Archive for the ‘Governence’ category

Increasing the Valuation of P/C Insurance Companies

September 19, 2010

From JP Berliet

The financial crisis demonstrated that risk management had not been working effectively in many insurance companies. As a result, investors lost confidence and reduced their exposure to the industry, thereby causing valuations of companies to decline more than market averages and their cost of capital to increase.

In addition, continuing weakness in the economic environment have been exacerbating pressures on premium rates and competition in most lines. These factors are leading investors to expect that the financial performance of many companies is unlikely to improve in the short term or might even decline, thereby generating additional pressures on valuations. At present, insurance companies thus face a double challenge to:

  • Identify and pursue opportunities to enhance their intrinsic value by increasing profitability and growth
  • Restore the confidence of investors, to reduce their cost of capital and convert financial results into higher company valuations.

The “Risk Management and Business Strategy in P/C Insurance Companies” briefing paper outlines an approach that insurance companies can use to meet this double challenge.

To enhance their intrinsic values, insurance companies need to develop sharper risk insights that they can use to:

  • Achieve loss costs and earnings volatility advantages relative to their competitors
  • Reduce both the amount and the cost of the capital they require
  • Identify and pursue opportunities to grow profitably.

Success in these areas is unlikely to be sufficient, however, to restore investors’ confidence in companies in which governance and management process weaknesses cause investors to discount expected financial results more heavily. The briefing paper implies that the crisis caused the valuation of many companies to suffer from such discounts, including:

  • Governance discounts reflecting imbalance in addressing solvency risk concerns of customers, creditors and regulators relative to value risk concerns of shareholders
  • Credibility discounts resulting from misalignment of companies’ risk management and business management processes and strategies
  • Resilience discounts due to the opaqueness of financial statements and business strategies, which prevent investors to assess a company’s risk of financial distress.

To reduce governance, credibility and resilience discounts imposed by investors, insurance companies need to restore investors’ confidence by remedying underlying weaknesses in their risk and value management frameworks.

The following sections suggest how insurance companies should go about this as well as enhancing their intrinsic value, thereby creating for shareholders value enhancements that compound each other.

Increasing intrinsic value

Insurance companies can use data about risk exposures and analytics to develop and implement underwriting, pricing, claim settlement and renewal strategies that provide an economic advantage relative to competitors and increase their intrinsic value by:

  • Achieving favorable risk selection, i.e. building portfolios with lower expected losses and lower loss volatility
  • Reducing the capital required to support risk assumption activities
  • Lowering their cost of capital.

Since risk insights are not directly observable, they cannot be easily duplicated by competitors and can provide a more sustainable competitive advantage than improvements in products or service that can be readily emulated. Risk insights can help companies achieve margin increases that increase their intrinsic value. However, strategies that increase financial performance and intrinsic value will not necessarily increase company valuations and realized returns for shareholders. For valuations and realized returns to increase, intrinsic value enhancements need to be seen by investors as consistent with their investment objectives and risk tolerance.

Establishment and maintenance of the risk data infrastructure, analytical tools, decisions rules and reporting mechanisms required for companies to compete on analytics is arduous, slow and costly, but can lead to value creation breakthrough and opportunities for continuing growth. Conversely, companies that do not set out on this path should expect to be trapped in strategic stalemates and to experience declining financial performance. There are few less stark choices for Management and Board of Directors to contemplate.

Reducing governance discounts

Shareholders of insurance companies lost billions of dollars in value as a result of the financial crisis. They doubt that risk management fixes and tightening of prudential regulations can address their concerns about risks to the value of their investment in insurance companies. From their point of view, these fixes and tighter regulations appear to be designed to address risks of insurance businesses that can cause insolvency and are of primary concerns to customers, other creditors and regulators.

Investors believe that many of the weaknesses in risk governance frameworks and risk management revealed by the crisis result from:

  • Failure effectively to manage differences in risk concerns of shareholders and other stakeholders
  • Misalignment of risk tolerances, risk policies, risk limits and risk management strategies
  • Management By Objectives frameworks, policies and processes that rest on aggressive, but inappropriate, performance targets and generate moral hazard.

