Supply chain risk: the basics

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1 How risks can be detected, measured and mitigated When floods inundated parts of Thailand in July 2011, many locations were under water continuously for over two months, causing an estimated USD 40 billion of private sector damage, 80 percent of that to manufacturing operations. But that was just the direct impact. Indirectly, the flood knocked out nearly one-third of the world s hard-disk supplies. March 2015 Factories and inventories and lost wages were covered by conventional insurance, but what about the customers? They were hit, too. Dell cited the shortage of hard disk drives as a key reason for missing its sales targets in the third-quarter of The flood also affected production of automobiles. Assembly-lines in Thailand, not surprisingly, were forced to close. But so too, due to delivery shortages, were lines as far away as Canada, South Africa and the U.S. All told, Toyota lost output of 260,000 vehicles, earnings of USD 1.55 billion and 44 percent of its expected net revenue. Stories like this abound. Massive supply chain disruptions were also triggered by 2011 s Tohoku tsunami and the resulting Fukushima nuclear meltdown, or 2012 s Storm Sandy that pounded the U.S. East Coast. And there are many more examples. Broken links: examples from the chemical industry A toxic leak and subsequent extended shutdown of an ammonium nitrate plant led not only to a shortage of explosives for customers mining operations, but also a squeeze on supplies of a by-product, carbon dioxide, to another customer segment, the carbonated drinks industry. A few years ago, the food processing industry was caught out by a global shortage of hydrochloric acid. Rapid growth in shale gas recovery through fracking a process to tap previously unrecoverable reserves, particularly in the U.S. had led to unprecedented demand for the raw material. This triggered unforeseen shortages for traditional users. An explosion rocked a Japanese plant that produces 20 percent of the world s super absorbent polymer the sponge-like material used in nappies/diapers. One of the world s largest producers of nappies announced to the media that supplies of its leading brand were affected. Fire at a small specialty plant in Germany led to a major crisis in the automotive industry. All of the leading car producers realised that they were dependent on the plant for the supply of resins used in brake and fuel systems. Supply of the key raw material was already tight, due to high demand from the solar panel industry. 1

2 Zurich Insurance Group ( Zurich ), and others, have highlighted this indirect cascading effect of destructive events. The idea that risk doesn t end at the factory gate that it extends up and down and across the suppliercustomer network is widely accepted by today s risk managers. But what can be done about the seemingly inevitable supply chain disruption? How can these risks be detected, measured and mitigated? This white paper provides a basic introduction to this growing problem, covering three basic steps: (1) developing risk intelligence; (2) assessing resilience; and (3) mitigating risk and insuring the rest. Zurich has much expertise in this area. We ve made supply chain risk a priority. We offer tools to assess risk and resilience, and insurance to cover the risk that cannot be avoided. You can find more information at en/industry-knowledge/supply-chain and at 1. What could happen? Risk intelligence At Zurich, we start our approach to supplychain resilience by analyzing the question: what can go wrong? To answer this, we draw on two major sources of data. One is our proprietary disruption database. Developed by Zurich in collaboration with academics at the UK s University of Bath, this is a comprehensive list based on public information of what can go wrong in a supply chain. Its nearly 3,000 events are characterized by cause, effect, region, sector, duration and date, and some events are added each year as they occur. Causes of disruption Source: Business Continuity Institute, Supply chain resilience

3 Another source is our own history of insurance claims. These claims number well over a million, across all lines of business and geography, for thousands of customers. We supplement these sources with specialist databases in the three main areas of risk: country risk, natural catastrophes and operational risk Country risk It once was said that Henry Kissinger, the former U.S. Secretary of State and National Security Advisor, could predict how dredging operations in South African ports could trigger movement in global oil prices. In other words, Kissinger displayed an extraordinary perception of how politics, economics and business are interconnected, all around the world. International companies frequently face such complex decisions: what could happen at our factory in Mexico, if local bread prices rise? Should we expand capacity at our plant in Algeria, Texas or Taiwan? How do we react to pandemic-produced restrictions on travel? 1.2. Natural catastrophes Earthquakes, floods, mudslides, volcanoes and the like these are everyday problems for insurers and insured alike. Less obvious is the issue of how these can affect suppliers and customers. The analysis comes down to rarity and severity how often might a catastrophe happen, and how bad might it be? 1.3. Operational risk Operational risk is the risk of business operations failing due to human error. One of the biggest soft spots is IT. Unanticipated failure of computing or telecommunications is consistently ranked as the number one cause of supply chain disruption across all sectors and regions. 2. How bad might it be? Resilience assessment An ideal supply chain balances the costs of risks and the costs of mitigating those same risks. Conceptually, this is easy to understand. In practice, it can be a very complex procedure involving not just known unknowns but also unknown unknowns. Mitigation typically consists of Challenge: How to balance costs and risks in value chains 3

