Catastrophes Issue Wake Up Call on Supply Chain Risks

By | May 24, 2011

The Japanese earthquake and tsunami that occurred in March 2011 served as a wake up call of sorts for businesses vulnerable to supply chain exposures. Subsequent intense weather events in the United States during April and May have underscored the importance of preparing for and insuring against disruptions to supply chains for operations that rely on the products and services of other entities.

“Two years ago there was hardly any interest in this subject,” said Bret Ahnell senior vice president and western division manager for insurer FM Global. While he questioned whether the current interest in supply chain risk management would have staying power, he said there are certainties when it comes to natural catastrophes.

“We don’t know when they are going to occur but we do know … where they can occur,” he said. “We know where the earthquake, windstorm, flood zones are all over the globe. Probably more importantly is — we do know that they are going to occur again. Not a matter of if, definitely a matter of when.”

Ahnell said the problem now is that because many companies have been focusing on costs and efficiency, “they have turned a blind eye to the risk associated with their supply chain.”

It’s critical that companies assess the risk/reward implications associated with their supply chains, he said. After all, they need to understand the risks they have before they can develop a program to manage them.

Internationally, because of the earthquake and tsunami, Japan has been the focus of attention. However, Ahnell said, there are “other parts of the world that are probably even exponentially greater exposures to supply chains.” Among them: the Pearl River Delta in China, which has a huge concentration of manufacturers of electronic systems and components; and Taiwan, which plays an important role in the semi-conductor industry.

Ahnell said it is FM Global’s practice to focus on site specific property related risk when it works with insureds in developing programs to mitigate their supply chain exposures. Site specific property risks include: hazards to which physical structures are exposed; hazards in the manufacturing process and any ensuing downtime; situations that may disrupt a company’s ability to produce or to operate; and inability access the facility; the lack of or interruption of incoming power; and the ability or inability to ship or receive products.

“All of these are property related risks that people have a tendency to treat as [a] blind spot, they just don’t want to go there,” Ahnell said.

The Importance of Personalization

Developing a supply chain risk management program is not a one size fits all endeavor, said Bradley Johnston, chief administrative officer with Temple-Inland, which manufactures corrugated packaging and building products.

Each company needs to look at its own operations, transportation modes, and where and how it receives supplies to determine how much diversity it needs in the supply chain, he said.

However, while companies tend to focus on diversity of suppliers, the approach needs to be more holistic. For example, transportation in and out of a facility can be a tremendous risk, he said.

“You can go look at a supplier and see if they are financially viable and if they have good back up systems, if they have good safety systems. But if they have transportation issues that may not even be near them but somewhere in the chain between you and them, it’s very important to analyze those very carefully,” Johnston said.

In addition, Johnston said, during and after a catastrophe, there may be supply issues that occur outside of the company’s normal operations. For instance, Temple-Inland’s major mills in South Texas and Louisiana were greatly impacted by Hurricanes Katrina and Rita in 2005. While the company had a plan in place for continuing to supply its customers via operations in other parts of the country, it faced obstacles in the hurricane affected states what were outside of the norm.

It was “a matter of getting supplies in that we didn’t normally worry about getting to people, such as fuel, generators, gasoline. … We took RVs into those locations so our employees could get back in to our facilities. These weren’t normal supplies that we used in our operation. But they were critical and to have a supply chain source for them lined up, especially in a natural disaster in our own country, when other people were competing for those resources at the same time was critical. … So personalization is really important,” Johnston said.

Insurance: A Complementary Strategy

Insurance can be an effective strategy as part of the plan for managing supply chain risks but it shouldn’t be viewed in isolation, said FM Global’s Ahnell. “It should be there as a complement to other probably more sustainable strategies.”

Still, there are important aspects to consider when it comes to basic insurance policies. One is whether the “contingent time element coverage provides for both direct and indirect suppliers, customers, contract manufacturers, etc. It’s really that indirect that people need to look at because are you picking up just that first tier or are you picking up the second, third, fourth, fifth tier all the way down the line,” Ahnell said. “It’s a very important thing to look at. The standard coverage out there is going to pick up just that first tier. Keep in mind there is the broader coverage available.”

Typically the time element extension coverage is not extended to the supply chain, it has to be added. In addition, coverages for “civil authority, ingress/egress, those things that inhibit you from getting to the facility, service interruption, power interruption, extended period of liability, all those types of things … make sure they’re extended to cover your supply chain,” Ahnell said.

One important specialty coverage that companies often overlook, he said, is logistics extra expense, which provides for the extra cost for rerouting shipments to maintain the normal supply. It can be of great value to an organization, depending on its location and the type of supply chain it utilizes.

Peril restrictions and territorial definitions are also important aspects to be aware of, he said. “If you had a policy, for example, that just covered the U.S. and Canada and you had key suppliers in Japan, and did not cover Japan as part of the territorial definition you didn’t have any coverage. So make sure your territorial definition is broad enough.”

Know Your Suppliers

The more a company knows about its suppliers, the more insurance capacity it will be able to find at the price it expects to pay, Ahnell said.

FM Global focuses on the risk quality aspects of a company’s suppliers — things like whether the facility is going to be there after an event, the physical protection of the facility, diversification and redundancy.

If a “particular supplier is down based upon a physical loss, it may take weeks, it may take months to get them back into service,” Ahnell said. “Yes, they may get reimbursed through insurance to get them back up and running, but that time period that they are down may be too long for you and you may already have lost customers through that process.”

So, he advised, companies should focus on other risk management strategies and view “insurance as the backstop for all the other strategies.”

Every supply situation is different, whether it’s transportation or sole source suppliers, Johnston said. There are likely to be other companies competing for some of those resources, so it helps to be creative in selecting and vetting a supplier.

One message a firm communicates to its suppliers when it sends in a team to look at their facilities is that the supplier is important, he said. It’s an inclusive exercise that generates good will.

“A lot of the things you do including sending in people … to look at their facility to improve their safety and their fire hazard risk … are improvements for their businesses,” Johnston said. “What you’re telling them is, ‘you are critical.’ … They know you’re making the commitment and the time and effort to make sure they can supply you.”

Property risk evaluation is a critical part of the overall equation in assessing a supplier and should be considered at the front end of negotiations before the companies begin conducting business together, Ahnell said.

“Would you go and buy from a facility you’ve never been to before?” he asked. “Why would you entrust a supplier with a critical process … without ever visiting their facility?”

A company may be outsourcing a key process but it is not outsourcing the risk, he said. “You still own that risk … and because of where these suppliers are today that risk is generally going up.”

Editor’s note: This story is based on a webinar on supply chain risk hosted by Advisen, in which Ahnell and Johnston participated.

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