Investors readily conclude that these weaknesses are likely to continue to hamper the financial performance of many insurance companies and that they need to impose a “risk governance” penalty on companies’ results and prospects when assessing their value.

Even though the existence and magnitude of this risk governance discount have not been formally confirmed by research, observations of investors’ response to the crisis suggest that this discount has been contributing significantly to the relative decline in the valuation of insurance companies. The associated valuation penalty should not be expected to decrease until risk management becomes demonstrably more central to strategy development and execution and is seen to address value risk concerns of shareholders more effectively.

In companies where risk management has been a peripheral, compliance driven activity, the needed change in perspective and management processes will be challenging.

Reducing credibility discounts

The crisis demonstrated that there were significant disconnects between insurance companies’ risk assessment capabilities and their business decisions. It revealed that, in many if not even most companies, risk management frameworks:

  • Focus predominantly on financial risks and the resulting solvency risk concerns of customers, rating agencies and regulators, customarily over a one year horizon
  • Are designed to assess and ensure a company’s capital adequacy but not to help manage its cost of capital
  • Are not capable of integrating the impact of operational risks and strategic risks that can expose shareholders to significant losses in the value of their holdings
  • Assume that companies can raise funds in the capital market as needed to support their ratings and continue writing business on competitive terms
  • Understate the amount of capital required to support a company’s value as a going concern
  • Ignore systemic risk.

Investors understand that these weaknesses of risk and management frameworks prevent insurance companies to meet the risk tolerance concerns of their stakeholders, especially shareholders. They have lost confidence and have been adding a significant penalty, in the form of an implicit “credibility discount” to the terms on which they now make capital available to companies.

Insurance companies need to address each of the weaknesses identified above. It will take some time, probably years, for companies to demonstrate that the required framework and process enhancements improve risk and business management decisions, consistently. Insurance companies that do will benefit from a reduction of their credibility discount that will enhance their valuation.

Reducing resilience discounts

Companies that need to raise capital during a financial crisis can suffer crippling losses in value through dilution of shareholders interests and can become vulnerable as acquisition targets. Companies can rapidly lose their ability to control their destiny, especially if and when investors lose confidence and impose a “resilience discount” on their valuations. Companies are not defenseless, however, because they can bolster their inherent resilience in anticipation of potential crises by:

  • Maintaining enough capital to remain solvent and protect their ratings under conceivable stress scenarios, at a high confidence level. Ideally, they should ensure that their capital is large enough to provide i) a buffer against the incidence of risks that are difficult to measure or unknown and ii) a strategic reserve to take advantage of unforeseen opportunities (e.g. acquisitions)
  • Achieving a high valuation and a sustained record of meeting shareholders’ return expectations. This creates a virtuous circle in which a higher valuation earned as a reward for good financial performance mitigates the resilience discount, thereby increasing valuation further. Companies with a sustained record of good performance have the credibility needed to raise capital on acceptable terms when markets recover. Meanwhile, companies without such a record and credibility may not be able to do so or may have to accept more onerous terms.

It is thus important for an insurance company to:

  • Demonstrate that it can be relied on to achieve shareholders’ earnings expectations, while also meeting their earnings volatility constraint
  • Increase the transparency of its risk, capital and strategy decisions.

Doing so will help an insurance company persuade investors that it is resilient and, over time, reduce its resilience discount.


Although risk is the primary driver of value creation in insurance businesses, risk can also destroy value. Ideally, management must balance these opposing effects of risk.

The “Risk Management and Business Strategy” briefing lays out how a company should accomplish a desirable balance between risk and return by:

  • Focusing its risk governance framework and risk management processes on meeting both the solvency risk concerns of customers, creditors, rating agencies and regulators as well as the critical value risk concerns of shareholders
  • Using analytics to develop tools that lead to sharper risk insights, tighter alignment of risk and business decisions and strategies that increase its financial performance and valuation.

