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Charting Supply Chain Risk in China – It’s Worse Than in Japan

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When the earthquake and tsunami hit Japan in March, it was seen as a worst-case scenario.

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In some ways it was. It was the most costly disaster in human history, for example, and the economic toll has been estimated north of $200 billion. Likewise, the meltdown at the Fukushima Daiichi nuclear plant was among the scariest realities that nation could ever face.

The other context in which the catastrophe has been, almost undoubtedly, the worst ever is in terms of supply chain disruption. Toyota, for example, was forced to delay the launch of new wagon and minivan versions of its popular Prius hybrid line of automobiles. Other carmakers and electronic companies were also hard hit by an inability to get crucial parts.

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In hindsight, however, the disruption was not quite as bad as initially feared. Toronto’s Globe and Mail reported as much in June.

While there are shortages of vital parts for cars and electronics – including some computer chips, silicon wafers and batteries – the big surprise is that the March 11 natural disaster wasn’t more of a disaster for the complex and time-sensitive global supply chain.

The system is proving remarkably resilient – in part because Japan is far less connected to the global economy than many other advanced countries. That’s because Japanese manufacturers moved faster, and earlier than most, to lower-wage countries offshore, most notably to China.

The worst-case scenario envisioned after the Japanese disaster, including widespread and lengthy shutdowns of plants around the world, hasn’t happened.

There are two sides to this coin.

On the one hand, let’s all give a round of applause to those who helped make the system “remarkably resilient.” Indeed, later in that article, Garland Chow, a professor and supply chain expert from the University of British Columbia, added that “Ten years ago, this kind of disaster would have been twice as bad because they weren’t ready.”

Then again, if the Japan disruption wasn’t as bad as expected, will it serve as enough of a lesson that a lot of work still needs to be done in terms of improving supply chain resiliency? Will companies become complacent? Will they continue to diversify sourcing options enough to weather the storm equally well if a true worst-case crisis occurs?

A new report by Swiss Re may shed some light on that question.

“China and Natural Disaster – A Case for Business Resilience” offers a simple, concrete, unmistakeable reason why a disruption in China could be much, much more difficult to navigate than the March disaster in Japan.

I’m not a mathematician, but it seems that less than half of North American companies relied on Japanese manufacturers but nearly all of them rely on those in China. Fortunately, more are realizing the vulnerability they have there. In fairness, most of those surveyed by FM Global already were concerned about the disruption potential of a disaster in China. But a full 61% are now more concerned after seeing what happened in Japan.

The below graphic shows how they are reacting.

If you can’t read the mitigation strategies for natural hazard exposures in China listed in the chart below, click here to see a larger image. But the key takeaways come from the top three areas:

  • 70% are considering “increasing alternatives sourcing”
  • 65% are considering “increasing collaboration with suppliers on mitigating risk at their locations”
  • 61% are considering “implementing a more robust risk assessment process.”

“A natural disaster-related supply chain disruption in China would have far-reaching and long-lasting negative economic impact,” said Vinod Singhal, Brady Family Professor of Operations Management at the Georgia Institute of Technology’s College of Management. “It would slow down the global economy because China is not only a major exporter of goods, but also a major importer of goods. It would cause shortages in many consumer and industrial products that could lead to inflation and devastate the share price of companies.
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”

Fortunately, it seems like most companies do plan to improve their resiliency efforts in China. But there are still nearly a third of companies that aren’t. Hopefully, we will never have to find out if “good enough” is good enough.

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FM Global CEO Shivan Subramaniam — Like Everyone at RIMS 2011 — Discusses the Japan Earthquake

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The tragic earthquake and tsunami that devastated Japan in March has come up in virtually every conversation I’ve had at RIMS 2011 Vancouver. Whether we’re talking about the timing of the inevitable market turn or the new era of costly catastrophes or the growing concern over supply chain risks in an increasingly globalized world, the focus always drifts to Japan.

The only thing I’ve talked about more this week is how beautiful Vancouver is.

It’s no wonder considering this dual disaster will likely become the costliest in history. And as the globe rethinks nuclear safety, learns the engineering lessons of strict building codes and ponders the value of just-in-time manufacturing, I got the chance to sit down with FM Global CEO Shivan Subramaniam to discuss all the risk management implications.

