits are set so that the expected loss from a credit event, while regrettable, is not disastrous, since no policy can be designed to be event-free under all circumstances. An important step is to ensure that you know which legal entity within a bank group you are dealing with and which has a rating. If you are dealing with more than one entity in a banking group, set an overall bank group credit limit as well as limits for individual legal entities (and even branches – see next section). But bank risk is about to become a lot more complicated and highly dependent on the structure of the banking group involved.


==Bank recovery, resolution and bail-in==
The crucial role of banks in keeping any economy alive has meant that in recent times there has always been some sort of implied state support for banks, particularly if those banks are large and systemically important for the jurisdiction concerned. This has been borne out in practice as states stepped in to support or rescue their banking sectors. But sentiment has changed. It is no longer politically acceptable for governments just to pick up the bill for rescuing a bank. In some cases the sheer size of the banking sector as compared to its host state means it is not practical either.
A failing bank can traditionally survive if it is recapitalised with new capital from its own shareholders or in extremis from the government. The theme being explored now, and indeed beginning to be implemented, is to create a legal regime that will allow the cost of rescuing and recapitalising a failing bank or shutting it down to be placed back with the creditors of that bank. There needs to be a mechanism to share the pain so as to allow the bank to survive and to protect retail depositors. If, for example, bond investors have lent the bank £100 then if the bond-holders’ claim is written down to £70 this creates £30 of new capital in the bank balance sheet. This is termed “bail-in”. It contributes to restoring solvency of the bank but of course does not generate any new liquidity. It must be hoped that with the bank’s stronger capital position, the market or central bank will be prepared to give access to liquidity.
The problem is to devise a fair set of rules around bail-in and the starting point is an assumption that retail depositors should not suffer bail-in, or at least not up to certain limits. A bank that is funded heavily by retail deposits was normally regarded as safer than one heavily funded from the wholesale markets, on the presumption that retail deposits are stickier. In the event of a problem, wholesale funding will quickly be withdrawn and dry up whereas retail money is slow to be withdrawn. In the new world of bail-in, the perverse result is that a bank with most of its funding from retail deposits will have to bail in its few bond-holders and wholesale depositors to a far larger extent – so a disproportionate risk falls on wholesale depositors, making them even more like “hot money”, withdrawn at the first signs of trouble. This is aggravated if retail deposits or the guarantee scheme they benefit from are ranked above wholesale deposits in bank resolution.
Then, in a bank group there are further complications and risks from bail-in. Will the creditors being bailed in be at the parent or holding company level or at the operating subsidiary level? And will a problem with a sister subsidiary in a banking group, if it cannot be resolved within that subsidiary, trigger a bail-in in a solvent member of the group.
Foreign branches of banks raise particular problems. Will depositors be treated similarly to those at the home country branches? The home-country’s retail depositor insurance does not usually apply but the host-country’s scheme may. Will the head office support wholesale depositors? Is the branch required by the host country to be “ring fenced” from the rest of its legal entity with local capital and liquidity demanded? Enquiry has to be made individually for each foreign branch. Branch credit ratings (e.g. Fitch National Ratings) are only occasionally available.
The implications for investing corporate cash with banks, be that directly through deposits or indirectly via a money market fund, are very significant. Any credit assessment will need to build in consideration of the exact entity you are dealing with, the make-up of its funding mix, the hierarchy of preference for the different funding providers, any ring fencing and the entity’s relationship with and risk from other businesses in the same group, and any applicable local regulations.
If counterparty risk is a big concern then mitigating this through taking collateral is a possibility. It sounds rather self-defeating for the bank to take a deposit and then give back an equivalent amount of collateral, but the point is that the collateral can be a longer-term asset that the bank wants to continue to hold and that can be put to good use supporting immediate liquidity. This form of secured deposit is known as a repo or repurchase agreement (strictly speaking a reverse repo) and is beginning to be used by some larger companies, and is set to become more usual.
==Implementation==
Everyone, right down to the private investor with money in his/her bank account, is now acutely aware of the risk of default. The heightened risks and awareness mean that the monitoring and reporting of counterparty exposures has become a more frequent exercise for company treasury departments. Although most companies already keep track in real time as part of the dealing process, new end-of-day reports are being created for senior management along with other related information.