In the aftermath of the crisis, however, insurance companies are facing skeptical investors, many of whom have lost confidence in the industry. To overcome this skepticism and get the full valuation benefit from strategies that increase their intrinsic value, insurance companies need to:

  • Meet shareholders’ return expectations and risk tolerance constraints consistently, by utilizing risk insights from well developed risk management frameworks and processes that can integrate Enterprise Risk Management and Value Based Management more tightly
  • Correct weaknesses in governance frameworks, management processes and capabilities that are perceived as creating risks for investors.

Insurance companies can regain investors’ confidence, and might shorten the time needed to do so by using the framework presented in the briefing to develop their priorities and action plan. Once progress is demonstrated, reductions in investors’ discounts will increase the companies’ valuation multiples and compound returns from enhancements in intrinsic value for shareholders.

Jean-Pierre Berliet

(203) 247-6448

Survival of the Firm is not Mandatory

September 1, 2010

Is that idea really understood by top management and the board?

Does the board leave every meeting certain that the firm will still be in business when the next scheduled board meeting comes around?  How did they get to that certainty?

Can management tell them the likelihood that the firm will experience a fatal loss and how much that likelihood has changed since the previous board meetings?

Can management tell them exactly what sorts of events could put the firm out of business?  Have they discussed the sorts of “highly unlikely” events that might take the firm down if they suddenly did happen?

Those are, of course, the conversations that the board might well demand to have if they really understood that Survival is not Mandatory.

Responsibility for Risk Management

July 28, 2010

Who should have responsibility for risk management?

Is it the CRO? Is it the Business Unit Heads? Is it everyone? or is it the CEO (As Buffet suggests)?

My answer to those questions is YES. Definitely.

You see, there is plenty of risk to go around.

The CEO should be responsible for the Firm Killing Risks. He/She should be the sole person who is able to commit the firm to an action that creates or adds to a firm killing risk position. He/She should have control systems in place so that they know that no one else is taking and Firm Killing Risks. He/She should be in a constant dialog with the board about these risks and the necessity for the risks as well as the plans for managing those sorts of risks.

At the other end of the spectrum, there are the Bad Day Risks. Everyone should be responsible for their share of the Bad Day Risks.

And somewhere in the middle are the risks that the CRO and Business Unit Heads should be managing. Those might be the Bad Quarter Risks or the Bad Year Risks.

As the good book says, “To each according to his ability”. That is how Risk Management responsibility should be distributed.

Reconciling Risk Concerns

June 6, 2010

From Jean-Pierre Berliet

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 were shown to reconcile the risk concerns of policyholders and shareholders.

Creditors, including policyholders, and rating agencies or regulators whose mission it is to protect creditors, and shareholders are all interested in the financial health of an insurer, but in different ways. Creditors want to be assured that an insurance company will be able to honor its obligations fully and in a timely manner. For creditors, the main risk question is: what is the risk of the business? This is another way to ask whether the company will remain solvent.

Shareholders, however, are interested in the value of the business as a going concern, in how much this value might increase and by how much it might decline. For shareholders, the main risk question is: what is the risk to the business? Shareholders are interested in what ERM can do to increase and protect the value of their investment in a company. While both creditors and shareholders are interested in the tail of the distribution of financial results, as an indicator of solvency risk, shareholders are also very interested in the mean of these financial results and their volatility, which could have an adverse impact on the value of their investment.

Policyholders and shareholders’ views are different but not incompatible: a company could not stay in business if it were not able to persuade regulators that it will remain solvent and should be allowed to keep its license, or obtain from rating agencies a rating suitable for the business it writes.  Its value to investors would be significantly impaired..

Insurers recognize that the main drivers of their risk profile are financial risks, including insurance risk accumulations and concentrations, and the related market risk associated with their investment activities. They understand that resulting risks are best controlled at the point of origination through appropriate controls on underwriting and pricing and through reinsurance and asset allocation strategies that limit the volatility of financial outcomes. Stochastic modeling is being used more broadly by companies to understand how such risks accumulate, interact and develop over time and to evaluate strategies that enhance the stability of outcomes. Capital adequacy is the ultimate defense against severe risk “surprises” from insurance and investment activities. It is of interest to policyholders who want to be certain to collect on their claims, but also to shareholders who want assurance that a company can be viewed as a going concern that will write profitable business in the future.

