United Grain Growers Enterprise Risk Man-converted

Kelas Akhir Pekan 19
FINANCIAL RISK MANAGEMENT
Dr. Erni Ekawati, MBA
CASE 1
United Grain Growers
Kelompok 2 :
Galih Honggo Baskoro
Moh. Dederianto
Vanessa Winastesia
2013
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Kelas Akhir Pekan 19
United Grain Growers
1. Company Overview
Based in Winnipeg, Manitoba, UGG provides commercial services to farmers and markets
agricultural products worldwide. It was founded in 1906 as a farmer-owned cooperative, and
became a publicly traded company on the Toronto and Winnipeg stock exchanges in 1993.
Figure 1 provides information on UGG's stock price since going public.
Although UGG is a public company, it retains some of its farmer cooperative roots. The
company has both members and shareholders. At the time of the initial public offering, the
members of the cooperative (farmers) automatically became members of the new
organization, and they also received limited voting common shares (thus making them both
members and shareholders of the new organization). An individual, who is not currently a
member, can apply for membership if the individual does a minimum amount of business
with the company. The initial public offering, as well as subsequent equity offerings, allowed
nonmembers to become shareholders.
Although a member is not entitled to share in any profit or distribution by the company
(unless the member is also a shareholder), members have control rights. Of the 15 people
on UGG's board of directors, 12 must be "members" who are elected by delegates
representing members from various geographical regions.
2. Key Issues / Problems
 Understand corporate’s risk exposure through the utilization and implementation of
enterprise risk management
 UGG’s total asset mostly financed by long term debt where the company was exposed
by credit risk. In the other hand, the agriculture business is risky due to the weather
factor. The ERM is needed to reduce the UGG’s business risk.
3. Analysis
We define the risk management process in UGG based on ISO 31000, as figured below.
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Figure 1 Risk Management Process (based on ISO 31000)
1. Establish context
UGG is comprised of four main business segments: Grain Handling Services, Crop
Production Services, Livestock Services, and Business Communications. UGG's four
business units help farmers plan, produce, and market their products.
Figure 2 United Grain Growers business segment
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



Grain Handling Services
Western Canada is a major producer and exporter of wheat, barley, canola, and
other grains and oilseeds. The role of UGG's Grain Handling Services unit
(comprised of Farm Sales and Services, Marketing and Transportation Services, and
Terminal Services divisions) is to identify sources of grain and oilseeds and deliver
them to exporters and to domestic end users, such as food processors. A farmer's
production of grain and oilseeds usually is transported to a country elevator, where
the product is weighed, graded, blended, purchased, and stored. From the elevator,
the product is shipped to a domestic consumer (e.g., a mill) or to an export terminal.
The farming industry in Canada is regulated by several government agencies. The
Canadian Wheat Board (CWB) markets human consumable grains on behalf of
farmers. About 85 percent of the wheat and 45 percent of the barley produced in
Canada is sold through the CWB. The CWB must ensure that the sales it has
arranged are available to customers at the agreed upon site and date. Thus, the
CWB contracts with companies like UGG to collect, store, and deliver grains. About
60 percent of UGG’s grain handling unit’s business is on behalf of the CWB. The
prices paid to farmers and the prices for storage and transportation of “board grains”
are determined by the CWB.
The Canadian Grain Commission regulates grain handling and maintains quality
standards for Canadian grain. Firms like UGG must obtain an operating license from
the Commission. The Commission also maintains extensive records of the grain that
is shipped from country elevators and from export terminals.
Crop Production Services
This unit provides inputs (e.g., seed, fertilizer and crop protection products) to
farmers. In addition, through its farm sales and services division, it provides a range
of consulting, agronomic, and financial services to farmers. UGG tries to differentiate
itself from its competitors by developing distinctive products sold under brand names
and by providing supervisor services to farmers.
Livestock Services
Provides inputs to producers of cattle, hogs, and poultry. This unit also faces
competition from a number of other grain and feed companies.
Business Communications
UGG’s smallest business unit is Farm Business Communications, which provides
information needed to run a profitable agribusiness. In addition to publishing
periodicals (Farm Investor Newsletter and Disease, Weeds & Insects), this unit has
developed web-based information on weather, market prices, and agribusiness
news.
