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AJ Buono

Dr. Miller

Corporate Risk Management

Project #2 – Risk Treatment and Analysis

19 April 2016

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To: Steve Miller, CEO, Caterpillar INC.

Executive Summary:

In my last report identified several risks that our corporation Caterpillar INC. could incur

(which can be found in Appendices A and B). Furthermore I narrowed down the three risks in

which I recommended to be further analyzed (Products Liability, Natural Disasters, Labor

Disputes / Expiring Collective Bargaining Agreements) (“Caterpillar 10K”). In addition, I have

provided several risk treatment techniques for each risk to reduce the loss if the risk occurs.

For products liability exposure I used the risk treatment techniques through both risk

control and risk financing. My analysis and treatment suggestions included analysis in the case in

which we were to purchase a general liability policy for products liability with limits up to $200

million dollars and conducting extensive inspections bi-quarterly.

Similar to our products liability I used risk control and risk financing techniques in

treating our natural disaster risks. Using a visual approach in the analysis I was able to identify

probabilities of certain linked scenarios occurring as well as the costs / benefits of purchasing a

Cat Bond.

Finally, for our labor disputes and expiring collective bargaining agreements the analysis

conducted visually as well as quantitatively shows how the probability of certain scenarios if the

risk were to occur and the success of planning a funded retention to treat this exposure

Thank You,

AJ Buono

Chief Risk Officer, Caterpillar INC.

Risk Analysis/ Treatment In-depth Analysis:

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Risk #1 Products Liability

As previously discussed in my initial report I identified product liability as a top risk our

company faces. It’s our duty as a global leader in manufacturing construction and mining

equipment that we produce the best quality products in the market that are safe for the client’s

use. From my initial findings I found the frequency of the risk to be a 3 and the severity at a 4

giving this risk a medium impact on the firm (Appendix A & B). Furthermore, through my

identification process when looking at the previous loss histories we faced up to $100 million

dollars in losses. This number became important in the process of accurately treating this risk

which included purchasing general liability and umbrella coverage as well as bi-quarterly

inspections. By treating this exposure it’ll considerably reduce the impact of this risk on our

firm.

As stated earlier to properly treat this risk I decided do this dually through both risk

financing and risk control. First, through risk financing I am suggesting we should purchase a

general liability policy along with several excess levels to properly cover our product liability

exposures. Insurance is one of the more popular risk financing and risk treatment techniques

used in cases such as these. Overall, insurance helps provides the funds needed to meet the

financial consequences of when a hazard risk occurs (Corporate Risk Management 6.8). The

commercial general liability policy covers for several exposures one of them being products

liability, including the legal costs for settling products liability cases until the limits are

exhausted. Our previous losses suggest we should only purchase $100 million dollars in limits

however I disagree with the assumption. In my view at this time, we need to prepare for the

worst case scenario until we have the risk under control. Henceforth, I recommend we purchase

around $200 million in limits of a general liability policy because we may run into cases where

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the losses exceed $100 million dollars during the policy period. This is why I suggest we

purchase an extra $100 million in limits compared to our loss histories, otherwise we will have to

pay losses after the limits are exhausted. The insurance program I have put together includes;

primary general liability coverage of $1 million limits, a buffer umbrella policy that has limits of

$10 million, and six layers of excess coverage to bring the limits up to $200 million with the

assumption we will pay the first $500,000 of any products liability claim through a deductible.

Later, I will discuss how this insurance program will lower our expected losses by $80 million

through discrete loss distribution over time. Moving on from risk financing, I have also

recommended a risk control technique to treat this risk. This suggestion is to hire outside

inspectors to visit our manufacturing facilities twice a quarter. This is a loss prevention technique

that aids in reducing the frequency of a risk from occurring (Corporate Risk Management 7.5).

By having inspectors coming in to our manufacturing facilities 8 times a fiscal year, they’ll be

able to look over our manufacturing equipment, evaluate the common practices of our production

employees and provide us better suggestions for our operations within manufacturing. Through

this loss prevention technique it will not only lower the frequency of our products liability

exposure it can assist in lowering our insurance premiums as well as possibly considering a

reduction in limits needed in the insurance policy in the future.

