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Quantifying the exposures of global interdependencies.

James H. Costner, CPCU, ARM, is senior vice president of national accounts services for Corroon & Black Corp. Teresa L. Pahl, CPCU, ARM, is vice president of Corroon & Black International's central region.

Business interruption exposures are generally the most misunderstood and underestimated component of risk analysis. For many firms, such exposures have grown significantly as global business operations have become more interdependent. Indeed, subsidiaries, without being fully aware of the consequences, have become dependent on each other for product completion or distribution.

Fortune 500 companies were the first to take advantage of international operations. Their reasons for doing so are obvious. Differences in labor costs and the availability of advanced communications technology made a globalized approach to manufacturing operations not only viable but cost-effective. Today, as the cost of embarking on such a strategy becomes more affordable to midsize firms, the movement continues to accelerate.

However, this strategy has not been pursued exclusively by U.S. companies. The recent dollar devaluation and the attractiveness of the United States as a safe haven for investment has led foreign firms to make similar moves. That has occurred chiefly in industries where labor costs have not deterred such a strategy and in which trade pressures did not demand a quid pro quo approach to remain in the good graces of the U.S. business community. As a result, managing business interruption exposures has become complicated, especially due to the interdependency between the parent organization and its foreign subsidiaries-a relationship not unlike that of a key supplier or customer. The risk manager's challenge, therefore, is to accurately quantify the potential exposure and then treat it accordingly.

Business interruption insurance has been defined in various ways. Succinctly stated, it is insurance designed to do for the insured, if the interruption is caused by an insured peril, just what the business would have done if no interruption had occurred. Its loss is measured by the impact on production and the length of time required to resume operations.

Categorizing the Losses

There are four basic types of business interruption losses. One is loss of net profit when a firm is shut down following property loss. This is calculated as the decrease in net income after taxes. An expense that would not have been incurred if the firm had been operating as usual can also be categorized as an interruption loss. Such losses include the cost of re-establishing the firm's links with clients or preventing a cessation of operations.

Likewise, financial loss from expenses that must continue is also a business interruption loss. These potential losses include salaries, utility costs and debt payment. Finally, business interruption exposures can arise from damage to or destruction of third-party property, known as contingent business interruption.

Normally, business interruption coverage insures against reduced or interrupted profits and normal operating expenses that must continue when the loss stems from an insured peril to physical assets. These policies cover loss of net profit and both types of financial losses. Conversely, contingent business interruption insurance is purchased under specialized forms that address the exposures of contributing or recipient locations.

Interdependency exposure is closely related to contingent business interruption. However, there seems to be a widespread misunderstanding that firms purchasing contingent insurance are protected against lost revenue from direct damage loss at a foreign subsidiary. This is not the intent of contingent insurance, which is designed to protect against net income losses resulting from direct physical loss at a non-owned supplier or key customer.

Risk managers must treat foreign interdependency situations separately in terms of limits and conditions. To accomplish this, they must identify those processes and/or plants that could cause a significant loss because of interdependency. This involves understanding the impact points in the production process and the internal relationships between the parent firm and the subsidiaries.

Interdependency business interruption losses are typically covered on the basis of impact to the profit and loss statement of the entire corporation, not just to the particular location suffering the physical damage and/or time loss. The method to identify these exposures is not much different from the one used in any net income exposure analysis. The financial statements of the subsidiaries must be reviewed to quickly identify and quantify relationships. The risk manager must then create flowcharts and diagrams that emphasize how material flows through subsidiaries. Visiting these facilities, interviewing key personnel there and consulting with external experts are also used to assess whether an interdependency situation exists and to what extent it must be treated.

