Protecting Your Company from Ruinous
Supply Chain Disruptions
In recent years, manufacturers have increasingly come to rely on (and take for granted) an idealized supply chain for supplies and materials that allows “just-in-time-deliveries” featuring:
- Global sourcing
- Clockwork-like shipping
- Just-in-time delivery
This model enhanced profits by sourcing from low-cost providers and minimizing inventories.
Over the last several years, and for a number of reasons, uncertainty has been introduced into nearly every aspect of that model. Multiple shocks to the supply system caught most companies unprepared. In the face of the COVID pandemic, and many did not survive. Those that did made shrewd, ad hoc adjustments.
Now, with the benefit of a recovering global economy, these companies have the opportunity to take a breath and a consider a more thoughtful approach to modifying their supply chain strategies to minimize their risks when the next regional or global shock hits.
We’ll explore those basic supply chain security strategies in this Whitepaper.
Business Continuity Event
an event (whether a natural or man-made phenomenon or occurrence), which interrupts the normal business activities, including (but not limited to) business functions, operations, or processes of the customer, (whether anticipated or unanticipated), and which prevents or delays a party from performing its obligations to third parties or receiving the full benefit of the provision of the services in accordance with the provisions of this Agreement; (from LexisNexis)
How We Got Here
Since the beginning of the 20th century, supply chains have evolved from localized, to regional, to national, to continental and to intercontinental, thanks to innovations in transportation, storage systems, containerization and, maybe most important, computerization.
Business quickly seized the advantages these breakthroughs offered. Granted, there were periodic sector or regional supply disruptions along the way, including within the last decade, due to natural disasters, manmade disasters, business failures and tariff-driven shortages, such as those related to Brexit and U.S.-China relations.
The impact of these episodic and regionalized disruptions, though, was quickly dwarfed by the cascading supply interruptions and delays stemming from the COVID pandemic. Supply chains were not only weakened, they were severed. Business lockdowns followed the path of the virus, beginning in China and quickly spreading worldwide. Suddenly supply chain management was more than an academic, business school exercise, it was at the top of the news and on the minds of every manufacturer trying to survive in spite of a depleted workforce.
While many businesses didn’t survive, those that did scrambled and adjusted on the fly, a remarkable testament to their skills and adaptability. Hopefully, they understand that supply chain-related risks won’t end when COVID recedes, just as the risks didn’t begin with the onset of COVID. Moving forward, supply chains will remain vulnerable to:
- Shipping and trucking bottlenecks that may take years to resolve through added capacity and labor
- Shortage of and increased cost for storage and warehouse space
- Economic/political conflict, including trade wars and protectionist policies
- Military conflict in regions with critical infrastructure and raw materials
- Periodic and sudden labor strife at key nodes in the supply chain
- Greater attention to issues of sustainability as well as diversity, equity and inclusion (DEI) with regard to source sites in certain regions of the world
- Increased complexity and regulation in moving good and materials across borders
The pandemic clearly was a supply chain management wake-up call for organizations around the world. According to the Business Continuity Institute’s (BCI) Supply Chain Resilience Report 2021, nearly 80% of organizations now have business continuity arrangements in place to manage supply chain disruption, up from 70.9% in 2019. They also reported that organizations performed greater levels of due diligence at the procurement stage of supplier relationships in 2020, with 38% of those surveyed now reporting business continuity checks as being an integral part of the procurement process.
While none of the solutions proposed below are necessarily new or novel, what is new, is the fact that most organizations will need to significantly ramp up their activity in, and attention to, each to avoid future disruptions.
Nearly 80% of organizations now have Business Continuity arrangements in place to manage supply chain disruption, up from 70.9% in 2019. – BCI
During 2020, organizations performed greater levels of due diligence at the procurement stage of supplier relationships with 38% now reporting Business Continuity checks are an integral part of the procurement process.
Explore more complex value chains. Globalization has resulted in longer and more complex value chains, with operations being outsourced and diversified by customers and suppliers all over the world. In assessing exposures, a company needs to consider primary, secondary and even tertiary manufacturers, producers and suppliers, as well as freight companies, terminal operators and potentially dozens of intermediary parties.
Companies should conduct these reviews, focusing on the resilience of each partner-link in the chain as well as the resilience of that supplier’s suppliers. They’ll need to identify redundant sources both in terms of specific goods and services as well as geographic location. Maintaining multiple suppliers (and potentially customers) that are all subject to the same regional shocks is not an optimal solution as local suppliers are liable to be as affected by the same disaster, this is particularly true in the case of CAT storms and other natural disasters.
Sourcing from companies in China creates a special case. Even though the country’s share of global exports is declining, with low-cost production shifting to markets like Mexico and Vietnam, the nation is still a major source for products and materials. But it’s also one of the most volatile locations, given a variety of internal and multilateral political considerations. Companies that rely heavily on Chinese sources are well-advised to take a “China + 1” sourcing strategy.
Invest in Stability. With this supply chain exploration research and related information about options in hand, and in alignment with their risk tolerance levels, companies should go through the process of rebuilding, revising and, most likely, expanding their supply chains. Inevitably they will need to pay for certainty, for example by multi-sourcing, choosing more predictable transportation partners and maintaining larger inventories.
This investment-in-stability strategy should extend to investing time in building relationships with chosen suppliers and shippers to better understand their strengths and vulnerabilities and to help those entities better understand and appreciate the company’s priorities.
