Managing contract risk during a pandemic

How the coronavirus pandemic presents an opportunity to strengthen contract terms and implement better risk management tools

There are a growing number of instances in which inappropriate contractual arrangements have been trigged by the coronavirus pandemic, causing unnecessary disputes with third parties and compensation losses. Such differences can decrease the chance of recovering pre-existing profitability and reputation levels in the mid and long-term.

By facilitating sound risk assessment techniques, risk managers play a significant role in renegotiating and prioritising contracts and contract terms during the pandemic crisis

Risks must be transparently disclosed and notified

Early communication of performance risks and materialised events to contract counterparts can help secure the renegotiation of terms and delivery due dates. Of course, this depends on the wording of the force majeure provisions in current contracts and their applicable common laws.

An active risk management function ensures that the contract performance risks, which are rapidly evolving during a pandemic, are communicated to the third parties with alternatives to protect the business relationship.

The late or partial performance of contractual obligations is more comfortable to be excused where risks are transparently disclosed and notified. If force majeure provisions are invoked, the documentation of risk and events is needed to demonstrate higher operating costs or the inability to perform obligations.

Supply chain disruption

The segmentation of clients in the third-party risk framework focuses on the operational capabilities to serve strategic contracts. An organisation’s most strategic clients will need to be prioritised during the disruption of internal operations and/or the supply chain, and consequently, segmentation rules will need to be updated.

Risk managers can supply the process by helping to identify which contracts to default and terminate by updating the client segmentation in the third-party risk framework.

Assess the probability of default

The monitoring of third-party solvency and liquidity is critical for planning treatment measures in response to risks affecting contract performance. These measures are related to the reassessment of warranties and reserves, as well as the initiation of exit plans.

Ongoing third-party due diligence can help predict emerging trends in the financial ratios of counterparties and segments to provide early warnings. It is also essential to include the monitoring of guarantors. Risk managers can assess the probability of default and losses using data-driven tools.

Quantitative methods in the pre-contract process provide better decision-making insights for negotiation of pricing and contractual conditions, as well as helping to define flow-down requirements for sub-contractors. Quantified exposures facilitate the calculation of reserves, insurance coverages and guarantees.

A sound assessment technique is even more relevant during the coronavirus crisis. In addition to maintaining a contractual risk registry for operational requirements and pre-requisites, the assessment of a full range of potential scenarios validates the assumptions used in financial plans for modelling the contract profitability and establishing the liability terms.

The need for better tools

Monte Carlo Simulations are an effective method that can be used to calculate the impact on the contract value of operational risks. It can also be applied to changes in the assumptions used to model pricing and profitability.

Beyond the immediate impact of the outbreak in the business continuity plans, the coronavirus pandemic presents an opportunity to implement better risk management tools for decision-makers. The operating and financial consequences of the coronavirus crisis will challenge the ability to perform contractual obligations for many years to come.

Data-driven risk processes will enable line managers to protect long-term, trusted relationships with third parties. In the future, clients will seek higher indemnities and insurance requirements, where significant contractual risks have been identified. This will trigger the need for better allocation of cost and schedule risks in sales and supply chain contracts.

Professor Hernan Huwyler is head of Vendor Due Diligence and Third-Party Risk at Danske Bank