What Is a Contingency?
A contingency is a future possibility of a negative event such as an economic recession, natural disaster, or pandemic. While the exact nature and scope of contingencies are often unknown in advance, they can still be prepared for through analysis and protective measures.
In finance, managers use predictive models to identify potential contingencies and create plans to mitigate risks. These plans usually take a conservative approach to prepare for slightly worse-than-expected outcomes.
A thorough contingency plan might include organizing a company’s affairs to handle negative outcomes with minimal distress.
Key Takeaways
- A contingency is a potentially negative event that may occur in the future.
- Companies and investors can plan for various contingencies through detailed analysis and protective measures.
- A well-prepared contingency plan can minimize loss and damage from unforeseen events.
- Such plans can include purchasing options or insurance to cover potential losses.
- Banks are required to set aside a percentage of capital to protect against negative contingencies like economic recessions.
How a Contingency Works
Financial managers often recommend storing reserves of cash to ensure liquidity during periods of poor sales or unexpected expenses. Opening credit lines while a company is financially strong can also ensure borrowing access during less favorable times.
For instance, pending litigation is considered a contingent liability. Contingency plans usually include insurance policies that cover losses during and after a negative event. However, these policies may not cover all costs or all scenarios. For instance, business interruption insurance often does not cover pandemics.
The government had to provide financial relief through the CARES Act during the coronavirus pandemic to address this gap. Insurance companies may impose exclusions, and they can’t replace customers lost due to internal issues like data breaches.
Businesses need comprehensive contingency plans to minimize revenue loss and additional costs during disruptions. Business consultants are often hired to create and implement these plans.
Types of Contingency Plans
Protecting Assets
Contingency plans might also address contingent assets, which are benefits that accrue upon the resolution of some uncertain future event. They might involve purchasing insurance policies to cover potential damages from events like fire or wind damage.
Investment Positions
Investors use strategies like stop-loss orders or option strategies to protect against financial losses. Asset diversification is another method to minimize risk if one asset class declines in value.
Contingent Immunization
Contingent immunization is a contingency plan in fixed-income investing where the fund manager switches to a defensive position if the portfolio drops below a predetermined value.
Business Continuity and Recovery
Companies need disaster recovery plans, also known as business continuity plans (BCP) or business recovery plans. These plans ensure that the business can continue operations during and after a disruptive event.
Critical business functions and potential impacts are analyzed, and plans are made to recover critical functions like systems, production, and employee access to technology. For example, a pandemic plan could include a remote work strategy and investments in necessary technology.
Cybersecurity
Cybercriminals often exploit disasters, so cybersecurity measures must be included in contingency plans to protect against threats and malicious attacks.
Special Considerations
A contingency plan should also safeguard against loss of intellectual property by maintaining secure off-site backups of critical files and patents. Plans should also prepare for operational mishaps, theft, fraud, and public relations crises.
How a company reorganizes after a negative event should be clearly outlined in the plan, similar to how Cantor Fitzgerald resumed operations after 9/11.
Benefits of a Contingency Plan
A thorough contingency plan minimizes loss and damage from unforeseen events and helps maintain operations during disruptions. It can also prevent public relations disasters, ensure consistent customer service during strikes, and result in better insurance rates and credit availability.
Banks and Contingencies
Post-2008 financial crisis regulations require bank stress tests to predict how banks might handle negative contingencies. Banks must maintain a percentage of capital reserves based on risk-weighted assets to survive negative events.
For example, a bank with $7 million in tier-1 capital and $70 million in risk-weighted assets would have a 10% capital ratio, exceeding the 6% requirement.
Why Is an Environmental Contingency Plan Important?
Businesses at risk for environmental accidents, particularly hazardous material spills, should have plans to respond quickly and minimize damage, costs, and liability.
What Is Contingency Theory?
Contingency theory suggests that the best organizational management style depends on specific situations, meaning what works for one company may not work for another.
What Are the Steps in Creating a Contingency Plan?
- Identify key risks and rank them by likelihood and severity.
- Conduct a business impact analysis (BIA).
- Shape your plan including preventive controls, an incident response plan, a disaster recovery plan, and a business continuity plan.
- Train employees, frequently test, and update the plan.
The Bottom Line
A contingency is a possibly negative future event or circumstance, and preparing for such events helps limit the damage done. Proper planning ensures that businesses, governments, and individuals can manage risks effectively.
Related Terms: Risk Management, Business Continuity Plan, Investment Portfolio, Economic Recession, Disaster Recovery.
References
- U.S. Congress. “H.R.748 - CARES Act”.
- Cornell Law School. “Minimum Capital Requirements”.
