Author Dirk Herrenpoth

Contingent business interruption losses – not everything grinds to a halt

In today’s increasingly complex and interlinked global economy, even relatively minor disruptions can have huge consequences and bring entire areas of production to a standstill. Insurers then face substantial accumulation risks from contingent business interruption (CBI) losses. However, not all industries are affected to the same extent.

The value chain of manufacturing companies is subject to constant change. The need for companies to cut costs as a result of globalisation requires ever leaner and ever more flexible production processes. In order to minimise the amount of tied-up capital, companies reduce their stocks to a minimum and purchase primary and intermediate products ad hoc on the global market. The result has been the creation of interdependencies between companies in recent years. The downside to this is that production can soon come to a vir- tual standstill if essential components are not delivered on time. Even minor disruptions somewhere can cause considerable losses further downstream and perhaps far away.

From “just in time” to “just in sequence”

This problem is compounded by the fact that the number of suppliers for many products is falling (in extreme cases there may in fact be only one) as the number of end-product manufacturers increases due to the global outsourcing trend. The proliferation of high-performance IT systems has accelerated this development and has seen the “just in time” principle evolve into the “just in sequence” principle. The basis of this process is that the supplier delivers components not just in time and in the right amount but also in the right order (or sequence). Depending on the production system involved, the whole procedure can take anything from several days to as little as a few minutes.

This development poses a major challenge for insurers that cover CBI losses, as there are so many factors involved that can lead to a breakdown in production. Here are a just a few examples: wage disputes (strike), payment difficulties (insolvency) or loss events (fire, earthquake). As things stand, breakdowns in production from CBI losses are only covered if they result from events causing physical damage such as fire or earthquake.

Earthquake paralyses Japanese car industry

In mid-2007, an earthquake at Chuetsu in Japan showed just what can happen when production is disrupted. Riken Corporation, a company that supplies essential motor and transmission parts to the Japanese auto industry, experienced a total breakdown in production even though only a few machines had suffered minor damage. Not long after this, the production lines of all major Japanese car manufacturers stood idle. The loss in production amounted to some 120,000 vehicles. A team of hundreds of engineers needed a week to restore production at Riken. The effects of a fire in autumn 2007 at the Matsushita Battery Industrial Co. were felt far beyond the borders of Japan. The damage forced the company to cease production of lithium ion cells altogether. Batteries urgently needed by OEMs (original equipment manufacturers) for notebooks, mobile phones and digital cameras could not be delivered on time. Several major international customers in telecommunications and camera production suffered CBI losses as a result. The overall insured CBI loss is estimated at several hundred million euros.

Conventional mechanisms of accumulation control inadequate

Individual CBI losses do not pose any significant problems for the insurance industry. They take on special significance when a supply failure forces a number of different customers to halt production. Such accumulation potential can reach enormous proportions. However, it is not just the dimension that makes these accumulations critical. Given the global division of labour and the dynamics involved in the world economy, these accumulations are highly intransparent and subject to a rapid process of change. The standard accumulation control mechanisms (such as for natural hazards) simply do not work here.

Securing the supply chain is the top priority

Some branches of industry, such as the oil and pharmaceutical sectors, are less susceptible to accumulation-related CBI losses due to their value chains, and easy access to raw materials and alternative suppliers. However, the production strategies and manufacturing technologies used in other sectors, such as the automotive and semiconductor industries, make them much more vulnerable. To get an idea of the actual vulnerability involved, Munich Re has conducted a detailed analysis of these sectors, especially the auto industry. This sector not only has the highest exposure, the exposure also fluctuates strongly depending on the degree of production dependence. In talks with European suppliers and manufacturers, Munich Re has managed to gain valuable insights into risk management, contingency planning and the manufacture of key products. The study has revealed that companies give absolute top priority to “securing the supply chain”.

Manufacturing techniques entail significant risks

Essential components in the automotive industry are usually supplied by external companies and delivered as required “just in time” or “just in sequence”, with only so many components being stored at the assembly plant as are needed to ensure that production does not run into difficulties. From a CBI perspective, the manufacturing techniques in use are especially problematic. Many components are protected by patents or registered designs or are so specialised that it is not possible to switch to other suppliers at short notice. Naturally, the car industry is fully aware of these problems and does everything possible to avoid the worst case of a complete stop in production. This is a matter that not only concerns a company’s financial risk but also its reputational risk. In emergencies, therefore, there are task forces in place to carry out measures designed to keep production going. During our analyses, we frequently heard that when the worst happens, manufacturers and suppliers work together with as little red tape or fuss as possible to come up with a viable solution.

