Kim Burgess and Richard Waterer examine the causes of recent elevated supply chain risk, and how insurers can address it
Equipped with standard actuarial techniques, we can quantify an entity’s vulnerability to supply chain breakdowns. This could be on behalf of a client that wishes to understand its exposure for risk management purposes, or as pricing actuaries using rating tools. Both scenarios present the same challenge: how can we standardise any model to make it applicable to all inherently non-standard, unique business structures? Parametrisation is further complicated by globalisation, multilayered tiers and disruptive events.
At its peak, the pandemic is estimated to have created supply chain challenges, costs and losses for up to 77% of the global business community. Unconventional spikes in demand in sectors such as technology, food and beverages led to shortfalls in commodities, ingredients and components. COVID-19 turned workforce availability into a significant trigger of supply chain risk as periods of lockdown and isolation forced many companies into operating plants and logistics with a skeleton staff, causing a ripple effect across international value chains.
In Aon’s latest flagship research report, the 2021 Global Risk Management Survey, supply chain risk had re-entered the top 10 global risks at number eight. For US multinationals, it was the fifth most significant priority, and for multinationals based in Europe, the Middle East and Africa, it was number three. This points to a globally connected world in which western economies have become dependent on complex supply chains. When they break down or fail, the impacts can be staggeringly high. Consider the inventory of events in 2021: the Suez Canal blockage, at one point costing global industry US$9.6bn a day; the Texas cold snap; a major fire at a Japanese semiconductor fabrication plant; and the driver and fuel shortages triggered by Brexit.
Supply chain interruptions occur regularly and are costly. Every year, at least one in 20 major supply chain failures costs a company more than US$100m. According to McKinsey, expected losses from supply chain disruptions equal, on average, 42% of one year’s EBITDA, over the course of a decade. A wide range of industries is exposed to supply chain risk, including aerospace, automotive, mining, petroleum products, electrical equipment, glass and cement, computers and electronics, chemicals, and pharmaceuticals.
This is not a new phenomenon caused by the pandemic – supply chains have become increasingly fragile during the past two decades. Companies have sought to drive efficiency and margin through their sourcing of materials, ingredients and components, and through the distribution of their end products. Liquidity strategies based on limited use of inventory and just-in-time fulfilment have further increased exposure to supply chain disruption. Supply chain efficiency has become a set of financial key performance indicators.
While this has helped optimise short-term financial performance, it has also accelerated risk and reduced resilience. As companies become aware of the threat from supply chain disruption, and prepare to trade some efficiency for a degree of resilience, they have encountered challenges.
Modelling and quantifying supply chain risk
Data lies at the heart of understanding a company’s exposure to supply chain risk. Without data, companies cannot pre-emptively quantify the impact of a risk event, even if they know how the supply chain operates.
The role of data in maintaining supply chain visibility is evident. However, obtaining it can be more challenging than building the supply chain model itself. Where this is the case, an organisation usually falls into one of three categories: it does not know enough about its suppliers; it has the data but is unwilling to share it with external parties; or the data may be available but the company does not know what to do with it. It is in each company’s interest to have oversight and maintain details of its supply chain, from tier one to tier three where possible, and to be open to sharing it for modelling and risk management purposes.
Reviewing supply chain risk begins with obtaining company-specific information. The information gathered at this stage covers an overview of the organisation, detailing entities, sites and so on, identification of key functions performed at each location, and production details, including product mix and volumes. This is followed by supply chain mapping, in which detailed information on each supplier is gathered – for example addresses, type of supplier, supply volumes and utilisation. Finally, an overview of the company’s risk management process is obtained by understanding the impact of supplier failure, governance, business continuity and previous incidents.
Where more sophisticated procurement and supply chains are adopted, loss modelling can be deployed to quantify the impact of possible future events. The key steps in the process are:
- Identify suppliers by tier and map the manufacturing process
- Understand the interconnectivity of suppliers and processes
- Identify critical failure points and the frequency of loss scenarios
- Quantify the impact of a disrupting event.
