Integrating Risk Capacity and Business Strategy
From Jean-Pierre Berliet
To succeed as a “going concern”, an insurance company needs to conduct its business so as to:
• Maintain insurance strength ratings it needs to retain and attract policyholders
• Maintain a capital position deemed adequate by regulators
• Meet shareholders’ expectations for earnings level and stability.
The first two conditions call for a company to demonstrate that it will honor its promises to pay indemnification benefits promptly and fully, i.e. that it is and will remain solvent and have the capital on hand to continue to conduct ‘business as usual’ in the future. They call for a company to determine how much risk capital it needs to ensure its credit worthiness, in relation to risks that it assumes to execute its strategic plan.
The third condition calls for a company to sustain and even enhance its credibility with capital market investors, to support its market valuation, keep its cost of capital and thus also the cost of its risk capacity competitive. If the level and stability of its earnings did not meet the requirements of capital market investors, a company could lose investors’ support. This could cause its valuation multiples to decline and the cost of its capital and risk capacity to increase.
Together, these three conditions require a company to establish a capacity management framework (focused on insuring solvency and the quality of promises made to policyholders) aligned with its business strategy management process (focused on meeting shareholders’ expectations for financial performance). Note, however, that no such alignment can enable a company to create value for its shareholders unless the company is positioned to achieve a competitive advantage in attracting, serving and retaining customers. It thus behooves management always to verify that their company:
• Can achieve a competitive advantage based on superior risk insights, service capabilities, deal flow generation, cost of capital and operating efficiencies
• Provide products that attract, serve and retain customers
• Has the capital required to sustain the ratings it needs to compete and the willingness to assume the resulting performance volatility
• Has the organizational capabilities needed to manage and control underwriting, claim processing, investment and risk management activities
• Has the insights and processes needed to ensure pricing discipline and alignment of management and shareholders’ interests.
Based on such an explicit understanding of its strategic position and capabilities relative to its competitors’, alignment of risk capacity management and business strategy management calls for a company to integrate relevant strategy considerations outlined above in the components of its risk strategy, especially:
• Risk policy, specifying risks that will be assumed to accomplish financial objectives while meeting risk tolerance constraints of external stakeholders
• Risk appetite, defined as the amount of risk capacity that can be deployed/utilized in pursuit of its strategy in light of the company’s total risk capacity
• Risk limits, which reflect its risk policy and appetite for risk and control risk taking in the development and execution of its operating plans and budgets
Based on projections of financial results expected under a particular risk capacity deployment strategy and business strategy, embodied in a set of risk limits, a company can ascertain whether its plan can meet the return objectives and risk tolerances of its stakeholders. As needed, it can also seek to identify and assess alternative strategies that may provide superior trade-offs between risk and return that may call for changes in risk policy, risk appetite, risk limits and business strategy (the iterative process by which such enhancements can be identified and developed is shown on Figure 2).
Figure 1 displays how solvency risk concerns of policyholders and other credit-focused stakeholders and value risk concerns of shareholders, expressed as risk tolerance constraints, at stated confidence levels and over a defined time period, help to frame a company’s risk strategy. The components of the risk strategy (i.e. risk appetite, risk policy and risk limits) reflect boundaries set on the deployment of a company’s risk capacity by i) the amount of the (paid-up) capital available to support risk assumption and accumulation, and ii) the cost of this capital, generally measured by shareholders’ total return requirement (TSR).
Figure 2 demonstrates how a company can align its business strategy, risk capacity and risk strategy management processes to meet the solvency risk concerns of policyholders and the earnings (value) concerns of shareholders. It demonstrates the distinct places of risk capacity, risk appetite, risk policy, risk limits in the business strategy and risk strategy management processes and highlights the centrality of risk limits to the integration and alignment of these processes.
Managing conflicting agendas
Financial risks generated by, or in connection with, the issuance of insurance contracts manifest themselves in the volatilities of a company’s operating cash-flows and reported earnings that are of concern to i) policyholders and other stakeholders with an interest in its credit worthiness and solvency (rating agencies and regulators) and ii) shareholders with a focus on risk to the value of their investment. These two groups of stakeholders have conflicting views about how a company can best address their risk concerns.
Policyholders, as the most senior creditors, view increases in capital as added protection and a natural protection against the risk of default by a company. By contrast, risk to value for shareholders caused by the volatility of financial results cannot be remedied efficiently by addition of capital (i.e. increases in risk capacity). First, other things being equal, an increase in capital would need to be very large to generate enough income to mitigate earnings volatility sufficiently. Second, such increase would so dilute returns that it would undermine rather than support valuation multiples. Consequently, shareholders look to insurance companies to manage and control the volatility of their cash-flows and earnings through development and implementation of appropriate risk policies designed to limit the volatility of their financial results.
In addition, however, shareholders also concern themselves with declines in relative valuation multiples. Such declines result generally from the incidence of strategic risks, i.e. events that reduce a company’s future earnings or revenue growth prospects by causing i) its competitive position to erode or ii) changes in its operating environment that undermine the viability of its business model. Shareholders expect companies to support their valuation multiples and protect them from strategic risks by i) building flexibility and real options in their strategies, ii) transferring or avoiding risks that cannot be mitigated, iii) pursuing strategies that can support their expectations for profitability and growth.
Based on the framework for integration of risk management and business strategy outlined above, an insurance company could develop a road-map to:
• Align its business strategy with the risk tolerances of its stakeholders as well as the amount and cost of its risk capacity
• Develop the decision frameworks and analytical capabilities needed to integrate its risk and business strategy management processes
By following such a road-map, an insurance company could develop and execute business and risk strategies that enhance its financial performance and its relative market valuation.
February 14, 2011
Note: This article is abstracted from the “Risk Management and Business Strategy in P/C Insurance Companies” briefing paper published by Advisen (www.advisen.com) and available at the Corner Store.