==Conclusion==
==Energy and consumer products sectors most at risk==
Experienced treasurers have always maintained that when it comes to investing temporary company cash, the priorities are Security, Liquidity and Yield (SLY) in that order of importance. They have been proved right again and again and this will continue to be the treasurer’s mantra, even if the practicalities of achieving it have become a lot more complicated.
While our sample of negative rating actions is too small to draw robust statistical conclusions, our analysis provides insights into how and when natural catastrophes can affect companies’ creditworthiness.
No sector is immune to the effects of natural catastrophes. However, the energy sector (through a direct impact on production and distribution facilities and market dislocation) and the consumer products sector (through supply chain and market disruptions) appear most exposed, together representing more than one half of the affected sample. This is about double the proportion of rated companies that make up each of those sectors.
 
 
 
[[File:Figure3_Rating_actions_by_sector.jpg|700px|center]]
 
 
 
In around 40% of cases, natural catastrophes led to a one-notch downgrade. In a further 30%, we assigned a negative outlook that we subsequently resolved by affirming the rating. However, on average it took about 15 months for the credit profile of these latter companies to recover sufficiently for us to revise the outlook to ‘stable’. Across the rest of the sample, natural catastrophes contributed to multi-notch downgrades, and in about 10% of cases to default. Overall, this affected nearly twice as many speculative-grade than investment-grade companies because the former are more vulnerable to a downgrade, as our default statistics illustrate.
 
 
 
[[File:Fig4_rating_actions_by_type.jpg|700px|center]]
 
 
 
In half of the cases in our sample, a natural catastrophe was the main trigger for the rating action. In the remainder, it was a contributing factor: often, other more material negative developments had already weakened the credit profiles of companies affected by a catastrophe. As a consequence, the natural catastrophe led to downgrades in the vast majority of those cases. By contrast, in 50% of cases when the natural catastrophe was the main trigger, the negative rating action was a revision of the outlook to negative, which was resolved with a rating affirmation.
 
 
In about 40% of cases, natural catastrophes directly affected the operations of the company by physically disrupting its operations. For one third of cases, the main negative effects were indirect and focused mainly on the company’s supply chain. In the remaining cases, the widespread market and economic disruptions caused by natural catastrophes adversely affected the company’s credit profile. This caused unfavorable price movements and increased price volatility. In certain cases, the market and economic disruptions led to simultaneous negative rating actions on several companies operating within the affected sectors, two examples being power companies and automakers in Japan.
==Katrina and Tōhoku took their toll==
Hurricane Katrina in 2005 and the Tōhoku earthquake and tsunami in 2011 constitute the two biggest natural catastrophes of the past 10 years. They are also responsible for triggering almost 50% of rating actions in which natural catastrophes were a factor. Katrina, in particular, was behind almost all of the cases that ended in default. The effects  of Katrina were wide-ranging, from large direct losses to major supply chain disruptions and price increases across a wide variety of industries.
 
 
The most notable company that the Tōhoku earthquake and tsunami affected was the Tokyo Electric Power Company (TEPCO), the owner of the Fukushima nuclear power plant that was severely damaged by flooding caused by the tsunami. The Japanese government’s subsequent request to shut down nuclear reactors for safety inspections following the Fukushima disaster exacerbated the tsunami’s effect on TEPCO’s business. As a result, we downgraded our long-term corporate credit rating on TEPCO to ‘B+’ from ‘AA-’ between March and May 2011. Other power companies with nuclear operations that we rated in Japan similarly suffered multi-notch downgrades. The earthquake also caused widespread market disruption, which led us to revise our outlook on several Japanese automakers.
 
