L21-Spring 2011 Module 1 L21 Enterprise Risk Management- A Case Study Objective: UGG Case-describe...

L21-Spring 2011 Module 1

L21 Enterprise Risk Management- A Case Study

Objective: UGG Case-describe and illustrate enterprise risk management (ERM)


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)


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


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


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


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%


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


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


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


Choice 1 --Retention

Disadvantages ?


Choice 2--Weather Derivatives


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.


Weather Derivatives


Weather Derivatives

Weather Index

UGG’s Payoff Unhedged Profits

A weighted average of various temperatureand precipitation measures in western Canada


What Derivative Contract will provide a hedge?

If hedged, what is the payout structure like?


Disadvantages of Weather Derivatives


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?


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


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


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


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


Unnecessary Coverage Argument

Which one may be more costly?Problems for Bundled Policies?


Disadvantages of Insurance


Accomplishments & Lessons

L21-Spring 2011 Module 1 L21 Enterprise Risk Management- A Case Study Objective: UGG Case-describe...

Documents

Transcript of L21-Spring 2011 Module 1 L21 Enterprise Risk Management- A Case Study Objective: UGG Case-describe...