ENTERPRISE RISK MANAGEMENT

THE MYSTERY OF ERM

Example of successful initiation of ERM program
helps clarify advantages

By Michael J. Moody, MBA, ARM

Previous articles discussed the value of looking at risks from a holistic point of view. This complete, 360-degree look allows companies to examine and measure all of the risks they are subject to and then to determine which risks are the most serious. By focusing on the most serious risks, enterprise risk management (ERM) allows corporations to develop strategies that mitigate them. Frequently, a comprehensive review of risks can identify major loss exposures; however, it should also be able to note opportunities for positive results via earnings stability.

And now that major U.S. stock exchanges and governmental agencies have begun to require stronger enforcement of corporate governance, in theory, one would expect much more interest in an enterprise risk management approach. In addition, the continued hardening of the property/casualty insurance market would appear to require companies to take advantage of any natural hedges that might be available to them within their own organizations, as well as operating efficiencies gained by integrated programs.

With the exception of several highly visible financial services organizations, ERM continues to be underutilized--despite the obvious reasons noted above. Why is this concept so slow to take hold?

Search for answers

ERM has been slow to catch on for a variety of reasons. One primary reason is the lack of real examples. The source of most examples has been ERM programs that have been implemented in financial service firms. One widely publicized non-financial service program was United Grain Growers (UGG), which completed its program in the late 1990s. A number of case studies and articles have been written about this transaction. It might be beneficial to review this case to see some of the particulars.

UGG considers ERM

United Grain Growers is a publicly traded company that is one of Canada's leading agri-business firms. It was started in 1906 and has a diversified group of products and services that include four main areas: sales of crops inputs and services, grain merchandising, livestock production services and farm business communications. However, one of UGG's major sources of revenue continues to be grain shipments. While UGG completed a merger with Agricore Cooperatives, Ltd., in November 2001, its risk profile remains similar to that of UGG.

In the late 1990s, company finance and risk management personnel began embarking on an extensive risk assessment process, with the assistance of The Willis Group. While this process did extend over several years, it provided significant insight into the company's risk profile. Along with representatives from Willis, the risk management committee identified 47 exposure areas. From those, they chose six major exposure areas for further investigation. These six risks were:

* Environmental liability

* Counterparty risks

* Credit risks

* Commodity price and basis risks

* Inventory risks

* Effects of weather on grain volume

UGG's risk management program at that time was made up of traditional property and casualty insurance policies issued for individual risks and hedging products to protect its financial risks. However, despite these protections, UGG's earnings exhibited considerable volatility. A comprehensive analysis determined that the main source of this volatility was an annual variation in the amount of grain that UGG shipped. Further, this grain volume variation was almost exclusively tied to weather-related issues.

Potential solutions

After reviewing the alternatives, UGG narrowed the viable options to three:

The first alternative was to leave the program alone and continue to purchase individual property and casualty insurance policies and derivatives. Unfortunately, this option had led to the volatility problems that UGG was currently experiencing. One of the key problems was the poor financial position this left the company in; and, with an aggressive investment program required for major building construction projects, continued retention of this volatility was not desired. In addition, the huge amounts of capital required to cushion these earnings swings was very cost inefficient. The risk management committee soon excluded this option.

Weather derivatives had recently been introduced to the market and represented yet another alternative for UGG. Sold over the counter, these contracts could be tailored to meet the specific needs of UGG. Weather variables such as average temperature, rainfall, snowfall, or the number of heating or cooling degree days could be incorporated into the derivatives. The derivatives were feasible; however, sufficient questions surrounding their effectiveness remained. The major shortcoming to this alternative was that it had relatively few participants. UGG decided to forego the weather derivatives alternative.

One alternative remained. UGG wanted to construct an insurance contract that incorporated all of its property and casualty risks, as well as possible losses when grain shipments were abnormally low. With input from Willis, UGG approached Swiss Re New Markets about designing such a product. Swiss Re structured an innovative risk financing approach that met the majority of UGG's requirements. In addition to providing traditional insurance coverage for most of UGG's property and casualty risks, the program incorporates a substantial amount of protection against revenue losses due to unusually low grain handling volumes.

New approach has appeal

UGG's management could see the advantages of the new enterprise risk management approach. It was clear from the start that it would provide more stability in earnings growth going forward and represented a major value-added approach to UGG's risk transfer efforts. Accordingly, UGG implemented the innovative program on January 1, 2000. Both UGG and Swiss Re gained significant recognition for this innovative approach to risk management. In fact, UGG received the risk management award from Treasury Management International magazine in 2000. When presenting the award, magazine Editor Judith Cowan noted UGG's innovative approach and stated that it "recognizes UGG for excellence in establishing one of the world's first enterprise-wide risk management programs within a non-financial organization."

The Swiss Re program was implemented and continues to be a central component of UGG's enterprise risk management program. To illustrate the value of the ERM, when reporting the company's current financial results on September 19, 2002, management stated that there had been a marginal increase in grain handling activities. They further noted that "current year earnings also reflect a partial recovery of the company's income reduction from low industry grain handling volumes under UGG's integrated risk financing."

Future of ERM

For the most part, UGG has viewed the integrated program used with Swiss Re as an initial step in its ongoing ERM process. UGG was able to gain a number of specific advantages from this implementation. First and foremost is the competitive advantage that the program provided via earnings stability. This allowed UGG to carry out an aggressive capital expenditure program, which included construction of more cost-effective physical plants. When it did become necessary to borrow funds, UGG was able to do so at more favorable terms.

Further, the purchase of the integrated product was done at a combined cost that was similar to UGG's prior insurance program; thus, the overall cost of risk remained the same. Being a product innovator also created good PR for the firm.

And finally, management was left with a much clearer picture of the company's complete risk profile. This exercise alone proved to be beneficial because the Toronto Stock Exchange had recently required publicly traded companies to secure a better view of their risks. UGG was an early complier.

Summary

As the editor of Treasury Management International pointed out two years ago, UGG's movement to ERM was noteworthy. Today, however, it should not be unique. If ERM is going to fulfill its promise, implementation by other companies needs to begin. While enhancing shareholder value has become less of an issue in the face of recent events, reducing earnings volatility is still a valid corporate objective. Insurers, reinsurers, brokers, consultants, and corporate risk managers must begin to avail themselves of ERM. *

The author

Michael J. Moody, ARM, is managing director of Strategic Risk Financing, Inc. (SuRF). SuRF is an independent consulting firm that has been established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.