2. Risk assessment
a. Risk identification
UGG started by forming a risk management committee, consisting of the CEO, CFO,
risk manager, treasurer, compliance manager (for commodity trading), and manager
of corporate audit services. This committee, along with a number of UGG
employees, then met with a representative from Willis for a brainstorming session to
identify the firm’s major risks. This process identified all exposure areas, as shown in
exhibit 1 and the risk taxonomy in exhibit 2. six risk area were chosen for further
investigation and quantification. The six risks were :
(1) environmental liability
(2) the effect of weather on grain volume
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(3)
(4)
(5)
(6)
counterparty risk (suppliers or customers not fulfilling contracts)
credit risk
commodity price and basis risk, and
inventory risk (damage to products in inventory)
The process of risk identification were described by the table shown below.
Business
Segments
Crop
Production
Services
Risk
Causes
Impact
 Utilization
of
hazardous
material
 Less concern of
workers
 Inappropriate
working tools
 Global warming
 Unexpected
natural
environment
behavior
 Neglecting
agreement
or
contracts
 Delay in delivery
 Unqualified
supplier
bad debt
Operation
shutdown
Commodity Price &
basis risk
Price Volatility
Profit loss
Inventory risk
 Inappropriate
Storage Method
 Less concern of
worker
 Warehouse or
facilities are not
functioning well
Profit loss
Environmental
liability
Grain Handling &
Marketing
Weather impact
Grain Handling &
Marketing
Counterparty risk
All
Business
Segments
All
Business
Segments
excepted Business
Comunication
All
Business
Segments
excepted Business
Comunication
Credit risk
Profit loss
Profit loss
Profit loss
b. Risk analysis
The process of risk analysis took the task of gathering data and estimating the
probability distribution of losses of six risk exposure mentioned above. It used
probability distribution to quantify the impact of each source of risk on UGG annual
loss. (exhibit 3 show the detail of UGG’s risk analysis)
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c. Risk evaluation
Weather becomes the main source of unmanaged UGG’s risk because it can’t be
controlled. Indirectly weather risk affects the UGG’s profit because the main business
of UGG is in the farm industry. UGG’s Profit depends on the Grain volume that can
be sold by the company. Grain volume comes from crop yield that very affected by
weather condition (illutstration on exhibit 4)
To summarize, Ken and Michelle established a relationship between weather and
UGG’s gross profit using the following steps and information:
Weather  Crop Yields  UGG’s Grain Volume  UGG’s Profit
Table 27.4
Table 27.1
Table 27.2
They illustrated their results by graphing UGG’s actual gross profit and what gross
profit would have been if the effects of weather were removed.
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3. Risk treatment
There were three alternatives plan to mitigate the risk.
Retention
One approach was to continue operating as they had been and not try to reduce their
weather exposure. As previously discussed, this approach exposed their profitability to
large swings due to weather variation. There were several disadvantages of such
volatility. First, UGG had been and planned to continue making large investments in
storage facilities (grain elevators). The ability to finance these capital expenditures from
internally generated funds would allow the firm to avo id the costs associated with raising
external capital. And, to the extent external capital would be needed, the rate that the
firm would have to pay on borrowed funds would likely be higher if they retained the
weather risk. Second, the variability in its cash flows caused UGG to hold extra equity
capital as a cushion against unexpected low cash flows in any given year. If the firm
could reduce its weather risk, it could increase the proportion of the firm financed with
debt without paying higher yields, which in turn would allow it to gain additional interest
tax shields. Third, although much of UGG’s current business could be characterized as a
commodity business, UGG tried to distinguish itself from competitors by creating
products 7 with brand names and by providing on- going services to customers. Stability
in the firm’s cash flows would help the firm characterize itself as a company that
suppliers and customers could rely on for service and high quality products for many
years. Moreover, the importance of supplier and customer relationships was likely to
increase in the coming years as the marketplace for agricultural products adjusted to
scientific advances. Analysts predicted that over the next decade, food producers would
demand specific genetically engineered crops, which in turn would require farmers to
plant specific seeds. The coordination of these activities between farmers and food
producers would require an information, storage, and transportation network. UGG saw
itself as a provider of these intermediary services. The main advantage of retaining the
weather risk was the cost associated with shifting it to someone else. In addition, Mike
and Peter were not sure that the capital markets really would reward the firm for
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eliminating weather risk, given that this was a risk that most investors could easily
diversify on their own.
Weather Derivatives
In the late 1990s, weather derivatives were a relatively new risk management tool.
These contracts were sold in the over-the-counter (OTC) market by firms such as Enron.
A contract could be tailored on a number of dimensions to meet the specific needs of the
buyer. For example, the underlying variable determining the payoffs could be one or a
combination of weather variables, such as average temperature, rainfall, snowfall, a heat
index, or the number of heating or cooling degree days. The payoff structure could
resemble a put option, a call option, a swap, or combinations of these structures. Exhibit
13 provides an example of how UGG could potentially use a weather derivative.