A final area of investment should be in minimizing the company’s financial risk exposure by utilizing insurance-based solutions – products that have recently been brought to the market by major carriers that protect a company from the kinds of intangible losses that arise when a supply chain is severed. These products will be discussed in more detail below.
Include force majeure contractual clauses. Moving forward, businesses should be more diligent than ever in reviewing the contracts underlying their commercial relationships with suppliers and customers. One of the most important contractual elements related to supply chain continuity is the force majeure clause.
A force majeure event is one that occurs outside the reasonable control of a party, and which prevents that party from performing its obligations under that contract. A force majeure clause is a contractual provision that outlines the obligations, rights and remedies of parties to the contract when a force majeure event prevents or delays full or partial performance of obligations under the contract.
In the past, these clauses were almost considered “boilerplate language” relegated to the “miscellaneous” sections of a contract. Moving forward, they will need to be front and center in negotiations and well defined in the contract language itself.
Invest in supply chain management technology. The phrase is misleading. “Supply chains” are rarely linear, and supply chain management is not always easily reduced to flow chart diagrams.
Supply chain management is all about data – specifically the connectivity, visibility, certainty and transmission speed of that supply chain data. In fact, one of the most promising, practical applications of quantum computing, which can consider more variables and factor uncertainty far better than traditional computing, is in supply chain management.vi In the meantime, though, there are relatively powerful technology tools to manage supply chain activity that use traditional computing power.
Insure against supply chain risk. Supply chain-driven risks have recently expanded beyond what has traditionally been considered insurable. But the risk management industry has kept pace and is now covering a wider range of these threats and perils, extending coverage from tangible assets to intangible assets, as well as earnings and cash-flow risks.
While there may be many ways to structure a risk management plan, below are some of the most common insurance products used to help insure the risk and some important details to consider for each.
Contingent Business Interruption
It’s well understood that traditional Business Interruption (BI) insurance indemnifies an insured for an interruption in business or a reduction in revenue following damage to the insured’s own premises by a covered peril. Now it’s possible to cover the insured’s loss of revenue and the expenses they incur due to an interruption in business at a third party through Contingent Business Interruption (CBI) insurance.
It’s important to review CBI policy wording to ensure the coverage is broad enough to encompass the insured’s potential exposures. CBI is often limited to direct or first-tier customers or suppliers, but the policy can be extended to indirect or second-tier customers and suppliers as well, often at a lower sublimit.
In addition, it’s important to review the CBI policy’s exclusions, such as limitations on catastrophic perils. While an insured may not have locations in a high hazard catastrophic area (such as A/V Flood zones or High Hazard Earthquake zones), a critical company in their supply chain may be located in one of these areas. Even if a policy covers CBI, it may not apply if the policy contains restrictions or exclusions for certain perils or within defined high hazard areas where the otherwise insurable event occurs.
Non-Physical Damage Business Interruption (NDBI) Coverage
Companies face threats and potential interruptions from numerous types of disasters, regardless of whether that incident results in physical damage to the insured’s property. These events include cybersecurity attacks, product recalls, environmental or pollution incidents, regulatory risks, reputational damage and weather-related disruptions, among others. Non-Physical Damage Business Interruption (NDBI) coverage offers a solution for these risks, providing protection against intangible asset exposures. Often these products can be tailored to address the insured’s risks to specific exposures. This coverage can be added to an existing Property/Business Interruption policy or provided on a standalone basis.
Supply Chain Insurance
Similar to NDBI, Supply Chain insurance does not limit coverage to physical loss or damage. It provides coverage for business interruption as a result of a delay or disruption in the receipt of products, components or services from a supplier. Covered events could include strikes, civil or military action, political risks, regulatory actions, pandemics or other significant delays in supply due to events such as natural disasters.
This coverage is especially important for companies with complex supply chains involving domestic and/or international partners and suppliers and whose own business or output is dependent on those suppliers. Companies in the manufacturing, automotive, technology and pharmaceutical sectors, among others, typically will benefit from the added protection of Supply Chain insurance.
Parametric solutions can close coverage gaps in conventional insurance policies by providing protection for loss events that were previously deemed uninsurable. Parametric or index-based products are structured to pay out a pre-defined sum if an agreed, reliable and independently reported trigger is met.
These triggers are often based on the physical, objective measurement of a hazard, such as a natural catastrophe or a weather event. Parametric triggers can also be based on an index, yield or other quantifiable metric. This customizable product can also be structured on a dual trigger basis, such as a wildfire event within a predefined radius followed by a decline in hotel bookings, with demand being measured by an independent industry index.
Our complex business world doesn’t lend itself to simple solutions – nor simple supply chains. Suppliers and transportation companies don’t exist in a vacuum; they’re subject to events and situations outside of their control, and their customers can suffer the consequences.
Those customers have options to minimize these supply chain risks, as we’ve discussed above. Risk minimization strategies carry price tags, though, either in terms of direct costs or greater complexity in the supply chain.
But given the collective experience of the turmoil that has defined the past five years, that seems a small price to pay for greater certainty in supply, costs and business continuity.
This material is for general information only and should not be considered as a substitute for legal, medical, tax and/or actuarial advice. Contact the appropriate professional counsel for such matters. These materials are not exhaustive and are subject to possible changes in applicable laws, rules, and regulations and their interpretations.