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Contents Introduction 3 1 Contigent business interruption 5 1.1 Suppliers’ and customers’ extensions 5 1.2 CBI–an underestimated risk 6 1.3 Underwriting aspects 7 Risk quality of suppliers and/or customers 7 Degree of insured’s dependency 8 Some principles affecting the extension 9 Insurance terms and conditions 11 Further conditions and extensions 13 Accumulation and reinsurance aspects 14 1.4 Public utilities 16 1.5 Loss of access (ingress/egress) 16 Annex 1: The risk management process with external dependencies 19 2 Virtual world, real threats 23 Exposures 24 The legal environment 24 Technical dependency 25 Malicious acts and hacktivity 25 2.1 Information Systems Business Interruption (ISBI) 26 The sum insured 27 What cannot be covered 27 Extensions 27 Risk assessment 28 2.2 Conclusion 29 Annex 2: E-commerce business marketplaces and the electronic supply chain 30 3 Other special covers 33 3.1 Contingencies 33 Non-physical damage 34 Accumulation 34 3.2 Advance loss of profits insurance (ALOP) 36 Cover 36 Insured party 36 Exclusions 36 Sum insured 36 Period of insurance 36 Loss settlement 37 3.3 Liquidated damages and force majeure covers 38 The liabilities 39 The insurance covers 39 Conclusion 40 Annex 3: Business interruption in livestock production 41 4 Related reading 45 Introduction After an insured business interruption, the insured should find himself in nearly the same financial position he would have been in had the loss never occurred. Easier said than done! Anyone ever involved in a business interruption claim can attest to how difficult it is to juggle its many inherent challenges. These not only include “intangibles” such as reduction in turnover compared to projected business results, but also relate to various problems of business operation maintenance and/or re-launch of production under adverse circumstances. A Swiss Re business interruption publication which appeared in 1998 addressed major characteristics such as internal and external susceptibility to disruptions, income at risk, objectives and forms of cover, but it touched only briefly on special issues. The publication in hand probes BI specialities which have gained importance over the past few years. In today’s “global village”, business processes in industry and commerce form a chain of interrelated activities by highly diverse, but interdependent parties. Technological progress is moving at tremendous speed. Raw materials and products need to be finished and assembled according to extremely tight schedules. In particular, international companies now outsource part of their original activities or enter complex partnerships with external organisations. By doing so, they lose a degree of control over resources, business processes and the very product itself. Insurance markets and insurance products could hardly stagnate in this ever-changing environment. The growing exposure linked to the use of internet and telecommunication services has become crucial. Sudden and accidental failure of IT systems, minimum requirements on protection and backup procedures, and the assessment of new types of cyber risks are among these burning issues. Not all the products, wordings, extensions and alleged simplifications devised by the trade in the soft cycle represented genuine improvements. Indeed, with regard to business interruption, some rather suspect methods of insuring large companies’ interdependencies were occasionally applied. Non-transparent exposures and accumulations were the unfortunate result of such practice. Outlining the problems of BI insurance and offering some solutions in this publication is to underline Swiss Re’s decisive strategy. In return, the authors anticipate a fruitful dialogue with underwriters around the globe. 3 Swiss Re: Contingent business interruption and other special covers 4 Swiss Re: Contingent business interruption and other special covers A Fire in Albuquerque Sparks Crisis for European Cell-Phone Giants Extract adapted from a report by Almar Latour, Staff Reporter, “The Wall Street Journal”, 29 January 2001 ...the blaze in an Albuquerque, N.M. semi-conductor plant burned for just 10 minutes last March. But far away in Scandinavia, the fire touched off a corporate crisis that shifted thebalance of power between two of Europe’s biggest electronics companies, both major players in the global electronics industry. Both companies bought computer chips from the plant, which is owned and operated by Philips Electronics NV of the Netherlands. The flow of those chips, which are crucial compo-nents in the mobile phones they sell around the world, suddenly stopped. Philips needed weeks to get the plant back to capacity. With mobile phone sales booming around the world, neither customer company could afford to wait. But how the two companies responded to the crisis couldn’t have been more different. Company “A”, which was Europe’s largest corporation by market capitalisation at the time, met the challenge with textbook crisis management effort. Company “B” moved far more slowly. And it was less prepared for the problem in the first place. It didn’t have other suppliers, and in the end, came up millions of chips short of what it needed for a key new product. “We did not have a contingency plan”, con-ceded the marketing director for consumer goods at Company “B”. 