Suppose that, based on Willis’ analysis of the sensitivity of crop yields to weather and
the sensitivity of gross profit to crop yields, UGG’s expected gross profit exhibited a
pattern depicted in Figure A of Exhibit 13. The vertical axis measures expected gross
profit and the horizontal axis measures a weather index, which equals a weighted
average of various temperature and precipitation measures in western Canada. As the
index increases, expected gross profit increases (because crops yields increase, which
in turn increases UGG’s shipmentsof grains and seeds). For simplicity, the illustration
assumes that the relationship between gross profit and the weather index is linear. Since
low values of the weather index correspond to low expected profits for UGG, a derivative
contract that would pay UGG money when the index is low would provide a hedge.
Hedging their weather risk with derivatives was feasible, but it suffered from several
difficulties. Although Willis had performed a sophisticated analysis of the effect of
weather on UGG’s gross profit, the results of this analysis had to be converted into a
desired contract structure. That is, the underlying weather index that determined the
derivative contract’s payoff would need to be specified. Next, the effectiveness of the
derivative contract in hedging UGG’s risk would have to be assessed. UGG then would
have to obtain price quotes in a marketplace that had relatively few participants.
The Insurance Contract Idea
When discussing the weather analysis, Mike McAndless and Peter Cox thought of an
alternative way of dealing with the firm’s weather risk. They knew that the primary
reason weather was important was because weather affected UGG’s grain shipments.
They therefore wondered whether they could construct an insurance contract that would
pay UGG when its grain shipments were abnormally low. The obvious problem with such
a contract is the moral hazard problem – UGG’s pricing and service also influences its
grain shipments. One solution to this problem was to use industry-wide grain shipments
as the variable that would trigger payments to UGG. Industry shipments would likely be
highly correlated with UGG’s shipments, which would imply that the basis risk would be
minimal. In addition, because of its relatively low market share, UGG would have
minimal effect on the value of industry-wide shipments, which would significantly reduce
the moral hazard problem. Mike and Peter also considered the possibility of integrating
grain volume coverage with UGG’s other insurance coverage. Currently, UGG
purchased a number of different insurance policies for various traditional risk exposures.
For example, they purchased a variety of policies to cover their property exposures (e.g.,
a boiler and machinery policy to cover losses on machinery and equipment) and liability
policies to cover their exposure to tort liability (e.g, environmental impairment liability).
Each policy had its own retention level and its own coverage limit. By integrating it
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various coverages under one policy, UGG could replace the individual deductibles and
limits with an overall annual aggregate deductible and limit that would apply to all or a
subset of losses, including grain volume losses. Mike called Willis and asked them to
investigate the possibility of structuring an insurance contract on industry grain
shipments. Willis then contacted several major commercial insurers, including a division
of the lar ge reinsurer Swiss Re, called Swiss Re New Markets. Located in New York,
this group structured innovative risk financing deals for commercial entities.
4. Recommendations
Based on the analysis above, our recommendation of this case prefer to UGG to take an
Insurance contract. The weather was important and affected UGG’s grain shipments. They
could construct an insurance contract that would pay UGG when its grain shipments were in
abnormally low.
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EXHIBIT 1. UGG RISK UNIVERSE
STRATEGIC RISK (S)
EXTERNAL DYNAMIC
- Government Regulation
- Competitor Rivalry
- Macro Economic Instability
- Reputation
- Socio-Politic
STRATEGIC INISIATIVE
- Corporate Vision & Mission
- Strategic Objectives
- Key Performance Indicators
CORPORATE GOVERNANCE
- Corporate Goal Achievement
- Management Control System
- Risk Management
- Crisis Management
- Covenant
- Business Continuity Management
RESOURCE ALLOCATION
- Organizational Structure
- Human Resources Management
- Strategic Planning
COMMUNICATION
- Media
- Employee Communication
- Government Communication (esp.
