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By ALLEN MELTON, Americas practice leader for insurance claims services with Ernst & Young LLP, and RYAN D. PRATT, a senior manager in the insurance claims services practice with the firm.

The world is getting smaller. We have all heard it. The globalization of commerce, manufacturing and markets has led to the ever-increasing "shrinking'' of business relationships and world visibility in the past 20 years.

Imagine then what would happen if a major, catastrophic loss hit one of these global markets, what impact it would have on the economies and businesses around the world. Not so hard to just imagine any longer.

When Ernst & Young and Risk & Insurance®Magazine set out to develop the second annual Catastrophic Claims Survey in 2011, it was without the knowledge one of the world's largest economies would suffer a crippling blow from a massive earthquake and tsunami.

Nearly 250 risk and insurance professionals from various industries were queried on their experience with claims, disaster recovery and -- most notably -- supply chain risk.

It wasn't until after the response to the survey that the events in Japan cast a bright spotlight on the true and real risk that a global economy and a global supply chain can have on businesses and the insurance industry overall.

There are many facets to a supply chain that cause companies around the globe to assign teams of people to identify, optimize and mitigate supply chain risk.

Whether it is the study of logistical patterns of shipping operations to squeeze pennies off each delivery or the identification of backup resources should one supplier fail to meet next year's supply contract, companies spend thousands of hours a year studying and analyzing supply chain risks. In fact, more than 70 percent of respondents indicated their company's supply chain is critical or very critical to its operations.

The importance of a supply chain goes beyond those personnel that have to deal with suppliers, vendors, logistics and customers on a daily basis. Survey results show that senior management is very concerned with the issue--rightly so and deal with it on a regular basis. In Chart 1, more than half of the respondents indicated their senior managers address supply chain risks at least monthly.

For those respondents that deemed supply chain as "very critical,'' the percentage that address it at least monthly jumps to more than 80 percent.

SUPPLY CHAIN RISK AND INSURANCE

Risk management's role in evaluating and addressing supply chain risk varies widely. For some companies, risk management is critical to the success of communicating with the business to understand where contingencies and interdependencies pose risks to the company.

However, more often it is left to operations or even individual business units to understand the risks present and manage around them via operational adjustments to the business.

In fact, less than 25 percent of those surveyed stated that risk management played a key role in identifying and mitigating supply chain risk. This result is eye-opening considering that regardless of the plans that were made, adjusted and revised there are some risks that are simply unpredictable or unavoidable.

In response to this, the insurance industry has recognized the risks associated with their policyholders' complex supply chains and global interdependencies.

To help mitigate this risk, many property policies include contingent time element or contingent business interruption endorsements that specify what areas of a company's supply chain it will cover i.e. vendors, suppliers, customers. The broadest of these endorsements even allow for the effects of catastrophic loss and damage to second-tier or indirect suppliers and customers.

Considering the long history of property insurance, these endorsements are relatively new and only about one-half of companies have this tool in their risk management arsenal (see Chart 2).

Given the recent global events this will likely change in the months and years to come.

THE JAPAN EFFECT

So many superlatives have been used to describe the events in Japan, and they don't begin to adequately describe the effect these events have had on the country and its people.

From a business perspective, the rippling effects of the third-largest economy in the world taking a direct hit are still being felt globally. Companies all over the world are facing either their own loss of physical assets or the indirect effects of the lingering repercussions of these events.

Ernst & Young and Risk & Insurance®surveyed an additional 375 risk managers to determine how companies were affected by--and are addressing the crisis in Japan. Of those surveyed, nearly one in every three respondents indicated that they either suffered direct loss or had suppliers or customers that sustained damage.

It is no surprise that those industries hardest hit include technology and automotive companies, but others including consumer products, financial and professional services also are realizing the impact to their customers, suppliers and their own people.

Valuable resources, time, raw materials, and information have become scarce as Japan and its people focus internally to recover from such an epic disaster.

As the country begins the process of assessing damage and rebuilding its infrastructure and economy, so too are companies worldwide evaluating how they will find alternative sources of supply and demand for their products.

A complex interplay between suppliers, customers and companies' own interdependencies has often yielded more questions than answers, as to how businesses have been damaged or how they will recover. Of those surveyed, more than 60 percent of respondents indicated they were either taking a "wait and see'' approach or are still gathering data and information to assess the impact to their business.

Many Japanese companies and operations were so severely damaged by these events they will never recover. This will leave gaping holes in supply chains and business networks that will have to be filled over time.

How companies will ultimately fare and recover remains to be seen. It is neither an easy fix nor one that will happen overnight. More than half the respondents that sustained some sort of loss from these events replied that they will continue to feel the effects for more than six months, and one in five for a year or longer.

CONTINGENT TIME ELEMENT

Those that have ever dealt with a business interruption claim know the complexities that come along with it. Assessing how the financial results were affected, the expected results had no loss occurred, how results at other locations may have been affected by the events, and tying all of that back to physical damage as the driving force of loss. Take all of that and assume your company sustained no physical harm and you have a recipe for confusion on how to approach this type of claim.

Contingent time element claims require information from and communication with suppliers and/or customers and often with indirect suppliers and/or customers. Understanding how any of the above was affected by a catastrophic event is critical to the proof and ultimate success of such a claim, as it is incumbent on the policyholder to reasonably demonstrate that its lost income--or increased costs--are a direct result of loss insured by the policy. Gathering adequate information about damage to indirect suppliers and customers can be extremely challenging, since there is usually not a standing relationship or open line of communication between the insured and its tier-two suppliers.

Often businesses do not even recognize they have a covered contingent loss because it is never brought to light internally. A supplier goes down, an alternative supplier is identified, albeit at a higher cost, but personnel directly involved think it is just part of running a business without the knowledge that the company may have insurance coverage for this type of event.

Ultimately, this may cut into the profit margin derived from the product or business unit, but it is either absorbed in the noise of rising costs, or worse compensated for by cutting costs elsewhere. Given this, the results of Chart 3 may not be surprising.

The events in Japan and the resulting claims will shed light on how policyholders and insurers will interpret and attempt to apply contingent time element coverage to their businesses. The outcome of these claims over the next several years will further shape the future of contingent coverage and resulting claims.

Supply chain risk is not getting any easier. However, with the proper level of communication, risk management can be the key to understanding the dependencies that business units, products or services carry as part of their ongoing operations. Often it is through this communication and education of the operations about potential risk and the opportunity for recovery that risk management will identify potential problems and solutions for mitigating against previously unforeseen disasters.

August 1, 2011

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