If your internal supply chain breaks, what’s the cost?

17 August 2016

An incident at one of your offices, warehouses or plants could affect production at many seemingly unrelated locations. The business interruption could be huge.

Supply chain risks have been a hot topic in recent years. But risks relating to corporate interdependencies – internal supply chains – are less often discussed, despite being on the rise. 

With more companies taking areas of production back in-house, a failure to map out interdependencies could leave companies with unexpectedly severe business interruption and financial losses following disruption to one of their locations.

As operations are brought back in-house they often go from being dual-sourced (sourced from two or more places) to single-sourced (produced in a single site), thereby increasing the concentration of risk, and often reducing risk mitigation. 

Out of action

A company might not realise its interdependencies until there’s a loss, says Adrian Brennan, Partner at Echelon Claims Consultants. “Suddenly damage at one seemingly stand-alone unit has a knock-on effect on the operational viability of other units.”

Some companies, for example, keep some of their intellectual property on a single site, says Tim Cracknell, Head of Risk Consulting at JLT Specialty. “One civil aircraft engine manufacturer, for example, has one specialist operation in the UK that produces unique parts for one of its best-selling models. 

“The expensive production technology and secret process used for this single aircraft part is a crucial component within the overall engine. So if the site was inoperative, say because of a fire, the construction of hundreds of engines and the aircraft for which they are being built could be delayed for many months.” 

The risk is often seen when one location is interdependent upon an entirely different type of location. For example, a JLT Specialty luxury brands client has a mill that produces bespoke cloth for iconic garments, and a separate factory where the garments are assembled. “The activities of the mill and the factory are very different, very separate, but without one, the other cannot function,” says Cracknell. 

End-to-end exposures 

A company with two or more interdependent sites should have an interdependency clause in its insurance policy. More generally, companies should conduct a business interruption review with their broker and insurer, to discuss how their insurance policies would deal with a loss involving interdependent locations.
Brennan recently worked on a flood loss for a UK manufacturer – the second flood loss the company had incurred. The company has various manufacturing units situated around the UK. When they were flooded, the company’s main unit was insured on a stand-alone basis and didn’t have cover for group interdependencies.

“The company was therefore unable to recover end-to-end margins. They were not operating their transfer pricing margin, so they were only able to achieve part recovery through their insurance. However, the company has now arranged group insurance, so interdependency between manufacturing and selling units is recognised,” says Brennan. 

When buying insurance for interdependent units or locations, companies should consider: 

  1. How to set sums insured for individual entities within the group. 
  2. The end-to-end exposure in the event of a loss. 

It should be noted that the interdependency coverage can also be beneficial to insurers, as its absence can cause inequity. 

For example, a claim arose in Thailand, following the 2011 floods, which affected a single manufacturing plant, owned by a Chinese group. The damaged plant was insured on a stand-alone basis and, to mitigate the loss, some of the production transferred to the Chinese group. 

“It was unclear whether sales generated subsequently in China should have been used to reduce the Thai insurance claim, but the stand-alone basis of coverage meant that the financial benefits gained elsewhere in the group could not strictly be taken into account,” says Brennan. 

Critical thinking 

So what can companies do to better understand their exposures? 

Ideally companies would map out and quantify all of their interdependencies, and specialists in the insurance market can provide this service through their business interruption consultants. 

“Companies should also establish disaster scenarios and develop associated business continuity plans, so that key staff know how to manage and respond in the event of knock-on business interruption in the fastest, most favourable manner to the group,” says Cracknell.

Speaking about the challenges in underwriting interdependency risks in the Energy Sector, Michel Krenzer, Onshore Energy Manager, EMEA team SCOR Global Property & Casualty, says companies are often not able to provide a detailed enough picture of existing interdependencies. 

Krenzer says companies should, at the least, understand and present: 

  • What interdependencies are critical? 
  • What quantities flow from one location/unit to another and at what frequency? 
  • What mitigations are in place if one of these interdependencies is interrupted? 

“Ask yourself, what if there is a problem in getting materials from one location or plant to another? Is that critical or not? Can you get the same production or product from elsewhere?” says Krenzer. 

Even if it is not feasible to map out all movements, risk managers should work with process engineers and other departments to map out the critical junctures, Krenzer says. 

“Many companies have spent resource getting a better handle on their external supply chains. But external supply chains and interdependencies, ultimately, cannot be considered in isolation because they are part of the same wider network whereby a company produces and delivers goods and services,” says Krenzer.

“If you are only as strong as your weakest part, then it is time companies looked more closely at just how interrelated different parts of their company really are.”

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For further information, please contact Tim Cracknell, Head of Risk Consulting on +44 20 7558 3941 or email tim_cracknell@jltgroup.com