Methodologies used by rating agencies on behalf of creditors describe in detail how the rating process deals with the three main drivers of a company’s financial position and of the volatility (risk) of this position. In response to rating agency concerns, insurance companies focus on determining how much “economic capital” they need to remain solvent, as a first step toward demonstrating the adequacy of their capital. Analyses they perform involve calculation of the losses they can suffer under scenarios that combine the impact of all the risks to which they are exposed. This “total risk” approach and the related focus on extreme loss scenarios (“high severity/low frequency” scenarios) are central to addressing creditors’ concerns.

To address the solvency concerns of creditors, rating agencies and regulators and the value risk of shareholders, insurance companies need to know their complete risk profile and to develop separate risk metrics for each group of constituents. Knowledge of this risk profile enables them to identify the distinct risk management strategies that they need to maintain high ratings while also protecting the value of their shareholders’ investment. Leading ERM companies have become well aware of this requirement and no longer focus solely on tail scenarios to develop their risk management strategies.


LIVE from the ERM Symposium

April 17, 2010

(Well not quite LIVE, but almost)

The ERM Symposium is now 8 years old.  Here are some ideas from the 2010 ERM Symposium…

  • Survivor Bias creates support for bad risk models.  If a model underestimates risk there are two possible outcomes – good and bad.  If bad, then you fix the model or stop doing the activity.  If the outcome is good, then you do more and more of the activity until the result is bad.  This suggests that model validation is much more important than just a simple minded tick the box exercize.  It is a life and death matter.
  • BIG is BAD!  Well maybe.  Big means large political power.  Big will mean that the political power will fight for parochial interests of the Big entity over the interests of the entire firm or system.  Safer to not have your firm dominated by a single business, distributor, product, region.  Safer to not have your financial system dominated by a handful of banks.
  • The world is not linear.  You cannot project the macro effects directly from the micro effects.
  • Due Diligence for mergers is often left until the very last minute and given an extremely tight time frame.  That will not change, so more due diligence needs to be a part of the target pre-selection process.
  • For merger of mature businesses, cultural fit is most important.
  • For newer businesses, retention of key employees is key
  • Modelitis = running the model until you get the desired answer
  • Most people when asked about future emerging risks, respond with the most recent problem – prior knowledge blindness
  • Regulators are sitting and waiting for a housing market recovery to resolve problems that are hidden by accounting in hundreds of banks.
  • Why do we think that any bank will do a good job of creating a living will?  What is their motivation?
  • We will always have some regulatory arbitrage.
  • Left to their own devices, banks have proven that they do not have a survival instinct.  (I have to admit that I have never, ever believed for a minute that any bank CEO has ever thought for even one second about the idea that their bank might be bailed out by the government.  They simply do not believe that they will fail. )
  • Economics has been dominated by a religious belief in the mantra “markets good – government bad”
  • Non-financial businesses are opposed to putting OTC derivatives on exchanges because exchanges will only accept cash collateral.  If they are hedging physical asset prices, why shouldn’t those same physical assets be good collateral?  Or are they really arguing to be allowed to do speculative trading without posting collateral? Probably more of the latter.
  • it was said that systemic problems come from risk concentrations.  Not always.  They can come from losses and lack of proper disclosure.  When folks see some losses and do not know who is hiding more losses, they stop doing business with everyone.  None do enough disclosure and that confirms the suspicion that everyone is impaired.
  • Systemic risk management plans needs to recognize that this is like forest fires.  If they prevent the small fires then the fires that eventually do happen will be much larger and more dangerous.  And someday, there will be another fire.
  • Sometimes a small change in the input to a complex system will unpredictably result in a large change in the output.  The financial markets are complex systems.  The idea that the market participants will ever correctly anticipate such discontinuities is complete nonsense.  So markets will always be efficient, except when they are drastically wrong.
  • Conflicting interests for risk managers who also wear other hats is a major issue for risk management in smaller companies.
  • People with bad risk models will drive people with good risk models out of the market.
  • Inelastic supply and inelastic demand for oil is the reason why prices are so volatile.
  • It was easy to sell the idea of starting an ERM system in 2008 & 2009.  But will firms who need that much evidence of the need for risk management forget why they approved it when things get better?
  • If risk function is constantly finding large unmanaged risks, then something is seriously wrong with the firm.
  • You do not want to ever have to say that you were aware of a risk that later became a large loss but never told the board about it.  Whether or not you have a risk management program.

