Publication- Business Interruption Insurance – (June 2015)

POSSIBLE ACCUMULATIONS UNDER THE BUSINESS INTRERRUPTION POLICIES

A business Interruption policy covers the consequences of fires or breakdown of machineries to the production capacity of an organization and therefore protects the income of that organization. The damage may be caused by single insured perils or the occurrence of Natural Perils.

The purpose of these covers is to indemnify the insured against the adverse effect which damage to property will have on the income of the business.

In practice, the BI policies can be extended to cover the Suppliers premises, Customers premises, Transit risks and public utilities.

In most cases, particularly in the Global Market Situation, these suppliers and customers are located in all parts of the world and for these goods to reach the customers, they have to be transported over long distances; over a period of time, and thus the goods are exposed to various risks prevalent in the particular area. For example, the risk of hurricanes can be more pre dominant in the Americas, but we in this region import and also export goods to America, then our BI policies are exposed to these Predominantly American Risks.

The occurrence of these perils will cause production delay and shortages in the importing country, which may result in loss of profits due to interruption in the business process. Many companies now see supply chain interruptions as one of their biggest risks. This is due to the fact that instead of producing components directly, firms seek to improve their efficiency by purchasing products made to measure by upstream manufacturers. These not only deliver the products in time, but also ensure that the delivery is executed in the right order.

This may call for the BI policies to cover all possible causes of losses, since various goods will originate from areas where some type of perils are more prone to occur than in others.

A situation occurred in 2011, when the global Economy was shaken by the events of the Japan Earthquake and Thai Floods. Due to the occurrence of the two catastrophes, productions processes dependent on raw materials produced in the two countries were affected, leading to stoppages in production and consequently, losses.

The situation can be further aggravated by having one or a highly specialized supplier deliver to different branches of industry or when they are concentrated in a single area and are affected by a single loss event. This was the case experienced all over the world as a result of occurrence of the Japanese Earthquake and the Thailand Floods mentioned above. Most of the suppliers concerned were manufacturers of computers, electrical and Electronics Appliances, and Semi-Conductor factories. Most of these factories were located in Japan and Taiwan (Two countries with high exposure to natural hazards).

This type of risk was frequently overlooked in the past, however, it is emerging that every link in the supply chain is important to the system as a whole.

For the Insurance Industry, this becomes problematic if a key supplier for an entire branch of industry fails, causing a ripple effect and leading to supply shortage in other companies. In the worst case, it could lead to global domino effect with losses due to supply chain disruption in a large number of companies in very different regions. Due to their structure, the automotive and electronics industries are particularly susceptible to the Business Interruption losses.

If production grinds to a halt, the companies concerned must deal with the consequences that go beyond the direct financial loss. Loss of Customer and damage to company’s reputation can impair the brand and lead to a loss of confidence on the capital markets. To make supply chains more robust, companies should therefore choose an approach encompassing the entire risk exposure and value chain, and going beyond the mere coverage of the BI covers. Ultimately, this means seeking out as many suppliers as possible, and their production locations, to identify weak spots. The supplier’s contingency planning should also be reviewed.

Once critical components have been identified in the production chain, along with potentially dependent relationships between suppliers, alternatives have to be found. For example, supply relationships could be diversified instead of relying on just one or a few manufacturers, even if this does mean higher costs. A more robust supply chain can also be achieved by companies stocking a certain level of critical components in their own warehouses. In the event of a disruption, business continuity plans have proved to be an invaluable part of a corporate risk management. This requires close collaboration between a company’s executive management and its risk managers.

THE INSURANCE INDUSTRY CONNECTION

Since failures in the supply chain can lead to enormous financial burdens, this has resulted in a new BI approach by the Insurance Industry as well. Underwriters have been shaken by the unknown and therefore uncontrolled accumulation risks which are frequently associated with supply chain disruptions in particular. Effective accumulation control, however, is the only way to ensure that commitments made can also be discharged reliably.

Even complex risks can also be accepted when backed by broad risk expertise and thorough risk management, which should be the central factor.

In order to offer industrial clients more specifically tailored covers and at the same time reduce the uncertainties existing on the insurance side; we need to consider a new approach when insuring disruptions in the supply chain. A first step could be the policy holder’s risk management, with identification of possible weak points in the production process, as well as critical relationships with suppliers. Within the framework of risk management, the risk can be reduced considerably through suitable organisation of the production sequence and connections. The remaining risk is then only covered specifically for the failure of parts, which have been identified as being particularly critical, and only on the basis of correspondingly good risk data and at an adequate price. The advantage of this approach is that it reduces complexity while making the accumulation risk more transparent and manageable, with the result that risk management and insurance products can be combined more effectively.

For this an insurer should engage in thorough studies to know the risks associated with their business interruptions and disruptions in the supply chain and assess their possible liability/accumulations. To improve control of the company’s own portfolio, many BI covers may now require that the policy holder provide a detailed and qualified risk assessment of the supply chain and quantify the maximum financial loss.

The complexity and constantly changing nature of supply chains, however, continue to pose a major challenge for underwriters. Certain risk factors remain intangible, such as when they concern the flexibility of production process or the quality of the policyholder’s risk management. In such cases, the underwriter must rely on data that are rarely standardized and which clients tend to consider “sensitive”.

The Insurance Industry will continue to demand greater transparency as long as the essential information is needed to assess a risk is not fully available, be it due to lack of cooperation or an inability to procure the required data. Only then can we achieve our goal of offering BI covers with adequate terms and conditions, as well as reasonable limits of indemnity. We can offer our clients suitable BI covers once adequate transparency is assured and the premiums are appropriate.

The Insurers must also impose restrictive terms and limits if the risk and the resultant exposure to accumulations cannot be adequately assessed. The particular challenge for globally operating reinsurer is to contain the BI accumulations risk from treaty business, particularly as large portion of the BI losses may be borne by a few Reinsurers, especially following a natural catastrophe.

Although BI risks cannot be completely identified, especially in treaty business, the insurer’s/Reinsure’s aim is nevertheless to control at least the particularly critical Bi scenarios. These scenarios are characterised by three factors:-

  1. Even without BI, high losses due to Natural Catastrophes must be expected in a region
  2. The Insurance Industry is susceptible to Business Interruption losses on account of critical relationships with high sums insured and
  3. The risk of accumulation is high because of critical suppliers ‘production facilities are threatened.

Viewed from this vantage, this yields critical scenarios particularly for areas where the country of domicile import most of their inputs.

All in all, there is still considerable scope for improvement on all sides where disruptions of the supply chain are concerned. Industrial companies can fall back on the expertise of external specialists, who can identify the individual risk sources and offer solutions. With their extensive risks knowledge, insurers are no doubt the first people to contact.

KENNETH OBON’GO OBALLA

TRAINING MANAGER, ZEP-RE

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