Risk Adjusted Performance Measures

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

To be useful, a RAROC framework must be based on a credible and robust method of attributing a company’s capital to its individual lines of business or business segments.

Many calculation methods, often based on stochastic corporate models of insurance, have been developed for the purpose of attributing capital. Unfortunately, these methods have been shown to produce results that are sensitive to the methodology selected and to changes in i) risk measures and tolerance targets, ii) correlations assumptions, iii) the relative growth and performance of individual segments and iv) the applicable risk assumption horizon. Instability of capital attribution results undermines the confidence that senior executives can place in RAROC as a guidepost for decisions.

Meanwhile, investors and Directors insist on understanding how management “allocates” capital across activities. From their vantage point, capital “allocation” refers to how capital (as a proxy for “insurance capacity”) has been or will be deployed across lines and business segments as a result of explicit decisions to seek particular exposures or types of business. They correctly see that management moves (i.e. “allocates”) capital across lines and business segments whenever underwriting activities are redirected. As a result, they seek to hold management accountable and demand that executives be able to demonstrate that capital is or will be deployed toward uses in which realized returns are commensurate with risks assumed.

Performance benchmarks

It is customary to compare RAROC performance to a company’s cost of capital or to its return on equity target, depending on whether the capital attributed to business segments is the company’s “economic capital” or the company’s available capital measured under GAAP accounting rules. Both ways can be misleading, for different but important reasons.

Comparing RAROC to a company’s cost of capital is problematic when attributed economic capital is used for calculating RAROC. Since economic capital is derived from consideration of the company’s total risk and represents an amount of assets available to pay obligations to creditors, return on economic capital cannot be compared to the company’s cost of capital. The company’s cost of capital represents expectations of return by investors in compensation for systematic risk assumed for owning shares of the company, not for being exposed to total risk, a part of which can be diversified away. Further, this cost of capital performance benchmark should be used to assess returns on the value of investors’ ownership positions rather than returns on the nominal amount of economic capital supporting a business segment or a company. Adjusting a RAROC measure to reflect the impact of these complexities and make the resulting adjusted RAROC comparable to a cost of capital estimate derived from observations in the capital market would not be straightforward, and appears to involve resolution of methodology issues for which no approach has yet been developed. Much caution is needed to use a calculated RAROC to assess financial performance and drive business and risk management decisions.

Comparing RAROC to a company’s ROE target can also be misleading when the company’s available capital measured under GAAP rules is used to calculate RAROC. The potential for misleading signals exists because there is no direct and simple relationship between measures of ROE under GAAP, measures of economic returns (such as GAAP income return on economic capital; economic income on the “fair value” of net assets; return on embedded value), and a company’s cost of capital. Accounting adjustments needed to reconcile risk adjusted return metrics with reported statements are neither simple nor easy to grasp intuitively. Although it would be possible to develop a mapping of GAAP ROE into corresponding measures of economic performance, I am not aware that any company has actually attempted to do this to calibrate its performance benchmarks. In any case, relating such benchmarks to a company’s cost of capital with confidence would remain problematic for reasons explained in the preceding paragraph.

It is important to note that methodology issues discussed above in connection with the calculation and interpretation of RAROC would also apply to other measures of risk adjusted performance, such as RAEVA. They would not, however, apply to return on embedded value metrics (or the more recently developed return on European Embedded Value metric), based on a framework that aligns the calculation of returns with the change in value orientation of calculations made by investors in the capital market.

In a number of leading companies, difficulties involved in calculating and interpreting correctly RAROC or other measures of risk adjusted performance such as RAEVA are leading management to fall back on traditional performance measures, such as loss ratios and combined ratios or investment spreads, calibrated to reflect differences in risk levels, and to explore the feasibility of adopting additional performance metrics such as earnings at risk or embedded value at risk.

©Jean-Pierre Berliet

Berliet Associates, LLP

(203) 247 6448

jpberliet@att.net

May 22, 2010

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