L21-Spring 2011 Module 1
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 departmentse.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 SegmentsEarnings before Interest and Taxes
=Gross margin-Expenses excluding depreciation-DepreciationEBIT
$(5,000)
$-
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
$35,000
1988 1990 1992 1994 1996 1998
Year
C$
(in th
ousa
nds)
Grain Handling
Crop ProductionServices
LivestockServices
Business Communications
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
• 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– 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
Weather Index
UGG’s Payoff Unhedged Profits
A weighted average of various temperatureand 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 )$25UGG’s gross margin on per ton on grain shipment15%marketshare of UGG
• Coverage depends on loss subject to retentions and policy limits
L21-Spring 2011 Module 1
Bundling of Coverages
Boile
r & M
achin
ery
Pro
perty
in T
ransit
Extra
Expense
Enviro
nm
enta
l
Impairm
ent L
iability
Charte
rer's
Lia
bility
Gra
in V
olu
me
Retention Coverage
Illustration of how coverage was bundled
Pro
perty
Lia
bility
Gra
in
Volu
me
Retention Coverage
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