Enterprise Risk Management Case Study Ppt

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  • Presentation on theme: "L21 Enterprise Risk Management- A Case Study"— Presentation transcript:

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

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

    3 Enterprise Risk Management
    Arguments for ERM:Process provides managers with a better understanding of the firm’s full range of risksMany of the reasons for managing risk suggest looking at an aggregate performance measure (e.g., cash flows)Arguments against ERMToo time consuming to implementLack of uniform metricsCultural incompatibilityInadequate IT systemsL21-Spring 2011 Module 1

    4 United Grain Growers Case
    UGG was one of the first to use ERMBackground on UGG:Operates in western Canada, a public company and the 3rd largest provider of grain handling servicesProvides commercial services to farmers and tries to differentiate itself from competitors by developing brand name products and by providing superior servicesMain business: grain handling service; crop production services; livestock service; business communicationsCapital expenditure program: replace old grain silosRecently increased financial leverageL21-Spring 2011 Module 1

    5 EBIT for UGG’s Business Segments Earnings before Interest and Taxes =Gross margin-Expenses excluding depreciation-DepreciationL21-Spring 2011 Module 1

    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 debtReturn on equity (net earnings to book value of equity)=1.17%L21-Spring 2011 Module 1

    7 UGG ERM Process Formed a RM Committee Brainstorming session
    CEO, RM, CFO, Treasurer, Compliance manager (for commodity trading), Manager of Audit ServicesBrainstorming sessionWillis Corporation (insurance broker), RM committee, other employeesIdentified 47 main risksThe top 6 risks were chosen for further investigation:Environmental liabilityEffects of weather on grain volumeCounter-party riskCredit riskCommodity price and basis riskInventory riskL21-Spring 2011 Module 1

    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 performanceL21-Spring 2011 Module 1

    9 Focus on Weather RiskKen Risko, statistician for Willis Risk Solutions, found weather was the most important source of riskWeather (temperature & precipitation) affects Crop yieldswhich affects UGG’s grain volumewhich affects UGG’s gross profitImplementing regression analysis using data fromL21-Spring 2011 Module 1

    10 Choice 1 --RetentionDisadvantages ?L21-Spring 2011 Module 1

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

    12 Weather DerivativesSold in the OTC market by Enron, Goldman Sachs etc, and CMEThe 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

    13 Weather DerivativesL21-Spring 2011 Module 1

    14 Weather Derivatives Unhedged Profits UGG’s Payoff Weather Index
    A weighted average of various temperatureand precipitation measures in western CanadaL21-Spring 2011 Module 1

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

    16 Disadvantages of Weather Derivatives
    L21-Spring 2011 Module 1

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

    18 Grain Volume CoverageAvgShpmnts = Average industry shipments in past five years (in tons)Shpmntst = industry shipments in year tIf Shpmntst < AvgShpmnts, then a loss occursMagnitude of loss = $25*15%* ( AvgShpmnts – Shpmntst )$25UGG’s gross margin on per ton on grain shipment15%marketshare of UGGCoverage depends on loss subject to retentions and policy limitsL21-Spring 2011 Module 1

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

    20 Transaction CostsBundling approach  Bundle multiple risk exposures into one contractUnbundling approach  hedge each exposure with a separate contract1st point: if there are fixed costs per contract, then unbundling approach might be more costly2nd point: Unbundling approach will result in unnecessary coverage, which increases costs that are proportional to the amount of coverage3rd point: Unbundling approach is more complex, which can make it more costly to supplyL21-Spring 2011 Module 1

    21 Unnecessary Coverage Argument
    Illustrate unnecessary coverage with unbundling approach with an exampleTwo exposures: Property LossLiability LossFirm does not want total loss to exceed $40 millionOption 1:Purchase coverage on each loss with a deductible of $20 millionOption 2: Purchase coverage on total loss with adeductible of $40 millionL21-Spring 2011 Module 1

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

    23 Disadvantages of Insurance
    L21-Spring 2011 Module 1

    24 Accomplishments & Lessons
    L21-Spring 2011 Module 1

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