When Bad Things Happen to Good Supply Chains

From the 2011 tragedies of the Tōhoku earthquake and tsunami in Japan to last year’s devastating Hurricane Sandy closer to home, Mother Nature has a way of reminding us to reexamine catastrophe preparedness.

These events, and the tragic aftermath that follows, also serve to remind the insurance industry of the challenges in quantifying risk and accounting for exposure in an increasingly complex supply chain environment. As a result, risk managers are being asked new questions as insurance underwriters require them to seek information from a broader range of stakeholders within and outside of their organizations.

Following the Chain

Generally speaking, on a per-occurrence basis, underwriters already know what an individual insured’s supply chain loss could cost through their receipt of business interruption worksheets. After all, whether an interruption is the result of circumstances at your facility or at a supplier’s or customer’s facility, the result is the same—you can’t produce your product and profits are lost and/or extra expenses incurred. What underwriters don’t always know is which supplier or customer is more likely to have an interruption, what percentage of revenue is exposed based on any one supplier or customer, what interdependencies exist across operations and suppliers, where these losses will occur in the world and due to regional accumulations of values and the catastrophic nature of the occurrences, the magnitude of all losses related to the occurrence.

So underwriters, on a serious fact-finding mission, are increasingly interested in knowing who your suppliers and customers are, how they protect their facilities, where they are, what natural catastrophes they may be exposed to, whether there are alternatives to using their products, and if there are response plans in place designed for a large loss event. As the data being sought is external to the risk manager’s organization, they will have to seek this information from those who communicate and have relationships with suppliers and customers and these parties have never had to gather this type of information before.

Adding to the complexity is that it’s not just a matter of identifying who, what, where and how much from a company’s largest suppliers and customers. The modern supply chain is much larger than suppliers and customers; it also includes suppliers’ suppliers and customers’ customers. All told, it encompasses a seemingly infinite set of variables and exposures, as any single failure anywhere in the supply chain can bring operations and profits to a standstill.

And risk managers, who are already strapped with the complexities of accumulating and collating underwriting information on their own company, are suddenly faced with having to collect additional information through people who are not accustomed to being asked for such information, across international and cultural borders, from outside parties during a time when risk management departments have suffered dearly in the wake of the economic downturn. Although purchasing and procurement professionals consider a multitude of risk issues and seek inputs from multiple parties in making their sourcing decisions, it is unlikely that they know how well a supplier’s facility is protected, or if it is in a high-hazard flood or earthquake zone, nor is it likely that input from their company’s insurance risk managers is actively sought in the procurement process.

And therein lies the problem.

Exposing Every Exposure

The most basic links in a supply chain are contributing properties (suppliers), your own production inputs and processes, and recipient properties (customers). Extending beyond the basics are your supplier’s suppliers and customer’s customers.

For example, contingent properties can include:

• A supplier’s single-sourced production facility, including utility services such as electricity, gas and water.
• Production facilities of any high-volume supplier.
• Any supplier production facility on JIT schedules.
• Supplier and customer facilities exposed to catastrophic events.
• Warehouses from which suppliers provide goods or at which a customer receives product.
• Customer’s production facilities to which a product is delivered for production input.
• Retail locations at which a customer receives a product.

To fully understand the entire scope of the supply chain’s potential exposures, a risk manager will need to:

• Identify contingent properties.
• Provide information pertaining to the likelihood of a loss at those properties.
• Determine the extent to which a disruption at a contingent property will prevent the company from producing.
• Look beyond the direct contingent properties and consider your supplier’s suppliers and customer’s customers.

After identifying the contingent properties, risk managers will have to seek out information pertaining to their suppliers and customers and be able to present their findings to underwriters. With regard to suppliers, the following should be explored:

Are the supplier’s facilities well protected?Well-protected facilities may experience loss events such as fires but will not suffer catastrophic damage, and can generally recover quickly with little or no interruption. Are you able to obtain a copy of their property insurance carrier’s, and/or internal, loss control reports?

How quickly could they reestablish production, and are there plans to do so?Business continuity planning allows for a rapid and organized response to a loss event. Even though a supplier’s facility may be devastated, pre-planning may allow one to reestablish production within days, significantly reducing or preventing a production interruption.

Does the supplier have multiple manufacturing sites and excess capacity to draw from, and where on the priority scale do you fall relative to their other customers?Having facilities to draw from in the event production stops at another makes reestablishing production much easier.

Are there proprietary technologies or processes involved, and would your supplier be willing to license those technologies or processes to others to fill your needs?Suppliers want customers to be happy, and in a disaster scenario, may have to loosen the reins on trade secrets, but in a way that allows them to retain those technologies and processes exclusively upon recovery.

