A Berkshire Hathaway Company

Supply Chain Insurance—Can It Be an Attractive Insurance Product?by Leo Ronken, Gen Re, Cologne

ContentsPerils and Exposures 2

Supply Chain Loss Examples 2

Insurability and Challenges of a Supply Chain Insurance Contract 3

Underwriting Challenges 3

A Possible Framework for Supply Chain Insurance 3

Summary 4

About this NewsletterCreated for our clients, our Insurance Issues publication series provides an in-depth look at timely and important topics on insurance industry issues. To speak further with Gen Re about your risk transfer needs, or the concept of Supply Chain Insurance, please contact your Treaty or Facultative representative.

After 190 years of relative inactivity, the Eyjafjallajökull volcano in the south of Iceland erupted on March 20, 2010 and continued to do so over the following weeks. Large plumes of volcanic ash rose up to the Tropopause level (around 10 km). Ash clouds and particles traveled towards Europe, leading to the decision to close the majority of European airports for six consecutive days in April 2010, and causing global turbulences in supply chains.

This year’s Japanese earthquake and tsunami again highlight the global impact such events have on the commercial and trading world. Apart from direct losses to production facilities, the vulnerability of global supply chains caused by issues associated with infrastructure, energy, utilities, transportation and restrictions to streets, ports and airports is apparent. In the semiconductor and automobile industries, as an example, companies around the world have had to reduce or even stop their production, as needed parts are not being delivered from Japan.

Besides the discussion in the risk management community to strengthen the resilience of supply chains after a major event, the discussion continues about the potential implications to the insurance industry, as well as the demand for specialized insurance products to cover the breakdown of a supply chain for whatever reason.

This article looks at how the insurance industry, with its current products, already responds to the breakdown of a supplier and what the underwriting challenges and requirements are for a special supply chain insurance product.

June 2011

Insurance Issues®

2 Gen Re

Perils and ExposuresSome of the perils and exposures associated with a supply interruption can be insured with traditional products. To name a few:

> Business Interruption (BI), Contingent Business Interruption (CBI), and interdependency coverage which is limited to insured losses caused by material damage at the insured location (Named Perils, All Risks)

> All Risks property, goods-in-transit or stock throughput policy to cover physical risks of the supply chain

> General Liability policy to cover the liability risks including indemnities for lost or damaged inventory under the custody and control of the third parties

> Crime coverage (theft, robbery, etc.)

> Trade credit insurance

> IT/Data/Communication insurance contracts, computer misuse insurance

> Other special contracts, e.g., guarantees, bonds, debt guarantee, collateral securities

However, these policies have limited coverages. They do not cover all perils and hazards, such as war, strikes, radioactive contamination, confiscation, insolvency or delayed payment, losses due to material, manufacturing construction or design failures, losses due to inappropriate packaging and loading, financial losses, and so forth. On the other hand, some of these might be included in an insurance policy at a

higher premium. Agreed sublimits and deductibles for CBI, interdependencies and loss limits for supplier-rated exposures are often considered to be too low. In general, only first-tier suppliers are covered and losses arising from intentional misconduct or gross negligence are excluded.

As a consequence of the recognition that supply chain failure can quickly lead to massive financial problems, threatening the profitability and stability of an enterprise, a few brokers and insurance companies have carried out feasibility studies of a supply chain insurance policy. Such a policy should cover, in the form of financial compensation, the economic consequences arising from interruption of the supplier chain if a failure of whatever nature in that chain were to lead to a reduced profitability of the company.

The indemnification of such a policy is linked to the anticipated loss of profit and/or increased cost of working arising out of this failure. The indemnification is limited to a maximum amount agreed, for example USD 100 million per supplier/customer and carries a significant deductible, such as 10% to 20% of the agreed loss limit. The policy indemnity period is 12 months in general. The period begins either from the first reduction in supply or from the first notification of the circumstances leading subsequently to a reduction in supply.

Insurance companies are now aware of the high-risk potential with supply chain failures. Most would insist as a

The big difference of Supply Chain Insurance

to classic Business Interruption policies is

that there is no limitation of the policy to material damage.

Supply Chain Loss Examples2011 Japanese earthquake and tsunami—GM closed down auto factories in Spain and Germany; Toyota closed down in the U.S.