4 Hazard Maps many parts: prevention, barriers, buffers, redundancy/alternatives and escape routes. Zurich has developed a range of methods and tools to help with this analysis. Our approach generally follows three steps: mapping company-specific risks; development of loss scenarios; and comparing costs Company-specific risk mapping Zurich s tools examine how potential disruptions might affect a specific supply chain and can be presented in the form of a map or a flow chart. For example, the flow chart on page 5 represents a fictitious company s factory, with natural hazard and transport overlays showing where potential dangers might lie. Numerous other overlays are possible: for example, to represent other hazards or supply routings (e.g. gas pipelines, rail networks). This allows a physical representation of risks of all types. Some become immediately clear. For instance, in this case, an alternative supplier in Mexico was thought to have mitigated earthquake risk adequately. But as it turns out, the alternative supplier was situated in the same earthquake zone as the main supplier. Flow charts that present how a product proceeds from its cradle to its grave are also a good way to identify specific risks. As the example (taken from the precisionengineering industry) shows, these can be astonishingly complex, especially when feedback loops and knock-on effects are considered Loss-scenario development Based on the mapping, the next step is to consolidate the findings into loss scenarios. Key inputs to this are the probability and severity of a loss. Typically these potential losses are then arranged in a risk matrix, which is typically ranked by severity (in the graphic, red represents the greatest, yellow a mid-range and green a less severe potential impact) Cost comparison The final step is to translate these findings into decisions about supply-chain risk. Which potential losses should be tolerated, which mitigated and which pooled under insurance cover? The approach is almost always situation-specific, often involving confidential data and analyses. The precise balance of risk and mitigation will sit differently for each sector, region and individual company. 4

5 Supply chain risk: Supply chain risk: sample flow chart (data removed) Risk evaluation of group-wide impacts with risk matrix 5

6 3. Mitigating risk, and insuring the rest The third step, after developing risk intelligence and assessing resilience, is to mitigate risk. This is of course based on the first two steps. Mitigation can be as simple as, say, moving all computers in a flood-prone location from lower floors that might become inundated to higher floors that won t. It can be as complex as building redundancy into tangled links of a complicated supply chain. Still, no matter how resilient the supply chain, there will be rare, severe risks that cannot be avoided. What are the damages? Losses come in three general types: business interruption, property and liability Business interruption As a percentage of claims, business interruption is larger than ever and still growing. According to Zurich claims data, business interruption typically accounts for about 40 percent of all covered damages, and in major events, it often accounts for more than half of losses. Business interruption policies do not always covers situations such as the interruption of a key component due to a strike at the manufacturers plant. (At the time of writing, Zurich was the only insurer that covers non-damage events to named suppliers, as well as damage events such as a fire at the supplier s factory.) 3.2. Property Property insurance is a core insurance product. And it is a key part of protecting a supply chain: factories, warehouses, depots and everything connected to them. Even if the supply chain is spread out all over the globe, these policies can be centralised (yet still comply with varying national requirements), which simplifies and streamlines their management. Specialist cover is available for trade credits and for political risks such as expropriation, political violence and currency inconvertibility. Focused policies are also offered for marine risks, including those of transporting articles of rare value, which can be industrial goods (say, a high-end turbine) or consumer items such as jewellery or fine art Liability According to Stericycle, a company that compiles statistics on product recalls, in the U.S. there were nearly 100 recalls of pharmaceuticals, 194 of automobiles, 129 of foods and 275 of medical devices in the second quarter of 2014 alone. 6

7 Disclaimer and cautionary statement This publication has been prepared by Zurich Insurance Group Ltd and the opinions expressed therein are those of Zurich Insurance Group Ltd as of the date of writing and are subject to change without notice. This publication has been produced solely for informational purposes. The analysis contained and opinions expressed herein are based on numerous assumptions. Different assumptions could result in materially different conclusions. All information contained in this publication have been compiled and obtained from sources believed to be reliable and credible but no representation or warranty, express or implied, is made by Zurich Insurance Group Ltd or any of its subsidiaries (the Group ) as to their accuracy or completeness. Opinions expressed and analyses contained herein might differ from or be contrary to those expressed by other Group functions or contained in other documents of the Group, as a result of using different assumptions and/or criteria. This publication is not intended to be legal, underwriting, financial, investment or any other type of professional advice. Persons requiring advice should consult an independent adviser. The Group disclaims any and all liability whatsoever resulting from the use of or reliance upon this publication. Certain statements in this publication are forward-looking statements, including, but not limited to, statements that are predictions of or indicate future events, trends, plans, developments or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties and can be affected by other factors that could cause actual results, developments and plans and objectives to differ materially from those expressed or implied in the forward looking statements. The subject matter of this publication is not tied to any specific insurance product nor will adopting these policies and procedures ensure coverage under any insurance policy. This publication may not be reproduced either in whole, or in part, without prior written permission of Zurich Insurance Group Ltd, Mythenquai 2, 8002 Zurich, Switzerland. Zurich Insurance Group Ltd expressly prohibits the distribution of this publication to third parties for any reason. Neither Zurich Insurance Group Ltd nor any of its subsidiaries accept liability for any loss arising from the use or distribution of this presentation. This publication is for distribution only under such circumstances as may be permitted by applicable law and regulations. This publication does not constitute an offer or an invitation for the sale or purchase of securities in any jurisdiction. Ltd Mythenquai Zurich, Switzerland Phone +41 (0)