Avoiding Your Medical Device Tsunami: Managing Supply Chain Risks

Mother Nature seems to be on a rampage, exhibiting quirky and extreme weather patterns. Globalization, outsourcing and the use of far-flung networks of suppliers and customers put medical device manufacturers at risk of business interruption, even if they do not feel Mother Nature’s wrath firsthand. Ice storms, tsunamis, tornados or hurricanes elsewhere on the globe can shake the financial foundations of device firms that physically are far removed from the events. The risk of business interruption due to the shutdown of a key customer or supplier is a contingent business interruption, also known in insurance circles as CBI. Insurance is available to address these risks.

In managing the problem, a key first issue to crystallize is the extent of your contingent business interruption risk. This can be crucial for mitigating supply chain interruptions. Contingent business interruption coverage reimburses you, not when you sustain direct physical loss to your property, but rather when a direct physical hit wallops a customer or supplier’s property and thereby interrupts your business. It reflects the modern reality that continuation of your business often depends on the reliability of key suppliers and customers.

Assume ABC Medical in Ohio offshores parts manufacturing or imports a key component from a factory in China’s Hunan province. The region suffers an earthquake or other natural calamity. Due to shutdown of the Chinese supplier, ABC cannot fill customer orders. Inventory shrinks. Faced with unfilled orders, ABC loses sales and market share.

Consider another scenario. XYZ Endoscopy depends heavily on a major customer for its sales. In fact, 75 percent of its business comes from one customer, which is located on the Gulf of Mexico. After a hurricane, the customer’s operation is crippled for months and it cannot fulfill further orders from XYZ, which is 1,500 miles away and insulated from the storm. XYZ faces possible insolvency if it cannot cushion the financial blow.

Many firms and managers may have business interruption insurance. This pays when an insured peril such as a fire or windstorm physically damages your property to the point where you cannot conduct business or do so normally. However, many companies are unaware of contingent business interruption insurance, overlooking its critical role in managing supply chain risks.

Comparison Shopping Pays
One factor shaping the decision to buy coverage may be the cost of the insurance. As in any other area of insurance protection, it pays to shop around from one insurance company to another. Weigh the price, but realize that contingent business interruption coverage is not a commodity where you are comparing apples to apples. Policies may vary wildly from company to company. Some insurers write contingent business interruption policies on a manuscript basis. This means that insurers do not use a “stock” template for the insurance policy. Instead, different insurers will have different policy wordings to govern what it does and does not cover.

Moral: Read closely (perhaps aided by your insurance agent or broker) each company’s wording to do a side-by-side comparison. Carefully read the different policy forms issued by different insurance companies, because there may be significant differences and nuances, the full effects of which only become apparent after a loss.

Admittedly, analyzing an insurance policy is as exciting as reading minutes of the Federal Reserve Board and nearly as tedious. Seek help from your insurance agent or broker to undertake a side-by-side comparison of different insurance products offered by different insurance companies offering contingent business interruption coverage.

Moral: Build in considerable lead-time in the process since reviewing, analyzing and comparing different policies is time-consuming. The more lead-time—the earlier you start before you need coverage—the better chance of making sound decisions about the policy that meets your needs and blends the best of price and features.

Key Points to Review
A loss triggers CBI coverage if three conditions are met: (a) direct physical loss to a “dependent property” (i.e., a supplier or customer), (b) loss or damage due to a covered cause of loss, and (c) loss that causes suspended operations at a covered location (e.g., your manufacturing plants). Some of the key points that will determine coverage under contingent business interruption include:

• Was the company that had a loss a customer or supplier? (If not, coverage may not apply.)
• Does the contingent business interruption policy define customer? (If not, that may be a plus. If the policy defines customer, read the definition closely.)
• Are there any sub-limits on coverage for contingent business interruption? (A sub-limit is a separate financial maximum the insurer will pay for a defined type of loss covered by the policy. For example, your home may be insured for $250,000, but your homeowners policy may have a special sub-limit on jewelry theft of, say, $5,000. The $5,000 is an example of a sublimit.)
• Would the loss be covered if the same event occurred at your location? For example, if the supplier’s or customer’s facilities are inoperable due to, say, an earthquake or tsunami, no coverage might apply unless you are insured for earthquake or tsunami at your location. Moral: Contingent business interruption coverage does not protect from all losses. Read the fine print to understand just what you are buying.

Risk Management Approach
One key takeaway: Diversify your supply chain before disaster strikes. Develop alternative suppliers and sources. Companies may have only a fuzzy idea as to the identity of their suppliers. Inventory and regularly update information on all suppliers. Further, developing networks of suppliers in a dispersed geographic area—not concentrating them in one locale—is sound supply chain risk management. Make contingency plans. Dig your well before you are thirsty.

Work closely with your insurance agent or broker to address your vulnerability to supply chain interruptions and to boost your preparedness. Scan the insurance marketplace for companies that write contingent business interruption coverage. Compare policy forms side by side. Exploit the negotiating heft of your insurance broker to negotiate the best deal. This especially is helpful if your broker brings a sizable volume of business—not just yours—to an insurance company or enjoys a “preferred” status with the insurer.

Much of the decision about whether or not to buy this coverage hinges on management’s philosophy about risk and its risk tolerance. How much does it value peace of mind? As in other realms, tradeoffs exist between what a company wants and what it can afford. To foreclose all risk, a device company might not have funds available for other vital purposes. At the other extreme, companies seeking cost savings by cutting their insurance budget could be crippled in the event of an unanticipated natural disaster somewhere else on the globe, a disaster which not only hampers a key supplier or client, but which has a domino effect on the policyholder.

Increasing outsourcing in medical product manufacturing, combined with globalization and aberrant weather patterns create a potent recipe for contingent business interruption. Don’t get caught. Safeguard your business by considering the risk, working with an insurance broker and considering insurance and non-insurance tactics to address the problem. Device companies that often make life-saving technologies for others can view this as a way to safeguard their own corporate life-support systems. 

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Kevin Quinley, CPCU, is principal of Quinley Risk Associates, a risk management consulting firm in the Richmond, Va., area. He has more than 25 years of risk management experience with medical device companies. You can reach him at www.kevinquinley.com or at [email protected]. 

Ten Tips for Managing Contingent Business Interruption Risk Manage contingent business interruption (CBI) risks by strengthening your supply chain. For starters, medical device firms preparing for a rebound should know their supply chain. Here are ten tactics: Identify in advance all key suppliers to your production facilities and supply chain. From your production facilities, identify the raw materials, utilities and components on which those facilities depend. Inventory the locations of your suppliers’ suppliers. Ask the insurer to expand the scope of coverage by endorsing the policy to include “unnamed” customers or suppliers. (An endorsement is an addition to the policy that changes to “usual” coverage and customizes it to your needs.) Make advance arrangements with “contingency suppliers.” Choose your deductible carefully. CBI coverage also will be subject to a deductible. Make sure it is an amount that you can tolerate. Of course, the higher the deductible you can live with, the lower your premium. Closely review the policy’s “period of restoration.” This is the time period considered by the insurer (not you and not the supplier) to be the reasonable amount of time needed for the dependent property to fix its damage and resume normal operations. Determine how long your business could survive if one or more of your suppliers suffered a temporary production stoppage. Line up alternative suppliers just in case, in advance of a loss. Start shopping for the coverage well in advance of the date you need it.