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Engaging corporate risk managers: Contingent Business Interruption - A clear view?

Source: Asia Insurance Review | Apr 2014

The floods in Thailand and earthquake in Japan in 2011 highlightedthe enormous accumulation potential of supply chain disruptions. Since then, companies have systematically combed through their production processes to identify all critical relations and components. Mr Christian Wegner and Ms Mary Weston of Munich Re examine contingent business interruption cover from an underwriting and claims perspective – an often complex and time-consuming undertaking.
 
The fact that many companies now see supply chain interruptions as one of their biggest risks shows just how deeply the global economy was shaken by the events of 2011. In a globalised economy marked by increasing specialisation and production processes involving ever-smaller percentages of made-in-house components, the danger that supply chain disruptions will lead to unwanted production stoppages is growing. 
 
The situation is further aggravated in cases where a small number of highly specialised manufacturers supply multiple branches of industry or where such manufacturers are concentrated within a single area and therefore present an accumulation exposure to a single loss event. 
 
The biggest catastrophe in the history of Thailand
In 2011, heavy rains flooded large parts of Thailand, claiming over 800 fatalities, affecting 14 million people, and causing severe industrial and agricultural losses. The World Bank estimated economic loss at around US$43 billion and insured losses stand at US$16 billion, including CBI losses in Thailand and elsewhere (Munich Re data).
 
The resultant production stoppages on large industrial estates were felt worldwide, particularly in the case of hard disk drives (HDD), as Thailand is the world’s second largest supplier of these hardware components, producing roughly one-quarter of the world’s supply. The sudden shortage in the fourth quarter of 2011 prompted average sales prices to rise by 28%. Prices were also driven up by higher costs of relocating production and the rising cost of components from suppliers similarly affected by the floods.
 
 
 
The CBI claims investigated by Munich Re in 2011 were due for the most part to property damage resulting from the earthquake in Japan and floods in Thailand. Most of the suppliers concerned were manufacturers of computers, electrical and electronic appliances, or semiconductors.
 
The most affected industries are highly dependent on semiconductor suppliers. The map reveals that many semiconductor manufacturers of critical importance to the global industry are located in Japan - a country with a high exposure to natural hazards. 
 
If production is interrupted, the producing companies have to reckon with consequences that go far beyond direct financial losses. Loss of custom and damage to a company’s reputation can tarnish the brand and lead to a loss of confidence on capital markets. 
 
To make their supply chains more robust, companies should therefore adopt an approach that not only covers CBI losses, but takes into account the entire risk exposure and value chain. Ultimately, this involves scrutinising as many suppliers as possible, as well as their production locations, in order to identify weak spots. Risk reviews should also include the contingency planning of both direct suppliers and their subcontractors. 
 
Challenges for the insurance industry
As failures in the supply chain can rapidly lead to enormous financial burdens, they have also prompted the insurance industry to adopt a new approach toward CBI. The unknown and therefore uncontrolled accumulation risks frequently brought to light by supply chain disruptions have made underwriters realise that effective accumulation control for CBI has not been paid enough attention in the past. This, however, is the only way the insurance industry can ensure that the commitments made can also be discharged reliably.
 
CBI losses are insurable in principle if the policyholder can provide a detailed and qualified assessment of the supply chain risks and quantify its maximum potential loss. With these data, the insurer should be able to determine which of their clients will be affected if a specific supplier or customer fails, and to what extent. This is particularly important in reinsurance, given the risk of further accumulations of losses. 
 
Over the past two years, Munich Re and various primary insurers have subjected the risks entailed in business interruptions and supply chain disruptions to intensive study and reassessment. Today, we have a much better understanding of the risks awaiting primary insurers and of the extent of our own exposure.
 
Risk management as the central factor
In order to offer industrial clients covers tailored more specifically to their needs and at the same time reduce the uncertainties existing on the insurance side, we need to consider a new approach toward insuring supply chain disruptions. A first step in this direction could be to scrutinise potential policyholders’ risk management and identify possible weak points in their production processes and critical supplier relationships. 
 
To minimise this risk, companies need to carry out in-depth analyses of their supply relationships and draw up plans to compensate for the potential failure of their suppliers (a process known as business continuity planning or BCP). 
 
Risk transfer is another risk management tool available through insurance. Class business interruption (BI) insurance protects firms against purely financial losses resulting from the stoppage of their own production facilities, while CBI offers policyholders protection against financial losses resulting from physical damage at a supplier’s or customer’s location.
 
The path ahead
As far as supply chain disruptions are concerned, there is still considerable scope for improvement on all sides. 
 
The impact of the floods in Thailand has demonstrated how important it is that insurers and reinsurers work closely together from the outset to ensure transparency regarding losses, loss adjustment and cover issues. The Thailand floods disaster has alerted both the global economy and insurers to the vulnerability of supply chains and thus also to the risk of contingent business interruption losses. The event showed that supply chains had not become, or were no longer, fully transparent.
 
The insurance industry will continue to demand greater transparency as long as the essential information needed to assess risks is not fully available, due either to a lack of cooperation or the inability to procure the required data. Only when transparency is assured, will we be able to achieve our goal of offering policyholders CBI solutions with risk-adequate terms and conditions and reasonable limits of indemnity. 
 
National insurance markets will have to identity the risks associated with natural hazards and other exposures such as CBI and offer appropriate products at prices commensurate to the risks. Munich Re will continue its efforts to ensure greater clarity regarding hand-to-assess risks, as well as better insurance protection in conjunction with construction standards and flood-prevention measures.
 
Mr Christian Wegner is Senior Corporate Underwriter at Munich Re in Munich and Ms Mary Weston is Head of Claims at Munich Re in Southeast Asia.

 

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