United Grain Growers Ltd. (UGG), a grain distributor from Canada, is being audited for its exposure to a number of key risks, especially the weather impact on grain volumes and operating income. Understanding these risks was crucial because the company was in the midst of a major modernization and diversification initiative. But although United Grain Growers Ltd. already managed conventional risks via a variety of control processes, United Grain Growers Ltd. was still confronted with the issue of how to deal with the biggest risk; the weather.
Peter Tufano, Stuart C. Gilson, Joshua Musher
Harvard Business School (201015-PDF-ENG)
Feb 27, 2001 (Revision: Aug 20, 2003)
Case questions answered:
- Briefly describe the ERM process used by United Grain Growers Ltd. in consultation with Willis.
- What risks did UGG identify?
- How did Willis quantify the impact of each source of risk on UGG’s performance?
- How did they determine that weather risk was UGGs main source of unmanaged risk?
- Given that any method of reducing the weather risk exposure will be costly, what are the benefits to UGG’s diversified owners from reducing the weather risk? (Hint: Think about the value-enhancing rationales for risk management)
- How could the parties structure a weather derivative to cover the exposure? More specifically, what would be the underlying index? Would they need a separate contract for each crop and each province?
- How could the parties structure an insurance contract to cover the grain volume exposure? How would a loss be defined? And, what would be the payment to United Grain Growers Ltd. conditional on a loss?
- What are the advantages and disadvantages of integrating the grain volume coverage with the firm’s other insurance coverage? That is, instead of having separate policies with separate deductibles and limits for the various exposures (including the grain volume exposure), what are the advantages and disadvantages of bundling all of the firm’s exposures in one policy with one deductible and one limit?
- Ignoring cost differences, are there any advantages of the insurance contract approach versus the use of weather derivatives?
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Case answers for United Grain Growers Ltd. (A)
Introduction – United Grain Growers Ltd.:
United Grain Growers Ltd. (UGG) provides commercial services to farmers and as a result faces many of the risks associated with the agricultural industry. In consultation with the Willis Group, UGG came up with a clever way of utilizing the idea of enterprise risk management to mitigate their six main risks by identifying a single underlying risk, the weather.
Background: In the 1990s, UGG formed a risk management committee to meet with Willis in order to try to find the firm’s major risks. They identified 47 exposure areas where the six major risks were chosen were an environmental liability, weather, counterparty risk, credit risk, commodity price and basis risk, and inventory risk. Willis then gathered data on these six risks and modeled the frequency and severity of them all. Using these distributions, they modeled how the risks would affect their expected performance. From this analysis, it seemed clear to Willis that the main source of unmanaged risk was from the weather.
Weather Derivative: The structure of this derivative would be based on a well-defined underlying weather index. This index would be negatively correlated with temperature and positively correlated with precipitation. That is to say, if the temperature is lower or precipitation is higher, the index would go up, indicating good weather. The index could be linear and look something like Index = 2.70*Precipitation – .76*Temperature. The structure of the payoff could be that once a predetermined value is hit, UGG receives payments for each unit that the weather index is below the predetermined value. This way United Grain Growers Ltd. receives more money for worse weather.
The great thing about this contract is that UGG doesn’t need a specific contract for each crop and province as the risks are positively correlated, which means they can be bundled nicely. Using a regression, they found that if the weather is bad in Alberta, then it is likely bad in Manitoba and Saskatchewan as well. Similarly, the temperature and precipitation effect oats and wheat in the same way. Having a single contract is also nice because this minimizes transaction costs for UGG. However, it may be a little difficult to formalize such an agreement and to find someone to agree to this contract as the marketplace has few participants.
Insurance Contract: Another option that United Grain Growers Ltd. has to manage its risk is to purchase an insurance contract for grain…