Published on: 01-Oct- 2012 | Comments: 0
A new strategy for managing shocks to the supply chain involves considering the risks using an “investment portfolio approach.” Simply put, this approach enables an organization to diversify and leverage its supply chain risk mitigation in the same manner as it diversifies and leverages its financial investments.
Building the Portfolio Approach
A starting point for the new approach is to assess the risks, the available mitigation options, and the potential costs of various supply chain disruptions (for example, lost sales, rebuild/recovery time, competitive position, and reputation). Organizations can then spread their risk efficiently across a portfolio of insurance products, retention options, and other financial tools—combined with a robust supply chain resiliency component.
By actively managing a supply chain risk mitigation portfolio, companies can more successfully plan for and recover from supply chain shocks. This can help to protect companies and their risk stakeholders from severe supply chain disruptions, whether property damage, cyber outages, political events, or other financially damaging events.
Too often, companies correlate supply chain risks only with traditional risk management and risk transfer options—typically the relevant, standard property insurance coverage and risk mitigation steps. A key to understanding the portfolio is to consider the transformation of supply chains over time. The terms “supply chain” and “supply chain risk” customarily connoted processes dealing strictly with raw materials extraction, physical manufacturing, and efficient shipping plans. Although these are still essential elements in many industries’ supply chains, today they also involve technology, data assets, de-centralized operations and suppliers, and complex financial and political considerations.
Developing a full picture of the modern supply chain’s complexities allows a company to properly build its portfolio. At the outset, a company should:
- Collect thorough data about suppliers and distributors: their locations, output, strengths, and weaknesses.
- Monitor supply chains to view trends and potential disruptions.
- Apply financial impact metrics, for example shock/disruption impact analysis and return on risk (mitigation) investment analysis.
Supply Chain Risk Mitigation Components
Companies have many options in building a supply chain risk mitigation portfolio. Evaluating the options requires decisions based on capital, cost, and flexibility. Once these issues are worked through, a company can build its portfolio based on its business objectives and its likely supply chain scenarios. The major portfolio components fall into three broad categories.
Just as the base of a financial portfolio for many investors is a broad-based mutual fund, the “core holding” of a supply chain risk mitigation portfolio is likely to consist of insurance products. There is much room for innovation in the risk transfer marketplace, which currently lacks a comprehensive supply chain insurance product as insurers are reluctant to be exposed to the potentially catastrophic losses at stake. Also, many companies lack a comprehensive understanding of their own or their suppliers’ supply chain risk and resilience. Nonetheless, traditional options do meet certain needs, while more innovative ones fill in the gaps for the modern supply chain.
Traditional insurance generally relies on business interruption (BI), contingent business interruption (CBI), and trade disruption (TDI) policies to cover supply chain losses (note that coverage is currently limited for second and third tier supplier disruptions). Such policies are designed mainly for physical damage-related disruptions and cover first tier suppliers.
Supply chain-focused insurance is relatively new. It covers select incidents with and without physical damage, and can begin to diversify a company’s portfolio. Such products, however, are often viewed as expensive and with rigorous requirements, such as providing detailed data about named suppliers and supply. As more companies purchase it and insurer competition increases, it is likely prices will moderate. New entrants in the area of cyber risk can also help cover many of today’s non-physical damage supply chain shocks.
Organizations can realize a sizeable return on a risk mitigation strategy that does not involve the insurance marketplace. They may find it in their financial interest to expand their risk retention holdings for selected supply chain risks rather than bringing them to the market. The three principal risk retention options are:
- Doing nothing in relation to certain supply chain risks, and instead focusing on profit maximization.
- Increasing capacities in output, stockpiling/diversifying inventories, establishing additional distribution hubs, managing supplier relationships and alternative suppliers, ensuring availability of personnel and skills sets, and actively monitoring the supply chain. This approach requires organizations to establish and perfect capital allocation channels—in line with corporate value drivers—to effectively mitigate risk before, during, and after a shock.
- Using a captive to handle some or all supply chain risks, freeing the company from the commercial insurance market, and allowing it to set its own criteria. At times when the market limits the availability of CBI and other coverage, captives become an attractive option.
Organizations can enhance their portfolio with financial instruments and strategies that help ensure that any shock to the supply chain or the enterprise itself does not adversely affect their financial health, share price, reputation, or investor outlook.
- “Safe” securities investments by risk averse companies, help provide a shield from negative economic events, whether a supply chain disruption or financial market crisis
- Hedging commodities to spread or mitigate risk, involving outsourcing commodity trading to firms that take ownership of procurement operations.
- Derivatives, including credit default swaps and similar innovations, which companies with untraditional, unorthodox supply chains use to spread and hedge against risk, including supply chain risk. Although potentially effective, there are high risks associated with such investment decisions (as seen by the disastrous fallout across the financial system after the 2008 financial crisis).
Responding to Supply Chain Volatility
The global economy requires organizations to be especially nimble when it comes to effective supply chain risk mitigation. The portfolio approach enables risk management strategies to be flexible, data-driven, and closely monitored so they can respond appropriately and effectively to supply chain volatility and complexities.
To learn more about strategies to manage supply chain risks, join Marsh’s upcoming New Reality of Risk webcast, “A Portfolio Approach to Managing Supply Chain Risk,” on Wednesday, October 24, at 11:00 a.m. (ET).
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