Archive for the ‘Compensation’ category

Risk Adjusted Performance Measures

June 20, 2010

By Jean-Pierre Berliet

Design weaknesses are an important source of resistance to ERM implementation. Some are subtle and thus often remain unrecognized. Seasoned business executives recognize readily, however, that decision signals from ERM can be misleading in particular situations in which these design weaknesses can have a significant impact. This generates much organizational heat and can create a highly dysfunctional decision environment.

Discussions with senior executives have suggested that decision signals from ERM would be more credible and that ERM would be a more effective management process if ERM frameworks were shown to produce credible and useful risk adjusted performance measures

Risk adjusted performance measures (RAPM) such as RAROC (Risk Adjusted Return On Capital), first developed in banking institutions, or Risk Adjusted Economic Value Added (RAEVA) have been heralded as significant breakthroughs in performance measurement for insurance companies. They were seen as offering a way for risk bearing enterprises to relate financial performance to capital consumption in relation to risks assumed and thus to value creation.

Many insurance companies have attempted to establish RAROC/RAEVA performance measurement frameworks to assess their economic performance and develop value enhancing business and risk management strategies. A number of leading companies, mostly in Europe where regulators are demanding it, have continued to invest in refining and using these frameworks. Even those that have persevered, however, understand that framework weaknesses create management challenges that cannot be ignored.

Experienced executives recognize that the attribution of capital to business units or lines provides a necessary foundation for aligning the perspectives of policyholders and shareholders.

Many company executives recognize, however, that i) risk adjusted performance measures can be highly sensitive to methodologies that determine the attribution of income and capital and ii) earnings reported for a period do not adequately represent changes in the value of insurance businesses. As a result, these senior executives believe that decision signals provided by risk adjusted performance measures need to be evaluated with great caution, lest they might mislead. Except for Return on Embedded Value measures that are comparatively more challenging to develop and validate than RAROC/RAEVA measures, risk adjusted performance measures are not typically capable of relating financial performance to return on value considerations that are of critical importance to shareholders.

To provide information that is credible and useful to management and shareholders, insurance companies need to establish risk adjusted performance measures based on:

  • A ( paid up or economic) capital attribution method, with explicit allowance for deviations in special situations, that is approved by Directors
  • Period income measures aligned with pricing and expense decisions, with explicit separation of in-force/run-off, renewals, and new business
  • Supplemental statements relating period or projected economic performance/ changes in value to the value of the underlying business.
  • Reconciliation of risk adjusted performance metrics to reported financial results under accounting principles used in their jurisdictions (GAAP, IFRS, etc.)
  • Establishment and maintenance of appropriate controls, formally certified by management, reviewed and approved by the Audit Committee of the Board of Directors.

In many instances, limitations and weaknesses in performance measures create serious differences of view between a company’s central ERM staff and business executives.

Capital attribution

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Aligning Interests

May 30, 2010

By Jean-Pierre Berliet

Companies that withstood the crisis and are now poised for continuing success have been disciplined about aligning interests of shareholders and managers

Separation of ownership and control creates conflicts of interests between managers and owners. To mitigate this situation, companies expend much effort to develop and implement incentive compensation systems that align the interests of managers and shareholders. The present crisis demonstrates clearly, however, that such arrangements are imperfect: large incentive payments were made to many people in companies that have performed poorly or even failed. There has been a public outcry.

But there is nothing really new in misalignments of incentives, or weaknesses in incentive designs that produce harmful results: they exist in every company to some degree. In a typical situation, managers are concerned about minimizing financial and career consequences of not achieving their objectives. If the situation requires it, managers will exploit every opportunity to change their operating plans to achieve their targets. They will seek and capitalize on opportunities to convert unreported intangible assets, such as market share, product or service quality, product leadership, plant productivity or customer service responsiveness into current profits by postponing and reducing related expenses. Financial results will look good, and they will be praised for accomplishing their objectives. Actions that they took, however, accelerated uncertain future income to the present period while undermining the company’s competitive capabilities and reducing the sustainability of its performance. This is dangerous. Mitigating this form of moral hazard is difficult because its effects are not readily apparent.