We started out talking about the magnitude of both this event and the recent tornadoes that devastated the Southeast United States. On top of their grand scale, Subramaniam was somewhat puzzled by how quickly forecasters churned out their damage estimates.

“I don’t understand how people could come out of the box with some of those estimates that they did because you weren’t even allowed within 20 miles of the [Fukushima Daiichi power plant],” said Subramaniam. “And the transportation systems were not allowing you to go to some of the affected places. And thirdly, the defense forces were preventing you from easily driving in and out of those places. So how do you even make some of those estimates?”

More importantly, the talk turned to the radiation crisis emanating from the Fukishima Daiichi — something it was relieving to hear he believes might not turn out as badly as some have been prognosticating.

“It might turn out to be completely overplayed,” said Subramaniam. “What might actually turn out, which is the camp I’m in, is that people are going to start to recognize that the Japanese preparation and the way they’ve come at this is singularly better than virtually any other democratic country would have reacted to a disaster — especially a radiation disaster.”

Some people have said that Japanese officials seemed slow to act. But Subramaniam thinks that the pre-emptive actions made to keep people out of the potentially-radiation-exposed areas will prove wise with hindsight. “It’s very possible that all of this is just good pre-emptive risk management,” said Subramaniam. “I think that’s what might come out more than anything else.”

In addition the radiation threat, the other longer-term issue he sees continuing to affect businesses and insurance in the area is power interruption. Given the complexity and fine-tuned nature of the Japanese economy, every disruption that occurs going forward could have significant business interruption ramifications. “They have just-in-time manufacturing. They have single source suppliers. Everything is tuned to be very, very efficient,” said Subramaniam. “To now encounter rolling power blackouts, that’s going to be the longer-term issue more so than a lot of the reconstruction efforts. From a business interruption standpoint, that’s going to be the wild card. Everything has been made so tight that even the smallest break just throws everything off.”

As is usually the case with matters of risk, however, where there is downside, there is upside.

In this instance, the silver lining will be most apparent for those companies who managed their risks before the disaster hit. “When you have a competitive product and you manage your risks properly,” he said, “these kind of disruptions [can] actually give you a competitive advantage because the others aren’t producing as much and you are. And in some cases you might actually end up with pricing power.”

This is something Sony is currently learning first-hand.

In the digital camera market, it has long looked upward at industry giants Canon and Nikon. But due to supply chain disruptions suffered by the two leading digital camera producers, Sony, which is number three in the market, has the chance to make a splash with sales in the near term.

It’s too early to expect the market to completely change, but Subramaniam said he wouldn’t be surprised to see Sony out-pace pre-quake sales expectations for up to the next 24 months. Ten years ago, I’m not sure anyone thought an earthquake in Japan could affect what cameras people were buying in Nebraska.

Brave new world, and all that, I guess.

FM Global CEO Shivan Subramaniam believes some companies that maintained good risk management before the Japanese quake may gain competitive advantages.

It wasn’t just FM Global’s chief who was talking Japan — it was everybody.

I also sat down with Nancy Sher Cohen, a partner at Proskauer Rose who focuses on insurance recovery for policyholder clients. Cohen was moderating a hot topic panel session on the insurance implications the next day, and she had some unique thoughts to share beforehand that piqued my curiosity. Specifically, she wondered whether or not cultural differences in Japan may play into there being fewer claims filed than we might otherwise expect.

“It’s one thing for Japanese companies to make insurance claims in the United States because, in the United States, people make claims — it’s just part of our culture,” said Cohen. “But in Japan, it’s not so clear to me that Japanese big business is going to want to pursue significant claims against Japanese insurers.”

To me, it certainly seems that when it comes to global big business, in 2011, there is now only one culture: money. Ultimately, I would expect capitalist motivations and bottom line prioritization to trump any other concerns. But Cohen wasn’t as certain that that would be the case. “Maybe that’s the way it will come out, but we’re not getting that sense … We’re being told by some of the brokers that they’re not yet seeing big claims being filed.”

She wasn’t saying that cultural factors were the reason but just that it was one of several factors, which also included policy specifics. “There are lots of exclusions in policies for earthquake or sublimits for earthquakes,” she said. “So, many of our clients are telling us they only have a couple million dollars in coverage for earthquake anyway. Some of them have flood exclusions so the tsunami raises issues about that. The nuclear aspect of it actually is the one where there might be more coverage, believe it or not.”