Canadian Wheat Board)
BUSINESS PORTFOLIO
- Business Unit
- Strategic Allies
FINANCIAL RISK (F)
MARKET
- Interest Rate
- Exchange Rates
- Commodities Price
LIQUIDITY
- Cashflow
- Internal/ Corporate Funding
- Hedging
- Liabilities/ Credit
- Insurance
ACCOUNTING
- Accounting & Report
- Internal Control
CAPITAL STRUCTURE
- Loan
- Capital / Equity
- Dividend
- Pension Fund
- Bond
TAX
- Tax
OPERATIONAL RISK (O)
SUPPLY CHAIN
- Inventory (Loss/ Short)
- Counterparty
Business Operation
- Demand Forecast
- Pricing Forecast
- Weather impact
CUSTOMER SERVICE
- Customer Expectation
- Service Quality
HUMAN RESOURCES
- Corporate Culture
- HR Competence
- HR Welfare
- Outsourcing
FACILITIES & INFRASTRUCTURE
- Building/ Warehouse destroyed
- Electricity Installation
- Transportation
- Working Tools/ Equipment damage
TECHNOLOGY
- IT Management
- Obsolete
- System Security
DISASTER
- Local Disaster
- National Disaster
- Forced Majeur
- Demonstration & Terorism
COMPLIANCE RISK (K)
CODE OF CONDUCT (COC)
- Ethics
- Fraud
LEGAL ASPECT
- Contract/ Agreement
- Right & Obligation
- Intellectual Property Rights
- Lawsuits
- Permits
ENVIRONMENT
- Environment Liability
- Socio, Politic, & Culture
EXHIBIT 2. RISK TAXONOMY
CODE RISK GROUP
S
F
O
C
STRATEGIC
FINANCIAL
OPERATIONAL
COMPLIANCE
RISK
S.1
EXTERNAL DYNAMIC
S.2
STRATEGIC INISIATIVE
S.3
CORPORATE GOVERNANCE
S.4
RESOURCE ALLOCATION
S.5
COMMUNICATION
S.6
BUSINESS PORTFOLIO
F.1
MARKET
F.2
LIQUIDITY
F.3
ACCOUNTING
F.4
CAPITAL STRUCTURE
F.5
TAX
O.1
SUPPLY CHAIN
O.2
Business Operation
O.3
CUSTOMER SERVICE
O.4
HUMAN RESOURCES
O.5
FACILITIES & INFRASTRUCTURE
O.6
TECHNOLOGY
O.7
DISASTER
C.1
CODE OF CONDUCT (COC)
C.2
LEGAL ASPECT
C.3
ENVIRONMENT
S.1.1
S.1.2
S.1.3
S.1.4
S.1.5
S.2.1
S.2.2
S.2.3
S.3.1
S.3.2
S.3.3
S.3.4
S.3.5
S.3.6
S.4.1
S.4.2
S.4.3
S.5.1
S.5.2
S.5.3
S.6.1
S.6.2
- Government Regulation
- Competitor Rivalry
- Macro Economic Instability
- Reputation
- Socio-Politic
- Corporate Vision & Mission
- Strategic Objectives
- Key Performance Indicators
- Corporate Goal Achievement
- Management Control System
- Risk Management
- Crisis Management
- Covenant
- Business Continuity Management
- Organizational Structure
- Human Resources Management
- Strategic Planning
- Media
- Employee Communication
- Government Communication (esp. Canadian Wheat Board)
- Business Unit
- Strategic Allies
F.1.1
F.1.2
F.1.3
F.2.1
F.2.2
F.2.3
F.2.4
F.2.5
F.3.1
F.3.2
F.4.1
F.4.2
F.4.3
F.4.4
F.4.5
F.5.1
- Interest Rate
- Exchange Rates
- Commodities Price
- Cashflow
- Internal/ Corporate Funding
- Hedging
- Liabilities/ Credit
- Insurance
- Accounting & Report
- Internal Control
- Loan
- Capital / Equity
- Dividend
- Pension Fund
- Bond
- Tax
O.1.1
O.1.2
O.2.1
O.2.2
O.2.3
O.3.1
O.3.2
O.4.1
O.4.2
O.4.3
O.4.4
O.5.1
O.5.2
O.5.3
O.5.4
O.6.1
O.6.2
O.6.3
O.7.1
O.7.2
O.7.3
O.7.4
- Inventory (Loss/ Short)
- Counterparty
- Demand Forecast
- Pricing Forecast
- Weather impact
- Customer Expectation
- Service Quality
- Corporate Culture
- HR Competence
- HR Welfare
- Outsourcing
- Building/ Warehouse destroyed
- Electricity Installation
- Transportation
- Working Tools/ Equipment damage
- IT Management
- Obsolete
- System Security
- Local Disaster
- National Disaster
- Forced Majeur
- Demonstration & Terorism
C.1.1
C.1.2
C.2.1
C.2.2
C.2.3
C.2.4
C.2.5
C.3.1
C.3.2
- Ethics
- Fraud
- Contract/ Agreement
- Right & Obligation
- Intellectual Property Rights
