Japan’s Ripple Effect

Japan experienced its largest earthquake in history on Mar. 11, 2011, a Magnitude 9.0 quake  that occurred off the eastern coast of Honshu, Japan. The quake triggered a 1-in-1,000-year tsunami event responsible for wiping out entire cities and ports. The quake and tsunami, which have officially killed 12,000 people thus far, damaged several nuclear reactor facilities, heightening the risk of a potential nuclear crisis and radiation contamination.

Economic loss estimates hover around $300 billion dollars. Preliminary insured loss estimates are about 10% of the economic losses. The impact of this catastrophe on the global supply chain – and the insured losses associated with disruptions to that chain – remain uncertain.

The Catastrophe(s) in Japan: Effects on the Global Supply Chain

The media is filled with stories of breaks in the global supply chain arising from the March 11 events in Japan. For example, Apple’s newly launched iPad2 has two main components manufactured in the affected area of Japan. Japanese car manufacturers are already feeling the pinch, with parts supply being squeezed. And the seafood industry is left scrambling because of fears that fish from this area are no longer safe due to radiation. The list goes on. It’s hard to find an industry that is not affected.

“Japan is the third-largest economy in the world, and this event is all-encompassing in terms of disruption,” says Ken Levine, FM Global’s chief agent in Canada. “Not only was there physical damage to manufacturing facilities, there have been rolling blackouts, the safety and well-being of the population and the workforce is still not clear, and damage to the infrastructure needed to transport goods is quite significant. This will impact supply chains considerably in the months and years ahead.”

Experts compare the Honshu earthquake to two recent events of similar scale, Hurricane Katrina and 9/11.

“If I was to look to Katrina and 9/11, this is much broader in terms of the fact that Japan is the third-largest economy in the world, geographically it’s relatively small and the industrial activity is therefore much more concentrated,” says Levine. “Barring the catastrophic loss of human life in both Katrina and 9/11, Katrina was very local: it did not affect a large swath of American industry or commerce.

“9/11, likewise, was a very localized event. Although it affected the business environment primarily, we were able to work around that.

“Japan differs, in that it touches a wide swath of industry. It’s compounded by the fact that we have the trifecta of catastrophes, with the ongoing threat of nuclear contamination exacerbating the problem.”

Just as what happened in the example of Hurricane Katrina, in Japan there is a huge issue around re-mobilizing a workforce and getting plants that may not have sustained much damage up and running again.

“With Katrina you couldn’t get people in because they had to be inoculated initially,” says Bill Rowland, manager of XL’s cargo book of business. “They had to have the proper amount of water, food and gasoline. The wildcard in Japan is the radiation.”

Just how long will this event take to unfold, and how will it unfold? There is no clear-cut answer, experts say.

“The loss itself will continue to unfold in multiple waves, meaning you have had the initial panic; you had some very specific examples of folks in the automotive and technology industries that had issues with supply right away,” says Gary Lynch, Marsh’s supply chain risk practice leader. “In the second wave, as purchasers react or over-react, that in and of itself creates another challenge.”

During the panic phase, companies tried very quickly to repurpose products, use alternate materials, find new suppliers or coil in all of the stock sitting out in the channel at the time. Suppliers able to meet the demand may find themselves scrambling to meet a spike in demand, fuelled by new purchasers who had been relying on Japanese suppliers. This in turn, causes the supplier to increase its demand for materials upstream, setting off a ripple effect. Lynch calls this the ‘bullwhip effect.’

The Bullwhip Effect

“You look at your forecast for the amount of goods you’ll have to supply,” says Lynch. “As that forecast becomes inaccurate, the behaviours on the back end then tend to respond upstream. Suppliers are trying to prepare for their other suppliers’ requests. And they are trying to anticipate their suppliers’ requests. So it reverberates, and you have more of an oscillation as you look upstream.” He adds that due to the recession, many manufacturers are much leaner, running from 85% to 125% capacity. This amplifies the need to ramp up production to meet increased demand.

