Lessons for Insurers (6)

In late 2008, the The CAS, CIA, and the SOA’s Joint Risk Management Section funded a research report about the Financial Crisis. This report featured nine key Lessons for Insurers. Riskviews will comment on those lessons individually…

6. Insurers must pay special attention to high growth/profit areas in their companies, as these are often the areas from which the greatest risks emanate.

All high growth areas are not risk problems, but almost all risk problems come from areas of high growth.

And high growth areas present several special problems for effective risk management.

1. High growth in the financial services field usually results when a firm has a new product or service or territory.  There is almost always a deficit of experience and data about the riskiness of the new area.  Uncertainty rules.
2. In new high growth areas, pricing can be far off the mark at the outset.  If the initial experience is benign, then the level of pricing can become firmly set in the minds of the distributors, the market and the management.  When adverse experience starts to undermine the pricing, it may be initially dismissed as an anomaly, a temporary loss.  It may be very difficult to determine the real situation.
3. If risk resources were included in the plan for the high growth activity, they were probably not increased when the growth started to exceed expectations.  As growth occurs, the risk resources are most often held at the level called for in the initial plan.  Any additional resources that are applied to the growing area are needed to support the higher level of activity.  Often this is simply a natural caution about increasing expenses in what may well be a temporary situation.  This caution is often justified as growth ebbs.  But in the situations where growth does not wane, a major mismatch between risk resources and business activity develops.
4. There is usually a political problem within the firm.  The management of the highest growth area are most likely the current corporate heroes.  It is very highly unlikely that the CRO will have as much clout within the organization as the heroes.  The only solution to this issue is support from the CEO for the importance of risk.
5. Risk efforts need to be seen not as “business prevention” but as a partner with the business in getting it right.  This is difficult to accomplish unless risk is involved from the outset.  If the business gets going and growing with procedures that are questionable from a risk perspective, then it is quite possible that changing those procedures might well hurt the growth of the area.  Risk needs to be involved form the outset so that appropriate procedures and execution of those procedures does not become a growth issue later on.

This is the most difficult and important area for the risk management of the firm.  The business needs to be able to take chances in new areas where good growth is possible.  The Risk function needs to be able to help these new activities to have the chance to succeed.

At the same time, the organization needs to be protected from the sort of corner cutting that leads to growth through drastically under-priced risks.

It is a delicate balancing act that requires a high degree of political skill as well as good business judgment about when to dig in the heels and when to let go.

Lessons for Insurers (1)

Lessons for Insurers (2)

Lessons for Insurers (3)

Lessons for Insurers (4)

Lessons for Insurers (5)

Lessons for Insurers (6)

Advertisement

You may not be able to Grow out if it

Growth does not always mean excessive risk, but excessive risk is almost always associated with high growth.

Growth has a way of masking problems.  Things are changing and it is often very difficult to understand whether the changes are just a lag in reporting the good things that come from healthy growth or if they are leading indicators of major problems.

The firm needs to grow risk management analysis and attention along with highest growth activities.  That needs to be demanded from the top.  No middle or even high level risk officer will ever have the authority to slow down the part of the company that is growing the best.  Firms need to have CEO commitment to extra risk analysis of the fastest growing business.

The firm needs to establish its operational capacity for handling growth.  The most common reaction to unexpected growth is to delay hiring additional staff (along with delaying adding additional risk staff as mentioned above).  After more delay and more growth, the business might seem much more profitable than expected.  Some of that excess profitability is coming from the understaffing.  Some of the profitability might be coming from mistakes in recordkeeping due to the understaffing.  A sudden delayed effort to fix the under staffing will most often hurt more than it helps in the short run.

And what is most likely to be shortchanged in an understaffed growing situation  Why it is quality control and recordkeeping.  So if there is a growing problem it is very hard to notice it.

So what to do?

Every great mistake has a halfway

moment, a split second when it can be

recalled and perhaps remedied.

Pearl Buck

Part of the process of planning for each new thing that might grow, if it is as successful as is hoped, needs to be to determine where that halfway moment might be.

