The psychology of risk

Natural disasters are impossible to predict, but as the Senior Vice President at FM Global explains, foreseeable risks are not worth taking

 
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In the current economic climate, where there are a number of competing risks to contend with, property risk management is often the last thing on many business leaders’ minds. In an environment where the focus is on cutting costs, property loss-prevention can in fact be perceived as an unnecessary expense. However, when disaster strikes, the loss of a key facility can be catastrophic for business, affecting bottom line, market leadership, and even share price.

The psychology of risk
The reality is that at senior management level, property loss prevention is often dismissed under the assumption that comprehensive insurance will protect a business if the worst should happen. While insurance is crucial for any business, it is only part of the story.  Insurance will allow a business to rebuild a major facility or critical manufacturing plant, but it won’t prevent the significant interruption faced while those facilities are unable to function.

Further complications can lead to lengthy claims processing, and it may be a while before a loss is recovered. Given the global challenges that companies can face, it is far better to engineer resilience into a business and its supply chain. The important thing for businesses to remember is that the majority of property loss is preventable, and in the long term, adequate risk prevention today can ensure resilience in the future. When considering natural catastrophes, people tend to believe it will never happen to them. The assumption is that if a natural catastrophe occurs, the consequences will have greater impact elsewhere. There is also a behavioural trait, known by some psychologists as the ‘Gambler’s Fallacy’, which assumes that because a disaster has happened once, it
won’t happen again.

To change these behaviours, it is important to look at risks relevant to the lifetime of a property, rather than discussing risks in terms of probability. For example, there may only be a one percent chance of flooding at a site each year, but if a site has a lifetime of 50 years, then the risk of that site flooding increases to 39 percent. Statistics presented in this way are far more compelling, and highlight that if a facility is located in a high-risk area, it’s not a case of if a catastrophe will happen, but when.

The bottom line
It’s clear that unpredicted interruption can have a severe financial impact on a business. The impact of the floods in Thailand in 2011 is still felt by many businesses that concentrated their operations and supply chains in Asia. Many technology companies, for example, had their operations set up in Bangkok where one third of the world’s hard drives were produced. When the area flooded, many businesses didn’t have adequate risk prevention strategies in place, and those that did capitalised on this by winning market share. Since then almost all major hard drive vendors have raised their prices, citing the devastating floods as the source of their troubles.

In fact, analysts have given the Thai floods as the primary reason for Seagate Technology recapturing the worldwide lead in hard disk drive shipments in the last quarter of 2011. As Seagate’s HDD manufacturing plant in Thailand is located on high ground, the company was less adversely affected by the floods, and was able to continue supplying hard drives when its competitors could not, leading to them becoming the market leader. Thailand is also relatively unexposed – if a similar event took place in China’s Pearl River Delta, where 30 percent of the world’s electronics are, one typhoon could paralyse the world.

It is important for business leaders to look at events like the floods in Thailand, and question whether their business operates out of areas at high risk from natural catastrophes, and if so, what can they do to ensure protection against the risk. Insurance isn’t enough any more. Thailand showed that if you face business interruption – a competitor who is better prepared would be able to supply customers in this eventuality. When moving operations, it is crucial that businesses analyse the risks and ensure that they have a loss prevention plan in place, which considers long-term threats.

Outsourcing to emerging markets
With the rise of globalisation and more European companies becoming increasingly dependent on the BRIC countries and Asia for production, it is crucial that companies focus on risk prevention and protecting supply chains. If this is not followed, reputation, market leadership, bottom line and even share price can be affected. Outsourcing can reduce costs, but it can also mean that businesses unknowingly take on greater exposure to natural disasters, lower safety standards and less reliable legal systems. Businesses must acknowledge the new risks and protect their bottom lines. If a business doesn’t have the right loss-prevention in place, outsourcing may end up costing more in the long term. It is not that companies should never outsource to emerging markets or higher risk countries, but by factoring the attendant risks into the decision-making process and, having identified those potential risks, put measures in place to prevent this from becoming a reality.

Countries at risk
From the Pearl River Delta to Mongolia, China is exposed to just about every natural catastrophe that could occur. Much of China and many of the developing business areas are in prolific earthquake zones. A recent study found that supply chains in the region are more likely to face business disruption by a natural disaster, particularly because China has not yet fully embraced many of the risk management practices followed in Europe.

A disaster in China of the level of the Japanese earthquake and tsunami would have far-reaching and long-lasting negative economic impact. It would slow down the global economy because China is not only a major exporter, 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. As a result of urbanisation, mudslides and river flooding from deforestation, European companies with operations in Brazil are at great risk from business interruption. Businesses need to make sure that any new buildings are built above flood lines, and that existing buildings have flood and mud slide protection built in.

India is a vast country with a wide range of climate zones, ranging from arid desert to mountain cold, with large subtropical and tropical zones in between. In Haridwar, temperatures can fall to 35ºF (2ºC) in winter, posing a potential freeze threat. Due to the high occurrence of monsoons in India, all the cities are exposed to flooding. While not sub-continent wide, there is also a high exposure to earthquakes in some areas that have concentrations of manufacturing.

In an increasingly global world, business leaders need to make sure that companies have adequate loss-prevention strategies in place. While risk management can often seem expensive when viewed as a one off cost, it is clear that these leaders must consider property risk management a priority, and must look at its value over the lifetime of a facility to consider the impact on share price and reputation that business interruption can have – investment in property risk management is vital for sustained business resilience.