So perhaps in part because of this, perhaps because people are still recovering rather than doing paper work, perhaps because of the human tragedy element, perhaps in part because business interruption claims can take a long time to figure out, and perhaps in part because of the cultural issues, this is why Cohen and her firm are not seeing quite as many claims in the immediate aftermath of the disaster as they did following 9/11 and Katrina.

And this is why she is asking the cultural question.

“Are there cultural issues there that suggest, maybe, the Japanese are going to be less likely to make these kinds of claims,” said Cohen. “I don’t know the answer myself. But I do know they’re not a naturally litigious society. So those companies may not gravitate towards making those claims.”

Could cultural differences in Japan lead to fewer insurance claims than expected?

At the session Cohen moderated the following day, RIMS President Scott B. Clark led the panel discussion with his story of being in Tokyo when the earthquake struck. Fortunately, he remained unharmed as the ground shook, and the only major fallout for him was the tumultuous decision surrounding when and how to evacuate the affected region. The bullet train to Osaka was temporarily halted, but once service resumed, Clark, along with RIMS Japan Chapter President Yoshi Hamaji, was able to board and get to a safer area. In Osaka, they were even able to carry out their their planned meeting.

From there, he was able to fly out to Honolulu a day earlier than expected, which came as quite a relief to Clark — for obvious reasons but also because he felt as though his presence was a nuisance to Yoshi, who in Clark’s view should have been focusing on his family and personal concerns, not the logistical issues of helping a colleague get out of the country.

After the story the panel got down to the insurance nitty gritty, mostly focusing on the business interruption aspects. One simple question from Cohen helped explain exactly why the resulting BI claims are so difficult to gauge. “We know when [business interruption] begins: when the physical damage starts. But when does the business interruption end?”

Does it end when the company turns the lights back on and restarts production? Or, as panelist Duncan Ellis of Marsh noted, is it truly “covering losses of profits you would have made.” The second view is a more nuanced, long-term outlook that weighs in factors like resulting supply chain limitations and doesn’t end until the company can resume operations in a way that gets it back to prior revenue levels. That can take a long time.

The answer may more often be the former than the latter, but the policy language — as always — will be the determining factor. Cohen said she worked with one company, for example, that had a business interruption policy that, due to odd language, didn’t even trigger when the event happened. This highlights something Ellis said: property damage claims are relatively easy, business interruption can be a pain.

Examining policy language becomes critical, then, for risk managers. Sub-limits remain a concern. If you have low sub-limits and are struck by a major earthquake, is $2 million really going to help?

And what if the trigger is something particularly strange? Remember when the Icelandic volcano Eyjafjallajökull erupted last year? For most, the resulting business interruption was not coverable. As far as the policies were concerned, this was a “non-incident event,” as Ellis termed it. Without a defined incident, it’s like the BI never happened. Except that it did.

But if you purchase a policy that provides coverage for everything but those events specifically excluded, said Cohen, you will have a much easier time getting your claims paid. Cohen called this an “everything but” approach and recommended risk managers negotiate for such language.

Really, these are just a few of the more notable discussions I had or heard about Japan.

There were plenty more that I will try to post when I return to New York.

And honestly, I wouldn’t be surprised to find myself talking about the catastrophe just as much next year. Unfortunately at RIMS 2012, however, I won’t also be able to off-set those depressing conversations about disasters with chats about how beautiful Vancouver is.

The Psychological Hurdle to Earthquake Preparedness

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The final death toll from the earthquake and resulting tsunami in Japan is now expected to exceed 18,000. While that number paints a far graver picture than the initial, much lower estimates, many believe that the human fallout from a magnitude 9.0 quake would have been worse if it wasn’t for the country’s strict building codes.

In that sense, Japan’s path towards resiliency should be a lesson to other nations threatened by seismic activity. Either modernize and fortify your construction and infrastructure or jeopardize the lives of your citizens when the next major earthquake hits.

Unfortunately, improved building standards are not the only impediment to better preparedness. A new study from a University College London researcher Helene Joffe has shown that there are some significant psychological hurdles as well — and the underlying rationale may vary from culture to culture.

In Japan, for example, responses to her survey about how safe people would feel if an earthquake hit revealed a fatalistic outlook, meaning that many people didn’t believe that improved building standards — or any other preparedness efforts, really — would ultimately make any difference.

