What Is a Contingency?

What Is a Contingency?

Let me explain what a contingency really is. It's a future negative event that might happen but you can't predict it with certainty, and it can impact investors and companies alike. These are potential adverse events, such as recessions or natural disasters, that can disrupt your operations. When you plan for them, you need to analyze risks and develop protective strategies to keep disruptions to a minimum. Companies often rely on predictive modeling and a conservative approach to handle uncertainties and mitigate risks effectively.

Understanding the Function of Contingency Planning

To prepare for contingencies, I recommend that financial managers keep ample cash reserves to maintain strong liquidity during poor sales or unexpected expenses. You should proactively open credit lines while your company is in a strong financial position to ensure access to borrowing in tougher times. For instance, pending litigation counts as a contingent liability. Your contingency plans should include insurance policies that cover losses during and after a negative event.

That said, insurance might not cover everything. Business interruption insurance often excludes pandemics, as many businesses learned during the coronavirus outbreak. The federal government stepped in with the CARES Act, providing relief to businesses, families, and local governments, including the Paycheck Protection Program with $349 billion in aid for small businesses to maintain payroll and expenses.

Some policies exclude acts of God like floods or earthquakes. Insurance also can't replace lost customers or fix reputational damage from data breaches. So, your contingency plans must go beyond insurance to address revenue losses, operational costs, and reputational risks. Many businesses hire consultants to evaluate scenarios and develop response strategies.

Exploring Different Types of Contingency Plans

Corporations, governments, investors, and central banks like the Fed all use contingency plans. These can cover real estate transactions, commodities, investments, currency exchange rates, and geopolitical risks. Contingencies might include contingent assets, which are benefits that accrue if an uncertain event resolves favorably, such as a lawsuit win or an inheritance.

Your plans might involve buying insurance that pays out if a contingency occurs, like property insurance for fire or wind damage.

Managing Investment Risks through Contingency Plans

As an investor, you can protect yourself from contingencies leading to financial losses by using hedging strategies, such as stop-loss orders that exit positions at specific price levels. Options strategies act like insurance, earning money when an investment loses value from an adverse event, offsetting losses partially or fully. These come at a cost, like premiums paid upfront.

Asset diversification is another key approach, spreading investments across types to minimize risk if one class, like stocks, declines.

Contingent Immunization

In fixed-income investing, contingent immunization is a contingency plan where the fund manager shifts to a defensive position if the portfolio drops below a set value.

Ensuring Business Continuity and Disaster Recovery

For disasters like pandemics, your contingency plan should ensure business operations continue. This is often called a business continuity plan (BCP) or recovery plan. Form a team to handle contingencies and manage disruptions. Identify critical functions and analyze how events impact operations.

The plan includes recovering systems, production, and employee access to technology. For a pandemic, develop remote work strategies to prevent disease spread and provide secure access. Invest in laptops, video-conferencing, cloud storage, and company communications.

Strengthening Cybersecurity in Contingency Plans

Cybercriminals exploit disasters to hack systems and steal data. Your contingency plans should outline procedures for cybersecurity teams to protect against threats and attacks.

Critical Considerations for Effective Contingency Planning

Address potential loss of intellectual property through backups in secure off-site locations. Prepare for operational mishaps, theft, and fraud. Have an emergency PR response for reputation-damaging events. Include reorganization procedures to return to normal operations and limit damage, as Cantor Fitzgerald did after 9/11.

Benefits of a Contingency Plan

A good plan minimizes losses, like using backup generators during outages. It protects reputation by communicating effectively in crises. It supports continuity, including protocols for strikes. It improves your risk profile, potentially leading to better terms from lenders and insurers.

Banks and Contingencies

Post-2008 crisis, banks must conduct stress tests to see how they'd handle negative contingencies and ensure sufficient capital. They maintain capital reserves based on risk-weighted assets (RWAs). For example, mortgages might have a 50% weighting. Tier-1 capital includes equity and retained earnings, needing at least 6% of RWAs. If a bank has $7 million in Tier-1 capital and $70 million in RWAs, its ratio is 10%, making it well-capitalized.

The true test comes in the next recession, showing the challenges in planning for every scenario.

Why Is an Environmental Contingency Plan Important?

If your business handles hazardous materials, you need plans for environmental accidents to reduce damage, liability, and costs.

What Is Contingency Theory?

Contingency theory says the best management approach depends on the specific situation; what works in one company might fail in another.

What Are the Steps in Creating a Contingency Plan?

Identify key risks by likelihood and severity, conduct a business impact analysis, then shape your plan with preventive controls, incident response, disaster recovery, and business continuity. Train employees, test frequently, and update the plan.

The Bottom Line

Contingencies are potential adverse events like natural disasters, economic downturns, or cyber threats. By developing plans with protective strategies such as reserves, insurance, and recovery plans, you can minimize disruptions, protect assets, and preserve reputation. Comprehensive planning is essential for resilience and continuity against unexpected challenges.