Are there alternative products or suppliers that can be substituted without compromising quality or performance of your product?If your suppliers don’t have adequate plans for alternative sites, you should. Even if they do have good plans, it’s advisable for you to have a plan anyway, as your supplier’s execution of their plan may be lacking in the midst of a disaster.

When using an alternative supplier, consider the existence of approval processes, such as PPAP (Production Part Approval Process) used in the auto industry.These approvals may be required by industry standards organizations, customers, or your own internal QC programs, and can take meaningful time and effort to reestablish. Ignoring such processes may lead to product quality issues and result in additional costs in the form of a product recall or service campaign that may not be covered by insurance.

Be aware of where your supply sources and customers are located geographically.Those in areas exposed to catastrophic risks could be a problem even if they don’t suffer any damage and do have a good business continuity plan in place. They may not have access to their property due to widespread infrastructure damage in the surrounding area. When this occurs, it may be days before you know if your supplier will be able supply you.

Keep in mind that a supply stream on a JIT delivery schedule will dry up much faster than one drawing from an inventory.

The most likely source for this information will be a company’s purchasing, procurement or supply chain department. They may be centralized in one location, but are more likely scattered around the world—and this is what makes this task so daunting to risk managers.

Accounting for Every Risk

Just as a supplier can halt production by suffering a loss, so can your customer. One can’t remain in business for long without customers. It’s unlikely that you have only one customer that will cause you to stop production completely, but many businesses depend on a small number of customers and can suffer a business interruption if just one is unable to receive goods.

For customers, you should investigate the following and be prepared to present the results to underwriters:

Will your customer be able to arrange an alternate delivery site for products?Does your product require special storage arrangements, such as refrigeration or climate control? If an alternate site is found, you may incur additional delivery costs in the form of fuel, tolls, taxes, etc.

What does the customer do with your product after delivery?In many cases, deliveries go to the customer’s production facilities as an input material, in which case your contingent exposure is both at the customer’s warehouse and production facility.

Is your product a component of your customer’s final product?If it is, your issues follow those of a supplier loss.

In a retail situation, the loss of a single location may not be perceptible; however, a widespread disaster such as a hurricane, earthquake or flood may affect multiple sites to which you deliver your product.Often, the event itself is short-lived, but you may be prevented by civil authorities from entering a damaged area for some time due to hazards created by the event, such as flooding, downed power lines, broken gas lines, chemical releases, fires, etc.

Much the same as the supply side of this equation, a customer can also expose you to contingent risks if located in areas prone to hurricane, earthquake and flooding.

The most likely source for this information will be the sales department and executive staff who regularly interact with customers, as well as production and logistics departments.

Getting to Know You

In order to efficiently tackle supply chain risks such as contingent business interruptions, risk managers will need to introduce themselves to people and departments they had not previously interacted with. These people and departments have not had to deal with insurance matters in the past and will question why they have to now. The risk manager’s job will be to educate the supply chain leaders on what information is important and why it is now being requested—and to inject insurance risk management ethos into supply chain decisions.

Once the education is complete, an efficient process will have to be developed to provide the appropriate people with a clear and understandable request for the needed information at least annually.

Will underwriters require detailed information on all the exposures discussed above? Perhaps not, but in today’s world of enterprise risk management, all of these exposures should be considered to fully understand your company’s risks regardless of whether an underwriter requests information or not.

Additionally, as improvements are made to reduce your supply chain risk, they can and should be shared proactively with your underwriter in order to positively impact future renewals by demonstrating a lower risk profile and commitment to risk reduction. This can often lead to better renewal results through lower pricing, increased coverage terms and most importantly, higher contingent business interruption limits. But, if underwriters do require detailed information and you are unable to satisfy their information appetite, limits for contingent supply chain risks may be reduced, premiums may increase, or you may not be offered the coverage at all.

And that’s the greatest risk of all.

Timothy Comer has extensive risk management experience, having worked for a global auto parts manufacturer and a regional real estate investment trust prior to joining Hylant, an insurance and risk management firm, in 2012. His international experience provides a depth of understanding to the challenges of a global risk.

Neil Silverblatt joined Hylant’s Chicago office in 2011 as a client service executive in the Property & Marine Risk Practice. He primarily oversees property, boiler & machinery, and terrorism placements for clients in the healthcare industry and for manufacturers of medical supplies. He also has extensive experience with layered and shared programs placed with the domestic and overseas marketplace.