Breaking the Chain

Article, Post MagazineApril 2009

Insurance / Property

The assumption that loss of production will translate into loss of sales my be incorrect, especially in light of excess capacity created by tough economic conditions, as Justin Crick explains.

Over recent history the trend to globalisation has led to the consolidation of previously national businesses into multinational groups. This has been particularly prevalent in the heavy industry sectors. This consolidation has, in turn, led to increasingly complex group structures, many of which have plants located throughout the world. Frequently, despite the geographical dispersion of the extraction or processing, the finished products are marketed collectively by a single trading division.

Until mid-2008, while the global economy was booming and the credit crunch had yet to bite, demand significantly outstripped supply in many sectors, from the extraction and processing of minerals, to the sale of finished products. This was evidenced by increasing prices, full order books and ever increasing lead times.

Large-scale change

Where this was the case, in a loss situation, a loss of production would invariably be irrecoverable and would therefore translate directly into a loss of sales. Frequently, only a cursory review of this underlying assumption was undertaken, citing the commodity nature of the product, increasing sales prices and lead times.

However, from mid to late 2008 the global market changed significantly. Production cuts, profit downgrades and redundancies have been experienced by most businesses. However, commodity related sectors have been hit particularly hard. Throughout the steel industry, for example, from the mining of iron ore to the manufacture of cars, the picture is particularly gloomy.

The following examples, from publically available information, illustrate the downturn:

Mining

• Rio Tinto – Iron ore production decreased by 18% Q4 2008, compared with last year.
• BHP Billiton – Coking coal production for the second half of 2008 fell to as much as 15% below capacity.

Steel Manufacturers

• Corus (Tata Steel) cut production by 20% between October and December 2008 then extended the cuts to 30% for the six months to June 2009.
• ArcelorMittal cut output by 30% in Q4 2008 and is continuing its temporary production cuts in Q1 2009, until its inventory reduction process is complete.

Car manufacturers

• 61,404 new cars were produced in January 2009, 58.7% lower than last year.

Given the excess capacity, in these industries, the assumption that a loss of production will translate into a loss of sales may be incorrect. This is especially so if all sales are made through a group trading division. If an Insured has excess capacity, the production “loss” could be made-up, in whole or in part, as follows:

• following reinstatement, via overtime or weekend working
• at an undamaged group location
• through subcontracting
• through the use of stock

Whether or not this can be accounted for in the loss measurement may depend on the policy wording in place, which will require careful consideration, particularly in relation to the accumulated stocks clause.

A review of the levels of production before, during and after a loss, should determine whether it has been possible to make up the loss of production. However, this may not give the full picture in relation to whether a loss of production will translate into a permanent loss of sales.

It may be necessary to review the order book and ascertain whether the apparent shortfall has led to order cancellations. If cancelled orders are used to evidence a loss of sales, the cancellation needs to be linked directly to the incident, which in the current economic climate may be difficult.
Undertaking a review of key customers may highlight reduced sales levels to key customers and illustrate that sales levels may have reduced in any event, which again calls into question the assumption that production equals sales.

Impact on price 

If a permanent loss of production can be established, it is important to identify when the sale, but for the incident, would have been made. This assumes that the policy does not specify a price. In periods of rapidly changing prices this can have a material impact on the valuation of a loss. A detailed understanding of the production “pipeline” and the contractual arrangements in place between the manufacturer and the customer is important to accurately quantify the impact of this. The fact that the reduced supply could affect the price may also need consideration (see “A major blow” Post Magazine, 13 November 2008).

Increased costs of working 

Despite the apparent excess capacity in numerous industries, it is still possible for Insured’s to suffer Business Interruption losses. In some cases capacity has been “mothballed”, for the eventual upturn. In a loss situation, it may be possible to recommission some of this capacity to make up the shortfall. The cost incurred in doing this may be substantial and a detailed cost benefit review should be undertaken.

Alternatively, given the “excess” capacity, subcontracting part of the process to enable the sales to be maintained may be a viable option.

It is therefore possible that a substantial proportion of any production loss and consequent loss of profit could be mitigated, albeit at an additional cost.

Loss mitigation 

Despite the apparent excess capacity in the market, due to the current economic climate, businesses can still suffer business interruption losses, although it is likely that there is the opportunity to mitigate the loss. However, the economics of any mitigation requires careful consideration.

As a result of this apparent excess capacity, the assumption that a loss of production will translate into a permanent loss of sales needs careful consideration. In addition to the review of stock, production and sales, both before, during and after the interruption period, a detailed review of the Insured’s customers, contracts and order book is necessary to establish whether a permanent sales loss has been sustained.

 

As appeared in Post Magazine, April 2009.

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