Expert Commentary

E-Supply—Opportunity and Risk

Supply chains powered by the Internet are changing organizational structures and business practices. While these changes have resulted in new manufacturing opportunities, they have also brought about increased risk and new insurance challenges. This article addresses these issues.


Risk Financing Info
September 2000

Supply chains powered by the Internet are changing organizational structures, business practices, and shifting selected risks. The explosion of the Internet engine has driven, and will continually cause, many changes in our daily lives--some good, others not so good; some obvious, and others quite subtle.

Personal Perspective: Business to Consumer ("B to C")

From a personal perspective, the Internet has made it very easy to find and obtain replacement parts for home repairs. For example, I have a 17-year-old large picture window that contains a small gearbox which operates a slim blind sandwiched between two panes of glass. Recently, the gearbox broke and had to be replaced.

Where do I find the nearest Pella store that might carry this small component? With the Internet, the search for the Pella website was easy, convenient, and practically free. So I was able to order the replacement part and, consequently, the blind in my window now works like new. The alternative would have involved a search through the phonebook, a trip to the regional store, detailing the order specifications, filling out forms, and waiting. Meanwhile, we would have had the inconvenience of having a large plate of glass propped up against a wall, trying to protect it from breakage until the repair was completed.

Business Perspective: Business to Business ("B to B")

Businesses have been aggressively reducing their plant, property, and inventory levels to improve financial performance. Financial performance has been helped by selling productive assets to outsource suppliers who have lower overhead costs, which notably improve the primary manufacturer's return on assets. This improvement has resulted in significant reductions to property, plant, and equipment, and inventory balance sheet accounts, accelerated with the help of management-consulting firms with supply chain practices.

Fixed assets have been sold to contract manufacturers and logistics suppliers who are under specific contract to the manufacturer who spun off the assets and/or business units. These supply chain partners are likely to have contracts with numerous firms in a given industry, which have traditionally been considered competitors. If they are operating with lower overhead costs and maintaining quality standards, it is a win/win situation for the primary manufacturers and their outsource partners.

Insurance Implications

From an insurance perspective, a portion of the premium has shifted from the manufacturer to the supply chain partners. Managing a virtual supply chain requires notable care and sophisticated "tools." These tools provide for tracking the quantity, quality, delivering points, and times so the primary manufacturer can deliver to customers as demanded.

From an insurance underwriting view, these emerging exposures need to be addressed. The restructured supply chains have reduced the number of suppliers, moved to just-in-time inventory, changed from paper to digital format, and provided for automatic reorder. Significant cost reductions have occurred, including lower transaction costs and a reduced number of suppliers, all of who operate via e-commerce conductivity. Corporate benefits have ranged from hundreds of millions of dollars to more than $1 billion of cost reduction for each enterprise.

Many insurance companies underwrite property programs covering business assets, business interruption, and contingent business interruption. Therefore, a loss experienced by the extended supply chain "partners" would be included in the definition of a loss to the primary manufacturer, even though manufacturers may not be affected by a direct peril.

Has the overall risk/exposure changed from a pre- to a post-outsourcing operating structure? One factor to consider when answering this question is the management separation relative to outsourced suppliers. If the primary manufacturer is dependent on the supply chain to assure timely delivery of their completed products to customers, they will have to communicate expected quality control standards for component parts, as well as production and warehouse environments, and closely manage compliance.

Insurers' Solutions

Individual insurance companies may no longer be able to insure the entire reconfigured manufacturer. With e-supply, the manufacturer's extended supply chain and improved gross margins most likely have increased its business interruption exposure. Most underwriting rating plans focus mainly on reported insurance values based on tangible fixed assets. In many cases, business interruption values are reported and reviewed for exposure growth, but are not always included in the rating process. Currently, business interruption worksheets do not reflect the net exposure resulting from outsourced suppliers. The worksheets simply do not capture critical information necessary to understand the exposures and how well they are being managed.

Questions such as the following need to be asked.

  1. Are outsourced operating standards clearly defined and communicated?
  2. How do outsourced standards compare to the primary manufacturer's standards for its own core vertically integrated processes?
  3. Do the outsourced suppliers comply with the required standards based on audit results?
  4. Is there an executive report card for outsourced suppliers, contract manufacturers, or logistics partners that is available for review?
  5. At what point are supply chain partners replaced due to lack of performance?
  6. What are the contingency plan's sources for alternative sources of suppliers?

Remember that most corporations will have hundreds to thousands of partners in their supply chain network that source thousands of products into global distribution channels. Underwriters cannot hope to manage the process, but they can understand the key risks and how well their clients are managing them.

Underwriters need to ask for supply chain exposure information to assess how these exposures are being managed. Supply chain risk assessment may not lend itself to a quantification process, but after reviewing 10 to 20 different risks, one can determine on a relative basis the quality of risk management. In building a database over time, there may be the ability to quantify and rate the process. Risk managers need to stay on top of these exposures, and the better ones have answers to the necessary questions.

Conclusion

Supply chain risks deserve at least as much attention as underwriters give to earthquake accumulation risk. If a critical supplier goes down as a result of an insured peril, there may be 10 to 15 primary name-brand manufacturers who will sustain a measurable business interruption loss. Other suppliers could also be running at full capacity, leaving few if any alternative supply sources in the short-run. Given these circumstances, a business interruption loss can be far greater in a fast-paced industry that has significantly reduced its owned productive capacity in order to enhance financial performance.

Insurers need to understand these key exposures and be able to assure themselves they are receiving a fair premium relative to the degree and quality of the exposure. Insurers should consider hiring a management-consulting firm with supply chain experience to assist in constructing a knowledge model surrounding accumulation risk associated with supply chain interdependencies. It is far better to plan ahead than to merely react to stakeholders' interests and/or personal deliverables.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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