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Managing Supply Chain Disruption Risk

We live in a world where leading U.S. manufacturers often manufacture very little. They remain masters of design, quality control and distribution.  However, to remain competitive, the actual manufacturing process is outsourced to offshore companies that can deliver at lower costs.
03/28/2012

We live in a world where leading U.S. manufacturers often manufacture very little. They remain masters of design, quality control and distribution. However, to remain competitive, the actual manufacturing process is outsourced to offshore companies that can deliver at lower costs.

The net effect of this trend is that companies are decreasing their risk of being driven out of business due to fierce global competition, but they are increasing their susceptibility to rare but catastrophic events, which if left unmanaged, could have the same result.

There are a variety of risks associated with supply chains. Lack of reliability or quality from suppliers or contract manufacturers can have broad impact on a company’s sales, customer service and inventory control efforts. This article focuses on the area that most risk managers are focused – natural catastrophe risk which can lead to supply chain disruption.

Risk Assessment

In assessing supply chain disruption exposure, the first thing a risk manager or executive should seek to understand is where the plants are located that produce your products. Are there multiple locations in different regions? If so, is there enough capacity at other locations to replace lost production if a location was shut down? How long would it take to provide tooling and qualify a substitute location prior to the production of your products?

The next thing to understand is what your contractual obligations to your customers are. Do contracts provide for liquidated damages in the event of failure to deliver? Are there force majeure provisions?

A final thing to assess is the competitive risk associated with loss of supply. If you lose supply and production capacity, but all of your competitors do as well, revenues might just be deferred rather than entirely lost. The financial loss may be absorbed by higher unit costs across the entire sector, provided your supply contracts with customers do not lock you in at set price levels.

Risk Mitigation

Determine what the options are for alternate suppliers. It might be wise to pay a bit more for having multiple suppliers if the redundancy reduces your risk exposure. Obviously quality and reliability are important in sourcing decisions, but single-sourcing with the best provider can increase the risk of catastrophic losses.

It’s the point that Nicolas Taleb makes so effectively with his analogy of the human body having two kidneys for good reason. Until there is a problem with one, the other just seems like dead weight.

This same thought process applies to the amount of extra inventory to hold. Leanness creates operational efficiency, but increases supply chain disruption exposure.

Insurance

FM Global is reported to have experienced significant losses from the Japan earthquake-tsunami, most resulting from contingent business interruption (CBI) coverage. They, as well as most other insurers, are increasing the level of scrutiny on such exposures.

To underwrite CBI risks, insurers are looking for the same type of C.O.P.E. information as they do with owned locations.

  • Construction: year built, wall and roof structure, compliance with building codes, adherence to construction best practices
  • Occupancy: section/floor of the building occupied, risks associated with the operation 
  • Protection: fire detection and suppression, security systems
  • Exposures: neighboring operations and geographical risks 

Insurers also want to understand and see documentation of the supplier’s disaster recovery planning. Major suppliers are likely use to these types of questions given the sophistication of their customers.

Commonly Misunderstood Aspects of CBI Coverage

Many executives do not understand the limited aspect of protection afforded under most contingent business interruption coverage grants. The following aims to clarify some common misunderstandings.

  • Only minor levels of contingent business interruption (CBI) coverage can be secured on a blanket basis. To secure higher limits, specific vendors and locations must be specified. Blanket coverage generally only applies to “first tier” suppliers and not loss that results from damage sustained at suppliers to your suppliers’ locations. Coverage for secondary tier suppliers generally must be negotiated and specifically scheduled for coverage to apply.
  • Only the types of perils and property insured under your own property policy are covered for CBI losses. Consider that roadways are often not insured types of property, so if the interruption arose due to inability to access a location, coverage might not be afforded. Also, CBI coverage is typically not provided for a location that does not sustain direct damage but just has prolonged loss of utilities.
  • Often, perils are more limited than your own property policy. Flood and earth movement coverage are many times excluded for CBI locations, even if covered under your own policy.
  • Earth movement is broader than earthquake. Many just think of the shake risk. Consider that land- slide risk resulting from typhoons/hurricanes can be substantial. One also needs to consider land subsidence risk. Due to population surges in developing areas, ground water can be over-pumped.
  • There is no uniformity regarding how tsunamis are treated. One must be careful if both earth movement and flood are not insured at the same level. Some specifically include tsunamis within the definition of earth movement. Others may treat a flood as the proximate cause of tsunami loss.
  • Standard CBI coverage does not insure port closures, political risks, or general business failure or insolvency of business partners. A company would need to look toward broader trade disruption insurance for such coverage.
Conclusion

There will always be a delicate balance of managing global competitive risk versus supply chain risk. Given ongoing financial reporting pressures, primary focus is often given to competitive risk. This necessitates that those who manage hazard risks do their part to ensure that prudent risk assessment, risk management and risk financing decisions are made regarding supply chain exposures.

This article has suggested three ways to assess supply chain disruption exposure, as well as sought to clarify common misconceptions regarding typical contingent business interruption insurance coverage. The last thing a risk manager or financial executive wants to do is report to their board or shareholders, after a catastrophe has taken place, that they did not in fact have the insurance coverage that they thought they did.