3 essential steps to quantify supply chain risk

Assessing supply chain exposures goes beyond simple cat risk. Educate your clients on what could go wrong--and how to prevent it.

SEP 22, 2014 | BY JILL DALTON

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The generally soft global commercial property insurance market and reduced number of major natural catastrophes during the past year may help corporate insurance buyers stay on budget. It may also give them an opportunity to improve risk management programs and prepare more effectively for potential disasters.

One lesson learned from the series of large-scale natural disasters that occurred in various parts of the world in recent years is that managing catastrophic risk requires more than effective planning and crisis management. Good management also requires a thorough knowledge of a company’s most significant risks. For example, businesses that depend on complex international supply chains cannot underestimate the implications of a regional disaster event or the potential downtime of a key supplier.

To prepare for such events, risk managers and supply chain and operations executives must take great care in quantifying exposures and then prioritize them based on magnitude and probability

By knowing precisely the values at stake, they can prioritize and apply resources against the firm’s most serious vulnerabilities. Risk quantification also uncovers opportunities for cost savings, identifies potentially serious gaps in insurance coverage, reveals critical business interdependencies and can improve the overall efficiency of a company’s supply chain.

Three essential steps to quantify supply chain risk are:

1. Financial impact evaluation. Assess the potential financial consequences of a supply chain disruption (both negative and positive). These include identifying products most at risk (most profitable or most vital), impact of an interruption of those revenue streams, increased expenses to mitigate loss and remain in business, short-term reduction in operating costs when suppliers are down, and market share implications.

2. Process mapping. Create a management checklist for quantifying supply chain risk, including:

-        mapping the entire supply chain from raw materials through components to finished product and customer purchase/delivery;

-        analyzing risk by supplier, location of facilities, power sources, potential political exposures, distribution points, shipping and transport providers and routes, and related infrastructure concerns;

-        identifying mitigation strategies, including availability of excess inventory wherever it may be located;

-        charting interdependencies, and

-        developing and quantifying worst-case scenarios.

3. Develop a team approach. Depending on the type of firm, industry, and nature of supply chain, the team should involve any or all of the following:

-        supply chain management

-        risk management

-        operations

-        accounting/finance

-        marketing and sales

-        communications

-        transportation/shipping/logistics/inventory management

-        legal/government relations

-        information technology

-        human resources

-        product development

-        procurement, and

-        senior management.

Effective supply chain quantification can be a focused step as part of an overall enterprise risk management (ERM) initiative and may be structured to fit within the ERM framework. In this context as well, risk quantification also helps firms prioritize their risk management investments more effectively, a critical benefit in light of limited risk management resources. Additionally, for companies in highly regulated industries such as pharmaceuticals, the quantification process also can help provide documentation necessary to satisfy regulatory requirements.

As risk managers develop strategies to manage their exposures to catastrophes, they need to understand the breadth of their business interruption (BI) coverage and contingent BI and recognize the limitations of those insurance policies as well. In addition to reviewing your insurance program, re-examine your business continuity program as well as your contractual relationships with suppliers.

Today, it’s not enough simply to look at the volume of trade you do with any individual supplier and use that as a proxy for assessing the value of that relationship to your firm. Although volume in financial terms might be useful for establishing insurance limits or credit lines, it’s important to look at what would happen if that trading partner were to go down due to a catastrophe or other reason, or if it was unable to provide a product because its suppliers are down.

It may be that you have a large volume of trade with one supplier, but if that relationship is disrupted, you can readily find alternatives elsewhere. On the other hand, you may have another relationship with a smaller vendor where the volume of trade in financial terms is much less.  However, the component or material provided cannot be readily replaced, and even a short-term outage can potentially result in a major hit to your firm’s financial performance.

Even after you’ve taken the time to understand, assess, and quantify your exposures and worked to address your serious supply chain risks on a priority basis, you need to recognize that this is a dynamic process. Revisit your supply chain risk management and insurance program periodically, and make adjustments as economic and financial conditions evolve.

Program modifications also may be required to reflect changes in commercial insurance market conditions and attendant coverage reductions or restrictions sought by your insurers.

You also may need to make program adjustments to accommodate changes in your organization’s structure, mergers and acquisitions, and to reflect any developments that lead to an increase or decrease in customer demand for a specific product, group of products, and other market dynamics.

Today, assessing supply chain exposures goes well beyond simply knowing about potential catastrophic property risks, such as hurricane, earthquake, tsunami and flooding.  Product recalls, tampering, political insurrections, cyber events, worker actions, trade embargoes, terrorism, pandemics, and other events all can cause supply chain disruptions with potentially significant financial consequences.

Understanding exactly what’s at stake from a potential outage – regardless of cause – is the key to effective supply chain risk management and disaster planning.  Whether you ultimately need to strengthen supply chain resiliency, purchase insurance, or allocate added resources, quantification will give you the framework for taking actions that provide the greatest benefits to the business and its stakeholders, and do so on a cost-effective basis.