ENTERPRISE RISK MANAGEMENT

UNITED GRAIN GROWERS

I.

HISTORY AND BACKGROUND

United Grain Growers (UGG) based in Winnipeg, Manitoba, was founded in
1906 as a farmer-owned cooperative and became a publicly traded company
on the Toronto and Winnipeg Stock Exchange in 1993. Although UGG is

public company, it retains some of its farmer cooperative roots. The company
has both members and shareholders. An individual can be both a member and
a shareholder. Although a member is not entitled to share in any profit or
distribution by the company, members have control right.
This company provides commercial services to farmers

and

markets

agricultural products worldwide. UGG is comprised of four main business

segments: Grain Handling Service, Crop Production Service, Livestock Service,
Farm and Business Communication. This business units help farmers plan,
produce, and market their products. For your information, Western Canada is a
major product of wheat, barley, canola, and other grains and oilseeds.

In Canada, the farming industry is regulated by several government agencies,

one of them is Canadian Wheat Board (CWB). CWB markets grains for human

cunsumption on behalf of farmers. 85% of the wheat and 45% of the barley
produced in Canada is sold through the CWB. This government agency, must
ensure that the sales it has arranged are available to customers at the agreedupon site and date. Thus, the CWBs contracts with companies like UGG to
collect, store, and deliver grains which is 60% of UGGs grain handling units
business on behalf of the CWB. The CWB also determines the prices paid to
farmers and the prices for storages and transportation of their grains.
Other agency, The Canadian Grain Commision (CGC) regulates grain handling
and maintains quality standards for Canadian grain. UGG and other firms must
obtain an operating license from the commision. CGC also maintains extensive
records of the grain that is shipped from country elevators and from export
II.

terminals.
PERFORMANCE
UGG is the third largest provider of grain handling service in Western Canada.
It has a market share of approximately 15%. UGG tries to differentiate itself
from its competitors by developing distinctive products sold under brand
names and providing superior services to farmers. It is done by the Crop
Production Service, through its Farm Sales and Services division which
provides a range of consulting, agronomic, and financial service to farmers.
Tabel 27.1

Tabel 27.2

Tabel 27.3

III. PROBLEM IDENTIFICATION

Based on tabel 27.3 which show us EBITDA 1998 1999 decreased and capital
expenditure increased. Most of these expenditures were for large grain
elevators with high throughput. This condition created ROE performance was
just 1.17%. As well that in 1999, the percentage of the firms total assets
financed with debt increased to 36.76% with the issuance of another
$50million in long-term debt.
Figure 27.2
Figure 27.2 show us that two largest UGGs business units, Grain Handling
Service and Crop Production Services account for more than 80% of UGGs
earning in most year. This figure also show the volatility of UGGs earning
especially in the main business segment, the two largest business units. This
volatility express and indicate risk of the firms faced.
Because of the risk, UGG started its Enterprise Risk Management (ERM)
process. Steps in this process:
1. Forming Risk Management Commitee
This commitee consist of:
- Chief Executive Officer (CEO)
- Chief Financial Officer (CFO)
- Risk Manager
- Treasurer
- Complience Manager (for commodity trading)
- Corporate Audit Service Manager
2. Brainstorming for Identify & Qualitatively Rank the Firm Major Risk

The commitee along with a number of employees met with the

representative from Willis Group Ltd., a major insurance broker. This
meeting was purposed for brainstorming and identifying the firms major
risk. After identified, they rank the risk and found the top six risk for further
investigation and quantification. They are:
(i)
Environmental liability
(ii)
The effect of weather on grain volume
(iii)
Counterparty risk (suppliers/customers didnt fulfill the contracts)
(iv)
Credit Risk
(v)
Commodity price and basis risk
(vi)
Inventory risk (damage to products in inventory)
Willis Group Ltd. Gathered and estimated the probability distribution of lossess
from each of the six risk exposures and associated correlation. It used these
probability distribution to quantify the impact of each source of risk on several
measures of UGGs performance (ROE & EBIT). In addition, Willis used the
correlations between the six sources of risk to quantify the impact of the six
sources of risk in combination on UGGs performance. The analysis includes the
estimation of frecuency, severity, total losses, and EBIT with and without the risk.
Willis Risk Solutions analysis led to the conclusion that, of the six risks originally
identified. UGGs main source of unmanaged risk was from the weather.
Therefore, they focused on understanding how weather affected UGGs
performance especially influenced by temperature and precipitation.
Statistic calculation and analysis held by Willis Risk Solution showed the
relationship between crop yields and weather, crop yields and UGGs grain
volume. Further analysis also related the UGGs grain volume to UGGs financial
results.

Weath
er

Crop
Yields

UGG's
Grain
Volume

UGG's
Profit

Figure 3.1 Willis Risk Solution Steps for Relating and Analyzing
Figure 3.2 / 27.4 scan
Figure 3.2 show us the summary of this analysis. It shows how weather
influences the UGGs gross profit. UGGs actual gross profit (1980-1992) is seen
more volatile than UGGs gross profit if the weather would have been constant
over the period. The weather would have been constant over the period if only
the firm took an alternative solution to hedge this risk.
IV. ALTERNATIVE SOLUTION
As the previous conclusion, UGGs main source of unmanaged risk was from
the weather. There three alternative solutions for this risk.
1. Retention
It means continuing operating as UGG had been and not trying to reduce
their weather exposure. Basically, retention exposed UGG profitability to
large swings due to weather variation, means high volatility. So, retention
means UGG retained the weather risk. This volatility creates three
disadvantages by using this alternative solution. They are:
(i)
Cost of debt increase when the risk increase
UGG had been planed to continue making large investment which is
financed with internal generated funds. But, to the extent, raising
external capital (debt) is needed. The rate of the firn would have to
pay on borrowed funds (cost of debt) would likely be higher if UGG
(ii)

retained the weather risk.

