Homeland Security Watch

News and analysis of critical issues in homeland security

January 20, 2012

Discounting risk can be costly

Filed under: Catastrophes,Preparedness and Response,Strategy — by Philip J. Palin on January 20, 2012

The chart is taken from a December edition of Fortune Magazine.  These estimated costs — almost certainly underestimated — reflect a record-setting $380 billion in global economic losses; nearly two-thirds higher than in 2005, the previous record year. (See more from Munich RE.)

This week’s leader in The Economist is entitled, “The Rising Cost of Catastrophes” (see below and for a link to a more detailed article).  In the run-up to the 2012 Davos Summit the World Economic Forum has identified key global risks and gives special attention to the implications of the earthquake-tsunami-nuclear emergency in Japan.  They warn about “seeds of dystopia” being planted worldwide.  Fortune, The Economist, and WEF… in the business world this is a thoughtleader trifecta.

The unprecedented scale and recurrence of these losses may — but I emphasize, may — have begun to influence strategic decisions by some major players.  A once-upon-a-time client lost nearly $1 billion as a result of the floods in Thailand. They are certainly learning from hard-knocks what a decade-ago I tried to communicate as a competitive opportunity as well as competitive risk.

So attention must be paid, either now through thoughtful mitigation or at some future point through even higher declared losses.

And yet, last week I was with three serious, practical business leaders who seemed unaware of the triple-header in Japan or the epic flooding in Thailand or the eventual shift in the San Andreas and New Madrid faults.   They have not personally experienced anything analogous.  Accordingly such high impact risks are only “theoretical”, which being serious, practical men they cannot allow to distract from what they know and know how to manage.

To ponder the experience of a peer from Sendai or Bangkok would require a kind of empathy, imagination and vulnerability that does not typically earn seven-figure bonuses.  Will the criteria for bonus payments shift to reflect a shifting context?  Hiring criteria?

The potentially catastrophic risks that I use as examples currently tend to be dismissed as either “ancient history” or “fanciful futures.”   It is helpful when Fortune and The Economist and the World Economic Forum begin to sing a similar tune.

Over the last year, Klaus Schwab, the founder of the World Economic Forum, has argued, “In the past the decisive factor in success was productivity, the efficiency with which you used resources.  Today the most important success factor is to recognize risks and mitigate those risks.”  If the pace of global economic growth continues to slow, risk-mitigation will become even more critical to bottom-line success… even survival.

– +–

The following was published in The Economist on January 14

COMMERCE has long been at the mercy of the elements. The British East India Company was almost strangled at birth when it lost several of its ships in a storm. But the toll is rising. The world has been so preoccupied with the man-made catastrophes of subprime mortgages and sovereign debt that it may not have noticed how much economic mayhem nature has wreaked. With earthquakes in Japan and New Zealand, floods in Thailand and Australia and tornadoes in America, last year was the costliest on record for natural disasters.

This trend is not, as is often thought, a result of climate change. There is little evidence that big hurricanes come ashore any more often than, say, a century ago. But disasters now extract a far higher price, for the simple reason that the world’s population and output are becoming concentrated in vulnerable cities near earthquake faults, on river deltas or along tropical coasts (see article). Those risks will rise as the wealth of Shanghai and Kolkata comes to rival that of London and New York. Meanwhile, interconnected supply chains guarantee that when one region is knocked out by an earthquake or flood, the reverberations are global.

This may sound grim, but the truth is more encouraging. When poor people leave the countryside for shantytowns on hillsides or river banks they are exposed to mudslides and floods, but also have access to better-paying, more productive work. Richer societies may lose more property to disaster but they are also better able to protect their people. Indeed, although the economic toll from disasters has risen, the death toll has not, despite the world’s growing population.

Preparing for the worst

The right role for government, then, is not to resist urbanisation but to minimise the consequences when disaster strikes. This means, first, getting priorities right. At present, too large a slice of disaster budgets goes on rescue and repair after a tragedy, and not enough on beefing up defences beforehand. Cyclone shelters are useless if they fall into disrepair. A World Bank study recommends using schools and other bits of normal public infrastructure in disaster-protection plans, so that the kit and buildings are properly maintained.

Second, government should be fiercer when private individuals and firms, left to pursue their own self-interest, put all of society at risk. For example, in their quest for growth, developers and local governments have eradicated sand dunes, mangrove swamps, reefs and flood plains that formed natural buffers between people and nature. Preserving or restoring more of this natural capital would make cities more resilient, much as increased financial capital does for the banking system. In the Netherlands dykes have been pushed out and flood plains restored to give rivers more room to flood.

