Business Interruption - Are you under-insured?

With Business Interruption near the top of many risk managers’ concerns, David Croft of Aon warns of the risk of under-insurance.

Recent catastrophic events have highlighted the inherent risks faced by companies arising from global supply chains. For example, the Japanese earthquake and tsunami, flooding in Thailand and more recently damage in the US from Tropical Cyclone Sandy have, significantly impacted both corporations and communities. Not only have companies suffered direct physical damage and resultant consequential loss but others, which rely on materials supplied from entities located in these regions, have also been impacted as a result of interruption to the supply chain.

Consequently, there is an increased focus on corporate exposure to Business Interruption losses which can often significantly exceed the costs associated with direct physical damage and have the ability to materially compromise a business, exposing a company to considerable financial strain. Therefore, it is necessary to periodically review a company’s exposures and how these can be effectively managed including the transfer of insurable risks as appropriate.

It is important to ensure that Business Interruption declared values and the type of cover implemented is sufficient to adequately transfer risk to underwriters where intended. In order to take comfort in the numbers which are submitted, management need to understand not only the Business Interruption exposures that the company faces, but also how these exposures can be appropriately treated to transfer insurable risk.

When considering exposures, companies typically focus on identifying and transferring risks which exist within the organisation. However, these recent events have highlighted the importance of appropriately assessing and managing risks both inside and outside a company.

Outsourcing, “just-in-time” stock management, centralised procurement and distribution, and the increasing complexity of business supply chains may all increase the reliance a company may place on its suppliers. These may potentially be new exposures which should prompt the Insured to review its specified/unspecified supplier sublimits or overall loss limit so that the insurable risks are transferred.

The risk management process must also involve an assessment of the risks faced by suppliers as interruptions along the supply chain can have catastrophic consequences to a business, particularly where businesses are reliant on a limited number of external suppliers, and/or where technology is centred around a specific regional hub.

It is also important to emphasise the importance of calculating the appropriate loss limits. Whilst a raw material sourced from supplier X, which only feeds Factory A within a group of companies, it may not be enough to consider the internal gross profit margin generated at this site as the only value at risk.

For example, if components from Factory A are combined with components from Factory B at an assembly plant (Factory C), the internal margin from all three sites needs to be considered to calculate the appropriate value at risk. The fourth annual survey of ‘Supply Chain Resilience’ Nov 2012, conducted by the Business Continuity Institute (BCI), revealed the following:

• 73% of survey respondents experienced at least one disruption with an average of five;
• 39% of analysed disruptions originated below the immediate tier one supplier;
• Unplanned IT or telecom outages jumped to the top of sources of disruption with 52% affected to some or a high degree compared with 41% in 2011;
• Failure of service provision by outsourcing suppliers has doubled from 17% to 35% of disruption and joins the top three causes;
• 21% suffered more than €1M in costs for a single incident; higher than 2011 and in spite of lower overall levels of disruption;
• 59% cited loss of productivity as the primary impact of the disruption experienced, up from 49% in 2011;
• 25% of respondents have still to consider supply chain disruption in their business continuity programmes;
• While 47% now look for evidence of a business continuity programme over a simple plan and 23% run joint exercises – all improvements on 2011 – 15% still do not collect any information from key suppliers and 41% do not validate that key supplier plans might work in practice.

As such, a critical part of assessing business interruption exposures present in a company’s various activities involves an assessment of the level of reliance on each stage of the supply chain. This will provide management with an informed decision basis for the appropriate transfer of Business Interruption risk and significantly reduce the risk of underinsurance in the event of a loss.

David Crofts is UK managing director, Aon Global Risk Consulting.

David Croft
UK managing director, Aon Global Risk Consulting