In order to analyze this risk I used a discrete loss distribution and an NPV analysis to

decide if the risk treatment techniques would be beneficial for the firm. With the given

deductible and program structure I assumed in the case a products liability loss occurred 50% of

the time the claim would simply reach our deductible meaning we’d pay at most $500,000

dollars for the claim (Appendix E). From there 40% of the time the claim would not only reach

our deductible but the reach the policy’s limits (Appendix E). Multiplying that 40% by the

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proposed policy limits ($200 million) I calculated the expected loss to be $80 million dollars

(Appendix E). Calculating the expected loss was useful for my NPV analysis of the risk

treatment techniques. Appendix H has the NPV analysis that was conducted for products liability

in which a positive $359,666,340 was calculated. In this analysis my assumptions included the

cost of the insurance which upfront cost of $2.9675 million dollars, and $8 million dollars for the

bi-quarterly inspections at our manufacturing facilities as well as the $80 million expected loss of

the insurance company which was all assumed as the loss reduction for implementation of these

risk treatment techniques. Overall within the next 10 years these treatments will provide a

positive investment to Caterpillar

Risk #2 Natural Events

Natural Events were the second risk I had recommended to be further analyzed. The

occurrence of one of these events could severely impact us operationally and financially

(“Caterpillar 10K”). From my initial report with the assistance of a cross functional team we put

together a Scenario Analysis and Scenario Tree which helped illustrate all the scenario’s the

could occur as well as which scenarios that are linked if a natural event occurs. (Appendix C). In

treating this risk we use a similar approach for what I did for our products liability exposure.

In this case I am recommending treating this risk again with risk financing and risk

control. Using the financial instrument of a CAT Bond and investing in a disaster recovery plan.

A CAT Bond is similar to insurance, however is specifically designed to cover for catastrophic

losses. The bond overall issued through a special purposes vehicle (SPV) to the company looking

to purchase the bond. If there is a catastrophe the party who purchased the CAT Bond gets paid

to cover the lose via the SPV and if the catastrophe doesn’t happen those who have been

investing in the CAT Bond from the outside receive a good return on the bond. In addition to the

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CAT Bond, I recommend Caterpillar should invest in a disaster recovery plan. Investing in this

plan will put together a set of procedures for when a catastrophe hits such as emergency

responses, other pre-loss procedures as well as post-loss procedures to continue operations while

reducing further losses from occurring (Corporate Risk Management 7.8). This disaster recovery

plan is a form of loss reduction, meaning the severity of the loss would decrease from

implementing this disaster recovery plan (Corporate Risk Management 7.6-7.7). For us at

Caterpillar, investing in a disaster recovery plan can help us reduce the damages to our facility,

responding to emergencies in the appropriate way and continue our operations such as boarding

up some of the vulnerable areas within our facilities, educating our frontline employees in how to

respond in the case that a catastrophic event occurs in the facility they are working in.

In my further analysis I used an event tree analysis to get a better understanding on the

consequences if a natural catastrophe were to affect our firm as well as conducted an NPV on

potential investments of a CAT Bond and a disaster recovery plan. Having already identified the

different scenarios if a natural catastrophe were to occur in Appendix C, I took this to the next

level and ran two event tree analyses, one for manufacturing facilities and one for distribution

facilities (Appendix F). The event tree analyses are another great visual to look at different

scenarios in case of if an event occurs, the linkages between different scenarios and providing a

probability measurement. In Appendix F, 9 linked scenarios were created with ranging

probabilities between 40% to .4%. This further illustrates the many situations Caterpillar could

possibly face if effected by a natural catastrophe. Moving on to the investments in risk treatment,

an NPV analysis calculated a positive $162,136,960 NPV (Appendix I). Some key assumptions

made were if our firm were suffering losses in the worst case scenario, ($500 million dollars)

while multiplying it by 10%, (the assumed frequency of the risk) to get expected losses of $50

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million dollars. Additionally, I considered the cost of a million dollar disaster recovery plan and

a $67.9 million dollar CAT Bond in the analysis. All things considered, these two risk treatments

would provide a positive investment for our company and can be put up to the test as losses

could grow rapidly with this risk.