 
Natural catastrophes don’t cause disruptions for all companies. Those whose business focuses on providing assistance during natural catastrophes could benefit, for example. By contrast, fewer-than-expected natural catastrophes could adversely affect such firms. In such instances, this has contributed toward negative rating actions. Other companies can benefit from higher prices as a result of natural catastrophes or because of reduced market competition if their peers suffer losses. However, these positive effects are rare.
==Climate change and global trade links raise the stakes==
Looking ahead, however, the picture is less certain. Growth in exposure in areas with high risk to extreme events, coupled with increased integration of the world economy through complex global supply chains, may exacerbate the impact of natural catastrophes. At the same time, the effects of climate change may increase their severity and frequencies. Scientific evidence, as summarised in the Intergovernmental Panel on Climate Change (IPCC) [http://ipcc.ch/pdf/assessment-report/ar5/syr/AR5_SYR_FINAL_SPM.pdf ''Climate Change 2014''] report, points in that direction. In essence, higher temperatures will lead to more heat waves and droughts. Because warmer air can hold more moisture, the likelihood of extreme rainfall and subsequently floods will increase. Furthermore, rising sea levels caused by global warming are likely to increase the impact of coastal flooding during storms and high tides.
 
 
If such extreme events were to occur, companies’ catastrophe insurance and overall disaster risk management could, in our view, become considerably less effective. The Japanese earthquake of 2011 provided a glimpse of what could happen when the magnitude of the event exceeded the levels assumed in the design of some of the tsunami protection measures, which as a consequence proved inadequate.
 
 
In an increasingly interconnected world, a major local natural catastrophe affecting an important link in the global economy is likely to have a worldwide and long-lasting impact. Moreover, certain risks may become difficult and costly to insure as the likelihood and cost of natural catastrophes events increases. For instance, following large insurance losses from contingent business interruption (CBI) resulting from the Tohoku earthquake and the Thai floods in 2011, insurers tightened up insurance policy conditions; increased rates; and, in some cases, reduced the insurance coverage for some companies. (CBI is an important tool for companies to protect themselves against losses as a result of supply chain disruptions.)
 
 
It’s unlikely that any company on its own can take adequate risk measures or purchase sufficient insurance to protect itself in the event of extreme natural catastrophes. Therefore, we consider that the international community as a whole will need to improve the resilience of the global economy to natural disasters so that their impact on companies is manageable. Climate change will in our opinion only add to this challenge.
 
Because we expect the frequency of natural catastrophes, along with their economic effects, to increase in the future, companies will in our view need to improve their level of disclosure about their exposure to such events. This will allow investors and analysts to assess how material natural catastrophe is for the companies they invest in or analyse. In that regard, we consider that the [http://www.un.org/climatechange/summit/wp-content/uploads/sites/2/2014/09/RESILIENCE-1-in-100-initiative.pdf 1-in-100 Initiative] should provide more insight into the resilience of companies to such events. The aim of this initiative is to promote companies’ disclosure of their exposure to natural catastrophes. It looks to participating companies to disclose the maximum probable annual financial loss that they could expect once in a hundred years (that is, with a 1% chance of occurring).
==So far, so good; but the future could be very different==
Generally, companies have managed to adequately withstand the effects of natural catastrophes over the past 10 years through a combination of liquidity management, insurance protection, disaster risk management and post-event recovery measures. In the future, however, the world could be hit by events that are significantly more devastating than recent ones. We believe such events could lead to a more widespread weakening of corporate credit profiles and subsequently to more downgrades than in the past.
==Notes==
Please refer to the [https://www.spratings.com/corporates/Understanding-Ratings-2.html Standard & Poor's website] for more information about ratings and read its disclaimers [http://www.standardandpoors.com/en_US/web/guest/regulatory/legal-disclaimers here].
 
 
''Under Standard & Poor’s policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.
''Copyright © 2015 Standard & Poor’s Financial Services LLC, a part of McGraw Hill Financial. All rights reserved. STANDARD & POOR’S and S&P are registered trademarks of Standard & Poor’s Financial Services LLC.''
''


[[Category:Book_Export]]
[[Category:Context_of_treasury]]
[[Category:Ethics_and_corporate_governance]]

Latest revision as of 11:30, 22 February 2018

Risk management
Treasurers Handbook
Authors
Miroslav Petkov Standard & Poor’s, London
Michael Wilkins Standard & Poor’s, London

Introduction

While recent history shows that natural catastrophes may have not been a major rating factor on corporate credit quality in the past, their effect in the future may increase considerably if, as scientific evidence suggests, we experience more frequent and more extreme climatic events. If such extreme events were to occur, companies’ existing insurance and overall disaster risk management measures could, in the opinion of Standard & Poor’s Ratings Services, become considerably less effective. Therefore, we see improvements in companies’ disclosures about their exposure to natural catastrophes becoming more relevant to our ratings analysis.