In insurance companies (and banks), business managers have even greater opportunities to “game” incentive plans:  they can increase reported business volume and profit in the current period by slightly under-pricing or increasing risks assumed.  This approach to “making the numbers” is particularly tempting in lines of coverage in which losses can take many years to emerge and develop; it is also particularly dangerous because losses from mispriced policies, especially in lines with high severity/low frequency loss experience can be devastating.  Similarly, investment officers can invest in assets that offer higher yields to increase portfolio performance, while involving risks that can result in significant capital losses later.

Based on these observations, Directors and CEOs of insurance companies need to work with management to:

  • Link incentive compensation payments to the ultimate outcome of business written rather than to current profits (especially when fair value accounting standards cause immediate recognition of profits on contracts).
  • Establish and empower an internal control and audit function to verify that managers’ actions are aligned with business strategies and plans.
  • Verify the integrity of underwriting and investment decisions, in relation to explicitly approved guidelines and processes.

The present crisis has demonstrated how unbundling of risk assumption businesses can increase moral hazard by redistributing risks, gains and potential losses across originators, arrangers of securitization transactions and investors/risk bearers.

Reconstruction of incentive programs and establishment of appropriate oversight and enforcement mechanisms are needed to reduce moral hazard and restore confidence in the financial system, including insurance companies.

©Jean-Pierre Berliet   Berliet Associates, LLC  (203) 972-0256 jpberliet@att.net

Risk Impact Thresholds

May 3, 2010

Tipping the ERM Scale Toward Survival

By MICHAEL A. COHEN

Enterprise risk management experts, and surely even many neophytes, are fairly adept at identifying exposures and events that can impede their organizations. What is much more difficult is measuring the potentially adverse impact of risks, making this the biggest X factor in the ERM process.

Consequently, it is quite challenging to determine how much risk exposure an organization can “tolerate”—that is, the extent of adverse risk impact a company can absorb so that the attainment of its goals will not be jeopardized.

It is equally difficult to assess a company’s “threshold” to absorb these risk consequences—that is, the cross-over points beyond which significant strategic and operational changes need to be made.

What Might Your Stakeholders Do?

TRIGGERS:

  • Financial Outcomes: impact on capital and earnings
  • Business Line inadequacy: products and features, service
  • Business Misconduct and reputational impairment: putting future viability at risk

REACTIONS:

  • Customers or producers might cease doing business with firm or reduce volume
  • Investors might sell stock lowering the price in the process
  • Board might replace management or reduce compensation
  • Lenders might charge a higher price for capital
  • Rating agencies might downgrade
  • Institutional customers might not be permitted to do business with firm

As a result, it is likely that many organizations are exposed to risks that would materially compromise not only their current course but their very existence. In fact, the events of the last two years have dramatically highlighted this exposure, and many firms have been greatly harmed. Just ask AIG and Lehman Brothers.  Measurement of risk impact—both quantitative and qualitative—is clearly the most critical endeavor to perform accurately in determining an organization’s tolerance for risk.  It is possible for each element of the risk measurement and reporting process to be flawed, as they are often performed in a vacuum—the result can be too narrow and theoretical in scope.  The quantifying component of risk measurement is built upon mathematics and modeling, utilizing:

  • A series of approximations and assumptions.
  • Identification of elements/variables to measure.
  • Determination of the relationship between the various risk factors and the outcomes they might jeopardize

The qualifying component, however, is often built on psychology—its effect on decision-making and the “emotional intelligence” of the individuals making judgments on risk. Consider the following:

  • People work on problems they think they can solve, and they avoid those they don’t think they can solve—due to complexity or political reasons. Elements in the latter category won’t be addressed.
  • They are slow and cautious in reacting to new information and reluctant to admit ignorance or mistaken assumptions. Solutions to risk mitigation may exist, but might not be implemented without inordinate study—paralysis by analysis.
  • They look at fewer as opposed to more perspectives, possibly missing a better solution.
  • They often place greater value on what they themselves have created than on what others have done, and may well miss out on higher-order thinking generated by a group and on the critical perspectives of others.

