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Modern manufacturing processes: Efficient but vulnerable

Growing competitive pressure and shorter product cycles have forced many sectors to optimise the efficiency of their manufacturing processes and to increasingly embrace a global division of labour. Industry and the insurance sector need to take account of the new business interruption scenarios these developments bring.

25.11.2015

In a bid to hold their own against the global competition, firms have been progressively cutting their unit costs in recent years. There are a number of ways for them to achieve this. Supply chains, for example, can be streamlined by making use of a small number of highly qualified and specialised suppliers. This has created oligopolies or monopolies for certain products, such as highly specialised microelectronic components.
Many such suppliers are geographically concentrated in industrial estates where the joint use of infrastructure yields further cost benefits. Clearly, the potential accumulation following natural catastrophes can be considerable. What is more, companies often work on a just-in-time or just-in-sequence basis as an efficient way of supplying the steadily increasing variety of models and versions their customers demand. Reduced stock levels and reserve production capacities help to cut costs.

Increased susceptibility of companies to business interruptions

Increasingly networked manufacturing processes also require a much more intensive exchange of data between all parties, dramatically increasing their dependence on internet availability, along with the risk of data loss, theft and manipulation. As companies focus on core competences with high added value, the percentage of components manufactured in-house frequently declines. This trend has now culminated in “fabless manufacturing”, a process in which the manufacturers of smartphones, for example, completely outsource their production and concentrate on development and sales/marketing only. This is closely linked to the worldwide division of labour.
Based on exploiting the cost benefits of individual production sites, this phenomenon greatly increases transport volumes between the individual production locations. Last but not least, sales channels are concentrated in the hands of a small number of partners who market large shares of the total production output. Numerous recent events have shown that these changes can have severe consequences when supply chains are disrupted, highlighting the increased susceptibility of companies to business interruptions.

Growing competitive pressure and shorter product cycles have forced many sectors to optimise the efficiency of their manufacturing processes and to increasingly embrace a global division of labour. © Munich Re
Source: Munich Re

Shortage of hard drives following flood

The Tohoku earthquake in March 2011 affected many manufacturers of microelectronic components in Japan and disrupted supply chains, prompting numerous companies to transfer parts of their production to industrial estates in Thailand. The intention was to make supply chains and production less vulnerable to natural hazard events. The floods which then inundated several of these industrial estates from July of that year onwards showed that these transfers had not actually minimised the risk to supply chains. Substantial losses crippled the factories responsible for producing half the world’s hard drives, including those of the two world market leaders. This created an international shortage of hard drives, often referred to as the hard drive crisis.
In March 2013, an earthquake caused severe damage to the manufacturing plant of the Taiwan Semiconductor Manufacturing Company (TSMC). The company is the world’s only manufacturer of a series of highly specialised chips for smartphones. As a result, a Chinese company performing the final assembly of the smartphones ran out of the chips required. Several OEM smartphone manufacturers were affected by this disruption to the supply chain for their devices.

Capsizing of a motor tanker

The vulnerability of modern supply chains is not only evident in the industrial centres of Southeast Asia with their frequently high exposure to natural hazards. Problems can also arise on heavily frequented waterways. In early 2011, the motor tanker Waldhof with a cargo of sulphuric acid capsized en route from Ludwigshafen to Antwerp and caused massive disruption to shipping on the Rhine for several weeks. Companies located both upriver and downriver of the incident were affected by this disruption in the transport of their raw materials and products; none of these suppliers or customers had suffered a physical loss. 

Changes in demand for insurance

Changes in many companies’ manufacturing processes shift their business interruption risks from the production facilities to the supply chains and sales channels. This leads to higher demand for business interruption covers which include risks associated with the supply chain. Whether or not the supply chain is part of the company initially plays a secondary role only from the company’s point of view, as the consequences are similar. In the case of multi-stage supply chains, the entire supply and distribution chain should naturally be covered where necessary. Coverage is also often now required for supply chain disruptions which were not caused by property damage (e.g. disruptions in air traffic due to volcanic ash). At the same time, shorter product life cycles and economies of scale require higher contribution margins to be generated and hence also higher sums insured for business interruption. 

Losses on the rise

For well over a decade, the growing vulnerability of complex manufacturing processes has been reflected in the steadily increasing share of BI losses in industrial property covers. Very large losses in particular are associated with an especially high BI share. This development has prompted several insurers to analyse BI risks associated with the supply chain in more detail than was previously the case. Their analysis also includes the companies’ own risk management. However, uniform standards are only gradually becoming established in the various industries.

Growing competitive pressure and shorter product cycles have forced many sectors to optimise the efficiency of their manufacturing processes and to increasingly embrace a global division of labour. © Munich Re
Source: Munich Re

Analysis of exposure

The first step towards minimising the BI risk is to analyse the existing exposure. To this end, the products and product groups with the highest contribution margin must be identified first, as they are particularly relevant for BI covers. Their manufacturing process is analysed with regard to potential disruptions. Capacity utilisation and possible technical reserves and redundancies within individual production locations must be taken into account, as well as the relationship between individual company locations (interdependencies, interactions). In addition to the perils commonly covered by business interruption insurances in the company concerned, such as fire, natural hazards and machinery breakdown, there is also growing demand for BI insurance cover for external influences.
The next step is to identify potential contingent business interruption losses (CBI losses). External factors able to influence production and distribution must be analysed for this purpose. This analysis includes external supply chains (from the supplier’s subcomponent to the end product) as well as the sales channels to the customer. Once the weak points have been identified, the next step is to check whether they can be remedied by technical or organisational means and at an economically viable cost. In many cases, this analysis shows that measures taken in the past to cut costs (by lowering stock levels, reducing technical reserves) have in fact increased the BI risk. Measures designed to increase a company’s resilience to business interruptions would in many cases swallow up all the savings made. The mostly conflicting interests of risk management and controlling/cost management are very much in evidence here. Companies often attempt to transfer the higher BI risk associated with streamlined, cost-optimised production to the insurers. Any such transfer must be preceded by qualified analysis of the BI risk. This analysis must identify and assess technical or commercial approaches which reduce the risk of default and establish an appropriate price for the additional risk carried. 

Outlook

The changes that have swept through industrial manufacturing processes are likely to be irreversible to a large extent. The underlying reasons are too compelling, the advantages too convincing. In future, companies and insurers must analyse and assess the associated additional risks in more detail in order to arrive at an effective and appropriate mode of risk management. Transfer to the insurance industry may prove to be the most viable solution from an economic perspective for risks which cannot be technically or organisationally minimised without breaking the bank. The development of such customised solutions requires an open, partnership-based relationship between all parties in order to make the individual exposures sufficiently transparent.

Munich Re Experts
Stefan Feldhütter
Risk Consultant
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