Retained risk (high risk) couldnt increase the proportion of the firm
finance with debt without paying higher yields.

Retantion creates variability in cash flows caused UGG to hold extra

equity capital as a cushion against unexpected low cash flow in any
given year. If UGG took this alternative, the firm couldnt reduce its
weather risk.

Meanwhile, if UGG could reduce its 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
(iii)

tax shields.
Variability in the firms cash flows would made the firm couldnt
characterize itself as a company that suppliers and customers could
rely on for service and high quality products for many years.

This alternative also has an advantage. Retaining the weather risk was the
cost associated with shifting it to someone else. UGG managers also were
not sure that the capital markets really would reward the firm for
eliminating the weather risk. It because most investors could diversify this
risk easily on their down.
2. Weather Derivatives
At that time, weather derivatives is one of new risk management tools. A
contract could be tailored on a number of dimensions to meet the specific
needs of the buyer. For simplicity, an 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 the weather risk with derivatives was feasible, but it entailed
several

dificulties.

Although

Willis

Risk

Solution

had

performed

sophisticated analysis of the effect of weather on UGGs gross profit, the

result of this analysis had to be converted into a desired contract structure.
Illustration pic from slideshare
3. Insurance Contract

The primary reason weather was important was because weather affected
UGGs grain shipments. The UGG managers wondered whether they could
construct an insurance contract that would pay UGG when its grain
shipments were abnormally low. The problem with such contract is moral
hazard, UGG s pricing and service also influences its grain shipments. One
solution for this problem was to use industry-wide grain shipments as the
variable tah would trigger payments to UGG.
UGG also considered the possibility of integrating grain volume coverage
with UGGs other insurance company. Currently, UGG purchased a number
of different insurance policies for various traditional risk exposures. Each
policy had its own retention level and its own coverage limit. Integrating
various coverages under one policy, UGG could replace the individual
deductibles and limits with an overall annual aggregate duductible and
limit that would apply to all or a subset of losses, including grain volume
V.

losses.
ANSWER QUESTION
1. Use the data in table 27.1 to calculate the correlation coefficient between
industry grain shipments and UGGs grain shipments.
2. Use the data in table 27.1 to calculate the correlation coefficient between
crop yields and UGGs grain shipments.
3. Given that any method of reducing the weather risk exposure will be
costly, what are the benefit to UGGs diversified owners from reducing the
weather risk? In other words, what characteristics of UGGs operations and
strategy would make risk reduction potentially beneficial to UGGs owners
who hold well diversified portfolios?
Mengingat bahwa metode apapun untuk mengurangi eksposur risiko
cuaca akan menjadi mahal, apa manfaat bagi uggs pemilik diversifikasi
dari mengurangi risiko cuaca? Dengan kata lain, apa karakteristik uggs
operasi dan strategi akan membuat pengurangan risiko berpotensi

bermanfaat

bagi

pemilik

UGG

itu

yang

memegang

portofolio

terdiversifikasi?
4. Should the UGGs rather unique ownership structure influence the decision
to reduce the weather risk exposure?
Haruskah UGG bukan struktur kepemilikan yang unik mempengaruhi
keputusan untuk mengurangi eksposur risiko cuaca?
5. How could the parties structure a weather derivative to cover the
exposure? More specifially, what would be the underlying index? Would
the contract be a put, call, or forward? Would they buy or sell? Would a
separate contract for each province and/or each crop be needed?
Bagaimana mungkin pihak struktur turunan cuaca untuk menutupi
eksposur? Lebih khusus lagi, apa yang akan menjadi indeks yang
mendasarinya? Apakah kontrak menjadi put, panggilan, atau meneruskan?
Apakah mereka membeli atau menjual? Apakah kontrak terpisah untuk
masing-masing provinsi dan / atau setiap tanaman diperlukan?
6. How could the parties structure an insurance contract to cover the grain
volume exposure? More specifically, how would a loss be defined? What
would be the payment to UGG conditional on a loss? (Hint: Use information
in Table 27.1 and Table 27.2)
Bagaimana mungkin pihak struktur kontrak asuransi untuk menutupi
eksposur volume gandum? Lebih khusus lagi, bagaimana kerugian
didefinisikan? Apa yang akan pembayaran untuk ugg syarat kerugian?
(Petunjuk: Gunakan informasi pada Tabel 27.1 dan Tabel 27.2)
7. What are the advantages and disadvantages of integrating the grain
volume coverage with the firms other insurance coverages? That is,
instead of having separate policies with separate duductibles and limits for
the various exposures (including the grain volume exposure), what are the
advantages and disadvantages of bundling all of the firms exposures in
one policy with one deductible and one limit? (Hint: review chapter 22)
Apa keuntungan dan kerugian dari mengintegrasikan cakupan volume
gandum dengan pertanggungan lain perusahaan? Artinya, daripada harus

terpisah dengan kebijakan deductible dan batas terpisah untuk berbagai

eksposur (termasuk gandum paparan volume), apa keuntungan dan
kerugian dari bundling semua eksposur perusahaan dalam satu kebijakan
dengan satu dikurangi dan satu batas? (Petunjuk: review pasal 22)
8. Ignoring cost differences, are there any advantages of the insurance
contract approach versus the use of weather derivatives? (Hint: Think
about basis risk , see chapter 25)
Mengabaikan perbedaan biaya, apakah ada keuntungan dari pendekatan
kontrak asuransi terhadap penggunaan derivatif cuaca? (Petunjuk: Pikirkan
tentang risiko dasar, lihat bab 25)