A supply chain or logistics network refers to a complex but inter-related system of companies whose aim is to transform raw materials and components into a finished product that is delivered to the end customer through the most efficient use of resources, particularly distribution, inventory and labour. This is a process that involves a wide array of people, activities, information and resources.
Due to the increased development of interdependencies between business and the widespread use of just-in-time business processes and manufacturing, supply chain risk represents the possibility that something could happen in one part of the chain that severely disrupts the rest. The complexity in modern manufacturing may compound the risks when supply chains become extended and multi-pathed and when various parts of the process are outsourced to organisations or offshored to other countries that could become unstable.
Just-in-time production methods that are widely used in manufacturing these days mean that companies keep only minimal stock with the benefit that they do not have precious capital tied up in inventory stockpiles. The downside is that the whole system is more exposed to potential supply chain shocks or disruptions as there is no surplus. A manufacturer that takes either daily delivery or delivery several times a day is severely exposed if the supply of those components comes to an abrupt halt. It is possible that the event causing the disruption to the rest of the supply chain of itself may be fairly minor and initially seen as insignificant.
Supply chain risk represents the tension between the pressure for a quick, efficient, flexible and least costly delivery of a product or service and the significant risk that something can go wrong in this process and that the chain snaps with severe consequences for the customer.
Traditionally, insurable events that cause physical damage to the goods or the transport infrastructure can impact the supply chain. However and now more importantly, other events where there is no actual physical damage can result in severe disruption. These events could be a terrorist attack, war or political risk, such as confiscation or nationalisation where the cost to the business can be far greater. Even something as relatively straightforward as a company becoming insolvent can result in a disruption that can have downstream consequences. There is a very real risk that if a company's supply chain fails, the customer is disappointed, the company's reputation is tarnished and the customer goes elsewhere, never to return.
There are numerous examples of specific events that have caused downstream supply chain problems.
- In 2000, there was a fire at a semiconductor plant in New Mexico that supplied parts to Ericsson for incorporation in mobile telephone handsets. Unfortunately, Ericsson had simplified the supply chain for these particular components so that it was reliant on this one particular source and had no alternative supplier that it could call on. This had the knock-on effect that it ultimately caused severe problems for the company in launching a new generation of mobile telephone handsets, and the following year the company divested its mobile phone business.
- The number of oil refineries in the US has fallen from 279 in 1975 to 149 in 2004. As a result, the oil industry is susceptible to supply shocks which can cause sudden price spikes with resultant impacts on manufacturing output and cost base. Hurricane Katrina in 2005 resulted in the shutdown of nine refineries in Louisiana and six in Mississippi along with various oil production and transfer facilities. Some 20% of US domestic refining output was lost. The problem was exacerbated when Hurricane Rita subsequently caused refineries in Texas to close.
- The Hanjin Pennsylvania container vessel fire in 2003 was a massive physical loss of cargo and a vessel. More than just a cargo loss, the container liner schedules were severely disrupted. Was it a freak loss and not likely to happen again? March 2006 brought a repeat with the Hyundai Fortune containership fire and another massive physical loss of cargo and a vessel, but more importantly, major supply chain disruption. Lloyd's List's headline on 30 June 2006: "Cargo boom prompts box capacity crisis" translates to inflexible container vessel schedules and a shortage of ships. Taking the Hyundai Fortune out of service meant a vast amount of cargo heavily delayed and supply chains snapped.
- Strikes which shut down the Los Angeles docks in 2002 caused widespread logistical problems for a variety of industries.
- In November 2004, the breakdown of the tanker Tulip Brilliant blocked off the Suez Canal and threatened Sony's supply of the popular mini-Playstation 2 for Christmas in Europe. Sony hired giant Russian Antonov cargo planes to airlift supplies to replace those stuck at sea.
- The 2005 bra wars debacle between the European Union and China meant that 75 million items of imported Chinese garments were held at EU ports in the summer of that year. It turned out not to be a one-off incident, as in 2006 we have seen the European Union turning against New Zealand butter! What next? Trade quotas are a business risk, but when governments impose embargoes, suddenly there is an insurable risk.
Managing the risk
How do organisations manage these risks? Supply chain risks should be subject to the same process as they apply to their physical damage exposures. The business should analyse its exposures, perform regular reviews and constantly monitor the system, including keeping track of the political risks overseas. Tried and tested business continuity plans are a key indication of good risk management. Where feasible, spare capacity should be built into the supply chain. The options are to retain, mitigate or transfer the risks.
A commonly held but mistaken belief is that standard business interruption insurance bought by many companies will respond to every loss. In reality, most business interruption insurance cover requires damage to a policyholder's property to trigger a recoverable loss.
There are, however, innovative risk financing solutions to the problems of supply chain disruption. Trade disruption insurance (TDI) covers the financial consequences of disruption to the supply chain, whether by way of lost revenue or increased costs of mitigation, and, critically, does not require physical loss or damage to the policyholder's assets. Disruption may be caused by natural perils (windstorm, earthquake and the like), political events (including embargo, war or terrorism), insolvency of a key supplier or customer, or physical events, such as closure of a navigable waterway.
Trade disruption insurance has become a sought after financial solution to a company's exposure to supply chain problems. It provides the benefits of flexible indemnities with tailor made triggering events, flexible definitions of the supply chain itself (where it starts, where it ends and what are the key components therein) and concentrates on the bottom line loss to a company rather than the more traditional, but not always satisfactory, solution of the physical loss or damage to a company's assets.
Will you be insured?
Several companies have already discovered the value of trade disruption insurance as part of their business continuity planning. For example, a US trader who was unable to move grain from the mid-west down to Houston, due to the flooding of the Mississippi River, incurred additional upstream warehousing costs. The trade disruption insurers bore the cost. A major distributor of bananas from Honduras had to use alternative transport routes following hurricane destruction to the country's transportation infrastructure. The additional warehousing costs and transportation expenses were covered.
Trade disruption insurance provides the added benefit that it can combine protection against both natural and political events under one policy. The financial motivation to outsource or offshore manufacturing processes to countries such as China is evident but in so doing, companies are exposed to increased political risk. Following the Tiananmen Square crisis in China in 1989, one US importer of clothing from Chinese suppliers relied on his trade disruption policy to bear the financial implications of being unable to move clothes from his suppliers when the security forces closed access roads.
In today's increasingly globally interlinked world of supply chains, it seems that the answer to the question "When the supply chain breaks, will you be insured?" is "Yes, quite possibly."
John Eltham is director - special risks with Miller Insurance Services Email: email@example.com
Rupert Sawyer is associate director - Special Risks with Miller Insurance Services Email:firstname.lastname@example.org Website: www.miller-insurance.com Paul Culham is an underwriter for R J Kiln within the Lloyd's market Email: Paul.Culham@Kilnplc.com Website: www.kilnplc.com