Source: Blatant World on Flickr.

Risk is what's left over when we think we've thought of everything else, according to financial advisor Carl Richards in his book, "The Behavioral Gap." That said, even if a risk is known, does that mean a company is adequately prepared to handle that risk turning into a reality?

Take railroads, for example. As the laws are currently set up, these companies are exposed to unlimited liability if a hazardous spill were to occur. As Canadian National Railway (CNI -0.36%) put it in a letter to the Canadian Transportation Agency, "Once the railway has received a car from a shipper, all of the risk and exposure associated with that car are then transferred to the railway even when the liability arising from the carriage of the dangerous goods is not caused by the negligence of the railway." The recent rash of train derailments of cars carrying highly flammable crude oil has shined a spotlight on this risk.

The real problem for railways is that while being exposed to unlimited liability, none carry enough insurance to cover enough of the liability for a true mass casualty event. While companies have a number of safeguards in place such as speed restrictions, reinforced tanker cars, and routing trains to lessor populated areas, it still takes just one misstep for a disaster to completely incinerate a railway operator's finances.

In their own words
Some cargos carry a greater risk of disaster. A train carrying chlorine, which was stored in a specialty reinforced car, burst in 2005 in South Carolina and killed nine people after it emitted a lethal gas cloud. The company was forced to pay out millions in civil penalties, as well as for the deaths, damages and injuries. Because of this, Norfolk Southern (NSC -1.05%) CEO Charles Moorman noted in an article in The Wall Street Journal that, "every time we pick up a carload of chlorine, we're placing a bet on the company."

Source: vxla.

A far more tragic event happened in Canada last year after a train carrying oil derailed. The ensuing explosion leveled a town and killed more than 40 people. The small railway that carried the oil only had $25 million in liability coverage. The damages alone from that disaster are already in the hundreds of millions, which is why the company was forced to file for bankruptcy.

The financial risk of such a disaster could be catastrophic for a railway operator. The Association of American Railroads noted in a review for the Canadian Transportation Agency that "a railroad moving hazardous shipments faces exposure to potentially ruinous liability." It went on to say that, "insurance does not provide viable means to fully mitigate this risk." Meanwhile, Canadian Pacific (CP 0.34%) said that, "insurance should be recognized for what it is; an inadequate secondary layer of protection." Clearly, given the risk, a better solution needs to be found.


The nuclear option
Outside of enforcing higher safety standards on rail cars shipping hazardous or explosive materials, there is another interesting idea worth considering, and that's taking a page out of the book from the nuclear power industry. The Price-Anderson Act was set up to limit the liability of any one company during the release of radioactive material. The losses above that level would be covered by a fund that all companies in the industry contribute to. A similar fund could be set up for the railroad industry to absorb the costs of a major disaster.

Overall, the regulations guarding the railroad industry from disaster need to be overhauled. Because of the lack of pipelines being built in both the U.S. and Canada, there will be an increase in crude oil being shipped by rail. That growth only increases the risk of a disaster, especially given the fact that the cars holding the crude oil appear to be inadequate to contain the oil.

Investor takeaway
Railways are enjoying explosive profit growth thanks to the increase of crude oil being shipped. However, railroads are overexposed to the risks of carrying that oil given the unlimited liability faced when carrying hazardous materials. It's something to keep an eye on, as we could see costs increase for railroads as well as for customers as the industry looks to reduce the risk of financial ruin.