Risk #3 Labor Disputes / Expiring/ Renegotiating Collective Bargaining Agreements:

The third and final risk I suggested we did further analysis on is our labor disputes and

expiring collective bargaining agreements exposure. At Caterpillar we have 8,200 production

employees who are covered under a collective bargaining agreement in which are set to expire in

the fiscal years of 2017 and 2018 (Appendix D). Without frontline employees our firm could see

delays in operations and a loss in profits due to any work stoppages from this risk. In order to

properly treat this risk Caterpillar must plan ahead in case we are unable to renegotiate terms

with the labor unions.

As stated earlier, Caterpillar needs to plan ahead for this risk due to uncertainty, if

settlements can’t be made before a collective bargaining agreement expires. In order to do so I

am recommending we plan a complete funded risk retention for this exposure. As we are

planning ahead this would be an investment thought and planned out ahead of time, and is

completely funded and accounted for, not partially (Corporate Risk Management 6.9-6.10).

Creating this planned funded risk retention will allow us to hire temporary workers in times of

dispute with the labor unions and work stoppages due to an expiring collective bargaining

agreement.

Similar to my previous analysis I used a visual to explain the different situations our firm

would be put in if this exposure were to occur. Using a Decision Tree I was able to further

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illustrate the different outcomes if we were to put together a planned funded retention for this

risk. Appendix G contains the Decision Tree analysis conducted for this risk. In the case that we

decided to follow through with financing the retention there are 3 outcomes that could possibly

happen. First, there might not be a dispute at all in which we are still holding on to the retention

we planned for. Secondly, if there is a full dispute with all 8,200 covered employees, then we

have a completely funded retention to go and hire temporary workers to continue our operations

while we settle the labor dispute or expiring collective bargaining agreement. Finally, if there is a

partial labor dispute and/ or work stoppage with some but not all covered employees (since not

all of them are covered under the same collective bargaining agreement), we have funding to hire

workers to temporarily keep operations going as we settle the dispute. The other decision we

have is if ultimately as a firm we decide not to not follow through with the funded retention,

Caterpillar can suffer major losses due to operational delays if there’s a labor dispute. From the

NPV analysis on this risk treatment technique I calculated the NPV to be approximately $226.5

million dollars (Appendix J). After taking into consideration the average annual salary of our

production employees ($92,365), legal and contact negotiation fees as well as the assumption

that we’d need temporary workers for about 1 month before a settlement was made. Our firm

would need to finance about $63.1 million dollars for fully funded risk retention for this

exposure.

Conclusion:

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Through my extensive analysis I was able to provide treatment solutions for these top

priority exposures Caterpillar faces. Although the NPVs for our potential investments in risk

management are great, we always need to consider conducting risk management. The costs may

be high but it doing it allows us many benefits such as providing us stability in contracting with

all our stakeholders and gain easier access to resources such as capital.

Appendices

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Appendix A: Risk RegisterRisk Description Risk Type Method Identified Likeihood (1 to 5 Severity 1 to 5) Risk Impact (combining both likelihood and severity)Union Disputes / Collective Bargaininig Agreements - Some of our employees are represented by a Union in which their collective bargaining with varying experation dates. Failure to renegotiate existing collective bargaining agreements could lead to interruption in business operation and other issues with labor unions

OperationalEmployee Survey's /

Interviews / Compliance Review

3 4 Medium

Natural Disasters- Large unexpected events such as natural disasters, war, terrorism and pandemics could lead into manufacturing and distribution centers, as well as disruptions in operations, supply of key compnent products

HazardExternal Expert/ Scenairo Analysis 1 5 Medium

Lawsuits / Investigations regarding Products Liability

HazardOnsite Inspections /

Loss Histories 4 5 High

Failure to Realize all benefits associated or benefits materialize later than expected with joint ventures, acqusitions, and other strategies

StrategicScenairo Analysis / Document Analysis- Financial Statements

1 3 Low

Cyber Liability Hazard / Strategic /

Operational

Cyber Assesment / Scenairo Analysis 3 5 High

5 Natural Disasters * Cyber Liability

Manufacturing's high dependance of the

demand of the cyclical Construction Industry

Lawsuits regarding Products Liability *

4-5Employee Injured on

the job / Worker's Comp.

