Costly Recalls

Across the globe, product recalls are rapidly becoming a common occurrence in the food and beverage industry. For example, from 2011 through 2012, the Canadian Food Inspection Agency (CFIA) reported 388 Class I and Class II food and beverage recalls across Canada – recalls that cause public harm.

In the United States during 2012 alone, there were 1,276 Class I and II recalls (as defined by the U.S. Food and Drug Administration, FDA) of food and beverage products. That equates to about 30 a week in the U.S., according to AIG analysis of FDA and Department of Agriculture data.

While these statistics alone are alarming, product recalls are only one chapter of a bigger and more complicated story: the actual product contamination event.

In addition to a recall, a product contamination incident may cause business interruption, loss of reputation (or brand damage) and loss of earnings. These are complicated and expensive events. As international supply chains continue to expand in complexity, so do risk exposures, increasing the likelihood of a product contamination.

Even plants with the best controls are at risk. Human error, mechanical breakdown or sampling failures can happen at any time.

A mistake can also originate with suppliers of ingredients or packaging materials. New or unexpected contaminants (e.g., melamine) are detectable only if specific tests are performed. Private label owners outsource production so they do not have direct control over the manufacturing and testing of their own products.

As detection technology gets better, governments respond in the interests of public safety. Regulators that monitor these types of events can force companies to take corrective action, ranging from product recall, extended product recall or suspension of production. A contamination at an ingredient supplier may prompt a government agency to order a recall of all products manufactured using ingredients purchased from the supplier, even though the products did not test positive for any contamination.

REPUTATION RISK

Reputations for providing safe food are valuable assets that firms have an incentive to protect. The potential long-term damage to a brand can eclipse the short-term cost of recalling products.

Results of a 2007 Harris Interactive poll show that 55% of consumers said that they would temporarily switch brands following a recall incident and 21% would avoid purchasing any brand made by the manufacturer because of health and safety concerns. Moreover, four out of five respondents indicated general concerns over recent food safety recall incidents.

The cost of a significant contamination event can many times dwarf the costs associated with the actual recall of a product. For large companies that have faced a recall in the past five years, 77% of respondents to a recent Grocery Manufacturers’ Association poll estimated the financial impact to be as much as US$30 million; 23% reported even higher costs.

Many companies understand intuitively the risk of a product contamination, but fail, for the most part, to recognize the true financial severity ahead of time. The three primary components of a major product contamination event include the following:

• product recall expenses (product replacement costs, recall and redistribution expenses, product destruction costs, and related crisis management consultant fees);

• business interruption (financial loss due to product unavailability, decontamination downtime, government action, brand damage and loss of contracts); and

• third-party liability (financial loss due to third-party property damage and bodily injury).

RUNNING THE SCENARIOS

Many companies can imagine a contamination and recall event associated with the failure of a single control point. However, “worst case” contamination scenarios are infrequent and, therefore, very difficult to model, without the right experience and expertise.

A “worst case” event may include a confection manufacturer who sells chocolate to dozens of food manufacturers. During routine government testing, Salmonella is detected.

The government strongly encourages the manufacturer to notify all customers that several lots of product must be recalled. In addition, the source of the contamination cannot quickly be identified, and the manufacturer is forced to cease production on its production line, destroy all recovered product, sanitize production equipment and storage facilities, and retest for the presence of the contaminant.

The expenses incurred by the manufacturer quickly escalate beyond recall costs, including the costs to provide replacement product to customers, loss of contracts with customers who find a new supplier, business interruption loss, and brand damage during clean-up and remediation. This scenario can be financially devastating to the manufacturer.

A limited, more likely scenario may include the cost of temporary product unavailability and shutdown of a single production line for a few days. For example, a juice manufacturer receives several complaints of juice boxes containing cloudy juice product that has been contaminated by mould. An internal investigation finds a packaging defect that affected 20,000 cases of juice.

The company is faced with a financial loss caused by recall expenses and replacement of the contaminated product. However, unlike a “worst case” contamination, the financial impact of this event is more easily modelled.

CONTAMINATION CONSEQUENCES

Whatever the case, the main consequence of underestimating the severity of a product contamination incident is financial vulnerability. If a company purchases an inadequate amount of product contamination insurance, the company may be exposed to a potential financial shock.

Unfortunately, some of these companies do not get a second chance as the product contamination put them out of business. This will continue to happen.

Working with a risk management partner with deep experience in this area can help companies avoid this fate by helping them to do the following:

• better understand potential product contamination exposure;

• understand the impact of retaining exposure on the balance sheet versus the risk transferred via insurance, captives or other means; and

• better manage third-party volumes or contractual indemnity provisions, by measuring the contamination risk at the supplier or contract manufacturer level.

The more food and beverage companies understand their potential financial risk, the more informed decisions that they can make about how to protect their customers, supply chain and bottom line.