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Skating Away on the Thin Ice of the New Day

April 23, 2010

The title of an old Jethro Tull song.  It sounds like the theme song for the economy today!

Now we all know.  The correlations that we used for our risk models were not reliable in the one instance where we really wanted an answer.

In times of stress, correlations go to one.

That is finally, after only four or five examples with the exact same result, become accepted wisdom.

But does that mean that Diversification is dead as a strategy?

I would argue that it certainly puts a hurt to diversification as a strategy for finding risk free returns.  Which is how it was being (mis) used in the Sub Prime markets.

But Diversification should still reign as the king of risk management strategies.  But it needs to be real diversification.  Not tiny diversification that is observable only under a mathematical microscope.  Real Diversification is where risks have completely different drivers.  Not slightly different statistical histories.

So in Uncertain Times, and these days must be labeled Uncertain Times (or the thin ice age), diversification is the best risk management strategy.  Along with its mirror image twin, avoidance of concentrations.

The banks had given up on diversification as a risk strategy.  Instead they believed that they were making risk free returns by taking lots and lots of concentrated risk that they were either fully hedging or moving the risk off their balance sheets very quickly.

Both ideas failed.  Hedging failed when the counter party was Lehman Brothers.  It succeeded when the counter party was any of the other institutions that were bailed out, but there was an extended period of severe uncertainty about that before the bailouts were finally put into place.  Moving the risks off the balance sheet failed in two ways.  First it failed because they were really playing hot potato without admitting it.  When the music stopped, someone was holding the potato.  And some banks were holding many potatoes.  It also failed because some banks had been offloading the risks to hedge funds and other investors who they were lending funds to finance the purchase.  When the CDOs soured, the loans secured by the CDOs were underwated and the CDOs came back onto the bank balance sheets.

The banks that were hurt the least were the banks who were not so very concentrated in just one major risk.

The cost of the simple diversification strategy is that those banks with real diversification showed lower returns during the build up of the bubble.

So that is the risk reward trade off of real diversification – it will often produce lower returns than the mathematical diversification but it will also show lower losses in proportion to total revenue than a strategy that concentrates in the most profitable risk choices according to a model that is tuned to the accounting or performance bonus system.

Diversification is the risk management strategy for the Thin Ice Age.

Risk Adjusted Compensation Analysis

March 20, 2010

Game Theory suggests that you can get pretty far simply looking at expected values.  But the expected values need to be done right, looking at both upside and downside.

Looking at the consequences of the compensation paid by financial institutions suggests that boards who approved the compensation did not do their Game Theory homework.  Management is given a huge share of the upside and their incentives are thought to be aligned with shareholders because of a stock component to their compensation.

Maybe that works, maybe not.  The math is simple enough.  They should check.  A Game Theory, risk adjusted compensation analysis (simplified for this post) would look like this:

Proposed Transaction:

Upside:  $100,000,000 – likelihood 60%

Downside:  ($100,000,000) – likelihood 40%

Expected Value: $20,000,000

So far so good.  Now the firm already has a risk adjusted compensation system.  Under that system, there is a cost of capital charge assessed against profits before calculating bonus.  In this case, the capital is based upon the $100,000,000 downside.  The cost of capital is 5%, so the “risk adjustment” is 5%.  The bonus formula will pay out 40% of the risk adjusted gain, half in cash and half in stock.  In the past, the compensation committee has seen this process and stopped there. It seems that they took care of every angle.