High Steel Prices

4 High dependance on Consumer Spending

Union Disputes / Colletive Bargaining

Agreements *

Failure to maintain postive credit ratings

3-4Interest Rate

Fluctuations / Cost of Acessing Capital

Oil Prices

3

Failure to Realize all benefits associated or

benefits materialize later than expected with joint

ventures, acqusitions, and other strategies

Failure to comply with Environmental

Regulations

Exposure to political risks in the countries we

operate in

Must follow inventory and sourcing decisions

of our dealers and original equipment

manufacturer customers- can impact

CAT positively or negatively

Operating within a highly competive

industry

2-3

2 Currency Exchange Rate Fluctuations

1-2

1 Changes is US GAAP Accounting Principles

1 1-2 2 2-3 3 3-4 4 4-5 5

Frequency

Seve

rity

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Revisited from project 1 Appendix A contains a shorten risk register highlighting the 3 key risks

that are analyzed in this report.

Appendix B Heat Map

Key: 3 Key Risks Identified

Severity / Frequency

1 (Low) to 5 (High)

Key High Severity / Frequency

Medium Severity / Frequency

Low Severity / Frequency

* after risk is identified as a Top 3 Risk

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Revisited from project 1, Appendix B contains the Heat Map has all 18 risks listed in the risk

register in Appendix A illustrates where each risk stands in regards to one another, factoring both

the frequency and severity of the risk. From the map and key the risks in red are considered

highly impactful, risks in orange have a medium impact and risks in green have low impact. The

top 3 identified risks have an asterisk next to them.

Appendix C

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Revisited from project 1 in Appendix C is a scenario tree for Natural Disasters which was

constructed together by a cross functional team that includes myself, our CFO Bradley

Halverson, V.P. of our Global Supply Network Frank Crespo, V.P. of Middle East, Asia and

Africa Distribution Raymond Chan, V. P. of Americas & European Distribution Phil Kelliher,

and Qihua Chen V.P. of China Operations. While taking in consideration several different

unexpected natural events we put together several different outcomes based on if the event were

to occur or not. As illustrated above there is at least 9 different situations that Caterpillar could

face in the case of if a natural event occurred near their operations.

Appendix D

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Appendix D is a snapshot of all the employees Caterpillar has, the footnotes below share how

many production employees are covered under a collective bargaining agreements as well as

when some of the agreements expire. (“Caterpillar 10K” 7).

Appendix E: Discrete Loss Distribution Products Liability

Above is a discrete loss distribution for our Products Liability risk. In this case it analyzed the

risk treatment technique of the purchasing of a general liability insurance policy with $200

million dollars in limits for products liability. Through this loss distribution we were able to use

the expected loss for products liability claims to be paid by the insurer as our assumption for loss

reduction in our NPV analysis for this risk treatment technique in Appendix H.

Ocurrence Probability Loss Payment Expected Loss / CostNo Products Liability Claim Made 10% $0.00 $0.00Products Liability Claim Made and payed by us through a deductible 50% $500,000.00 $250,000.00Products Liability Claim Made and payed by insurer ($200 million in Limits) 40% $200,000,000.00 $80,000,000.00Total 100% $200,500,000.00 $80,250,000.00

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Appendix F: Event Tree Analysis: Natural Disaster

Appendix F is an Event Tree Analysis Specific to Natural Disaster Risk that was identified. From

Appendix C the Scenario tree, several of the scenarios that were selected were those that had a

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common link or domino effect to them. The Event Tree Analysis was conducted twice once in

the case of if a manufacturing facility became destroyed as well as if a distribution center was

destroyed.

Appendix G: Decision Tree Analysis: Funded Reserve For Replacement Workers

In Appendix G there’s a decision tree analysis conducted for our expiring collective bargaining

agreements and labor disputes. This illustration displays visually some of the different scenarios

which could occur if or if not a planned retention is in place for this risk.