Manufacturers and suppliers take stock

Especially critical are those components needed to ensure that a finished vehicle can leave the production line. These include transmission or motor parts, cable forms or certain types of computer chip. Other components, on the other hand, such as navigation systems or special headlights can be fitted later or assembled by the local dealer. It is the process involving these critical components that many manufacturers are starting to reassess.

They no longer look for the most cost-effective solution but try to broaden their supply network and so reduce dependencies on single suppliers. This shift in risk awareness can also be seen in the fact that manufacturers have started to analyse entire processes in terms of internal and external dependence and to develop “failure scenarios” which then form the basis of how they select suppliers. Given these risks to operations, business continuity is also becoming an increasingly important factor in strategic planning.

For their part, suppliers also go to considerable effort and expense to ensure that there is no breakdown in the supply chain. In addition to state-of the-art risk management, such efforts include the way production is organised, for example in the form of international manufacturing networks, where mature products are made at a variety of locations. Where that is not possible, stringent fire-protection standards and active/passive firesafety measures minimise the likelihood of lengthy interruptions to production.

The idea that suppliers manufacture components for certain production series at the car maker’s plant is also a highly interesting concept. Although a close dependence exists, it only involves one production series and therefore virtually precludes any CBI accumulation. Moreover, in the event of a loss, manufacturer and supplier are both in the same boat, and the short channels in use facilitate speedy decisions.

Loss potential in the worst case

However, there will always be a residual risk: a series of unfortunate circumstances can trigger loss scenarios, emergency planning no longer works and many manufacturers suffer significant production breakdowns. Munich Re’s analysis has revealed that the CBI loss potential alone in the European automotive industry resulting from a worst case comes to some €2–2.5bn.

Underwriting – Lessons learnt

Given the dimensions involved, risk assessment needs to go beyond the policyholder to include suppliers and a company’s technical and economic dependencies. This is the central premise for continued insurance of CBI losses. From an underwriting point of view, therefore, this subject requires constant observation and analysis. Certain minimum standards have to be adhered to when structuring CBI cover. These include reasonable sublimits, a material damage proviso and due consideration of the quality of business continuity management when determining the amount of cover to be offered.

New developments in the pipeline

Besides conventional CBI covers, industry is increasingly requesting covers for business interruptions with no underlying physical damage. The insurance industry is working on the provision of capacities for this purpose. One option being examined is a separate cover outside existing property policies and treaties.

Products are currently being developed which focus on medium-sized companies. When working out the scope of cover and pricing, individual risk assessment, especially in terms of supplier dependencies, should be the primary concern. In this way, risks such as transit, strike or insolvency could be covered with adequate limits. However, perils such as breach of contract or quality defects are likely to remain uninsurable. An important success factor for this type of cover is accumulation control which goes beyond classic property risks.

Capital market solutions on the rise

Certain CBI risks could also be transferred to the capital market in the form of securitisation. However, investors only assume risks that are sufficiently transparent and can be modelled by agencies accepted in the market. As a rule, only natural hazard risks are securitised on a parametric basis. This means that the issuer receives the investors’ money when, for example, a defined windspeed (trigger) is exceeded at a certain location. The policyholder therefore carries the basic risk up to this defined trigger. When structuring the bond, it is especially important to ensure that this basic risk is kept to a minimum. In recent years, Munich Re has successfully securitised business interruption risks and is glad to make this know-how available to policyholders and insurers alike.

Although capital market solutions will become increasingly important in the future, it is traditional insurance that invariably provides better individual cover of the policyholder’s CBI needs. Also, insurance solutions are frequently superior to securitisation in terms of cost efficiency. As a risk partner, Munich Re examines all cover options to ensure that we can develop and offer clients the best available protection at all times.

Dirk Herrenpoth is a senior underwriter in Corporate Underwriting Property at Munich Re.

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