REDUCING MORAL HAZARD

By Jean-Pierre Berliet

The MBO (Management By Objectives) process translates business objectives into performance targets and drives incentive compensation awards. Certain weaknesses of MBO processes make companies more vulnerable to crises. .

The MBO process is central to crisis prevention.  Weaknesses in the MBO process of an insurance company must be corrected to ensure that management action do not unwittingly exacerbate risk and magnify the impact of crises.

Senior management often takes pride in its tough and disciplined approach to managing performance. This involves setting stretch objectives, rewarding managers who deliver, and punishing those who fall short. It is argued that a “greed and fear” approach is necessary to motivate managers and align their interests with those of shareholders. It is not widely recognized, however, that this approach can increase moral hazard and induce managers to make decisions that reduce the resilience of their company to crises.

In such performance management cultures, managers are incented to exceed management expectations by using all means available.  This may include:

• Reducing or postponing spending on product or service quality, product leadership, process productivity, or customer service responsiveness
• Under-pricing risks to increase business volume and earnings
• Taking on higher investment risks to increase current investment yields
• Under investing in market growth, thereby increasing short-term earnings but losing market share.

Actions like these can enhance short-term earnings, but they can also undermine a company’s competitive capabilities and value creation potential. This, in turn, can reduce the company’s ability to raise capital and thus its resilience. The introduction of risk adjusted performance metrics into a company’s control framework can help reduce the incidence of actions taken inappropriately to “game” the incentive compensation system. However, it is hard to detect moral hazard because the effects of actions taken can remain latent for years to come.

Moral hazard of this type tends to affect decisions where senior management focuses on reported financial results rather than on underlying operating success factors. Excessive, and sometimes exclusive, emphasis on financial results gives operating managers overly broad discretion to “make the numbers”. In many instances (e.g. AIG, Bear Stearns, Citigroup, Lehman Brothers) such an approach to oversight invited moral hazard with serious consequences. When combined with financial leverage and risk leverage, decisions tainted by moral hazard can result in enormous shareholder losses.

Insurance companies need to revamp their MBO frameworks to reduce the risk of moral hazard.  They need to establish corporate cultures in which discussions about objectives, strategies, and results, while never informed by perfect knowledge and foresight, are guided by “high road” values of trust and loyalty. Revamped MBO frameworks should explicitly include consideration of risk insights produced by ERM and verification of the alignment of actions taken with approved plans and strategies.

To accomplish such a transformation of their cultures, insurers may need to link their ERM and MBO processes through the implementation of:

• Risk-adjusted financial performance metrics
• Risk-adjusted performance benchmarks, related to expectations of capital market investors
• Incentive compensation awards linked to long-term measures of business value, including indicators of operational performance, and current profits.

Since no company operates with perfect foresight, Boards of Directors need to grant adequate discretion and flexibility to senior management for performance management.  Adjusting objectives and targets can be of critical importance when business conditions change unexpectedly. In an uncertain world, rigid enforcement reinforces greed and fear elements of corporate cultures, undermines trust, breeds cynicism and “gaming the system”, and increases moral hazard by inducing behavior that can, in time, fatally weaken an insurance company.

©Jean-Pierre Berliet

Berliet Associates, LLC

(203) 247-6448

jpberliet@att.net

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Tags: Governance

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