Standard statistical techniques are used to provide a view of the expected impact on the supply chain and the distribution around it. By acknowledging the multiple potential failure points and the triggers for each, stochastic modelling lends itself to supply chain risk. For example, where stock is held by a supplier, there may be seasonal, weekly or daily variation in the amount of stock held, and the number of down days can vary significantly by event. As more data is gathered, benchmark exposure curves can be calibrated and employed to obtain a view of the scale of contingent business interruption events. This provides greater insight into the potential range of outcomes, rather than solely focusing on more extreme estimated maximum loss scenarios to inform estimated costs, as well as limit decisions.
There are fundamental differences in the ways we construct and collect data for models, based on their approach and use. A model that is trying to build a proxy for the interconnectivity within a market requires industry information. With contagion being a significant concern for insurers, not only does the supply chain of one company need to be considered, but also the interlinking of mutual first, second or third-tier suppliers. This highlights the necessity for consistency and transparency in market submissions in terms of identifying key suppliers.
Challenges in supply chain risk management
A significant challenge in supply chain risk management is a lack of information about the supply chain. Who are the suppliers beyond the first tier? Which are critical? Procurement and supply chain professionals often define a critical supplier by the level of spend; in reality, risk will be more a characteristic of criticality, or a sole supplier.
Even when supply chains are better understood, there can be bottlenecks, where an individual supplier becomes critical to many companies within defined industry sectors and any interruption impacts multiple value chains. Consider how the global chip shortage is impacting the availability of automotive products, consumer electronics and smartphones. These accumulations and aggregations make insurance companies nervous, and have led to reduced capacity, increased costs and restrictions on named suppliers across many insured sectors.
The idea that companies can just switch suppliers in the event of a disruption underestimates the time and complexity involved. Original equipment manufacturers have rigorous quality checks built into their manufacturing processes; changes to the product make-up could slow down, or even halt, this process. In the heavily regulated food sector, for example, changing an ingredient supplier may be impossible if the new supplier fails to meet regulatory requirements around, say, labelling measures.
Finally, the definition of ‘supply chain’ is broadening and becoming more complex. It is not just about keeping your vessel moving or your supplier’s manufacturing facility intact – it is just as much about your supply chain’s ESG performance, the ongoing solvency of your critical suppliers, and your increased IP and cyber exposure, triggered by shared supplier systems and processes. Supply chain has become an enterprise risk.
“This points to a globally connected world in which western economies have become increasingly dependent on complex supply chains”
Global connectedness is driving the need for comprehensive insurance solutions to form part of an organisation’s risk response. These come in two main forms. The most common is contingent business interruption, which is often an extension of traditional property damage cover; this provides protection against the breakdown of key suppliers or manufacturers. However, it is limited to responding to physical damage to the supplier or manufacturer caused by specified named perils, such as fire or flood. For protection from wider economic and non-physical damage events, broader supply chain insurance may be available.
In either instance, assessing which coverage to purchase should begin with a thorough investigation of vulnerability and exposure to potential supply chain events, which actuaries can help to model.
Steps to address supply chain risk
There are steps that companies can take to start turning risk into opportunity:
- Build visibility around the supply chain. Procurement functions in multinational companies will often have insight into supply chain mapping but may not share this with risk professionals. Visibility needs to go beyond who the most important suppliers are and where they are based, and towards better understanding their levels of capacity and utilisation, and dependency on other third parties.
- Quantify the likely financial impacts that would follow the loss of a critical supplier, to guide decisions around investment in resilience and adequacy of insurance coverage. Understand the key risks that could impact your critical suppliers. Think broadly, beyond material damage losses, and better understand the measures being taken by suppliers to manage risk. Review your own supplier contractual terms from a liability perspective.
- Make your supply chain risk management strategy truly enterprise-wide, connecting risk and insurance professionals with senior directors in supply chain, procurement, treasury, strategy, and operations, around a common set of data and decision-making.
Time to strategise
The options available to companies to re-engineer their supply chains in response to an accelerating risk profile can be limited. With tensions in global supply chains expected to remain commonplace, an integrated supply chain risk strategy has a critical role to play in smoothing volatility. Intensified focus on supply chain management increases the role actuaries will play in helping organisations quantify the impact of supply chain events, and in placing appropriately priced insurance products.
Richard Waterer is global risk consulting leader at Aon
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