What Is a Contingency?

A contingency is a potential occ𒁏urrence of a negative event in the future, such as an economic recession, natural disaster, fraudulent activity, terrorist attack, or a pandemic.

Although contingencies can be prepared for, the nat𒐪ure and scope of such negatౠive events are typically unknowable in advance. Companies and investors plan for various contingencies through analysis and implementing protective measures.

In finance, managers often attempt to identify and plan using predictive models for possible contingencies that they believe ma🍬y occur. Financial managers tend to err on the conservative side to mitigate risk, assuming slightly worse-tha🌃n-expected outcomes.

A contingency plan might include arranging a company's affairs so that it can weather negative outcomes with the least distress possible.

How a Contingency Works

To plan for contingencies, financial managers may often also recommend setting aside significant reserves of cash so tha🌺t the company has strong liquidity, even if it meets with a period of poor sales꧅ or unexpected expenses.

Managers may seek to proactively open credit lines while a company is in a strong financial position to ensure access to borrowing in less favorable times. For example, pending litigation would be considered a contingent liability. Contingency plans typically include insurance policies that⛄ cover losses that may arise during and after a negative event.

However, insurance policies may not cover all of the costs or every scenario. For example, 澳洲幸运5官方开奖结果体彩网:business interruption insurance doesn't usually cover pandemics, which many businesses suffered through as a result ꦕof the coronavirus pandemic.

The Federal government had to step in and pass the Coronavirus Aid, Relief, and Economic Security (CಌARES) Ac🌌t, which provided financial relief to businesses, families, and local governments to stem the economic hardship caused by the pandemic. In particular, the 澳洲幸运5官方开奖结果体彩网:Paycheck Protection Program (PPP) offered $349 billion in aid to small businesses to help them maintain their payroll and expenses.

Insurance companies might also limit coverage or put exclusions in place for an act of God, which is an exogenous event, meaning outside of human control, such as a flood or an earthquake. Also, insurance can't replace the customers that were lost to competitors due to an event, particularly if it was an internal systems issue such as a data breach.

As a result, businesses need to have contingency plans established to help minimize the lost rev♚enue and increased costs that are involved when business operations have been disrupted. Typicallyꦍ, business consultants are hired to ensure contingency plans consider a large number of possible scenarios and provide advice on how to best execute the plan.

Types of Contingency Plans

Contingency plans are utilized by corp🌞orations, governments, investors, and central banks, such as the Fed. ﷺContingencies can involve real estate transactions, commodities, investments, currency exchange rates, and geopolitical risks.

Protecting Assets

Contingencies might also include 澳洲幸运5官方开奖结果体彩网:contingent assets, which are benefits (rather than losses) that accrue to a company or individual given the resolutio💙n of some uncertain event in the future. A favorable ruling in a lawsuit or an inheritance would be an example of contingent assets.

Contingency plans might ൩involve purchasing insurance policies that pay cash or a benefit if a particular contingency occurs. For example, property insurance might be purchased to protect against fire or wind damage.

Investment Positions

Investors protect themselves from contingencies that could lead to financial losses related to investing. Investors might employ various hedging strategies such as 澳洲幸运5官方开奖结果体彩网:stop-loss o𒈔rders, which exit a position at a spඣecific price level.

Hedging can also involve using options strategies, which is akin to buying i⛦nsurance whereby the strategies earn money as an investment position loses money from a negative event.

The money earned from the options strategy completely or partially offsets the losses f꧂rom the investment. However, these strategies come at a cost, usually in the form of a premium, which is an upfr♏ont cash payment.

Investors also employ 澳洲幸运5官方开奖结果体彩网:asset diversification, which is the process of investing in various types of investments. 𝕴Asset diversification hel﷽ps to minimize risk if one asset class, such as stocks, declines in value.

Business Continuity and Recovery

As part of a contingency plan for disasters, such as a pandemic, companies need to plan ahead to ensure that the business can operate during and after an event. This type of contingency plan is often called a 澳洲幸运5官方开奖结果体彩网:business continuity plan (BCP) or a 澳洲幸运5官方开奖结果体彩网:business recovery plan.