Third, governments must eliminate the perverse incentives their own policies produce. Politicians are often under pressure to limit the premiums insurance companies can charge. The result is to underprice the risk of living in dangerous areas—which is one reason that so many expensive homes await the next hurricane on Florida’s coast. When governments rebuild homes repeatedly struck by floods and wildfires, they are subsidising people to live in hazardous places.

For their part companies need to operate on the assumption that a disaster will strike at some point. This means preparing contingency plans, reinforcing supply chains and even, costly though this might be, having reserve suppliers lined up: there is no point in having a perfectly efficient supply chain if it can be snapped whenever nature takes a turn for the worst. Disasters are inevitable; their consequences need not be.

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9 Comments »

Comment by Claire B. Rubin

January 20, 2012 @ 6:58 am

The graphic is very helpful.

I commented on the same topic on RecoveryDiva.com this week.

Pingback by Update on 2011 — the Costliest Year for Disasters in U.S. and Worldwide « Recovery Diva

January 20, 2012 @ 7:00 am

[...] also the Jan. 19th posting by Phil Palin on Homeland Security Watch blog, which also provides a graphic and also cites the Economist article that I noted earlier this [...]

Comment by William R. Cumming

January 20, 2012 @ 9:07 am

Great post! Some of its premises I would argue are not proven one way or another including this one:

“This trend is not, as is often thought, a result of climate change.”

Married to a former World Bank staffer at one time it always amazed me that from its inception in the 40′s until the early 90′s The WB took almost no interest in the impact of natural and manmade disasters on their development calculations or projects. Doing slightly better now.

The world wide property/casualty insurance and reinsurance business has produced some useful analysis but in reality insurers don’t want to really insure risks but rather have almost guaranteed profits and continue as a largely unregulated pool of capital world wide.

Yet the conclusion that increased population and development has increased risk exposure seems to be a sound conclusion. Unfortunately, notions of “freedom” and “capitalism” in the USA are largely devoted to freedom from restrictions or government regulation not other than economic freedoms. And the economics profession [one that dominated the World Bank culture in the past and even now] cannot seem to make up its mind about the totality of the impacts of disasters on mankind. Dr. Howard Kunreuther, PhD, at Wharton has been the leading academic in this field for many years but even his writings and studies fail to document exactly the processes of government largess on long term development and recovery.

Perhaps much too short a period of record in many instances, and collection of basic data [even in developed countries] is often not done or largely ignored [stream gaging in the USA is always extremely underfunded by governments as are tidal storm gages]!

What seems to be having some impact on all this is the increased computer power becoming available world wide. Metrology did not exist as a profession 100 years ago but the advent of flight made it a necessity even though sailors had long made inroads through detailed recorded observations [the Royal Navy and the US Navy]!

And now Climatology looks like integration of world wide weather patterns will eventually result in almost completely accurate weather prediction due largely to computers. The computer power underlying the WEATHER CHANNEL is huge.

We also know that deep earth sensings may result in the physicists eliminating the seismologists [these are really statisticians in disguise] since physics and its ability to model fluids is directly related to study of the magma flows now understood to be the root of vulcanism [no not the warfare types]!

But of course ignorance of science and engineering seems to be a continued forte of the US government where like the Ostrich we stick are heads in the ground. The administration has formally advocated moving NOAA and the NWS to a defunct Commerce Department [under the reorg plan] and sending it to the Department of Interior. With some exceptions Interior hates science and disregards science almost entirely except for the USGS, Park Service, and Fish &Wildlife Service.

Can you name the Science Advisor to the President? Or which Committees of the Congress deal with Science and respect it and their members?

Most of the Science in the USA is conducted under the procurement and auspices of DoD! Does that make sense?

So again a great post not without some cracks in its premises.

Comment by Philip J. Palin

January 20, 2012 @ 9:10 am

Several readers have emailed me recommending reference also be made to a WSJ piece from last Wednesday. Because the WSJ does not allow easy access to many articles I am providing the full text. I have highlighted in bold a critical tension that I regularly see between “perceiving reality” and “deciding how to respond.”

–+–

Reinforcing the Supply Chain
Disasters Spur Companies to Assess Potential for Disruptions

By MAXWELL MURPHY

After a decade of streamlining their supply chains to make them less costly, the natural disasters and political upheavals that marked 2011 showed many multinational companies just how vulnerable those links have become.