2010 Iceland’s Eyjafjallajökull volcano ash clouds shut down airspace for six days

2008 South Korea laptop battery plant fire contributed to a shortage of notebook computer batteries

2007 Earthquake damage to Japanese factory supplying piston rings to eight of the 12 Japanese auto manufacturers—disrupted production for three weeks

2003 SARS outbreak in China—impacted Asian region and worldwide trading

2002 Harbor strikes at U.S. West Coast ports led to temporary closure of a major auto plant

2001 U.S./Canada border closures due to terrorist attacks

2000 Supplier plant fire in North America interrupts cell phone chip production for two of the biggest mobile phone producers (loss around USD 1 – 1.8 billion)

1999 Taiwan earthquake disrupts PC memory production

1998 Labor strike disrupts production of North American car manufacturer (loss around USD 2 billion)

1997 Brake plant fire interrupts worldwide production of Japanese auto manufacturer

3Insurance Issues, June 2011

pre-condition for the validity of a supply chain insurance policy that a detailed, qualified risk assessment of the supply chain be carried out in order to determine exposures and to estimate the maximum possible financial loss. The assessment could also aid risk prevention and protection measures for the supply chain.

The big difference of Supply Chain Insurance to classic Business Interruption policies is that there is no limitation of the policy to material damage. This means that in addition to the classic set of perils, covered causes of loss can include insolvency risks, illiquidity, transport risk, IT and communication failures, and political risks. There are only a few exclusions, such as: quality of supply and product recall; infectious disease unless solely at the supplier’s premises; war, terrorism and nuclear risks; and deliberate acts by the insured, including breach of contract and non-acceptance of either the supply or errors and omissions of the insured.

Insurability and Challenges of a Supply Chain Insurance ContractRandomness, predictability, independence and uniqueness are the four basic elements to test the insurability of an insurance product.1 Before going into more details, here are some thoughts about how far a supply chain insurance product might meet these criteria:

Randomness—This means the insured event is unpredictable and cannot be influenced by the parties at the time the contract is signed. With respect to supply chain insurance, the randomness is limited, as strategy and organization of the supply chain can be influenced directly by the insured.

Predictability—This means that there are known probabilities about the likelihood of an event happening, and the extent of damage that might be expected to occur. The specific problem is that appropriate loss probabilities can’t be calculated because no real loss history data are available. In addition, constant changes in the supply chain strategy and organization make it difficult to identify damage probabilities.

Independence—This is the concept that the loss for one insured should not affect the probability of loss for another. In fact, there is a huge accumulation risk inherent in the insurance of supply chains, particularly if a failing supplier is supplying more than one manufacturer.

Uniqueness—This principle holds that the inception of loss and the amount of loss are objectifiable. It is a question of the clarity of actual contract terms and conditions in describing the policy coverage and the loss definitions. If a supply chain policy is in existence, there is certainly also the problem of differentiating cover under this policy from that of other insurance solutions.

As a result, supply chain risks can in part be considered insurable, but significant problems will remain for those seeking to offer cover.

If a sufficient number of policyholders is willing to buy such a policy to enable an insurer to create an appropriate portfolio balance, further discussion would be needed to determine whether a sufficient diversification can be built in terms of

geographical spread and different lines of business in order to improve the risk balance to create a portfolio of independent risks.

Underwriting ChallengesAll studies so far have shown that the non-material damage trigger, as well as the complexity of an existing supply chain with thousands of supplies in such a chain, as the auto industry, can cause tremendous challenges to underwriters. These include:

> Supply chains’ complexity often requires intensive research to estimate exposures from:

– First-, second-, and third-tier suppliers

– Globalization, single sourcing and outsourcing

– Business contingency planning

– High level of dependence of insured on the supply chain

– Willingness of insured to constantly improve the resilience of its supply chain

> Potential accumulation exposures with other businesses

> Extended BI exposure

> Underwriting “detached” from the original risk of the insured, risk quality of the suppliers, estimations of redundancies or replacement possibilities

> Potential lack of transparency due to insufficient information

> Possible concerns of the insured about confidentiality

> Difficulty of pricing and exposure determination due to no real experience of loss probabilities, e.g., risk of insolvency

> Buildup of a sustainable portfolio

Furthermore, it seems that this product is mainly demanded by Fortune 500 companies with thousands of suppliers, yet the policies available in the market primarily are targeted at providing coverage for only a few suppliers. The suggested loss limits are seen as woefully inadequate by enterprises that could probably require indemnification in excess of USD 1 billion for potential supply chain disruptions. As a result, this kind of policy has not seen a lot of demand thus far.

