What Is A Contingency Plan? And The 4 Different Types Of It

 

What is a Contingency?

The word contingency is very common and is being used in our day-to-day lingo, but when it comes to the financial industry let us look at what exactly does it mean?.

It refers to an alternative when any potential occurrence of a negative event occurs in the future, like an economic recession, natural disaster, fraudulent activity, terrorist attack, or a pandemic.

Many businesses took a hit due to the coronavirus pandemic in 2020 forcing many employees to work remotely. This resulted in, companies changing their contingency and implementing a remote work strategy.

However, for some businesses, working remotely wasn’t an option, so they had to implement enhanced safety measures for employees and customers to prevent the spread of the virus.

Even if one can be prepared with contingencies, the nature and scope of sudden negative events are unknowable in advance. Through analysis and implementing protective measures businesses and companies along with investors plan for various contingencies.

In finance, predictive models for possible contingencies which may occur are often identified and planned by managers.

Financial managers tend to make a mistake on the conservative side while mitigating risk, by assuming slightly worse outcomes.

A contingency plan can also include arranging a company’s affairs so that it can cushion the negative effect with the least impact possible.

The Working of Contingency

In conditions where the company meets with a period of poor sales or unexpected expenses for it to have strong liquidity, financial managers may often in their contingency plan often recommend setting aside a good reserve of cash.

When a company is in a strong financial position, managers may attempt to proactively open credit lines to be able to borrow when the times are less favorable.

For instance, pending litigation is looked upon as a contingent liability. Insurance policies could be used as contingency plans to cover losses that may occur during and after a negative event has occurred.

You need to know that insurance policies may not cover all of the costs or in every situation. For instance, pandemics cannot be covered by business interruption insurance, in spite of many businesses suffering because of the coronavirus pandemic.

To provide financial relief to businesses, families, and local governments the help came from the Federal government which passed the Coronavirus Aid Relief and Economic Security (CARES) Act, to support the economic hardship caused by the pandemic.

Also, the Paycheck Protection Program (PPP) provided aid to small businesses by offering $349 billion and helping them to maintain their payroll and expenses.

In event of an act of God, which is outside of human control, like a flood or an earthquake insurance companies have their own limitations in coverage and exclude quite a few situations.

Also, the customers who have lost to competitors because of the event, particularly if it was an internal systems issue like a data breach do not get assistance from insurance.

So businesses always need to set up contingency plans to avoid or minimize the lost revenue and increased costs that happen when business operations get disturbed and face turmoil.

Business consultants are hired to provide advice and ensure how to best execute the contingency plans by taking a large number of possible situations into consideration and planning accordingly.

Different Types of Contingency Plans

Organizations, governments, investors, and central banks like the Fed all contingency plans. Contingencies can be planned for real estate transactions, commodities, investments, currency exchange rates, geopolitical risks, and many more.

Protecting Assets

Contingent assets, which are profits that accrue to a company or individual in the situation of some doubtful event in the future, are also contingencies.

An ideal example of contingent assets would be a favorable ruling in a lawsuit or an inheritance.

If a particular contingency occurs then a contingency plan could involve purchasing insurance policies that pay cash or a benefit. to protect a property against fire or wind damage a property insurance can be purchased.

Investment

For situations that could lead to financial losses related to investing investors protect themselves with contingencies, by setting up various hedging strategies like stop-loss orders, so to exit a position at a stipulated price level.

Similar to buying insurance is the option of hedging whereby the strategies earn money as an investment position loses money from a negative event.

The earning from the options strategy completely or partially offsets the losses from the investment. But these strategies involve cost, in the form of a premium, which is a truthful cash payment.

Investors also use asset diversification, where they invest in different types of investments. If one form of asset, like stocks, declines in value then asset diversification helps to minimize risk.

Business Continuity & Recovery

As part of a contingency plan organizations need to plan ahead so that the business is not affected and can run well during and after an event. These contingency plans are called a business continuity plan (BCP) or a business recovery plan.

To plan for any possible contingencies and manage the continuity and recovery plan during a disruption a business continuity team is formed.

Businesses should identify their critical business functions and get an analysis done of how an event could impact the company’s operations and processes.

The contingency plan needs to contain implementing the recovery of significant business functions like systems, production, and employee access to computers.

Cyber Security

During any type of disaster, cybercriminals usually take advantage of a crisis to hack into a company’s systems and steal data or disrupt business operations.

To protect an organization from threats and malicious attacks contingency plans are used to work on the procedures by the cyber security teams.

A contingency plan must be prepared for the loss of intellectual property through theft or destruction. So backups of critical files and computer programs, company patents, must be maintained in a secure off-site location.

Contingency plans must be prepared in case of operational mishaps, theft, or fraud. The organization must have an emergency public relations response to avoid severe damage to the organization’s reputation and its ability to do future business.

How a company will bounce back after a negative event should be included in a contingency plan.

There should be procedures mentioning what needs to be done to return the company to normal operations and avoid any further damage from the event.

The best example of a comprehensive contingency plan is Cantor Fitzgerald, the financial services firm which was able to resume operation in just two days after the 9/11 terrorist attacks because of their well-set contingency plan.

Conclusion

Various contingencies are planned by companies and investors through analysis and implementing protective measures.

To minimize the loss and damage caused by an unforeseen negative event a thorough contingency plan is required.

The purchase of options or insurance for investment portfolios is also the type of contingency plan.

Banks also keep aside a percentage of capital to protect the bank against losses, like in events of recession.

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