Beware the Risks Your Business Can’t Transfer

During the Pandemic, lots of businesses learned the hard way what business interruption insurance covers — and what it doesn’t.?In general, lost profits caused by an insured peril, such as fire, flood, etc., are included. Further, lost profits are often included when?suppliers?can’t supply as a result of the same peril.?

Insurance covers specified consequences from specified perils — i.e., risks insurers can predict. In these instances, they are willing to transfer the risk to themselves for a fee. For all other types of risks, the company in question is stuck with them.?

Unfortunately,?there are a lot of uninsurable perils (Covid among them) and uninsurable consequences as a result.?For example, when a vendor can’t ship a product on a timely basis — due to shipping container or rail backlogs, lack of people, government shutdown, unexpected market demand for whatever it is you need, etc. — its ability to operate and generate profit and cash flow will be disrupted. Customers may permanently switch to a different product and the market dies. That is an uninsurable consequence.

Today’s newsletter, then, is about risks that can’t be transferred using business interruption as an example.?Some suggestions…

Take a look at your company’s most recent business interruption insurance application.?

That application likely contains a tool provided by the carrier (often in spreadsheet form) to estimate how much coverage your business needs. You need to figure out the contribution to fixed costs that could be lost if unable to operate, essentially revenue less variable costs. Then add in cost for retaining employees, etc., so the business can crank back up when the inability to operate ends. That is how much your business stands to lose if it can’t operate.

For larger corporations, this analysis should be done on a product line level.?Why? Because some products / services / customers are much more profitable than others. The temporary loss of a big money-maker has a larger adverse impact than the loss of a ho-hum product or service.?The bigger the company, the harder this task becomes. The goal is to not risk losing $1,000 in contribution for lack of a $1 part.?

Remember that business interruption insurance only covers losses from a few specified perils.?

So,?look at what could stop your business from operating due to?other?perils.??

For example, a client of mine processes a raw material that is mined in many locations around the world. During the pandemic, demand for my customer’s product surged, but supply couldn’t increase in the near term and the largest producer supplied very large customers to the detriment of smaller ones. My small client survived because it had multiple sources for the raw material and carried larger inventories “just in case.” Many of its competitors did the opposite, buying from just a few low-cost suppliers and keeping inventories low. As a result, many were shut down for months.?

There are lots of other uninsurable perils.?A friend of mine does cyber risk assessments for hedge funds. Typically, his clients had robust backup systems in place. But they all relied on continued physical access to the main office, something that Covid got in the way of. The same thing could have happened from a chemical spill, mass shooter, or other localized event.

Consider the potential for long-term damage to your business.

The impact from an interruption in business can reach far beyond just the lost sales that occur in the short term.?If you are unable to supply your customers with whatever it is they need, they may be forced to switch vendors or find a suitable substitute. Hopefully, they will return. But some may like the new solution and stay with it.

At that point, not only have you lost the revenue that would have occurred?during?the shutdown, but you have also lost all future sales from that customer, along with any ancillary products and services purchased regularly, such as repair parts, service visits, etc. And, you now must spend additional dollars and resources to acquire more customers, to backfill from the loss.

A few more tips…

To assess these risks reliably, a thorough understanding?of your business, industry, supply chain, customer acquisition costs, time to acquire and reacquire customers, customer’s cost of switching, and product / service / customer profitability is needed. Yes, this is a lot to know.?But that knowledge is needed to run a business anyway.?My experience, however, is that in?larger companies in particular, procurement and supply chain people are focused on costs and often don’t know or understand all the items I just identified.

Be sure your business understands the risks of sole suppliers.?Search your supply chain; how long would it take to find a substitute? Why can’t there be more than one supplier? A friend of mine is a product manager for a small product line in a very large international company. A critical material, of which the company buys $3?billion?annually, came from a single vendor’s large plant in Texas. When the winter freeze struck last year, his production line was forced to shut down, as were many other, much larger product lines.

Develop alternative logistic options and/or suppliers with different paths to delivery.?Not only have ports been backed up and container prices gone sky-high, there have been issues with rail deliveries. Sometimes it is a shortage of the type of rail car needed, other times it is congestion on a particular route.

Re-evaluate inventory levels.?The client mentioned earlier that buys mined material, was saved because it ran with what some would consider high inventory levels. But their prior experiences with supply suggested that this was a worthwhile expense — and they were right.

Look for more transferable risks.?When digging into the retained risk pile, you may find risks that can be transferred.?

Distinguish between idiosyncratic and systemic risk.??I have written about this difference?before?: Idiosyncratic risk can be diversified away, while systemic risk cannot. If all of your competitors are having trouble getting raw materials, that is a systemic problem and hard to solve if your company is not prepared. Idiosyncratic risk means it is affecting just?your?business. Those situations may be easier to fix than systemic situations, but your competitors don’t have the same problem.?

Apply this thinking to more than just things your business buys.?For example, a friend of mine owns a company that installs and monitors alarms. He has one center where all the alarms ring and customers call — his business is not large enough to afford two. But, he has a contract with a service that can provide a backup location, and he has procedures in place to include that location if needed. Other examples include?customer concentration?, a risk that can be offset with trade credit insurance and, for large companies, insurance for specified countries.

Final Thoughts

The risks that your business can transfer represent just the tip of the risk iceberg.?Lurking beneath are many more risks that your business must retain. So, be proactive and mitigate the risk when it makes sense to do so.?

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Charlie Goodrich is Founder and Principal of?Goodrich & Associates, a management consulting firm that specializes in helping its business clients solve urgent liquidity problems. He holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia and has over 30 years' experience in this area.