Archive for the ‘Compensation’ category

Increasing the usefulness of ERM

June 27, 2010

By Jean-Pierre Bertiet

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:

  • Align performance metrics with management’s performance measurement philosophy
  • Integrate ERM into daily management activities

The following two sections discuss these issues and suggest action steps that insurance companies should take to establish ERM as a more robust and valuable management process.

1.  Aligning performance metrics with management’s performance measurement philosophy

To provide useful guideposts for business decisions, the risk adjusted performance measurement framework supporting ERM needs to reflect senior management’s views regarding alignment of responsibilities and performance metrics. Alignment is ensured by i) matching of the structure of the financial management reports to the boundaries of business segment, ii) accurate attribution of capital, premium revenues, investment income and expenses to business segments and iii) segregation in financial reports of the results associated with the current period from the impact of business written in prior years.

This alignment ensures appropriate distinctions between results of current and past decisions and a sharp focus on differences in drivers of performance.

In practice, leading companies are making explicit decisions about the design and features of the financial performance measures they develop by developing customized answers to questions such as the following:

  • Are business segments to be evaluated on a stand alone basis or in a portfolio context (i.e. after attribution of a capital credit for diversification)?
  • Are business segments to be evaluated as if assets they earned risk free, duration matched investment income? Or the average rate of return on the investment portfolio?
  • Are business segments to be evaluated in relation to their ‘consumption” of economic capital? Regulatory capital? Rating agency capital?
  • Should individual business segments bear the cost of “excess” or “stranded” capital?
  • Should performance benchmarks vary across business segments, in line with differences in the volatility of their total risk? Or differences in exposure/premium leverage across lines? Or differences in contribution to corporate debt capacity?
  • How granular does such reporting need to be?
  • Should performance metrics be developed in a policy/underwriting year framework? Would such metrics need to be reconciled with metrics based on fiscal year GAAP reported numbers?
  • How should the period performance of the in-force (or liabilities run off) be measured and separated from the performance of the “new business”? To what extent and how should the performance of “renewal” policies be separated from that of policies written for new customers in property, casualty companies?
  • Should the performance reporting framework provide only period measures of performance or should it be extended to capture the longer term economic value of insurance contracts, such as the change in the embedded value of the business?
  • Should the performance reporting framework be extended to incorporate stochastic performance metrics such as Earnings@Risk or Embedded Value@Risk?

Leading ERM practitioners, especially in Europe, have found that the usefulness, but also the complexity and cost of risk adjusted performance metrics are determined by the desired level of granularity in reporting, and design decisions in i) risk measurement,

ii) capital measurement and, iii) financial reporting. The availability and quality of risk and financial data determine to a significant degree the level of granularity that can be built to support ERM.

In my experience, success in establishing ERM is highly dependent on the level of effort that companies devote to designing a reporting framework that the organization can understand and embrace intuitively, without having to be trained in advanced financial or risk topics. Setting out to develop the most rigorous and actuarially correct framework is likely to result in poor acceptance by operating managers.

2. Integrating ERM into daily management activities

Many senior executives recognize that establishing an ERM process is an obligation that cannot be avoided in today’s environment. They also have a strong intuitive sense that the science of risk measurement and analysis offered by the actuarial profession and other specialists in risk does not yet provide robust answers to many important questions that are asked by people who manage the operations of insurance companies day by day. Differences in perspectives between executives in the corporate center and the managers of business units hamper the effectiveness of ERM. Bridging these differences is a major challenge to the establishment of ERM. This challenge is rooted in fundamental differences in the roles and responsibilities of these actors.

Corporate center executives who operate under oversight of the Board of Directors are highly sensitive to risk concerns of shareholders. It is natural for these executives to take an aggregate view of risk, across the business portfolio. They contribute to corporate performance by  making i) strategic risk management decisions in connection with capacity deployment, reinsurance and asset allocation, ii) operational risk management decisions principally in connection with the management of shared services. Their most important risk decisions, related to capital allocation, involve significant strategic risks.

By contrast, business unit managers have a different outlook. They are typically more focused on meeting the needs of policyholders. They are more likely to view risk as stemming from products and customers.  From their point of view risk management starts with product design, underwriting and pricing decisions, control of risk accumulations and concentrations, product mix and customer mix. With regards to operational risk, their activity places them on the front line to control the “execution risks” elements of operational risk. Business unit managers tend to view requests for support of ERM as distractions from serving policyholders and accomplishing their goals. They believe that they help protect shareholders from value loss by focusing on establishing and maintaining a competitive advantage.

The CFO of a very large insurance group confided to me recently that aligning the perspectives of executives at the corporate center with that of business managers was a challenge of great importance. He expressed the view that results from risk models cannot be used simplistically and that experience and business judgment are needed to guide decisions. Caution and prudence are especially important in interpreting decision signals when model results appear unstable or when complexity makes it difficult to recognize possible biases. He had become interested in using a combination of approaches to develop reliable insights into strategy and risk dynamics in his company.  He was particularly focused on finding ways to bring these insights to bear on the daily activities of employees who manage risk accumulation, risk mitigation and risk transfer activities, on both sides of the balance sheet. In his judgment, borne out by other discussions and my experience with clients, ERM comes to life and creates value best when a top down framework initiated by senior management is embraced bottom up throughout the organization.

Consistent with these considerations, ERM appears to work best in companies in which operating managers have “bought in” ERM and embraced the perspective it provides. In many of these companies, one observes that:

  • Risk management responsibility is owned by operating managers
  • Product definitions and investment boundaries are clear and matched to explicit risk limits
  • Policies and procedures have been co-developed with operating personnel
  • Product approval and risk accumulation are subject to oversight by the central ERM unit
  • Risk and value governance are integrated through a committee with authority to adjudicate decisions about trade-offs between risks and returns
  • Compliance and exceptions are subject to review by senior management

It is important to observe that none of the considerations discussed in the two sections of this note are about the technical components of risk management. Rather, they define a context for accountability, empowerment and appropriate limitations on the activities of people who run day to day operation in insurance companies.

©Jean-Pierre Berliet

Berliet Associates, LLP

(203) 247 6448

jpberliet@att.net

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.


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