Typically, a business continuity team is formed to plan for any possible contingencies and manage the continuity and recovery plan 澳洲幸运5官方开奖结果体彩网:during a disruption. Businesses need to identify their 澳洲幸运5官方开奖结果体彩网:critical business functions and perform an analysis of how an event might impact the company's operations🍬 and processes.

The contingency plan would include implementing the recover💦y of critical business functions such as systems, production, and employee access to technology such as computers.

For examp꧂le, a contingency plan for a pandemic would include developing a remote work strategy to help prevent the spre💙ad of disease and provide employees with secure access to their work.

As a result, companie𓂃s would need to invest in technology, which could include providing laptops and video-conferencing access to employees, creating cloud-based data storage, and facilitating access to company-wide communications such as email and internal data.

Cybersecurity

With any type of disaster, cybercriminals often try to take advantage of a crisis to hack into a company’s systems and steal data or disrupt business operations. Contingency plans are used to outline the procedures for 澳洲幸运5官方开奖结果体彩网:cybersecurity teams to prౠotect an organization from threats and mali♈cious attacks.

Special Considerations

A contingency plan should also prepare for the loss of intellectual property through theft or destruction. As a result, backups of critical files and computer programs, as well as key company paꩵtents, should be maintained in a secure off-site location.

Conti🅷ngency plans need to prepare for the possibility of operational mishaps, theft, and fraud. A company should have an emergency public relations response relating to possible events that have the ability to severely damage the company’s reputation and its ability to conduct business.

How a company is reorganized after a negative event should be included in a contingency plan. It should have procedures outlining what needs to be done to return the company to normal operations and limit any furtherᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚ damage from the event.

For example, financial services firm Cantor Fitzgerald was able to resume operation in ju♎st days after being crippled by the 9/11 terrorist attacks due to having a comprehensive contingency plan in place.

Benefits of a Contingency Plan

A thorough contingency plan minimizes loss and damage caused by an🌺 unforeseen negative event. For example, a bro꧙kerage company may have a backup power generator to ensure that trades can be executed in the event of a power failure, preventing possible financial loss.

A contingency plan can also reduce the risk of a p൲ublic relations disaster. A comp🅠any that effectively communicates how negative events are to be navigated and responded to is less likely to suffer reputation damage.

A contingency plan o🎐ften allows a company affected by a negative event to keep operating. For example, a company may have a provision in place for possible industrial action, such as a strike, so obligations to customers are not compromised.

Companies that have a continge🀅ncy plan in place may obtain better insurance rates and credit availability because they are seen to have reduced business risks.

Banks and Contingencies

As a result of the financial crisis of 2008 and the 澳洲幸运5官方开奖结果体彩网:Great Recession, regulations were implemented requiring bank stress tests to be ꦇperformed to test how a bank might handle various negative contingencies. The stress tests p𓂃roject how much a bank would lose—if a negative economic event occurred—to determine if the bank has enough capital or funds set aside to survive the event.

Banks are required to have a specific percentage of capital reserves on hand, depending on the total 澳洲幸运5官方开奖结果体彩网:risk-weighted assets (RWAs)ꦦ. These assets, which are typically loans, have var𒐪ious risk weightings applied to them.

For example, a bank's mortgage portfolio might receive a 50% weighting, meaning the bank—in a negative scenario—should have enough capital that's valued at 50% of the outstanding mortgage loans.

The capital, called 澳洲幸运5官方开奖结果体彩网:Tier-1 capital, can include equity shares or shareholders' equity and retained earnings, which are accumulated savings of prior years' profits. Although there are various components that go into the tier-capital ratio requirement, the ratio has to be at least 6% of the total risk-weighted assets.

Let's say as an example, Bank XYZ has $3 million in retained earnings and $4 million in shareholders' equity, meaning the total tier-1 capital is $7 million. Bank XYZ has risk-weighted assets of $70 million. As a result, the bank's tier-1 capital ratio is 10% ($7 million/$70 million). Since the capital requirement is 6%, the bank is considered well-capitalized when compared to the minimum requirement.

Of course, we won't know if the banking sector's contingency plan will be adequate until another recession occurs, which is a limitation of these plans since it's difficult to plan for every contingency.

The Bottom Line

A contingency is a potentially negative future event or circumstance, such as a global pandemic, natural disast🐈er, or terrorist attack. By designing plans that take contingencies into account, companies, governments, and individuals are able to limit the damage done by such events.