The earthquake and tsunami in Japan last March, which led to parts shortages, particularly for auto makers and electronics manufacturers, made companies more aware of “the fragility of the supply chains,” says Robert Sutton, vice president in charge of consumer retail, health-care and transportation customers at Deutsche Post DHL’s supply-chain business in Tokyo.

But this new awareness hasn’t necessarily led to action. That’s partly because boosting inventory even slightly to provide a cushion against supply disruptions can cost big companies millions of dollars, taking a noticeable bite out of the bottom line.

“I don’t see any of us moving away from very disciplined supply-chain management,” says Ford Motor Co. finance chief Lewis Booth. But, he adds, “There will be targeted changes.”

In some instances, companies are pushing their suppliers to strengthen their own supply chains and take steps to reduce their exposure to natural disaster and other risks.

After the Japanese quake, Jabil Circuit Inc., a contract maker of electronics components, met with most of its major Japanese suppliers to encourage them to develop more than a single source for parts and raw materials. Jabil, based in St. Petersburg, Fla., also urged them to stop clustering their factories around their headquarters, says John Caltabiano, vice president of global sourcing. Clustering can cut costs but it puts multiple facilities at risk in a disaster.

Erich Hoch, senior vice president and chief supply-chain officer for Jabil, says natural disasters have made “dual sourcing” a top priority for the company.

Justifying redundancies is one of the toughest aspects of managing a supply chain, because backstopping doesn’t pay off unless there is a disaster. When CFOs ask about the return on such investments, the answer is, “If we’re lucky, absolutely zero return,” says Sean Cumbie, vice president in charge of global supply-chain management at genetics-testing company Qiagen NV, based in Germany.

Last year’s disasters forced companies to broaden continuity planning, he says. Information-technology managers, for example, used to prepare response plans for computer servers going down. Now, they worry about the impact of a facility losing all its power for a week or more.

After the events in Japan and persistent flooding this fall in Thailand, auto makers couldn’t get crucial components or Thai-manufactured metallic paints, and some types of hard-disk drives were in short supply. Goodyear Tire & Rubber Co. warned last month that the Thai flooding could result in “a potential global shortage” of aircraft tires.

As the impact became clear, even companies that weren’t affected by the disasters felt compelled to take stock of their vulnerabilities. Another genetic testing company, San Diego-based Illumina Inc., escaped the natural disasters relatively unscathed, says Chief Executive Jay Flatley. Still, it plans to re-examine [its] risk profile” to decide whether to add backup suppliers so it isn’t “single sourced” on some components.

Qiagen, which outsources the management of its North America and European supply chains to United Parcel Service Inc., didn’t need to use UPS’s Singapore warehouses after the Japanese earthquake collapsed the shelving and ceiling fixtures at Qiagen’s Tokyo warehouse, Mr. Cumbie says. But it will use those facilities as of next month to store spare parts for its medical-testing instruments to make its supply chain in the Asian-Pacific region “more robust,” he says. And it may move more product there later this year pending a review.

Kit Boyd, vice president of global supply-chain engineering at Ingram Micro Inc., says its supply chain held fast during last year’s disasters, but they gave the company an “opportunity to re-evaluate continuity plans,” especially as they relate to vendors and clients. Many tech companies use Santa Ana, Calif.-based Ingram Micro to run their supply chains.

Contingency planning is time-consuming. Paul Tronsor, managing director of global operations control at FedEx Express, says his company is fine-tuning lessons learned from the Icelandic volcano eruption of 2010, which disrupted flights for days. He is traveling this week to FedEx’s facilities in Cologne, Germany, to brief employees on ways to minimize the impact of any future eruptions.

Last year also exposed the risks companies face when governments collapse. Alan Wilson, CEO of spice maker McCormick & Co., told The Wall Street Journal this month that the toppling of Eygpt’s government during the so-called Arab Spring protests in the Middle East prompted the company to stockpile the various herbs it bought there and secure alternative sources in more stable parts in the Mediterranean.

In 2012, risks may increase from doing business, even tangentially or unwittingly with countries such as Iran, which face heavy U.S. sanctions. Companies with global operations need to “keep an eye on the changing trade sanctions in various parts of the world to ensure that [they] stay compliant and conform to any new requirements that may develop,” says Qiagen’s Mr. Cumbie, and “to also be prepared should any…suppliers get caught up in sanction issues which might impact our end-to-end supply chain flow.”

