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ERM/Integrated Risk Outcomes

The concept of developing an ERM process was new in the late 1990s. UGG started by identifying and assessing its principal risks. As indicated earlier, since the 1970s a substantial amount was already being done to control and measure the cost of property, casualty, liability, environment, safety, and loss control risks, in addition to potential (if unhedged) grain price exposure; the additional dimension was to apply the same systematic procedures to all the company's major business risks.

The major risks were identified through the ERM exercise. Quantitative risk analysis confirmed (not unexpectedly) that weather had the greatest impact on UGG's earnings, cash flow, and debt stability. Almost 100 years of data was available on the Canadian prairies' crop production levels; this revealed that major droughts, such as occurred during the late 1920s and early 1930s, could reduce grain production and, consequently, UGG's grain handling volume in the subsequent year by as much as 50 percent. Since this could pose a significant threat to UGG's profitability, cash flow, and ability to control its debt level (and, therefore, investment plans), UGG's senior finance, risk management, and treasury personnel began searching for a means to control this risk at reasonable cost.

Two different approaches to the problem were explored: Aware that financial derivatives might offer a solution, discussions were initiated with financial institutions; but none could be identified that were able to hedge the risk. UGG then began collaborating with its insurance broker, who conceived an insurance solution – a structure that incorporated the grain volume risk with all UGG's traditionally insured risks (property, casualty, freight, liability, etc.) into an "integrated risk-financing program." UGG was intrigued by this concept, particularly since a quantitative analysis suggested that such a program would cost no more than the discrete insurance policies that UGG was currently buying – without grain volume insurance. UGG's executive management worked closely with the broker and market to address this never previously insured exposure. Swiss Re, largely because of its expertise, capacity, and triple A financial rating, provided UGG with a groundbreaking integrated risk-financing program that applied to the various event risks that had previously been addressed by monoline traditional insurance policies, and a parametric risk solution tied to the expected volume of grain passing through UGG's grain handling pipeline.

The effect of this on UGG's potential financial stability was dramatic; while it "protected" (put a floor under) grain handling earnings that represented approximately 50 percent of UGG's total gross profits, it had an even greater proportionate effect on the company's net profits and cash flow – providing, by stabilizing its debt structure, greater assurance of its ability to deliver on its strategic plan. The Economist pointed out that "for a large chunk of its own equity, it [UGG] substituted the imposing capital of the world's largest reinsurer."[1]

It is worth noting that while the financial media sometimes referred to UGG's risk-financing program as ERM, this was a misnomer; it was in fact an integrated risk-financing program (combining multiple property and casualty risks with the grain volume coverage). It was UGG's different approach to thinking about risk – considering both the upside as well as the downside from an enterprise perspective – that was the ERM in the company's process.

  • [1] "Outsourcing Capital."
 
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