What is a Contingency?
A contingency refers to the potential occurrence of adverse events in the future, such as economic recessions, natural disasters, fraudulent activities, terrorist attacks, or pandemics. In 2020, businesses were impacted by the coronavirus pandemic, compelling many employees to shift to remote work. Consequently, companies had to formulate and implement remote work strategies. However, for certain businesses, remote work was not feasible, leading to the adoption of enhanced safety measures to protect employees and customers and curb the virus’s spread.
Despite efforts to prepare for contingencies, the nature and extent of such events are often unpredictable in advance. Companies and investors address potential contingencies through analysis and the implementation of protective measures.
Financial managers often strive to identify and plan for possible contingencies using predictive models. They tend to adopt a conservative approach to risk mitigation, anticipating outcomes slightly worse than expected. A contingency plan may involve organising a company’s operations to navigate adverse outcomes with minimal distress.
How a Contingency Works
In order to prepare for unforeseen circumstances, financial managers often recommend maintaining substantial cash reserves to ensure strong liquidity for the company, even during periods of low sales or unexpected expenses. Managers may proactively establish credit lines during favourable financial conditions to secure borrowing options during less favourable times. Contingent liabilities, such as pending litigation, are considered in these plans, which also incorporate insurance coverage for potential losses following these events.
However, insurance policies may not cover all costs or scenarios. For instance, pandemics like the one caused by the coronavirus were not always covered by business interruption insurance.
Insurance companies may impose limitations or exclusions, especially for acts of God, such as floods or earthquakes. Also, insurance cannot compensate for the loss of customers to competitors resulting from events like internal system issues, for instance, a data breach.
Businesses must establish contingency plans to mitigate lost revenue and increased costs during operational disruptions. Business consultants are often engaged to ensure these plans consider a wide range of potential scenarios and provide guidance on effective execution.
Types of Contingency Plans
Corporations, governments, investors, and central banks like the Fed make use of contingency plans. These plans address a range of uncertainties, including real estate transactions, commodities, investments, currency exchange rates, and geopolitical risks.
Protecting Assets
Contingency plans may encompass contingent assets, which are potential benefits (as opposed to losses) acquired by a company or individual upon the resolution of an uncertain event. Examples of contingent assets include a favourable lawsuit ruling or an inheritance.
Contingency plans may involve the acquisition of insurance policies that provide cash or benefits in the event of a specific contingency. For instance, property insurance can be obtained to guard against fire or wind damage.
Investments
Investors shield themselves from potential financial losses related to investments through contingency planning. Strategies such as stop-loss orders, which exit a position at a predetermined price level, are employed. Hedging also includes the use of options strategies, resembling the purchase of insurance, where the strategies generate income as an investment position incurs losses due to a negative event.
The earnings from the options strategy offset the losses from the investment either wholly or partially. However, these strategies come with a cost, typically in the form of a premium, requiring an upfront cash payment.
Investors also use asset diversification, a method involving investment in various types of assets. Diversifying assets helps mitigate risk, particularly if one asset class, such as stocks, experiences a decline in value.
Business Continuity and Recovery
To effectively address potential disruptions like a pandemic, companies must proactively plan to ensure uninterrupted business operations during and after such events. This proactive planning is commonly referred to as a business continuity plan (BCP) or a business recovery plan.
A specialised business continuity team is often established to anticipate various contingencies and oversee the execution of the continuity and recovery plan during disruptions. Businesses must identify critical functions and analyse how an event could impact their operations and processes. The contingency plan involves implementing measures to recover essential business functions such as systems, production, and employee access to technology like computers.
For instance, a pandemic contingency plan may involve devising a remote work strategy to prevent the spread of disease and enable secure employee access to their work. This may entail investing in technology, such as providing laptops, facilitating video conferencing, establishing cloud-based data storage, and ensuring access to company-wide communication tools like email and internal data.
Cybersecurity
In the face of any disaster, cybercriminals often exploit crises to infiltrate a company’s systems, stealing data or disrupting business operations. Contingency plans outline procedures for cybersecurity teams to protect organisations from threats and malicious attacks.
Intellectual Property Depletion Due to Theft or Destruction
Contingency plans should also account for potential intellectual property depletion due to theft or destruction. Thus, maintaining secure off-site backups of critical files, computer programs, and key company patents is crucial. Contingency plans must prepare for operational mishaps, theft, and fraud, including establishing an emergency public relations response for events that could significantly harm the company’s reputation and ability to conduct business.
A contingency plan should incorporate strategies for reorganising the company after a negative event. It should outline procedures to return the company to normal operations and minimise further damage.
Benefits of a Contingency Plan
A comprehensive contingency strategy serves to minimise the impact of unforeseen adverse events by mitigating loss and damage. For instance, a brokerage firm might implement a backup power generator to ensure uninterrupted trade execution during a power outage, thereby averting potential financial losses. Additionally, such a plan can effectively lower the risk of a public relations crisis, as a company that adeptly communicates its strategies for navigating and responding to negative events is less likely to suffer reputational harm.
Furthermore, a well-prepared contingency plan enables a company affected by adverse events to sustain its operations. Consider a scenario where a company anticipates possible industrial action, such as a strike, and has provisions in place to ensure that customer obligations are not compromised. Companies with robust contingency plans often enjoy favourable insurance rates and increased access to credit, as they are perceived to have minimised business risks.
Example of a Contingency Plan
Due to the financial crisis of 2008 and the Great Recession, regulations were put in place mandating the conduct of bank stress tests. These tests evaluate a bank’s ability to navigate various adverse scenarios and determine the potential losses it might incur in the event of negative economic developments. The purpose is to assess whether the bank has sufficient capital or reserves to withstand such situations.
Banks are obligated to maintain a specific percentage of capital reserves, which varies based on the total of risk-weighted assets (RWAs). These assets, such as loans, are assigned different risk weights. For instance, a bank’s mortgage portfolio might carry a 50% weighting, indicating that the bank should have enough capital equivalent to 50% of the outstanding mortgage loans in a negative scenario.
The capital, referred to as tier-1 capital, encompasses equity shares, shareholders’ equity, and retained earnings — accumulated savings from prior years’ profits. While the tier-1 capital ratio requirement involves several components, the ratio must be at least 6% of the total of risk-weighted assets.
Consider Bank XYZ as an example, with $3 million in retained earnings and $4 million in shareholders’ equity, resulting in a total tier-1 capital of $7 million. If the bank’s risk-weighted assets amount to $70 million, the tier-1 capital ratio is 10% ($7 million / $70 million). Given the 6% minimum requirement, the bank is deemed well-capitalised.
However, the effectiveness of the banking sector’s contingency plan remains uncertain until another recession occurs. This uncertainty comes from the challenge of anticipating every possible contingency, highlighting a limitation in these plans.
Conclusion
A contingency refers to a possible adverse occurrence in the future, such as a worldwide pandemic, natural calamity, or terrorist incident. By formulating strategies that consider contingencies, organisations, authorities, and individuals can minimise the impact of such occurrences.
DISCLAIMER: This article is for informational purposes only and is not meant as official corporate advice. Please consult a business coach.
