Key Issue UGG (United Grain Growers) started implementing enterprise rise management by forming a risk management committee. This committee then met with a representative from Willis Risk Solution, a unit of Willis Group Ltd. UGG hired Willis Risk Solution to identify and qualitatively rank the firms major risk. This process identified 47 exposure areas and got the top six risks: 1. Environmental Liability 2. The effect of weather on grain volume 3. Counterparty Risk 4. Credit Risk 5. Commodity price and basis risk 6. Inventory Risk
The analysis conducted by Willis Risk Solution led to the conclusion that, of the six risks originally identified, UGG’s main source of unmanaged risk was from the weather. Argumentation 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.
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 Exhibit 10Exhibit 4 Exhibit 6 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. Their graph is reproduced as Exhibit 12. Alternative Solutions To manage the exposure to weather risk UGG managers explored several options: 1.
Retentions The retentions approach meant continuing operating as they had been and not trying to reduce their weather exposure. Retention exposed their profitability to large swings due to the weather. This option made the UGG’s financial perform will be very fluctuate. The high fluctuation is a bad news for investor. 2. Weather Derivative These derivatives appear in late 1990. These derivatives are traded on the OTC market by companies like Enron, Goldman Sachs, or Duke Energy.
A contract could be tailored on a number dimension to meet the specific needs of buyer 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. 3. Insurance Contracts This contract can be done by buying the premium of weather insurance to cover weather risk.. 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. By integrating it 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. The main idea of this solution is by bundling all the risk faced by the UGG with insurance so that the price of premium will be low. To make clearly the solution here the table of advantages and disadvantages of those solutions: Table 1: the advantages and disadvantages of the solution
This situation is not good for long time because the investors would not invest in UGG or if the investors would invest then they need high expected return. Figure 27. 4 From the table we suggest to choose the integrated insurance contract or weather derivative. The integrated contact means that the UGG integrates all the risks including grain volume loss so the premium of insurance can be low. The price of premium can be low because the bundling of insurance becomes more efficient if we compare with the insurance that separated each other.
To achieve this strategy the UGG should look for the insurance company that wants to cover all risks of UGG Company. Another solution is by using weather derivative with put option to minimize the risk of bad weather. The UGG can compare the premium of insurance after integrating all the coverages with the premium of weather derivative. Which one is cheaper whether premium of insurance or premium of weather derivative? If the premium of insurance is low then the UGG can choose the insurance contract.