A Possible Framework for Supply Chain Insurance The main challenge of supply chain interruption underwriting lies in the potential accumulation in the case of a supply chain failure. As an example, a key supplier for automobile brakes and gears can serve more than one automobile company. If its production gets interrupted, all customers using this critical part have to stop their production and seek an alternative supplier, which will take considerable time as these goods are normally custom-made and cannot be replaced easily. Hence, in an extreme case, the failure of one supplier may lead to the stoppage of all automobile production. Such an event has already occurred recently as a result of the Japanese earthquake.

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© 2011 General Re Corporation, Stamford, CT

This information was compiled by Gen Re and is intended to provide background information to our clients, as well as to our professional staff. The information is time sensitive and may need to be revised and updated periodically. It is not intended to be legal advice. You should consult with your own legal counsel before relying on it.

The difference is…the quality of the promise®

Therefore, it must be in the interest of any insurer, when drafting such a policy, to narrow the exposures from a supply chain interruption to a manageable size. A list of topics to be considered and addressed include the following:

> Only named suppliers, no endorsement for second- and third-tier suppliers due to missing transparency and impossibility of accumulation control

> Loss limit “each and every loss and in the annual aggregate” to keep the exposure to a manageable level

> Meaningful deductible >10% of loss limit (in terms of money/time) to keep the insured as an interested party in order to minimize the impact of a loss

> Clear policy terms and conditions to avoid misunderstandings and misinterpretations (e.g., indemnification of gross profit, loss of market share, extra expenses, etc.) between the insured and the insurer in the case of a loss

> No automatic reinstatement of the layer

> Only as a DIC (Difference in Condition)/DIL (Difference in Limits) policy

> Participation of the insurer in the original main Flexa/All Risks policies to balance risks, transparency, etc.

> Thorough and in-depth accumulation control to recognize the supply chain risks with the analysis of possible worst-case scenarios and already quoted/bound capacities to avoid over-lining of capacity

> Claims cooperation/loss settlement clause

> Exposure rating per named supplier with respect to the overall exposure as well as the quality of the supply chain risk management

> Availability of survey reports on the supply chain risk and suppliers, along with a description of potential hazards, available risk prevention and protection measures, as well as documented interest of the insured to minimize the supply chain risk

Finally, the biggest challenge will remain—accumulation control. So far there is no real solution available as to how to box the potential accumulation exposure arising from the failure of a major key supplier in a globalized production and trading environment. Studies to date have indicated that such a loss can reach multiple billions in U.S. dollars and have a similar financial threat to the insurance community as a major hurricane or typhoon.

Alternative solutions could be envisaged in the capital markets by transferring supply chain risks via derivatives, ILS (Insurance

Linked Securities), etc. under the pre-condition that the supply chain risks can be modeled in a clear and objective way. However, this is currently not a working alternative as similar problems exist here as with insurance solutions.

Summary As the failure of a supply chain in today’s globalized economy can have a huge impact on the profitability of an enterprise, an insurance policy against supply chain failure is being demanded by market participants, in particular by the insureds and brokers. A few insurance companies have carried out studies about the feasibility of such an insurance product and have drafted a framework for it. However, the studies also show that a supply chain insurance product has some hurdles and difficulties, which are mainly seen in the accumulation potential in the case of a loss and secondly in the underwriting challenges, as supply chains are often complicated and very different from case to case.

To be successful with a supply chain insurance product, it is essential to develop a greater understanding of each single supplier in a given supply chain, which will be more problematic the more suppliers are part of the chain. There will also be the problem of establishing a fundamental rating approach to calculate an appropriate premium for the exposures presented by a given supply chain. Finally, the problem of unknown accumulations is hard to solve, and the accumulation arising from the failure of a supplier sourcing more than one manufacturer can grow into the billions. Insureds so far report that they have an interest in such cover; however, they find that policies offered today provide cover for inadequate numbers of suppliers at rates that are too high and with limits that are too low to meet their needs.

At first glance, a supply chain policy looks like a product with a high demand by the insureds; however, it is more complicated than most other products and requires more caution in drafting and ultimately introducing to the market. As long as the accumulation exposure is not resolved sufficiently, we at Gen Re see this product as being in its early stages and needing further research to find an adequate approach.n1 “ The problem of insurability and risk policy of insurance?”,

D. Hesberg, Risk and Insurance, Karlsruhe, pp. 120 – 140.

Leo Ronken is a Senior Underwriting Consultant for Gen Re’s Global Property Facultative department in Cologne. He may be reached at +1 49 221 9738 939 or leo.ronken@genre.com.