But this year, one comp committee member hears a lecture on Game Theory and asks for additional analysis:

Risk Adjusted Expected Value Analysis:

Management:

Upside:  40% of $100,000,000 less $5,000,000 equals $38,000,000.  Pay $19,000,000 cash and $19,000,000 stock.  Stock is purchased at time of award.  Likelihood 60%

Downside:  Zero Current award.  Loss in value of stock holdings from past awards.  Back to that in a minute.

Shareholders:

Upside:  $62,000,000 of gains plus risk charge times 10 equals $620 million. Likelihood of 60%

Downside $$100,000,000 of losses times 10 equals ($1 Billion). Likelihood of 40%

Expected value:  ($2.8 million)

Now back to the employees…

The downside from their 0.1% of stock is ($1 million) so their expected value is $22 million positive.

So a real Game Theory based risk adjusted analysis would show that there is huge upside to management for risky deals and much smaller risk adjusted expectation for the shareholders. (In this example an expected loss).

Perhaps every deal should be presented on this risk adjusted basis.  It might take a few of these presentations, but sooner or later the lopsided deal will sink in.

But then the game will shift.  Already, the game is to present these deals optimistically, so that the likelihood of upside is overstated and the downside is underestimated.  If compensation is skewed as drastically as the above example, highly risky deals look just fine on a risk adjusted expected value basis to employees.  If the board insists that the shareholders really have a positive expected value, then the deals will need to be much less risky – at least on paper.

The stress testing that is being promoted as a major risk management tools (in part because of this very problem of over optimistic risk models) needs to then also be done to the risk adjusted compensation analysis.  The stress tests for this purpose do not need to be as drastic as the stress tests for solvency management.  What you should be looking for is the inflection point where the deal starts to fall into the situation where the management and shareholders are no longer on the same side, where their expected values are of opposite signs.  If that inflection point is found with a stress test that is somewhat close to the base model assumptions, then that is a flashing red light for the risk manager and the board.

Bonus Fury

January 29, 2010

is everywhere.  I am not sure that I have heard anyone actually explain what should be done or why they are furious, other than the general idea that there were bail-outs. 

I can think of two reasons to object to the mega bonuses that can be used to help direct future bonuses:

  1. There is not any evidence of any claw back being applied in the bonus calculations.  It is likely that a significant number of the folks who have the most culpability for the immense losses of the past are no longer there.  Doing a claw back from folks who were not involved would as is pointed out by the bankers be counter productive.  But they are only partly correct.  While many are gone, some do remain.  In addition, there are many folks remaining at the bank who were indirectly responsible (or should have been indirectly responsible) who are in the executive ranks and on the board as well.  There should be claw backs that apply to everyone who is up the chain of command and in a role with significant corporate wide responsibility.  This would be very productive and would send the signal that executives are responsible.  It would reduce the degree to which executives are willing to look the other way when a strong business unit manager insists on doing something that might not be in the best interests of the firm.  In addition, too little is said of board compensation.  Board members of firms that needed to be bailed out should suffer financial consequences.  Strong consideration should be given to reducing board fees in a manner that is commensurate with what is done to claw back bonuses for executives. 
  2. For almost two years now, the Fed has been depressing interest rates to levels that flirt with a zero value.  They do this to help the banks so that the banks will help the economy.  This has created a situation where the banks can operate with a zero cost of good sold.  Any business on the planet could show a profit with zero COGS.  To the extent that banks are taking earnings that result from these low interest rates and turning around and giving the resulting profits to their employees as bonus they are subverting the purpose of the low rates.  This fact has been true for a long time, but the Greenspan Fed that was famous for low interest rates and for ignoring the gross inefficiencies of the approach.   The lower interest rates take money from savers and transfers it to debtors and banks and bankers.  In this case, the interest rates are being kept low both to bolster bank profits as well as to keep money cheap to spur borrowing to encourage spending.  However, credit tightening by the banks has jacked up their effective margins (spread differentials less default losses).  So bank profits are soaring because they are (a) paying a trivial amount for funds and (b) not lending as much of the money to as many businesses and people as they had before.  In addition, in 2008, the banks were able to obtain debt capital at a rate averaging 0.7% with a government guarantee which is expected to rise to 4.7% (per Reuters).  The differential there is purely a gift from the taxpayers, but a gift that was meant to be used to recapitalize the banks to provide funds for loans. And the banks are paying bonuses on these gains, rather than keeping the excess profits to build up balance sheets to be used when they regain the courage to lend.  So this is proving to be a very inefficient way to move the economy.  The flow of funds through the bankers bonuses back into the economy is just too inefficient of a way to stimulate the economy.  Those excess profits that come from both of these interest expense subsidies must be excluded from the bonuses, or else the subsidies must be stopped and the money used in a more efficient manner to stimulate the economy. 