“This impact may not be as widespread as a major natural disaster,” he says, “but nonetheless it could create some disruptions.” As a result, he adds, Qiagen, whose holding company is in the Netherlands, will closely monitor any developments in U.S. sanctions against Iran, to ensure that nieither it nor any of its suppliers violate those sanctions, potentially disrupting Qiagen’s business.

Comment by Dan O'Connor

January 20, 2012 @ 11:43 am

Thanks for the point of view Phil;

Bill, really outstanding comments today.

While catastrophes can be mitigated, and disasters are inevitable; their consequences need not be, most decision makers do not operate on the premise that they will…

Ignorance is bliss, but willful blindness is a political necessity, or so it appears.

Metaphorically, its Baks’ sand pile all over again…we all know the sand pile will fail, but not where or when.

All that built up criticality in geographically high risk areas, flood plains, fault lines are what amounts to pre existing conditions coupled with the aggregation of population in urban areas and the inability to disperse that population overwhelms even the most effective and forward thinking planner(s).

Move away from the kryptonian “global warming” label and stick with cyclical climate change and one can see that there is a convergence of situations that will lead to bigger and bigger calamities.

I do not think it’s too novel an idea to put resources to prevention and preparedness for a more resilient capability. However, the gamble taken is tied to political realities and insurance models that see risk differently.

Risk mitigation is akin to an old John Wooden saying; If you don’t have time to do it right, when will you have time to do it over? Or is it?

Doing things right is expensive; not doing things right is even more expensive. I suppose it’s a combination of our national expectations of logistic capabilities, resource allocation, strategic importance, etc. But we tend to gamble a lot because history over the last century has proven that someone will arrive, feed us, clothe us, help us, and assist us. That’s our National expectation and reasonable based on historical precedent.

Insurance and precedent have altered both behaviors and expectation. So with that coupling in mind, there is a willful blindness for preparation, preparedness but almost over commitment and reliance on a JIT response and recovery mechanism.

While I agree with Phil’s; sentiment; “For their part companies need to operate on the assumption that a disaster will strike at some point. This means preparing contingency plans, reinforcing supply chains and even, costly though this might be, having reserve suppliers lined up: there is no point in having a perfectly efficient supply chain if it can be snapped whenever nature takes a turn for the worst” I do not believe their modeling and cost benefit analysis would indicate a necessity to be moral and prepared. I mean, that’s what we’re really talking about here; doing what’s right vice what’s “legal” or least costly.

The lawsuits for faulty brakes or chemically inferior tires (see Firestone circa 2000)are less expensive than the recall of every vehicle or product sort of mentality. We see drugs, products, software, and everything in between pushed out to consumers with the institutional knowledge that it’s cheaper to respond to the occasional problem than to mitigate the problem prior to release.

You have to admire Microsoft with its 4 billion beta testers…

It’s all a numbers game. Airliners overbook, retail chains build into their price point projected loss, marathons over register participants because of routine and predictable no shows, HMO’s use predictive medical models…everyone does it.

So the horizontal and vertical decision abstracts only ever meet in one place and the bet it is it won’t happen in the near future.

And the criticality builds! It’s difficult not to sound like an alarmist or chicken little about resilience, national preparedness, prevention, and the like. But true to Bill’s statement; there are ostriches everywhere with their heads buried in the sand hoping something doesn’t happen on their watch and allowing the accumulating of risk and increasing the risk for that critical system failure.

We are not a maintenance culture but a throw away and buy better one…its all a manifestation of post WW2 manufacturing and marketing…if it breaks, don’t fix it; replace it.

We are no longer in a position to operate on that premise.

Really excellent comments today. Thanks for sharing.

Comment by William R. Cumming

January 20, 2012 @ 12:50 pm

Thanks Phil for the WSJ article as I missed it online.

Pingback by Update on 2011 — the Costliest Year for Disasters in U.S. and Worldwide « Recovery Diva

January 20, 2012 @ 3:12 pm

[...] also the Jan. 19th posting by Phil Palin on Homeland Security Watch blog, which also provides a graphic and also cites the Economist article that I noted in the last [...]

Pingback by Discounting risk can be costly | #UASI

January 20, 2012 @ 6:42 pm

[...] Read more January 20, 2012 [...]

Pingback by Homeland Security Watch » Global Supply Chain Strategy

January 26, 2012 @ 12:11 am

[...] supply chain managers I know tend to discount low frequency, high consequence risks (see related post).  They discount this kind of risk because over the last twenty years they have become true [...]

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