1. L21 Enterprise Risk Management- A Case Study
Objective: UGG Case-describe and illustrate enterprise risk management (ERM)
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2. 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)
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3. 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
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4. 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
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5. EBIT for UGG’s Business Segments Earnings before Interest and Taxes =Gross margin-Expenses excluding depreciation-Depreciation
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6. 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%
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7. 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
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8. 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
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9. 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
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10. Choice 1 --Retention
Disadvantages ?
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11. Choice 2--Weather Derivatives
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12. 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.
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13. Weather Derivatives
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14. Weather Derivatives Unhedged Profits UGG’s Payoff Weather Index
A weighted average of various temperature
and precipitation measures in western Canada
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15. What Derivative Contract will provide a hedge?
If hedged, what is the payout structure like?
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16. Disadvantages of Weather Derivatives
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17. 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?
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18. 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
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19. Bundling of Coverages Illustration of how coverage was bundled
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20. 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
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21. 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
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22. Unnecessary Coverage Argument
Which one may be more costly?
Problems for Bundled Policies?
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23. Disadvantages of Insurance
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24. Accomplishments & Lessons
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