5 Swiss Re: Contingent business interruption and other special covers 1 Contingent business interruption What happens to a business after a fire? Production slows down or stops and turnover decreases; profits begin to diminish and eventually turn into losses as wages and other charges continue to accrue. What happens, however, if goods or services cannot be supplied to the busi-ness because of material damage at the premises of a supplier or, perhaps even worse, after a fire on the premises of an important customer? Depending on the type of industry, it may be difficult to find alternative suppliers or new customers. For some businesses, in fact, the risk of reduction in turnover triggered by an event outside their control may be as high as that of material damage on their own premises. Since most business processes extend beyond the boundaries of a single manufacturing or assembly plant, management’s awareness of dangerous interdependencies has risen sharply. The importance of adequate insurance against the consequences of business interference after property damage elsewhere than on the insured’s premises is growing fast, triggered by rapid technological and organisational changes. Therefore, it is essential for under-writers to pay strict attention to the assessment of contingent business inter-ruption exposure and to apply technical underwriting of the risk. 1.1 Suppliers’ and customers’ extensions Insurance for business interruption at the insured’s premises caused by mate-rial damage at the premises of a supplying company or customer is neither new nor “exotic”. In fact, almost every business–be it large or small–depends on raw material, semi-finished and finished products from outside sources and on customers to whom its goods and services are sold. In the motor trade, for instance, dependencies on certain sole producers of critical parts and components triggered the development of suppliers’ extension from the first half of the last century. Terms and conditions of the extension, as well as terminology, vary greatly from country to country. They may even differ according to the insured’s trade and occupation. Further, they are influenced heavily by diverse underlying BI systems, the US versus the UK system, for example. The purpose of CBI insurance (suppliers’ and customers’ extensions) US To pay for the insured’s actual loss of busi-ness income arising from the necessary suspension of his operations during the period of restoration and extra expenses ... UK and elsewhere To indemnify the insured for loss of gross profits arising from reduced turnover and higher working costs during the indemnity period ... ... as a result of an insured event (material damage at outside premises which the insured does not own, operate or control). 6 Swiss Re: Contingent business interruption and other special covers It is neither possible nor necessary to outline the existing differences in terms, variations in conditions and terminology. Technical literature describes the systems relevant to their particular markets. However, where it may prove helpful, differences are referred to in the relevant chapters. The principal elements of contingent business interruption are the same all over the world, and this publication addresses the main underwriting features. In difficult market periods, underwriters run the risk of overlooking some of these characteristics. 1.2 CBI – an underestimated risk Industry and commerce today are facing fierce competition, extreme cost con-sciousness and smaller margins. Raw material is transported in the most rapid, rather than the safest way, industrial robots are working at full or over their full capacity in serial production, semi-finished products and finished components are delivered only minutes before they are assembled. Duplication processes, back-up for critical elements and buffer stock to ease the effect of an incident Suppliers’ bottlenecks: Figure A There are basically two methods for estimat-ing a production outage. When only very little is known about a given production process, it is necessary to fall back on a “black box” model. In this example, the paint shop of an automo-tive assembly plant is gutted by fire, with the result that the subsequent steps–assembly and finish, for example–can no longer be executed. In fact, the preceding steps cannot be carried out either,and the entire operation is brought to a standstill. As a result, the purchaser–a sales organisation–sustains a contingent loss. The black box view: no matter which process segment is affected, the entire plant is forced to close. If information is scarce, any estimate regarding the loss probability and resulting business interruption period will only be very rough–if at all possible. 