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Exposures facing the electronics industry.

Today, electonics companies must compete in an increasingly dynamic and global industry where business interruptions and insurance coverage gaps could prove fatal, said Thomas Cornwell, vice president and electronics manager at Chubb & Son Inc. in Warren, New Jersey. "In this ever-changing and increasingly global industry, risk managers must ensure that they have adequate insurance coverage," he said at a recent College of Insurance seminar on the electronics and information technology industry. "However, many of these risks are not covered by general liability policies and must be augmented by errors and omissions (E&O) coverage."

The electronics industry is one of the most significant sectors of the U.S. economy, said John F. Mancini, senior vice president of the American Electronics Association, based in Washington, D.C. "Electronics is nearly a $1 trillion industry worldwide and accounts for nearly 2.3 million U.S. jobs," he said. Although the electronics industry has traditionally been associated with appliances such as televisions and radios, the industry today is highly diversified and consists of the hardware and software, telecommunications and industrial electronics sectors.

Yet with this diversification comes a host of risk management challenges, said Mr. Cornwell. For example, business interruption exposures remain a vexing problem for the industry. "The manufacturing processes in many segments of this industry involve very complex equipment and procedures," he said.

For example, circuit manufacturing requires the use of sophisticated equipment such as diffusion furnaces and ion implanters, as well as extremely toxic chemicals. "Besides its complexity, this equipment is not cheap," said Mr. Cornwell. "Per square foot, the value of the actual manufacturing area in one of these plants can be in excess of $5,000." Although major exposures include explosions and toxic releases, even a small equipment failure can lead to a significant business interruption loss. "The elaborate nature of these manufacturing facilities tends to increase the time it takes to get a line started again after a shutdown," said Mr. Cornwell.

To illustrate, Mr. Cornwell described "clean rooms," which are work spaces free of contamination from dust particles. Noting that these rooms have different rankings depending on the number of particles in the atmosphere, he explained that the clean rooms used in computer chip manufacturing-or wafer fabrication - are among the most sanitary. "For example, a hospital room is ordinarily a 10,000 clean room, which means that the room contains 10,000 particles of one micron or larger," he said. "However, a typical wafer fabrication manufacturer has anywhere from 100 to 1 of these particles in their clean rooms. So when one of these rooms goes down, it is impossible to clean it up and get it running again in a very short time."

Resuming Operations

For electronics firms, quickly resuming operations after a business interruption is critical, especially now that computer systems have open architecture. "With open architecture, the various components of a computer system are interchangeable, so a customer can easily switch to another vendor if its main supplier goes down," he said. This problem is exacerbated by the fact that many electronics firms utilize just-in-time (.lIT) manufacturing, which means that the company manufactures product to fill orders, and stores little finished merchandise or raw materials on-site. "The JIT process requires companies to maintain a well-run operation in which a shutdown or shipment delay can create big problems," he said. "And although electronics companies can use alternate facilities or farm out certain manufacturing tasks to board assembly operations, many of these firms also use JIT manufacturing," he said.

Besides circuit manufacturers and wafer fabrication operations, software firms also face a danger from business interruptions, said Mr. Cornwell. "Software developers are basically offices with a large number of interconnected PCs," he said. "They face a potentially big exposure in cases where the communication link between the individual PCs and the host system is severed." Since many of these firms rely extensively on customer service, a disruption to the telephone system could stymie service and reduce revenues, he added.

Because of these exposures, risk managers must ensure that they have an insurance program that will adequately cover a business interruption, said Mr. Cornwell. However, creating a seamless business interruption program can be challenging. "For example, an electronics firm may have an assembly plant in Massachusetts and another operation in Mexico," he said. "Since these operations are interdependent and the output at each facility fluctuates, it is impossible to determine how much business interruption coverage is needed for each facility."

In regard to basic business interruption coverage, "an extended period of indemnity is a must for a wafer fabrication or assembly operation, requiring a minimum of three months of coverage," said Mr. Cornwell. "Contingent business interruption coverage is also important, because if a company's supplier goes down, there could be a big business loss, especially if the company operates in JIT." Lost shipments can also trigger an income loss, and therefore should be addressed by a transit business income policy, he added.

Errors and Omissions

Risk managers must also supplement their general liability policies with E&O coverage, said Mr. Cornwell, noting that standard general liability policies are really designed for machine age industries and not for hi-tech companies. "Traditional general liability policies cover only property or bodily damage, but computers and semiconductors seldom cause property damage or bodily injuries," he said. "Instead, losses associated with theft use typically arise from the nonperformance of a component, product or software system." Therefore, in the case of a product performance failure, the general liability program will not respond. "In these cases, an E&O policy is needed, since it covers claims caused by a product's failure to perform.

E&O policies also cover losses due to nonperformance of contract. To illustrate, Mr. Cornwell gave the example of a software manufacturer that sold a software system to another firm with the contractual stipulation that the product would enable the company to perform certain accounting and inventory functions. When the product did not perform as promised, the company sued the software manufacturer for breach of contract. "Therefore, it's important to have an E&O policy for cases such as this where there is nonperformance of contract," he said. "In fact, between 80 to 85 percent of our E&O cases are for contract failures."

Also, whereas a general liability policy provides coverage only for the loss of tangible property, E&O insurance covers intangible property, said Mr. Cornwell. "For example, imagine a software firm that, while upgrading a client's system, accidentally erases $1 million worth of the client's data," he said. "If the company sues, an E&O policy would provide coverage because the lost data is intangible property."

Risk managers should also determine if their policies limit coverage to consequential damages, said Mr. Cornwell. "Some policies contain exclusions precluding the cost of goods or services supplied from any damage payment," he said. For example, imagine that an electronics manufacturer owes damages of $1.5 million to a plaintiff company, $1 million for consequential damages and the other $500,000 for the cost the plaintiff paid for the faulty system. "If only consequential damages are covered, the insurer would pay only the $1 million, leaving the manufacturer with the $500,000 loss," he said.

Mr. Cornwell added that although virtually all computer systems and software companies put limitations and exclusions in their product contracts, risk managers must be aware that many courts have declared such limitations null and void. "A manufacturer may have an exclusion of consequential damages or a disclaimer in their product contract, but the courts will not always accept them," he said. "And today, electronics firms are being sued not only for breach of contract, but also for fraud and negligent misrepresentation."

As for the future, the movement toward applying strict liability represents a particularly disturbing litigation trend for the industry, said Mr. Cornwell. As society becomes more dependent on computers, customers will expect

electronics products to be completely foolproof, he explained. "This is a very scary thought for insurers and risk managers, because there's no such thing as fault-tolerant systems or software," he said. "It's possible that at some time in the future all disclaimers, consequential damages and limitations in product contracts will be overwritten."

Mr. Cornwell said that the industry has also seen an increase in copyright and patent infringements suits. "Customers have demanded products that can be integrated with or migrated to other systems," he said. "These products, which are known as derivatives, have led to enormous numbers of copyright and patent suits, which are frightfully expensive to litigate." Since derivative products are growing in popularity, copyright and patent suits will continue to be a great concern for the industry, he concluded.
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Title Annotation:risk exposures
Author:Christine, Brian
Publication:Risk Management
Date:Jul 1, 1993
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