L21 Enterprise Risk Management- A Case Study Objective: UGG Case-describe and illustrate enterprise risk management (ERM) L21-Spring 2011 Module 1

Enterprise Risk Management Traditional approach: being questioned in the 1990s Manage each type of risk separately (silo approach) within separate departments e.g. pure risk manager & financial risk manager Enterprise risk management approach: Manage all risks in a unified framework Focus more on overall firm risk Some firms have established a new position: chief risk officer (CRO) L21-Spring 2011 Module 1

Enterprise Risk Management Arguments for ERM: Process provides managers with a better understanding of the firm’s full range of risks Many of the reasons for managing risk suggest looking at an aggregate performance measure (e.g., cash flows) Arguments against ERM Too time consuming to implement Lack of uniform metrics Cultural incompatibility Inadequate IT systems L21-Spring 2011 Module 1

United Grain Growers Case UGG was one of the first to use ERM Background on UGG: Operates in western Canada, a public company and the 3rd largest provider of grain handling services Provides commercial services to farmers and tries to differentiate itself from competitors by developing brand name products and by providing superior services Main business: grain handling service; crop production services; livestock service; business communications Capital expenditure program: replace old grain silos Recently increased financial leverage L21-Spring 2011 Module 1

EBIT for UGG’s Business Segments Earnings before Interest and Taxes =Gross margin-Expenses excluding depreciation-Depreciation L21-Spring 2011 Module 1

Consolidated Financial Highlights In 1999, EBITDA (earnings before interest, taxes, depreciation, and amortization) declined substantially relative to prior years. Total debt to net assets=37% , total assets financed through debt increased to 37% with the issuance of another $50 million in long-term debt Return on equity (net earnings to book value of equity)=1.17% L21-Spring 2011 Module 1

UGG ERM Process Formed a RM Committee Brainstorming session CEO, RM, CFO, Treasurer, Compliance manager (for commodity trading), Manager of Audit Services Brainstorming session Willis Corporation (insurance broker), RM committee, other employees Identified 47 main risks The top 6 risks were chosen for further investigation: Environmental liability Effects of weather on grain volume Counter-party risk Credit risk Commodity price and basis risk Inventory risk L21-Spring 2011 Module 1

UGG ERM Process - Gather data - Estimate loss distribution Willis tasks: - Gather data - Estimate loss distribution quantify impacts of each source of risk on measure of UGG’s performance, including ROE and EBIT - Estimate correlations among 6 risk exposures quantify impacts of the 6 sources of risk in combination on UGG’s performance L21-Spring 2011 Module 1

Focus on Weather Risk Ken Risko, statistician for Willis Risk Solutions, found weather was the most important source of risk Weather (temperature & precipitation) affects Crop yields which affects UGG’s grain volume which affects UGG’s gross profit Implementing regression analysis using data from 1960-1992 L21-Spring 2011 Module 1

Choice 1 --Retention Disadvantages ? L21-Spring 2011 Module 1

Choice 2--Weather Derivatives L21-Spring 2011 Module 1

Weather Derivatives Sold in the OTC market by Enron, Goldman Sachs etc, and CME The underlying variable determining payoffs can be average temperature, rainfall, a heat index or a combination. The payoff structure could be a put option, call option etc. L21-Spring 2011 Module 1

Weather Derivatives L21-Spring 2011 Module 1

Weather Derivatives Unhedged Profits UGG’s Payoff Weather Index A weighted average of various temperature and precipitation measures in western Canada L21-Spring 2011 Module 1

What Derivative Contract will provide a hedge? If hedged, what is the payout structure like? L21-Spring 2011 Module 1

Disadvantages of Weather Derivatives L21-Spring 2011 Module 1

What did UGG Do? Choice 3-Insurace Purchased multi-year insurance contract Bundled P&C coverages with grain volume coverage (e.g. boiler and machinery policy and environmental impairment liability) Grain volume coverage based on industry shipments Why not UGG’s own grain shipments? L21-Spring 2011 Module 1

Grain Volume Coverage AvgShpmnts = Average industry shipments in past five years (in tons) Shpmntst = industry shipments in year t If Shpmntst < AvgShpmnts, then a loss occurs Magnitude of loss = $25*15%* ( AvgShpmnts – Shpmntst ) $25UGG’s gross margin on per ton on grain shipment 15%marketshare of UGG Coverage depends on loss subject to retentions and policy limits L21-Spring 2011 Module 1

Bundling of Coverages Illustration of how coverage was bundled L21-Spring 2011 Module 1

Transaction Costs Bundling approach  Bundle multiple risk exposures into one contract Unbundling approach  hedge each exposure with a separate contract 1st point: if there are fixed costs per contract, then unbundling approach might be more costly 2nd point: Unbundling approach will result in unnecessary coverage, which increases costs that are proportional to the amount of coverage 3rd point: Unbundling approach is more complex, which can make it more costly to supply L21-Spring 2011 Module 1

Unnecessary Coverage Argument Illustrate unnecessary coverage with unbundling approach with an example Two exposures: Property Loss Liability Loss Firm does not want total loss to exceed $40 million Option 1:Purchase coverage on each loss with a deductible of $20 million Option 2: Purchase coverage on total loss with a deductible of $40 million L21-Spring 2011 Module 1

Unnecessary Coverage Argument Which one may be more costly? Problems for Bundled Policies? L21-Spring 2011 Module 1

Disadvantages of Insurance L21-Spring 2011 Module 1

Accomplishments & Lessons L21-Spring 2011 Module 1