7 Swiss Re: Contingent business interruption and other special covers have been abandoned and certain businesses depend on single-source supply to a dangerous degree. In short: in a modern, complex supply chain, redundan-cies are reduced and vulnerabilities greatly increased. How have business interruption insurers responded to this increasingly challenging environment within the last ten years? In many cases, they have not! 1.3 Underwriting aspects The main underwriting features for the extension of business interruption insurance to suppliers or customers can be categorised as follows: risk quality of supplier and/or customer; insured’s degree of dependency; insurance terms and conditions; accumulation and reinsurance aspects. Risk quality of suppliers and/or customers Whether directly or indirectly, everyone in a supply chain is interdependent; the main problem for the insureds’ business is that both the performance and safety measures of suppliers and customers are beyond their control. There-fore, delivery of vital material, parts and components cannot be safeguarded. Modern industrial concepts such as “extended enterprise” may mitigate the problem some, since close cooperation fosters better knowledge and under-standing of what transpires in the chain. Conversely, close cooperation may mean that products are developed and designed jointly. In case of an incident, replacement may become an even greater problem. Surprisingly, underwriting features–such as suppliers’ and customers’ situa-tions, the condition and locations, working processes, material, machinery and equipment, as well as protection and prevention measures–seem to have been of little concern to business interruption insurers in the recent past. But the revival of technical underwriting in the current market has seen a thorough risk analysis of key suppliers and customers once again become a standard, if not indispensable part of the job. We strongly suggest that, without exception, suppliers’ and customers’ risk quality be checked, the key elements of such an examination being: address and situation of premises; exposure of locations to fire, explosion and natural perils; exposure of locations to socio-political perils (if insured); structural and technical fire and explosion protection; organisational protection (eg intervention, emergency planning, staff resources); machinery, equipment, state of technology; work processes, storage, critical components and materials; neighbourhood; and key suppliers’ and customers’ own dependencies. New production methods and impact on risks Just-in-time production, outsourcing, single-source supply, the discontinuation of buffer storage and other “lean production methods” all have the effect of reducing safety margins. They also increase vulnerabilities and depend-encies in almost all industries and commercial enterprises. Underwriters with in-depth knowledge of these elements will better under-stand the vulnerabilities to material damage and be able to locate the “Achilles heel” of suppliers and customers. Degree of insured’s dependency Suppliers’ and customers’ extensions can only be granted to those business organisations – be they manufacturers, assemblers or distributors – which are aware of the effects of material damage to their suppliers’ or customers’ premises. While incidents at outside premises would invariably be beyond their immediate control, they – and their insurers! – should be able to assess the impact on their own operations. 8 Swiss Re: Contingent business interruption and other special covers Suppliers’ bottlenecks: Figure B A more sophisticated approach can be taken if more information is available about the plant. For example, in the automotive production process, the paint shop is a bottleneck because there is no redundancy within the plant, and every car body must go through this stage. Moreover, since the finish coat contains sol-vents, there is the possibility of an explosion and fire occurring at this vital point. This type of information facilitates the evalua-tion of organisational, technical and construc-tion-related fire-prevention measures, and conclusions as to what can happen if there is an “incident” in the paint shop. Estimates regarding property damage and the business interruption period will thus be considerably more accurate. 9 Swiss Re: Contingent business interruption and other special covers Such an analysis embraces the following: probability and duration of an insured loss; quantifiable effect on own business operations; loss mitigation possibilities (eg Can critical parts, equipment, components be ordered elsewhere? What is the time element under normal conditions and in the worst case to resume normal supply or to find alternative customers?); and extra expenses for the above measures. The insured’s business recovery plans should include: a general response concept in respect of supply shortage and delivery impediments; impact mitigation management (eg buffer storage of critical components, alternative outlets); resources planning for critical situations; image management (because of additional increase in cost of working!); adequate insurance programmes. Any incident at premises outside the insured’s control can become a crisis and any crisis may provoke a disaster. The underwriter’s duty is to determine whether or not the insured has taken all measures to minimise the “ripple effect”. Some principles affecting the extension Underwriters would do well to consider the following: Material damage proviso (UK system) One must understand that this clause does not apply to CBI extensions. Among other things, it cannot be automatically assumed that the cause of the loss is accepted by the material damage insurer. Without the suppliers’ or cus-tomers’ consent, it may even be difficult to find out the exact cause of the loss. Therefore, insurers do well to envisage an additional claims condition in order to expand the insureds’ actions in obtaining the required particulars. However, the non-appliance of the proviso