The economic cost of natural catastrophes has risen significantly over the past 10 years (see Figure 1 below). However, through a combination of existing preventive measures, most of the companies we rate have managed to mitigate the impact of such events on their corporate credit profiles. Nevertheless, with scientists predicting an increase in extreme climatic events, firms’ vulnerability to natural catastrophes is in our view likely to be sorely tested.

Overview

  • Generally, companies have so far managed to mitigate the effects of natural catastrophes through liquidity management, insurance protection, natural disaster risk management, and post-event recovery measures.
  • However, the more frequent and more extreme climatic events many scientists predict could adversely affect companies’ credit profiles in the future.
  • Greater disclosure of firms’ exposure to extreme natural catastrophes should, in our opinion, encourage them to bolster their resilience to these events and thereby aid transparency.




Catastrophes seldom trigger rating actions – yet

Although natural catastrophes can result in companies experiencing property losses and production and market disruptions, such events are not frequently a factor behind our negative rating actions. Since 2005, we have identified natural catastrophes (tropical storms, floods, droughts, and earthquakes) as the main or material contributing factor for at least 60 negative rating actions (comprising downgrades and outlook revisions). This compares with around 6,300 corporate credit downgrades on companies in total over that period. In addition, we revised our outlook on less than five companies to stable from positive as a result of natural catastrophes. Overall, we find that companies’ liquidity management, insurance protection, natural disaster risk management, and post-event recovery measures were adequate in mitigating the impact of natural catastrophes on their rating profiles during the period.



Energy and consumer products sectors most at risk

While our sample of negative rating actions is too small to draw robust statistical conclusions, our analysis provides insights into how and when natural catastrophes can affect companies’ creditworthiness. No sector is immune to the effects of natural catastrophes. However, the energy sector (through a direct impact on production and distribution facilities and market dislocation) and the consumer products sector (through supply chain and market disruptions) appear most exposed, together representing more than one half of the affected sample. This is about double the proportion of rated companies that make up each of those sectors.



In around 40% of cases, natural catastrophes led to a one-notch downgrade. In a further 30%, we assigned a negative outlook that we subsequently resolved by affirming the rating. However, on average it took about 15 months for the credit profile of these latter companies to recover sufficiently for us to revise the outlook to ‘stable’. Across the rest of the sample, natural catastrophes contributed to multi-notch downgrades, and in about 10% of cases to default. Overall, this affected nearly twice as many speculative-grade than investment-grade companies because the former are more vulnerable to a downgrade, as our default statistics illustrate.



In half of the cases in our sample, a natural catastrophe was the main trigger for the rating action. In the remainder, it was a contributing factor: often, other more material negative developments had already weakened the credit profiles of companies affected by a catastrophe. As a consequence, the natural catastrophe led to downgrades in the vast majority of those cases. By contrast, in 50% of cases when the natural catastrophe was the main trigger, the negative rating action was a revision of the outlook to negative, which was resolved with a rating affirmation.


In about 40% of cases, natural catastrophes directly affected the operations of the company by physically disrupting its operations. For one third of cases, the main negative effects were indirect and focused mainly on the company’s supply chain. In the remaining cases, the widespread market and economic disruptions caused by natural catastrophes adversely affected the company’s credit profile. This caused unfavorable price movements and increased price volatility. In certain cases, the market and economic disruptions led to simultaneous negative rating actions on several companies operating within the affected sectors, two examples being power companies and automakers in Japan.

Katrina and Tōhoku took their toll

Hurricane Katrina in 2005 and the Tōhoku earthquake and tsunami in 2011 constitute the two biggest natural catastrophes of the past 10 years. They are also responsible for triggering almost 50% of rating actions in which natural catastrophes were a factor. Katrina, in particular, was behind almost all of the cases that ended in default. The effects of Katrina were wide-ranging, from large direct losses to major supply chain disruptions and price increases across a wide variety of industries.