Establishing a Transfer Price

Critical to assessing interdependency exposures is an understanding of the relationship between U.S. firms and foreign subsidiaries. How firms account for costs associated with the transfer of product or material must be understood, because it is the key to quantifying the value of the subsidiary's contribution to the firm's overall revenue. For example, if a foreign subsidiary supplies raw material below current market price, the dollar value of a possible loss at the subsidiary's location resulting in lack of supply should be assessed at current market price, or as a function of the dollar value placed on the competitive advantage realized as a consequence of lower production costs.

For example, consider a firm that operates eight light production facilities in the United States; six of these facilities manufacture a finished product, the other two finish component parts. Yet there are also three foreign subsidiaries, in the Far East, Mexico and the United Kingdom, that supply specialized components to the six U.S. facilities for finishing. If there is a loss in any of the five facilities responsible for components, there will be production problems resulting in interruption of the firm's revenue.

A loss prevention program should aim to supply component parts if any of the component manufacturing plants suffer a direct property damage loss. To convince the company's financial officers, the risk manager must quantify the contribution margin provided by the component plants. This involves establishing a transfer price that can be used to place a dollar value on the product or material being supplied. The transfer price is then rolled into the total revenue calculation to determine the contribution margin of the subsidiary.

Because the firm must quantify the relationship between the parent and subsidiary, the contribution margin helps by showing the actual dollar value placed on the competitive advantage that the parent company realizes as a result of vertical integration. This is done by looking at the subsidiary as if it were selling, at market value, components to the firm. The actual dollar loss associated with interdependency is a function of impact on production, the time needed to bring the damaged facility back on line and the reduction in the subsidiary's revenues from being unable to extract a transfer price from the parent. This is the ultimate loss amount due to the parent's inability to realize the financial benefits of vertical integration.

True market values are then established, and the interdependency exposure is quantified regarding financial impact. Therefore, the risk manager should assess the exposure from the standpoint that contribution margin is not gross earnings. Insurers use gross earnings to compute the business interruption premium. Interruption coverage provides that, in the event of loss, the insured should recover gross earnings less costs that do not continue following a loss. This does not cover additional costs the company incurs due to the decrease in contribution margin of the subsidiary from a transfer price perspective. It only covers gross earnings. Subsidiaries can often operate in the red but, due to the supplier relationship, can also make a positive contribution margin to the parent's financial statement. The impact on that part of the operation is what then needs to be assessed.

It is also useful to apply this method of exposure analysis when reviewing interdependency from the standpoint of the subsidiary depending on delivery of a product for distribution and/or sale. The transfer price is similarly determined as a function of a key customer relationship as opposed to that of a key supplier.

Product Design

If the risk manager wants to treat the exposure with insurance, some unique product design approaches for interdependency can be employed. One is blanket business interruption insurance, which covers the interdependency exposure at all locations scheduled in the policy. Overseas locations in countries requiring admitted insurance can be scheduled in the master policy for the business interruption interdependency exposure. If more than one policy covers the same physical assets, make sure the definitions of property covered, business interruption loss and period of indemnity are concurrent.

Sometimes the proceeds of business interruption insurance are taxed differently than operating profits. The policies covering interdependencies should be endorsed so the insured is made whole if tax differentials exist. Similarly, in some countries, including the United States, the insured can incur a penalty on its future unemployment insurance premiums if it is forced to lay off employees during an interruption period. The penalty amount is not covered, but can be if the appropriate language is inserted into the contract or policy. Likewise, the cost of professional services incurred to prepare a proof of loss for a business interruption claim is usually not included in the definition of a business interruption loss, but can be if drafted into the contract language.

Once these steps have been taken, deciding how to treat the exposure becomes easier and will yield more accurate results. A careful, accurate and comprehensive examination of interdependency relationships and their financial impact within the company enables risk managers to treat the exposure with confidence, knowing that the conclusions reached are quantifiable and realistic.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:business interruption
Author:Costner, James H.; Pahl, Teresa L.
Publication:Risk Management
Date:Apr 1, 1991
Previous Article:Estimating loss reserves using an actuarial report.
Next Article:Developing what it takes to handle casualty claims.

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