What is Contingency
A contingency is a potential negative event that may occur in the future, such as an economic recession, natural disaster, fraudulent activity or a terrorist attack. Contingencies can be prepared for, but often the nature and scope of such negative events are unknowable in advance. In finance, managers often attempt to identify and plan for any contingencies that they feel may occur with any significant likelihood using predictive models. To mitigate risk, financial managers often err on the conservative side, assuming slightly worse-than-expected outcomes, and arranging a company's affairs so that it can weather negative outcomes with the least distress possible.
Common ways of dealing with contingencies include purchasing insurance policies that will pay off if a particular set of contingencies strikes - for example, property insurance against fire or wind damage. Contingencies related to financial investments can be mitigated through the use of hedging strategies, such as stop-loss orders, protective put options or asset diversification. These strategies, however, come at a cost, usually referred to as a premium, which must be paid regularly to maintain the protective coverage even if the contingency event never occurs.
BREAKING DOWN Contingency
To plan for contingencies, financial managers may often also recommend setting aside significant reserves of cash so that 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. Business consultants may also be hired to ensure contingency plans take a large number of possible scenarios into consideration and provide advice on how to best execute the plan.
Bank stress tests and the required capital reserves that most banks must now comply with are an example of ways to deal with contingencies.
There also exists the notion of contingent assets, which are benefits (rather than losses) that accrue to a company or individual given the resolution of some uncertain event in the future, such as a favorable ruling in a lawsuit or an inheritance.
Contingency Plan Considerations
A contingency plan needs to prepare for the loss of intellectual property through theft or destruction, so backups of critical files and computer programs as well as key company patents could be kept in a secure off-site location. Contingency 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 further damage from the event. Financial services firm Cantor Fitzgerald was able to resume operation in just two days after being crippled by the 9/11 terrorist attacks due to having a comprehensive contingency plan in place.
Benefit of a Contingency Plan
A thorough contingency plan minimizes loss and damage caused by an unforeseen negative event. For example, a brokerage 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 reduces the risk of a public relations disaster. A company that effectively communicates how negative events are to be navigated and responded to is less likely to suffer reputational damage. A contingency plan often 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 contingency plan in place may obtain better insurance rates and credit availability because they are seen to have reduced business risks.