Japanese participants, while being the most confident in the structural integrity of their buildings, had a more negative response than those in the US when asked “How safe would you feel being inside your house during an earthquake?” The Japanese also scored lowest on the number of seismic adjustments they had made: an average of seven, compared with nine in the US. Joffe says there was far more talk of worry, anxiety, fear and a sense of vulnerability from Japanese respondents, while those in the US had a much greater feeling of optimism.

Japanese participants gave the impression that damage is caused by the force of an earthquake alone rather than arising as the result of interactions between uncontrollable geophysical events and controllable features of the built environment, says Joffe. “We found the Japanese participants to be more fatalistic than we expected,” she says. “The feeling was that you can do whatever to your house but what is going to happen is going to happen and there is very little you can do to change that.”

Other survey participants came from Turkey, another nation with high seismic risks. Here, too, people had a “there’s nothing you can do” attitude, something that was skewed both by religion and a distrust of government.

In Turkey, there was much more talk of earthquakes being an act of God. There was also much more talk of distrust in government and corruption. “They thought that their buildings were badly built and that there was nothing they could do to prepare because everything was negatively affected by corruption,” says Joffe.

We already know that there many hurdles to better disaster preparedness: budget constraints, complacency, a lack of urgency and an “it won’t happen to me” attitude, to name just a few. But according to Joffe, this new information means that policymakers must also begin to incorporate cultural understanding into their efforts.

Joffe’s team says the current models of seismic adjustment need to give a more prominent role to these cultural influences. They will use their results to identify how best to motivate people to make changes.

“If we find that fatalism is leading the Japanese not to make necessary adjustments, then it may be better to go in on the engineering side and retrofit their houses,” she says. “In Turkey, on the other hand, you’re not going to change vulnerability without starting with corruption.”

For more on the other psychological hurdles, read this excellent piece that FM Global’s Ruud Bosman wrote for us recently highlighting research that his company conducted.

Learning Through Destruction at FM Global

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FMglobal

FM Global’s Research Campus is one of the more interesting things about the insurance industry. Basically, what the company did was build a giant, airplane-hanger-sized warehouse so it would have a place to blow things up. It’s not all fun and pyromania, however. The real value comes from what FM Global observes.

By testing the destructive potential of certain disaster scenarios, the company is able to better understand how building materials, walls, windows, roofs, houses, warehouses and even entire industrial facilities can be fortified to withstand the worst.

It’s all about loss control, really.

For example, the company might do an experiment to find out how much wind it takes to compromise the structural integrity of the Model ABC Roof Flashing sold by XYZ Company if it is installed with 12 half-inch nails. If the wind exposure (both in MPH and duration) that sends the flashing flying is a realistic figure to expect in a certain location (say, Florida) then you now know that it is not the best building material to use if you’re building a tiki restaurant in South Beach. On the other hand, if the flashing does withstand 160 mph winds for 30 minutes, the company now knows it won’t fail in anything but the most catastrophic storm.

Such knowledge is great for the industry at large — it helps all stakeholders learn how building materials hold up in disasters. And the proprietary results are even better for FM Global — they help the company be extremely confident in its underwriting decisions.

Rudd Bosman explains as much in the video below, which complements a new article on the campus that Fortune published in its latest issue. “We spent well over $100 million in capital expense on this facility. It’s absolutely worth it. It’s where we learn what we need to do to prevent losses from happening. That knowledge is invaluable.”

A few years ago, our Editor in Chief Morgan O’Rourke got the chance to tour FM Global’s Research Campus on a day where some serious explosions were taking place.

Outside, it was a quiet, clear January day in the woods of western Rhode Island. But hidden just off the road, in a relatively nondescript structure, I stood in awe some 100 feet away from the largest fire that I had ever seen. A fuel leak had caused a blaze nearly three stories high with flames so intense that the facility’s emergency sprinkler systems were actually making it worse. When the water came in contact with the burning fuel, it caused a reaction much like what happens when water is splashed on a grease fire in the kitchen. Huge fireballs erupted, threatening to engulf the ceiling and the sensitive machinery located there. Even from my distant vantage point, it was very hot and very impressive. It was also a simulation. Welcome to just another day at the office for the scientists and engineers at the FM Global Research Campus.

Check out the rest of Morgan’s feature for more on the most destructive place in insurance.

You can also find more about the campus on FM Global’s website.