When we talk about supply chain risk, we’re referring to the possibility of a disruption—whether it be the result of a natural disaster, such as a hurricane, or political risk, such as a protest—to any part of a supplier network that could result in facility downtime and halted production. As we wrote in our last supply chain blog post, contingent business interruption (CBI) occurs when disruption at one node in a supply chain affects other dependent nodes.
A typical supply chain analysis starts by defining an initial supply disruption and then estimating the combined business interruption (BI) and CBI loss to final production, which represents a “worst case scenario” with no mitigation. In this analysis, a day of supplier downtime can directly result in final production facility downtime and lost revenue.
In the real world though, it’s unlikely that an end production facility would not have any safeguards to mitigate a supply chain disruption, otherwise known as the “3 Rs” of supply chain risk management: Reserves, Redundancy, and Resilience. As an insurer, having information about each “R” is critical for developing accurate and fair pricing of CBI cover. So let’s discuss what each of the 3 Rs means and what you need to know about them.
As an underwriter considering writing CBI cover for let’s say, a retail clothing store, one of the first questions you might ask of a potential insured is about detailed reserve information (i.e., their inventory). Holding inventory in a store requires more square footage, which can be expensive and decreases profits. Given the shift to just-in-time delivery methods, limited stock holdings, and other operational efficiencies, striving for zero inventory is becoming more common across different industries.
Some companies, from the clothing retailer Bonobos to the glasses company Warby Parker, have innovated by not holding any stock on hand to sell in their brick-and-mortar shops. Instead they maintain just enough product for customers to “touch and try” a product in the store and then have it shipped directly from a production facility to their home. For most organizations, inventory is a balancing act between maximizing profit and ensuring business continuity. Without adequate reserves, a supply chain disruption can be crippling, especially if a corporation’s sales depend on being able to rapidly provide product to a customer —unless of course they have some sort of other backup—which leads us to the next “R,” redundancy.
Redundancy refers to backup or alternative suppliers and the amount of time it takes for an organization to switch between suppliers following a disruption. As we’ve seen in numerous historical catastrophes, disruptions to single and sole source global manufacturers can contribute to widespread shortages of critical products. For example, the 2011 Tohoku earthquake in Japan damaged the primary production facility for the specialty pigment Zirallic, which led to a global shortfall of a paint additive used by Ford, Volkswagen, BMW, Toyota, and several other auto manufacturers.
For the global corporation, geographic supply redundancy is key to being able to respond quickly and manage a disruption. For an insurer, the same information is a major factor in appropriately determining CBI policy limits and deductibles. Not having high-quality data about an organization’s primary and redundant suppliers is notoriously common and limits the utility of many popular supply chain modeling solutions. Fortunately, as we discuss in our Issue Brief on the challenges of modeling supply chain disruptions, there are alternative modeling approaches that can overcome this supply chain data dilemma.
What contingency plans does a corporation have in place to prepare for supply chain disruptions? When a disruption occurs, are there protocols in place for the corporation to be able to respond quickly? Having a sense of an organization’s business continuity plans is another key factor for assessing supply chain risk. The ability to quickly deploy and allocate resources, from people to emergency funds, can make a big difference in the number of claims an insurer might expect.
This response comes with a cost though, and it’s important for organizations to balance their spending on both preventive and reactive measures to minimize the likelihood of downtime. Quantifying the impact of resilience efforts can be challenging, but supply chain modeling can be used to perform sensitivity tests, which estimate the range of losses a corporation could expect depending on different resilience strategies.
In sum, the 3 Rs are essential to any supply chain risk assessment. Asking the right questions about reserves, redundancy, and resilience as you go through the underwriting process can help inform your CBI pricing decisions for both prospective and existing clients. Even in the absence of complete data, the 3 Rs can and should be included any time you’re modeling supply chain risk in order to provide you with a realistic quantification of the risk. Having a sense of where an organization stands in terms of their 3 Rs can make CBI pricing negotiations more transparent, which benefits all parties.
What data are your insured’s providing you about their mitigation efforts? Let us know in the comments below or send us a note at firstname.lastname@example.org.