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Appendix: H NPV Analysis Products Liability Risk Treatment

NPV Analysis Risk: 1

Year 0 1-10General Liability + Umbrella Coverage 2,967,500.00$ Bi Quarterly Inspections 8,000,000.00$ Deductible 500,000.00$ Loss Reduction 80,000,000.00$ Before Tax Cash Flow 80,000,000.00$ Tax (.245*70,000,000) 19,600,000.00$ After Tax Flow 60,400,000.00$

PV of Cash Flow Assuming 10% RORAfter Tax Flow 60,400,000.00$ Muiltplied by 10% ROR 6.1446Present Value 371,133,840.00$

NPVPV 371,133,840.00$ Intial Cash Outlay 11,467,500.00$ NPV 359,666,340.00$

Expected Loss Reduction (From Discrete Distribution) 80,000,000.00$

Inspections Cost Assumption 100,000.00$ Quarterly (X4) 400,000.00$ Twice a Quarter (X2) 800,000.00$ Total Inspection Cost Per Year 800,000.00$ For 10 Years (X10) 8,000,000.00$ Total Inspection Cost 8,000,000.00$

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Appendix H is the NPV analysis for treating the products liability risk our firm faces. From

project one we already discussed our $100 million dollar loss history in regards to products

liability. A key assumption made was that the total loss reduction was $80,000,000 from

Appendix E. Through the NPV analysis this risk treatment plan will provide positive value to the

firm.

Appendix: I NPV Analysis Natural Disaster Risk Treatment

Appendix I contain NPV analysis for the treatment of the Natural Disaster risk. From the

analysis we assumed the worst case scenario in which a natural disaster caused a domino effect

to our business causing a loss of half a billion dollars in which we took 10% of that as our loss

NPV Analysis Risk: 2

Year 0 1-10Disaster Recovery Plan 1,000,000.00$ Cat Bond 67,900,000.00$ Loss Reduction 50,000,000.00$ Before Tax Cash Flow 50,000,000.00$ Tax (.248*70,000,000) 12,400,000.00$ After Tax Flow 37,600,000.00$

PV of Cash Flow Assuming 10% RORAfter Tax Flow 37,600,000.00$ Muiltplied by 10% ROR 6.1446Present Value 231,036,960.00$

NPVPV 231,036,960.00$ Intial Cash Outlay $68,900,000.00NPV 162,136,960.00$

Total Losses 500,000,000.00$ Freq of Risk 10% 10%Total Loss Reduction 50,000,000.00$ Assumption Disaster Recovery Plan Cost 1,000,000.00$

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reduction as the frequency of natural disasters are low compared to other risks. From the analysis

with our treatment plan this investment contains a positive NPV.

Appendix: J NPV Analysis Labor Disputes and Expiring CBAs Risk Treatment

Appendix J contains the NPV analysis for treating the labor disputes and expiring collective

bargaining agreements. From Appendix D, we know there are 8,200 product employees covered

NPV Analysis Risk: 3

Year 0 1-10Funded Retention for Replacement Employees 63,116,083.33$ Contract Negotiation Fees 2,000,000.00$ Other Legal Fees 2,000,000.00$ Loss Reduction 63,116,083.33$ Before Tax Cash Flow 63,116,083.33$ Tax (.248*70,000,000) 15,652,788.67$ After Tax Flow 47,463,294.67$

PV of Cash Flow Assuming 10% RORAfter Tax Flow 47,463,294.67$ Muiltplied by 10% ROR 6.1446Present Value 291,642,960.41$

NPVPV 291,642,960.41$ Intial Cash Outlay 65,116,083.33$ NPV 226,526,877.08$

Average Production Employee Salary 92,365.00$ Assumption of 1 Month Needed for Replacement Workers 7,697.08$ X 8200 CBA Employees on Strike that need to be Replaced 63,116,083.33$

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under CBA’s for the NPV analysis we adequately funded for the situation if we were unable to

renegotiate terms for 1 month in which showed a positive NPV.

References

"Caterpillar 10K." Caterpillar. Caterpillar INC, 16 Feb. 2016. Web. <http://phx.corporate-

ir.net/phoenix.zhtml?c=92466&p=irol-

SECText&TEXT=aHR0cDovL2FwaS50ZW5rd2l6YXJkLmNvbS9maWxpbmcueG1sP2l

wYWdlPTEwNzQ0NzA5JkRTRVE9MCZTRVE9MCZTUURFU0M9U0VDVElPTl9FT

lRJUkUmc3Vic2lkPTU3>.

Corporate Risk Management. 1st ed. Malvern, PA: The Institutes, 2013. Print.