The most notable company that the Tōhoku earthquake and tsunami affected was the Tokyo Electric Power Company (TEPCO), the owner of the Fukushima nuclear power plant that was severely damaged by flooding caused by the tsunami. The Japanese government’s subsequent request to shut down nuclear reactors for safety inspections following the Fukushima disaster exacerbated the tsunami’s effect on TEPCO’s business. As a result, we downgraded our long-term corporate credit rating on TEPCO to ‘B+’ from ‘AA-’ between March and May 2011. Other power companies with nuclear operations that we rated in Japan similarly suffered multi-notch downgrades. The earthquake also caused widespread market disruption, which led us to revise our outlook on several Japanese automakers.


Natural catastrophes don’t cause disruptions for all companies. Those whose business focuses on providing assistance during natural catastrophes could benefit, for example. By contrast, fewer-than-expected natural catastrophes could adversely affect such firms. In such instances, this has contributed toward negative rating actions. Other companies can benefit from higher prices as a result of natural catastrophes or because of reduced market competition if their peers suffer losses. However, these positive effects are rare.

Climate change and global trade links raise the stakes

Looking ahead, however, the picture is less certain. Growth in exposure in areas with high risk to extreme events, coupled with increased integration of the world economy through complex global supply chains, may exacerbate the impact of natural catastrophes. At the same time, the effects of climate change may increase their severity and frequencies. Scientific evidence, as summarised in the Intergovernmental Panel on Climate Change (IPCC) Climate Change 2014 report, points in that direction. In essence, higher temperatures will lead to more heat waves and droughts. Because warmer air can hold more moisture, the likelihood of extreme rainfall and subsequently floods will increase. Furthermore, rising sea levels caused by global warming are likely to increase the impact of coastal flooding during storms and high tides.


If such extreme events were to occur, companies’ catastrophe insurance and overall disaster risk management could, in our view, become considerably less effective. The Japanese earthquake of 2011 provided a glimpse of what could happen when the magnitude of the event exceeded the levels assumed in the design of some of the tsunami protection measures, which as a consequence proved inadequate.


In an increasingly interconnected world, a major local natural catastrophe affecting an important link in the global economy is likely to have a worldwide and long-lasting impact. Moreover, certain risks may become difficult and costly to insure as the likelihood and cost of natural catastrophes events increases. For instance, following large insurance losses from contingent business interruption (CBI) resulting from the Tohoku earthquake and the Thai floods in 2011, insurers tightened up insurance policy conditions; increased rates; and, in some cases, reduced the insurance coverage for some companies. (CBI is an important tool for companies to protect themselves against losses as a result of supply chain disruptions.)


It’s unlikely that any company on its own can take adequate risk measures or purchase sufficient insurance to protect itself in the event of extreme natural catastrophes. Therefore, we consider that the international community as a whole will need to improve the resilience of the global economy to natural disasters so that their impact on companies is manageable. Climate change will in our opinion only add to this challenge.

Because we expect the frequency of natural catastrophes, along with their economic effects, to increase in the future, companies will in our view need to improve their level of disclosure about their exposure to such events. This will allow investors and analysts to assess how material natural catastrophe is for the companies they invest in or analyse. In that regard, we consider that the 1-in-100 Initiative should provide more insight into the resilience of companies to such events. The aim of this initiative is to promote companies’ disclosure of their exposure to natural catastrophes. It looks to participating companies to disclose the maximum probable annual financial loss that they could expect once in a hundred years (that is, with a 1% chance of occurring).

So far, so good; but the future could be very different

Generally, companies have managed to adequately withstand the effects of natural catastrophes over the past 10 years through a combination of liquidity management, insurance protection, disaster risk management and post-event recovery measures. In the future, however, the world could be hit by events that are significantly more devastating than recent ones. We believe such events could lead to a more widespread weakening of corporate credit profiles and subsequently to more downgrades than in the past.

Notes

Please refer to the Standard & Poor's website for more information about ratings and read its disclaimers here.


Under Standard & Poor’s policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook. Copyright © 2015 Standard & Poor’s Financial Services LLC, a part of McGraw Hill Financial. All rights reserved. STANDARD & POOR’S and S&P are registered trademarks of Standard & Poor’s Financial Services LLC.

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