Insurance and Risk Finance 640

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Insurance and RiskFinance 640

• Class 19
• December 1, 2004

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Enterprise Risk Management

• Traditional approach
• Manage each type of risk separately (silo
  approach)
• 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

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Enterprise Risk Management

• Arguments for ERM
• Process provides managers with a better
  understanding of the firms risks
• Many of the reasons for managing risk suggest
  looking at an aggregate performance measure
  (e.g., cash flows)
• Arguments against ERM
• Too costly to implement

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United Grain Growers Case

• UGG was one of the first to use ERM
• Background on UGG
• Operates in western Canada
• Provides services to farmers
• Main business grain handling
• Capital expenditure program replace old grain
  silos
• Recently increased financial leverage

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EBIT for UGGs Business Segments
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The ERM Process

• Formed a RM Committee
• CEO, RM, CFO, Treasurer, Manager of Audit
  Services
• Brainstorming session
• Willis Corroon, RM committee, other employees
• Identified 47 main risks
• Six 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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Example of Analysis of each of the 6 Risks
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Focus on Weather Risk

• Ken Risko, statistician for Willis Risk
  Solutions, found weather was most important
  source of risk
• Weather
• affects Crop yields (Table 27.4)
• which affects UGGs grain shipments (Table 27.1)
• which affects UGGs gross profit (Table 27.2)

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Removing Effects of Weather
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Choices and their Disadvantages
Disadvantages

• Retention
• Weather derivatives
• Insurance contract

Planned capital expenditures Increased
leverage Protect reputation
Basis risk (weather index ?crop yields ?shipments
?UGG profitability Thin market ? low
liquidity high costs
Moral hazard ? use industry volume Basis risk
(industry shipments ?UGG profitability) Thin
market ? low liquidity high costs Should UGG
integrate with other coverages?
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What did UGG Do?

• Purchased multi-year insurance contract
• bundled PC coverages with grain volume
• grain volume coverage based on industry
  shipments

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Grain Volume Coverage

• AvgShpmnts Average industry shipments in past
  five years (in tons)
• Shpmntst industry shipments in year t
• If Shpmntst lt AvgShpmnts, then a loss occurs
• Magnitude of loss 25 (0.15) ( AvgShpmnts
  Shpmntst )
• Coverage depends on loss subject to retentions
  and limits

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Bundling of Coverages
Illustration of how coverage was bundled
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Accomplishments

• UGG Lowered Their Cost of Risk
• Insurance Premiums remained about the same
• Better Coverage
• Better able to carryout strategic plan
• Capital Expenditures
• Lowered Cost of Debt Capital
• Better Understanding of their risks

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Lessons from UGGs Experience

• Cooperation from many individuals
• Buy-in from top managers was important
• Technical expertise Willis
• Patience ERM takes time it is on-going