“The losses initially are going to be a challenge, but then the reaction and the way that we’ve altered our supply chains on the fly could potentially create another wave of exposure that may dwarf what we initially see,” Lynch says.

Avoiding this type of overreaction involves foresight and careful consideration prior to an event. Many companies study the direct links in their supply chains, but they need to conduct multi-tiered analyses, experts say.

Art Ferland, director of customized services for Zurich Global Corporate Canada, says the logistics of a supply chain has to be assessed to the point when an underwriter – or a risk manager managing the company’s supply – feels the company can do little more to make the situation better. Applying risk profiling to identify the need for risk management improvements or a risk transfer product when the exposure cannot be mitigated by the company can help to provide clarity.

The absence or short supply of big-ticket items is not the only thing that can cripple an organization. Ferland illustrates this by pointing to a hospital’s operation. “When we talk about a hospital’s key elements, many people think immediately of the MRI machines or the x-ray machines,” he says. “But think about latex gloves: Those five-cent gloves are crucial to conducting surgeries and medical procedures. But if the single supplier disappears, then the hospital can’t function. A small item inconsequential to the overall cost of the finished product can cause a shut-down.”

The growing popularity of just-in-time production has compounded these risks, he adds. “It’s always important not to put all of your eggs into one basket,” says Rowland. “It’s important to constantly re-check and review how your logistics chain is set up and to find new options. Something might be more expensive when sourced from a different area, but it might be worthwhile to go that route to ensure that your customers are supplied.”

He points to one of his clients, an auto manufacturer, who recently pushed to make sure a significant number of its parts can be used in various models. Therefore, if something happens, they can shift quickly to a different supplier.

“Most of the organizations’ products, about 70 to 80%, are supported by external supply chains,” says Lynch. “When we map our supply chains, we usually look back one tier, But behind that [tier] are hundreds, if not thousands, [of other tiers] contributing to the delivery of that value. But for some reason, we lock in on that first tier and assume everything will be all right if it’s not directly affected. We don’t live in that world anymore. The infrastructure and source of materials needs to be factored in to risk management strategies.”

Available Insurance Coverage

If a Canadian company has experienced a break in its supply chain because one of its suppliers relied on a Japanese organization that can no longer deliver, what kind of insurance coverage is available?

Most likely the company can recover losses under contingent business interruption or contingent loss, said Henry Daar, executive vice president with Aon’s Risk Solutions Property Practice, during a Webinar.

“If you have a supplier that can no longer supply or meet your demand, you’ll have to find a new supplier,” he said. “If you had been paying the Japanese supplier $2 for each component, and your new supplier charges $3, that extra cost of $1 may well be recovered as a contingent extra expense. Extra expenses are those incurred to keep your business running as normally as possible. Even if you had to send an employee to South Korea to investigate a new supplier, but didn’t choose that supplier, you can likely still recover the cost of the trip.”

Typically, business interruption loss is covered only if direct physical damage is done to an insured property, Ferland says. But Zurich recently launched an all risk coverage for named suppliers that is triggered by all physical and non-physical occurences. This differs from coverage for trade disruption, because trade disruption requires named perils for un-named suppliers.

Nuclear contamination adds an extra wrinkle, though, since it is generally carved out of coverage. “If nuclear contamination is the sole reason that a customer can’t receive your goods, then it may be no coverage exists,” said Daar. “However, and this is a big ‘however,’ just because a nuclear loss is an occurrence later in the chain of events, the nuclear exclusion might not totally override the extra expenses and income losses that result from otherwise covered events. It’s going to be a fact-by-fact determination on the nuclear exclusion.”

One thing is clear: events like the Mar. 11 trifecta of disasters tend to spur a surge in demand for these types of coverages. But the impact on the global market remains unclear. Sources predict a hardening in catastrophe exposures and an uptick in demand for contingent loss and interruption coverages.

“We believe this will be a market-changing event,” says Levine. “On the strength of its magnitude, coming on the heels of the New Zealand earthquake and Australian floods, we can expect companies that had their balance sheets affected will be doing something more deliberate in terms of capacity and pricing.”