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Catastrophe Risk Management

Catastrophic Chemical Industry Losses—Structuring Coverage and Maximizing Recovery

Christopher Brophy | January 1, 2012

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A chemical plant on a sunny day with a large storm brewing in the distance

Chemical industry risk managers know their business and clearly understand the importance of strong loss prevention and risk management tools. Yet, even with this knowledge, maximizing insurance recoveries can be a tricky and contentious process. 1

The risk of a catastrophic loss in the chemical industry is real. Chemical plants work hard to identify loss prevention procedures and to maintain impeccable safety records. That said, losses do occur and often leave management scrambling to determine the cause of a given loss, implement a disaster recovery plan, identify workarounds to mitigate the loss, and tender/pursue insurance claims.

Most chemical companies have highly integrated production networks. Raw material feedstock is received, typically by pipeline, barge, or rail, and processed into intermediary chemicals. A portion of that product may be sold externally; the remainder may be further processed. Specialty chemical companies often start with a petroleum-based product, perform a series of chemical processes, and produce thousands of products for both commercial and consumer use.

A significant loss can disrupt the production process and require workarounds to mitigate the loss. Chemical plant managers are adept at modifying the production process, often by shifting production to other plants. This can help, albeit with higher production and freight costs.

Many chemical companies operate 24 hours per day, 7 days per week, and work to sell everything that they produce. They cannot shut down without incurring significant restart costs. Moreover, because they are already producing to their effective capacity, they have no way to "make more." As a result, after a catastrophic event, many chemical plants simply cannot recover their lost production. That's where insurance comes in.

Given the unique nature of the chemical industry, having the appropriate insurance coverage is essential. As many companies have learned the hard way, the failure to fully review and understand insurance policies at the purchase and renewal stage can lead to dire consequences when a claim is eventually tendered. The following is a brief summary of several key insurance policy provisions that can have a dramatic impact on chemical industry claims.

Insured Values

Many insurers require chemical industry policyholders to provide insurance values for property and business interruption on a location-by-location basis. For a sophisticated company with integrated operations and multiple locations, it can be very difficult after a loss to determine—and reach an agreement with the insurers regarding—the proper values. Thus, beginning the insurance procurement process with a comprehensive analysis of the insured's "maximum probable loss" (showing the risk at each location, the values at each location, and the ability of each location to mitigate damages) is a proactive way to hedge against a post-loss "values" dispute.

Deductibles and Waiting Periods

Most chemical industry policies include significant deductibles and waiting periods. The deductible for business interruption is often stated in terms of a number of days of "average daily value." The policy may also include a waiting period before a claim can be triggered. Generally, after that waiting period is reached, the policy is triggered, and the insured loss is measured from the date of the loss (not after the waiting period) less the applicable deductible.

In the event of a catastrophic integrated loss, deductible calculations can make or break a chemical company's insurance claim. Thus, although the temptation may exist to accept a higher deductible in exchange for a lower premium, chemical industry policyholders are well advised to weigh carefully the risks and benefits. What saves a few dollars at policy inception could cost millions down the road.

Period of Indemnity and Extended Period of Indemnity

While the period of indemnity is typically the time to complete repairs "with due diligence and dispatch," this definition may not be sufficient in the chemical industry. Losses will often persist at "downstream" plants well after repairs are completed at the damaged plants. If the period of indemnity is defined simply as the date of the loss through the time to complete repairs, the insurer may contend that there is no coverage for downstream losses incurred after the damaged facility has been repaired. Though such a result would be illogical from the standpoint of the insured, it is a coverage defense that an insurer could use to eliminate a significant component of a given claim.

Extended period of indemnity coverage can be helpful when losses persist after repairs are complete. Large supply contracts can be particularly vulnerable to long-term losses. Yet, because "period of indemnity" is a term that can be overlooked during the policy negotiation phase, it is possible for this key element of a chemical company's business to effectively go uninsured. In short, a policyholder's failure to remain vigilant on this point could end up costing millions in uninsured losses.

Preservation of Property

This clause provides coverage when a policyholder takes steps to prevent a loss before it occurs or to minimize the impact once it does. Suppose a chemical plant operating 24/7 is threatened by a significant impending hurricane. The plant manager may decide that a controlled shutdown is necessary, both for the safety of the employees and to minimize the impact should damage be severe. And that shutdown will have a significant effect on the insured's operations.

Insurers favor property preservation because when losses are minimized, so are insurance payouts. But policy terms can vary as to the scope of scale of appropriate actions. The time to review and understand these terms is at policy negotiation—not during a loss or after it has occurred.

Service Interruption

Many chemical plants use a significant amount of power in their production process. It is common for insurance policies to cover losses attributable to service interruption, often subject to a waiting period for a number of days. The loss of power coverage may have specific requirements, such as being attributable to damage within a certain number of feet from the insured's premises. Here again, it is essential that a policyholder address these issues in the policy negotiation phase. If the risks are not comprehensively analyzed, they cannot be properly insured.

Mitigation

When faced with a crisis, chemical companies work diligently to mitigate their damages. For example, if a loss occurs, management may reschedule future maintenance, or "turnaround," so that it takes place during the same time that the plant is closed for repairs. Such forward thinking by a policyholder can be a tremendous benefit to an insurer, as it can greatly reduce the ultimate insurance payout.

Contingent Business Interruption

This endorsement to a standard policy is especially important within the chemical industry. It allows the policyholder to recover when a supplier or customer suffers a loss "of the type insured" under the policyholder's own policy. For example, if a supplier is unable to provide your plant with a raw material because of earthquake damage, you would be able to recover if your policy includes coverage for earthquakes.

"Contingent business interruption" coverage can be extremely valuable, but only if properly structured. In some cases, contingent business interruption coverage only insures losses when direct suppliers or customers suffer a loss. It may not provide coverage when the loss is indirect—that is, when the loss is sustained by a supplier to the policyholder's supplier or by a customer to the policyholder's customer.

A simple illustration is a third party's declaration of force majeure. Contingent business interruption coverage could be triggered if the insurance policy at issue is broad enough to cover the specific third party. Bottom line: In the policy negotiation phase, it is essential that the chemical industry policyholder review and assess supply chain risks and secure appropriate coverage against them.

Conclusion

Maximizing insurance coverage after a catastrophic loss is difficult for any company but can be especially complex for policyholders in the chemical industry. Most chemical plants are integrated production networks that convert feedstock into thousands of intermediary and final products. The final production at one plant may be partially sold externally and partially used as feedstock at another plant. And, any break in the supply chain—whether it is experienced internally by the insured or externally by outside suppliers or customers—can lead to a costly workaround, irreplaceable production, lost sales, and extensive additional expense.

Once a loss occurs, it is too late to revise an insurance policy. Consequently, the chemical industry policyholder must be extremely diligent during policy purchase and renewal. Understanding specific insurance requirements, carefully calculating the property and business interruption values, outlining contingency plans, and anticipating the potential losses at each location are all key steps in maximizing future insurance recoveries. In sum, paying close attention to the potential impact of a loss at the insurance procurement stage will help to minimize issues and maximize recovery when a loss does occur.


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Footnotes

1 The author would like to acknowledge Christopher C. Loeber's help with writing this article.