- Lawsuits
- Permits
- Environment Liability
- Socio, Politic, & Culture
EHIBIT 3. CRITERIA & ANALYSIS
Risk Description :
Environmental Liability
Result :
A.1
Probability
A
Impact Scale
1
Risk Description :
C.3
Probability
C
Impact Scale
3
Risk Description :
Result :
A.2
Probability
A
Impact Scale
2
Risk Description :
A.1
Probability
A
Impact Scale
1
Risk Description :
B.1
Probability
B
Impact Scale
1
Risk Description :
A.2
Moderate
Might happen several times (Probability : 30% 60%)
C
High
High probability in occurance
PROBABILITY
Probability
A
Impact Scale
2
(60% - 100%)
Slight chance that it will happen (Probability : 0% 30%)
B
Moderate
Might happen several times (Probability : 30% 60%)
C
High
High probability in occurance
PROBABILITY
(60% - 100%)
Slight chance that it will happen (Probability : 0% 30%)
B
Moderate
Might happen several times (Probability : 30% 60%)
C
High
High probability in occurance
(60% - 100%)
Medium
Annual Loss : 1.000.0000 < x <
4.0000.000
3
Disaster
Annual Loss : x > 4.0000.000
Minor
Annual Loss : 0 < 1.000.000
2
Medium
Annual Loss : 1.000.0000 < x <
4.0000.000
3
Disaster
Annual Loss : x > 4.0000.000
Slight chance that it will happen (Probability : 0% 30%)
B
Moderate
Might happen several times (Probability : 30% 60%)
C
High
High probability in occurance
(60% - 100%)
Minor
Annual Loss : 0 < 1.000.000
2
Medium
Annual Loss : 1.000.0000 < x <
4.0000.000
3
Disaster
Annual Loss : x > 4.0000.000
Minor
Annual Loss : 0 < 1.000.000
2
Medium
Annual Loss : 1.000.0000 < x <
4.0000.000
3
Disaster
Annual Loss : x > 4.0000.000
IMPACT
Low
Slight chance that it will happen (Probability : 0% 30%)
B
Moderate
Might happen several times (Probability : 30% 60%)
C
High
High probability in occurance
(60% - 100%)
Minor
Annual Loss : 0 < 1.000.000
2
Medium
Annual Loss : 1.000.0000 < x <
4.0000.000
3
Disaster
Annual Loss : x > 4.0000.000
IMPACT
Low
Slight chance that it will happen (Probability : 0% 30%)
B
Moderate
Might happen several times (Probability : 30% 60%)
C
High
High probability in occurance
(60% - 100%)
CRITERIA
1
CRITERIA
A
CRITERIA
1
CRITERIA
A
CRITERIA
1
IMPACT
Low
CRITERIA
1
CRITERIA
A
PROBABILITY
2
IMPACT
Low
PROBABILITY
Annual Loss : 0 < 1.000.000
CRITERIA
A
PROBABILITY
Minor
IMPACT
Low
CRITERIA
1
CRITERIA
A
6
Inventory Risk
Result :
B
5
Commodity Price & Basis Risk
Result :
Slight chance that it will happen (Probability : 0% 30%)
4
Credit Risk
Result :
Low
3
Counterparty Risk
IMPACT
CRITERIA
A
2
Weather Impact
Result :
PROBABILITY
1
CRITERIA
1
Minor
Annual Loss : 0 < 1.000.000
2
Medium
Annual Loss : 1.000.0000 < x <
4.0000.000
3
Disaster
Annual Loss : x > 4.0000.000
EXHIBIT 4. RISK MAPPING
UGG RISKS EXPOSURE:
High
1
2
3
4
5
6
C
2
PROBABILITY
C.1
Moderate
B
4
A
B.2
B.3
1
A.1
UGG
RISK PROFILE
C.3
5
B.1
Low
C.2
Environmental Liability
Weather Impact
Counterparty Risk
Credit Risk
Commodity Price & Basis Risk
Inventory Risk
3
A.2
UGG RISK APETITE:
EXTREM
MODERATE
LOW
6
A.3
1
2
3
Minor
Medium
Disaster
IMPACT
2
1,3,4,5,6
EXHIBIT 5. MITIGATION PLAN
MITIGATION PLAN
NO
1
RISK DESCRIPTION
Weather Impact
RISK LEVEL
C.3
RISK
PRIORITIZA
TION
1
ALTERNATIVES
1. Retention
2. Weather Derivatives
3. Insurance Contract
CHOOSEN MITIGATION
Insurance Contract
RESIDUAL RISK
% RATE OF
MITIGATION COST
COST / IMPACT
N/A
N/A
DURATION
1 Year
PROBABILITY
C
High
IMPACT
2
Medium
RISK LEVEL
C.2 Moderate
MONITORING
MECHANISM
Internal Control of
Insurance portfolio