Tackling the top risks

Companies that attempt to shortchange their risk management practices will find the consequences can be severe, ranging from a loss of competitiveness to going bust.

This is the warning in a report by FM Global, Managing Business Risk Through 2009 and Beyond. It details the risks identified by 500 financial executives across Europe and North America including supply chain disruption, property damage and competition. But there are other issues beyond this, such as the underinsuring of property and the issue of properly maintaining a company’s reputation.

An example of supply chain risk took place in March 2000 when lightning struck a small section of a Philips factory in New Mexico. Although the fire was put out in under 10 minutes, the section of the unit that was damaged specialised in making chips for mobile phones.

The Dutch electronics conglomerate immediately informed its two major clients, Ericsson and Nokia, that there would be a one-week delay in the supply of chips.

Nokia realised that it could take months before the plant returned to full production, causing it to miss the launch of its new phones.

It did two things: it pushed Philips to source the chips from its plants around the world and paid alternative suppliers extra to conduct testing and speed up production.

Ericsson believed a one-week delay was routine. By the time the shortage became apparent, the supply of chips worldwide had been bought up by Nokia.

At the year’s end, Ericsson announced a $2.34bn loss, which it attributed to component shortage. It retreated from the mobile phone market a year after the fire.

Supply chain risk is likely to increase as many businesses continue to outsource. There are an increasing number of interdependences, unlike in the past where the supply chain was vertical. A number of global businesses may be affected by a single supplier going out of business, as exemplified by the Nokia and Ericsson case.

Classic techniques

Disruptions to the supply chain accounted for 14% of the business risks that would threaten revenue in UK, according to the report. Of the financial executives surveyed, 24% expected supply chain risk to increase through to 2009, with 8% expecting it to decrease.

“Supply chain risk can be countered by using classic risk management techniques – understanding risks, identifying where they lie and quantifying them,” says Andrew Cornish, head of major accounts for broker Lockton International.

He explains: “The way you contract with the supplier may need to be reviewed. You need to really understand the financial impact of losing a supplier.

“Another method to counter this risk is through insurance. Large organisations may do this through self insuring or transferring the risk to an insurance company.”

The report explains that where many companies once operated principally in their own country, with highly vertical risk models, they now outsource non-core activities, locate facilities in distant countries and rely on just-in-time inventory. All this makes the margin for supply chain error significantly smaller.

Damage to property as result of fire, explosion, mechanical failure, electrical breakdown or a natural disaster came in third place.

The report suggests that downside risks – which never benefit a company – while seen by financial executives as most likely to impact revenue, tend to be the easiest to manage. It states: “Companies can take proactive measures to minimise these risks by building redundancies into their supply chain or installing fire protection systems in offices and manufacturing plants.”

While property risk ranks as one of the top three concerns, only 7% of financial executives expect it to increase through to 2009; 10% anticipate it to decrease.

The report attributes the benign outlook of property risk to being out of sync with actual developments in the property insurance market. This is the case for companies that have been outsourcing or acquiring their manufacturing activities in other parts of the world, where measures to prevent property loss is less ingrained.

Building and property consultants CNP estimates that 50,000 commercial properties across the UK are currently underinsured.

CNP chief executive David Nurser says: “The extent of under and overvaluation of commercial property has a direct impact on premiums.

“It also means that every year thousands of insurance claims fail to meet the costs of rebuilding a property destroyed by an insured risk because the rebuild costs are out of date, or have been incorrectly assessed.

“With the rising costs of construction in the UK, it is simply not good business to continue without having the reinstatement cost of a property assessed at least every three years.”

Cornish too points out that while most properties in the UK are insured they may not be insured for the current replacement cost assessment value.

He says: “Building costs have gone up as has the cost of steel which has risen dramatically in the last few years. Customers should be aware of keeping values updated.”

Competition risk

Competition risk is here to stay and is likely to intensify, according to 62% of financial executives surveyed.

More than half warn of a loss of competitiveness, which can translate into a loss of market share and a reduction in their company’s valuation.

The internet, e-mail and text messaging have increased the speed at which business is conducted, also leading to competition springing up unexpectedly.

The report cites Apple as a case in point whose iPhone will take on competitors in the portable music player, cellular telephones and portable internet devices categories all

at once.

Apart from the risks listed above, the issue that most affect members of Airmic is reputation. Damage to reputation can be severe, resulting in a loss of market share, stock price and ability to attract funding.

David Gamble, Airmic executive director, says most large companies have a crisis management plan detailing who will respond in an event so there can be maximum communication to the market.

The other threat is climate change but this can also be viewed as a big opportunity.

Gamble says: “The difficulty of recognising climate change as a threat is that it won’t be fully clear for another five to 10 years.

“Getting people to do things in time, like avoiding building on flood plains, is difficult because it doesn’t look like a problem is going to happen.”

Turn it on its head and climate change can be an opportunity to be tapped into – sustainable housing can help reduce energy consumption and mills can generate energy to help pay a mortgage.

The biggest challenge to risk management in the coming years will be obtaining adequate resources in the form of budget, time and people.

Financial executives expect new risks to be introduced through the development of new products, the introduction of new technology and changes attributable to merger and acquisition activity.

More than a third say getting senior management to make risk management a top priority is a significant challenge.

Jon Lott, managing consultant at financial services consultancy Troika, disagrees: “In our experience, senior management of insurers are taking risk much more seriously than they used to, driven by the FSA, Sarbanes-Oxley and Basel II.

“Until a few years ago, major insurers and brokers wouldn’t have had anyone with ‘risk’ in their job title. Now risk departments are attracting high-quality recruits and are a key part of business.”

James Peace, development director, Risk Solutions Business, Royal & SunAlliance says: “The comment that senior management should make risk management a top priority is interesting while not entirely unexpected.

“The outlook of businesses varies in the short term and long term. There have been changes to the ownership structure – large FTSE companies generally take a long term approach to risk management, setting up captive insurance companies.

“What we’re seeing a lot more of nowadays is takeovers by private equity firms, like KKR’s bid for Alliance Boots. Does that influence their view on risk management? Does it make them more short term in their thinking? Will private equity firms typically buy insurance on a more conventional basis rather than using a captive?

“Banks and finance houses typically invest for three to five years with a ‘get out’ strategy. They may not be interested in supporting a long term captive programme.”.