So there are probably several alternatives to make this more efficient and less bothersome.   We just need to figure out exactly what about it that is bothersome and frame it in a way that can direct policy.  Otherwise, we end up with piecemeal solutions aplied in a wack-a-mole approach to problem solving.

Black Swan Free World (10)

November 17, 2009

This is the final post in a 10 part series.

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

Of the ten suggestions, this one has the most value by far.  Unfortunately, this one may be the suggestion that has the least chance of being taken up.  No one is talking about any part of this.  We seem to be moving to try to set the world back into the place that is was, or very close to it.

We should be asking “What should be the place of banking in our economy?”  This is not a question of allowing the free market to choose.  The free market has nothing to do with this.  The role of the banking sector is entirely determined by the government.  The banking sector had grown to eat up a huge percentage of all of the profits of the entire economy.  Does that make any sense to anyone?  Banking can be a symbiont with the economy or it can be a parasite or it can be a cancer.  Before the crisis, banking had definitely moved beyond the level of parasite to becoming a harmful cancer.  Too much of all of the profits of all of business activity in the entire economy were being diverted to the banks and with the pay structure of the banks, into the pockets of a very small number of bankers.  Did that make any sense whatsoever?  Is there any way that anyone can show that situation makes for a healthy economy?  The bubbles that happened twice could be seen as the way that bankers justified their huge take from the economy.  If values were growing rapidly, no one seemed to mind that bankers took so much out of the deals.

Finance Share of GDP PhilipponSource:Evolution of the US Financial Sector Thomas Philippon

However, if the economy and the values of businesses and assets in the economy grow at only a sane pace, and bankers try to go back to the level of take from the economy that they have grown accustomed to, then the amount of total profits left for the rest of the economy are bound to be negative.  So unless we re-think things and figure out how to muzzle the banks, then we are headed for more bubbles that will justify their stratospheric incomes.

The financial sector, once it exceeds a certain share of the economy, should be viewed as a tax on the economy.  Many protest the taxes that the government imposes because the money is not well spent.  Well, the money from this tax goes to personal expenditures of the bankers themselves.  There is not even any pretense that this tax will be spent for the common good.

One question that really needs to be answered is how much of this financial “innovation” that is touted as the result is really beneficial to the economy and how much of it is just unnecessary complexity that hides that take of the bankers and hedge funds.  The excuse that is always given is that all of this financial innovation helps to provide lubrication for businesses.  But that is more like an excuse than a reason.  Mostly the financial innovation has fueled bubbles.  It has led to the excessive leverage that feeds into one sided deals for hedge fund managers.

More often than not, financial innovation has helped to fuel the extreme fixation on short term gains in the economy.  Financial innovation has featured hollowing out companies to maximize short term values.  Quite often the companies “helped” by this process turn into worthless shells somewhere along the process.  This destroys that productive capacity of the economy to allow for the extraction of the maximum amount of short term profits.

Financial innovation helps to turn corporate assets into profits and to take those profits out of the firm through leverage.

So Taleb’s suggestion that we think through Capitalism 2.0 is a good and timely one.  But we need to start asking the right questions to figure out what Capitalism 2.0 will be.

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)


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