September 10th, 2012

Contingent Business Interruption: Life Support for Industry

Posted at 11:00 PM ET

speed_morley_thumbMorley Speed, Managing Director

This summer hospitals in the United Kingdom have faced a critical shortage of specialized tubes required for intensive care dialysis machines produced by a specific supplier.

This shortage results from earthquakes two months earlier in Italy. Two manufacturers in the earthquake-affected region who were forced to close produce tubing for the supplier, which has tried to ration the remaining stock until factories in the region are able to restore production. It is not expected that full supplies will resume until mid-October. In the meantime hospitals in the United Kingdom must manage their supplies to ensure that patients receive proper care.

The relatedness of these events may appear surprising but can no longer be termed unusual. Both the scale and complexity of global manufacturing interdependencies, compounded by just-in-time processes, contribute to the vulnerability of supply routes to abrupt and devastating blockage.

Management consultants, PRTM, in their report, “Global Supply Chains 2010-2012,” reported that 85 percent of 350 respondents expected the complexity of their supply chains to grow significantly by 2012. At the same time market transparency and greater price sensitivity mean that supply chain volatility and uncertainty “have permanently increased.”

PRTM reports that risk management must apply itself across the entire supply chain. However, “many companies lack the capabilities critical for … managing an increasingly complex and global supply chain.”

Traditional insurance products are insufficient to address these increasingly complex challenges. The standard business interruption policy only indemnifies an insured for a reduction in revenue following damage at its own premises. Contingent business interruption (CBI) is a generic term for extensions to the standard cover that provide for reduction in revenue as a result of damage at locations other than the insured’s own premises, whether it be suppliers or customers. In some cases insurers are providing cover on a “non-damage” basis, which protects against insolvency or political risk among an array of contingencies that might disturb the supply chain.

Such considerations may appear somewhat remote or esoteric, but a more familiar example arises from the Thailand floods. Some analysts suggest that the Thailand floods caused a 30 percent reduction in new hard-drive production numbers, with a corresponding increase in cost of 24 percent. There was an impact on the manufacturers who relied on those supplies, with one losing its significant market advantage to its competitor.

But not only natural catastrophes can cause supply chain disruption. An explosion occurred at a factory in Germany that makes cyclododecatriene (CDT), the key component in a nylon resin used in auto fuel lines. This manufacturer and another produce nearly 50 percent of the global output. Shortly afterwards car manufacturers in Detroit were told by the fuel line manufacturer that uses the nylon resin that, as a result of this explosion “the possibility of production interruptions at some of your facilities in the next few weeks is high.”

With these events in mind, the insurance industry contemplates the concept of supply chain risk, questioning whether it is a threat or an opportunity. The industry is undecided whether CBI coverage should be enthusiastically marketed as a positive differentiator or consigned to the “accommodation business” category. Supply chain risk is now a fact of life. When the butterfly in the supply chain flaps its wings a hurricane may well ensue. There is therefore no doubt that there are many potential customers for a viable CBI offering. The key question, therefore, is how such an offering can be made viable.

The obstacles to viability for CBI are not dissimilar to those faced in the past by other nascent products, such as covers for directors & officers or satellites. At the outset there is a substantial information deficit, which is skewed in favor of potential customers. Moreover, by their very nature, supply chain risks can be both unbounded and unpredictable with spike losses arising from unknown accumulations and concentrations of risk. This is symptomatic of the structural consolidation in the global economy, where a single company like Nokia, for example, has revenue that represents 20 percent of the Finnish gross domestic product. There is also the fundamental problem of scale. Although insurers naturally incline to large numbers of homogenous risks, the development of a new product initially attracts a limited number of high-profile prospects. Furthermore there is a concern over adverse selection against insurers, a factor which featured prominently in the early days of environmental impairment liability covers.

In such circumstances the underwriting process is very intensive, which results in unacceptably high frictional costs. Moreover, following detailed risk assessments, prospects may eventually elect to re-engineer their risks rather than transfer them. Alternatively, underwriters, with their enhanced knowledge, may decide that the risk is unacceptably severe. This further compounds the cycle of frustration in terms of scale.

Historically in product development, these obstacles have been surpassed as (re)insurers evolved more efficient distribution and increased penetration. Without sacrificing underwriting integrity, commoditization of the product broadens and homogenizes the potential portfolio and as a consequence, a positive cycle of growth, experience and expertise secures viability of the product.

In all cases the critical factor is the accumulation of appropriate information for underwriting and pricing decisions. This gives confidence to insurers to commit capital and reinsurers to provide capacity. At Guy Carpenter we have been working with our Marsh colleagues in Strategic Risk Consulting who specialize in supply chain and business continuity to understand the breadth and depth of information available to risk managers within the original insureds. Our goal is to rectify the information deficit, allowing us to more fully support our treaty clients in providing meaningful cover to their customers by creating and enhancing reinsurance capacity.

It is our view that as a “knowledge aggregator” Guy Carpenter is in a pivotal position to add value throughout the insurance and reinsurance chain. Whether it is by risk mitigation or by risk transfer, value can be created by understanding the vulnerabilities of supply chains. Even once the chain has been disrupted, proactive intelligence can be applied to give “first mover” advantage to well-prepared insureds. Our Post-Catastrophe Preparedness Response Specialty is working on an initiative to apply its capabilities to supply chain management in exactly this context.

The scope for future innovation is enormous. Some insurers have embraced CBI as a positive opportunity and are pushing the boundaries to provide imaginative solutions that include political risk and insolvency. While we do not underestimate the practical difficulties of delivering such products, at Guy Carpenter we are excited to be working with our clients to assist in delivering “real-world” solutions to the “real-world” of supply chain risk.

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