mentioned above should not be misunderstood. The CBI extension is governed by the underlying business interruption cover which must be in respect of material damage. The effect of the extension is only to add certain premises over which the insured has no direct influence and not to expand the character of the cover–for example by the inclusion of non-physical loss or damage. Difference in perils Another effect of the missing material damage proviso for premises outside the insured’s control may be that extra perils are added to the extension. However, if suppliers’ or customers’ premises are heavily exposed to natural perils (eg flood) and if such perils are added, these considerations must, of course, be reflected in the rating. For the sake of better transparency, it is far preferable to keep insured perils identical. 10 Swiss Re: Contingent business interruption and other special covers Schematic representation of the insured’s external dependencies Many organisations are linked up with the insured company, creating dependency cas-cades across many levels including suppliers and their suppliers, customers and their suppli-ers, power suppliers and communications services, and even operations that are not contracturally linked up with the insured, eg leader locations. 11 Swiss Re: Contingent business interruption and other special covers Insurance terms and conditions Further to be considered are: Rating CBI risks are often underrated or even “tend to be forgotten” in the rating process. However, in order to technically rate the risk, the following simple, yet effective approach, should be considered: Parameters The basis is each supplier’s/customer’s material damage rate (within the relevant locations). This indicates best how often a CBI loss may occur at the insured’s premises. In other words: it reflects the probability. Once the probability has been determined, the likelihood of a CBI loss, ie the vulnerability, must be assessed. This is no easy task, as the relevant factor is not automatically available. Roughly, the factor can be expressed as the supplier’s/customer’s theoretical “BI loading” in respect of the item(s) upon which the insured depends. The underwriter may improvise by esti-mating the adjustment factor–which should correct the underlying material damage rate–to achieve this artificial loss of profits rate. There may be a mitigation factor for redundancies and recuperation possibilities on the suppliers’/customers’ and on the insured’s side. This factor mainly depends on satisfactory results of supply chain audits and impact analyses. The degree of dependency is represented by the percentage of estimated gross profits chosen for each and every supplier/customer, ie the corre-sponding limits. Finally, credits may apply for deductible, waiting period and–in exceptional cases–for loss limits which do not meet the full exposure. Expressed as a formula, the above reads as: Net CBI premium = MD rate ? vulnerability adjustment ? mitigation factor ? degree of dependency ? BI TSI – (corrections for deductible + loss limit) Example: Net MD rate 0.5‰ Vulnerability factor 1.8 ie artificial BI rate for relevant item(s) = 0.9‰ Mitigation factor 0.7 BI sum Insured 50 million Degree of dependency 30% ie 15 million Loss limit 10 million credit, say, of 5% Deductible 2 million credit, say, of 20% Net CBI premium = 0.5‰ ? 1.8 ? 0.7 ? 0.3 ? 50 m ? 0.75 = 7 086 The resulting net premium must be loaded for cost and expenses as required. Limits It is best practice to calculate the percentage of the insured’s dependancy as precisely as possible for each and every named supplier and customer. The results of these estimates should be indicated either as a percentage of gross profits or as monetary limits. In view of the accumulation risk, underwriters should not tolerate any deviation from this practice. Deductibles and waiting periods Similarly, what might be considered “alibi” deductibles are no longer admissible. Production techniques that are geared to minimum costs and maximum output have made large companies increasingly vulnerable to supply-chain disruption. What is worse, there seems to be little room left for buffer stock. This means that business interruption following a supplier’s failure to deliver immediately is part of an entrepreneurial risk taken willingly and consciously, which, as such, should not be insured. Hence, underwriters must insist on meaningful monetary or time deductibles. 12 Swiss Re: Contingent business interruption and other special covers 13 Swiss Re: Contingent business interruption and other special covers Further conditions and extensions Named suppliers of suppliers (and the like) Although this type of extension may be perfectly legitimate for certain business classes, such as chemical and semiconductor industries and motor trade, under-writers should stay reserved. The cover can only be granted exceptionally and for specific reasons; it takes risk carriers another step back in the supply chain, thereby reducing transparency and creating almost uncontrollable accumula-tions. Technically, a simple amendment of the ordinary (named!) suppliers’ extension clause will do the trick: the named suppliers’ suppliers and the exact premises are added beneath the direct suppliers. If this type of risk is underwritten, the following principles apply:
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