Concentration of Power Risk

February 8, 2010


Guest Post from Max J. Rudolph, FSA CERA CFA MAAA

Rudolph Financial Consulting

A risk that we never talk about has become the elephant in the room. Some would call this ego risk, but at most institutions decision making occurs primarily at only the highest levels. It has been a year since I wrote a financial essay titled Does Your Company Need a Chief Skeptical Officer? I don’t think it has gotten any better. This is not due to poor goal setting. These senior officers believe they are doing what is best for their firm. Unfortunately, all of us tend to fall in love with our best ideas. We see that when we invest, where we hold losers far too long. When a manager has worked hard for a long period of time to develop an opportunity it can gain such momentum that it can’t be stopped no matter how poor the idea or the timing for the idea is. Many companies continued to write loans that previously had been securitized while liquidity in this market dried up. Others threw good money after bad on commercial real estate properties while existing properties were sitting vacant. There are very few companies that have instilled this skepticism in their risk culture. Berkshire Hathaway is one, where both Warren Buffett and Charlie Munger are comfortable in their own views and are encouraged to say what they think to each other. It will be interesting to see if this culture extends to the next generation of leaders at this highly successful firm. One way to ensure this is to practice consistent pricing discipline. When an opportunity comes about, the same financial analysis should always occur. This will include setting risk appetite, hurdle rates, and capital. It will not include having the CEO override the discussion.

There is no momentum to create this type of culture. Perhaps it should be developed at the board level with independent ERM experts providing the process and bringing in specific topic experts to anonymously consider these risks.

Warning: The information provided in this Post is the opinion of Max Rudolph and is provided for general information only. It should not be considered investment advice. Information from a variety of sources should be reviewed and considered before decisions are made by the individual investor. My opinions may have already changed, so you don’t want to rely on them. Good luck!

©2009 Rudolph Financial Consulting, LLC

Crisis Pre-Nuptial

January 21, 2010

What is the reaction of your firm going to be in the event of a large loss or other crisis? 

If you are responsible for risk management, it is very much in your interest to enter into a Crisis Pre-Nuptial

The Crisis Pre-Nuptial has two important components. 

  1. A protocol for management actions in the event of the crisis.  There is likely a need for there to be a number of these protocols.   These protocols can be extremely valuable, their value will most likely far exceed the entire cost of a risk management function.  Their value comes because they eliminate two major problems that firms face in the event of a crisis or large loss.  First is the deer in the headlights problem – the delay when no one is sure what to do and who is to do it.  That delay can mean that corrective actions are much less effective or much more expensive or both.  Second is the opposite, that too many people take actions, but that the actions are conflicting.  This again increasses costs and decreases effectiveness.  Just as with severe medical emergencies, prompt corrective actions are almost always more likely to have the most favorable results. 
  2. Setting up an expectation that the crises and losses either are or are not an expected part of the risks that the firm is taking.  If the firm is taking high risks, but does not expect to ever experience losses, then there is a major disconnect between the two.  Just as a marital pre-nuptial agreement is a conscious acknowledgement that marriages sometimes end in divorce, a Crisis Pre-Nuptial is an acknowledgement that normal business activity sometimes involves losses and crises. 

Risk managers who have a Crisis Pre-Nuptial in place might, just might, have a better chance to survive with their job in tact after a crisis or large loss. 

And if someday, investors and/or boards come to the realization that firms that plan for rainy days are, in the long run, going to be more valuable, the information that is in the Crisis pre-nuptial could be very important information for them.


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