OVERVIEW
There are ups and there are downs. Cyclical industries are characterized by factors sometimes out of their control.
Take energy: the industry was riding high on $110 a barrel oil in 2014. Less than a year later, prices had fallen by more than half thanks to a supply glut. Suddenly, companies that had made long-term capital investments when prices were high found themselves in dire straits.
And then there is the shipping industry, currently finding itself at the bottom of a cycle. Since the global financial crisis of 2007–08, the industry has suffered as exports declined significantly. At the same time, there are far more ships than there is cargo to carry. Growth in shipping volume has exceeded growth in exports every year but once since 2007. The Baltic Exchange Dry Index – a measure of shipping rates for dry goods and commodities – hit an all-time low in February 2016 and remains well off its May 2008 peak. Together these factors have sunk shipping industry earnings.
As challenging as the bottom of an industry cycle might be, it provides companies with opportunity – a chance to reassess their organization and take steps to reduce costs. Leaders, from the C-suite to risk management and finance, can begin by focusing on the areas they can control – strategy and operations. Both ship owners and cargo owners can capture value through more prudent enterprise risk management to control the overall costs associated with risk. Such efforts can enable companies to emerge in a better position to pursue new opportunities when the market ultimately bounces back.
IN DEPTH
When cyclical industries, especially capital-intensive ones such as shipping, make long-term investments, plans can be thrown into confusion by market downturns. The resulting overcapacity can extend to all facets of the enterprise. The shipping industry offers an example of how companies can find themselves with too much capacity as well as ways to wring cost savings from operations.
“Since the shipping industry is cyclical, a decade of growth led companies to add thousands of ships to their fleets,” said Steven Beslity, CEO marine at Aon. “Now they are stuck with severe overcapacity.”
This excess capacity isn’t likely to disappear soon. Some large shipping lines have made larger fleets an essential element of their strategy despite industry trends. Meanwhile, aided by low borrowing costs, smaller ship owners have expanded their fleets in an effort to seize market share. All told, net shipping capacity is expected to increase 3.1 percent in 2017, up from a 1.1 percent increase in 2016. And while the world’s economy has recovered since the global financial crisis, much of that growth has been generated by service industries or emerging market growth, neither of which has benefitted shipping.
Coincidentally, the marine insurance industry is facing its own overcapacity issues, which have softened pricing somewhat in the past few years. Beslity explains that as new players continue to enter the market, prices are becoming increasingly competitive as insurers seek premium volume.
Despite the overcapacity that will be the new normal for shipping lines for the foreseeable future, companies must still manage risk and purchase insurance to protect their assets. Doing both more effectively should be at the top of those companies’ priorities as they look to weather the bottom-of-the-cycle storm.
The right response to a cycle’s bottom
Like other businesses, shipping lines and cargo owners can benefit from turning a sharp focus to cost reduction and overall risk management efforts. Several strategies can help companies determine where opportunities lie, including:
- Analyzing and modeling risks thoroughly across the organization
- Using analytics to review historic loss and claims data
- Investing wisely in loss control and loss engineering efforts
- Reviewing insurance and risk transfer programs
One area that can generate cost savings is insurance program structures and the quality of the insurers with which companies are doing business. To optimize their loss retentions, companies can use sophisticated actuarial methods to set retention levels, in combination with stop-loss coverage to protect them against outsized events. Such moves can reduce their insurance costs and help them control costs should markets harden. William Penn, U.S. marine practice leader at Aon, notes that “shipping lines can capture savings of 15 to 20 percent in insurance costs and help contain cost increases should the market harden.”
Detailed analysis of loss and claims data can not only guide insurance purchasing decisions but also inform loss control and loss engineering efforts. This effort can push a company back into the black while making risks more attractive to insurance underwriters, further reducing cost of risk. A focus on loss control can also play a significant role in identifying and addressing the impact of emerging exposures such as piracy, which is on the uptick and cost shipping lines and insurers hundreds of millions of dollars in 2016. Other risks include cyber, the impacts of climate change, new “megaships,” and political risks across far-flung supply chains.
Given the extent of many of those supply chains, as well as the global nature of many marine operations, ship owners and cargo owners should seek out insurers that can provide global policy issuing and claims servicing capabilities.
“If you’re a global company, you’re going to want to look at the insurer’s global capabilities – their ability to issue local policies as well as their claims handling,” said Penn. “Companies that go with an insurer based solely on price may run into difficulty getting their claims paid.”
Capturing value across industry cycles
Heightened attention to risk management and reducing the cost of risk can play a significant role in surviving a challenging business climate and preparing for emerging risks. The experience of the shipping industry provides a valuable example for other cyclical industries seeking to withstand a downturn. To manage enterprise risk effectively and make the right trade-offs, executives should follow several best practices:
- Assemble multifunctional teams. Enterprise risk management isn’t a solitary pursuit, so it requires a team from different parts of the organization to ensure decisions are aligned with business strategy.
- Cast a wide net. Since decreasing risk for one part of the company can affect the overall risk exposure, executives should examine all facets of the organization.
- Assess the value of opportunities. Companies should take an enterprise view in order to make valid comparisons of initiatives and select the ones that generate the greatest value.
- Set priorities. With finite resources, executives won’t be able to pursue all initiatives. Using criteria such as total value and the investment required to capture it can help set the best course.
Perhaps the biggest benefit of an increased focus on risk management is that it can position an organization to seize opportunities it otherwise might have missed and maximize returns when good times return. The blessing and curse of a cyclical industry is that what’s down today will inevitably rise in the future.
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Source: The One Brief
