Quantifying the Full Costs of a Product Defect
There have been a number of recent high-profile defective product incidents, ranging from dangerous vehicles to faulty mobile phones and tumble dryers. The negative impact on a business can be wide-reaching and may include significant brand, operational, and financial damage. The question is, could you quantify the cost that such an event might have on your business?
What losses can result?
A defective product can lead to recall which involves the withdrawal, retrieval, and provision of compensation for defective goods. Costs will initially fall on the distributor, producer, or manufacturer of the final product, but other parties in the supply chain are also potentially liable through contractual subrogation for a defective component.
The direct costs resulting from a defective product can include:
- Transportation and repacking.
- Destruction and disposal.
- Product replacement.
More crucially, a product defect may result in adverse publicity, reputational damage, and loss of revenue. This can lead to an expensive and time-consuming recovery process to rebuild sales, market share, and trust in a brand.
How costly can these events be?
The costs associated with defective products can be significant. Several incidents in recent years have cost in excess of US$1 billion and one of the largest to date, caused by faulty phones, is estimated at over US$5 billion [1: pdf].
Several of the main costs usually fall outside the protection offered by traditional product liability insurance, meaning additional cover is needed to avoid the business bearing the cost. Loss modelling can help businesses decide whether buying "defective product insurance" is financially efficient in comparison to retaining the risk on balance sheet.
Why quantify potential losses, and how is it done?
Increased consumer safety regulation, global supply chains, and greater product integration means defective products pose a growing financial risk to businesses and even industries. In fact, March 2018 saw the development of a UK code of practice for product safety recalls, helping businesses understand their obligations .
By using industry claims and bespoke scenarios developed through discussions with business representatives, it is possible to statistically model a full range of potential loss outcomes and their respective likelihood of occurring.
Consideration is given to factors like supply chains, distribution networks, batch sizes, production costs, key customers, and contingency plans. The outcome can then inform the adequacy of policy limits and optimal retention levels in view of a business' risk appetite and risk tolerance.
Understanding the potential downside following a defective product incident helps focus response plans and inform insurance purchasing decisions. Insurers, brokers, and businesses can work together to reduce the likelihood and frequency of potential losses by identifying key risk drivers, and using risk models to quantify the impact of improvements.
Calculating your potential exposure is an important step in deciding on an informed risk financing strategy. How much would a defective product cost you?
2. PAS 7100 – Developed by the UK Department for Business, Energy and Industrial Strategy and the British Standards Institution (BSI) Read more