ERM Role in Implementing a Winning Acquisition Strategy (2)

From Mike Cohen

Part 2

(Part 1)

Execution of an Acquisition Strategy Goes Through Several Stages and Involves Many and Varied Complex, Interrelated Business Issues (they must be performed well, and there are numerous junctures where things can go awry … suggesting that many potential risks need to be addressed, and more effectively than they typically are)

– Defining the business case

– Considering the corporate strategy and the resulting (ideally enhanced) business model

* Fit vs. conflict

* Synergies; potential synergies are frequently overstated

* Diversification

– Assessing market opportunities and competitive dynamics

* Products

* Distribution

* Markets/segments

* Brand/reputation

– Financial impact

* Earnings

* Capital

* Economic value

* Assessment of an appropriate price

– Investments

* Asset classes

* Loss positions

* Liquidity

– Operational fit (or problematically, the need to ‘fix’ the target’s operations)

* Technology

* Administration

* Core competencies

– Integrating the target: melding the two organizations so that they can perform effectively together, while mitigating risk, volatility and confusion to the greatest extent possible

Q: Is an acquisition strategy a core competency of your company … can you execute such a transaction successfully?

Due Diligence Performed on any Acquisition Target: A Critical Activity on the Strategic and Tactical Levels

– Valuation, impact on future financial results

– Management/staff

– Profitability of new (potential), existing business

– Competitive market position; product management, distribution capabilities

– Synergies: strategic, operational, financial, market/product/distribution

– Investments

– Expense structure (opportunities for increasing efficiency and/or cost reduction)

– Technological capabilities or possible lack of fit

– Contractual obligations

– Areas of risk or uncertainty

Many acquisitions are viewed retrospectively as failures. A lack of accurate evaluation of/objectivity about prospective acquisition targets (using ‘rose-colored glasses’ leads many (most?) acquirers to have unrealizable goals for their transactions, and as a consequence the end results (strategic, financial or otherwise) do not meet expectations.  There is a considerable level of risk to the acquirer if the due diligence process is not conducted with sufficient accuracy and objectivity.

Evaluating the Capabilities of an Organization to Execute Successful Acquirer: Being a successful acquirer requires a number of skills and mind-sets:

– Knowing one’s own corporate vision, mission, strategy and operating model, and how  acquisitions complement them

– Having a disciplined approach: evaluating fit, paying an appropriate price based on economic value, both current and future

– Performing careful, accurate and objective due diligence on the target company and management counterparts … caveat emptor!

– Executing timely, well planned and orchestrated integration activities focus on achieving a favorable operational model and attaining a satisfactory level of cost savings; a number of  companies that acquired positive reputations as acquirers were in fact poor at integrating their acquisition(s), causing their organizations to implode

– Managing the staffs and corporate cultures sensitively. There is considerable amount of research that identifies human resource related issues as the most prevalent causes for acquisition failure; personalities (egos), conflicting management styles and cultures, and different compensation structures are all too common. Proactive conflict resolution is critical to steer the resulting entity past these pratfalls. Open and continuous communication is critical.

The General Lack of Success from Acquisitions is Attributed to Mismanaging One or More Critical Aspects of the Transaction with Material Risk

Strategy

– Incompatible cultures

– Incompatible business models

– Synergy non-existent or overestimated

Due Diligence

– Acquirer overpaid

– Foreseeable problems overlooked

– Acquired firm too unhealthy

– Overlooking aspects of the target where excessive divestiture or liquidation might be required

Implementation

– Inability to manage target

– Inability to implement change

– Clash of management styles/egos

Conclusion

An acquisition is arguably the most difficult business endeavor a company can undertake. This report discussed a considerable number of elements involved in acquisition activity; they are all complex, and there are many junctures in the process where a number of these elements can go awry or reach adverse conclusions, either derailing transactions that could have otherwise been successful or ‘proving’ the efficacy of transactions that upon closer scrutiny could not have succeeded and should have been avoided.

Studies of acquisition activity across all industries (not just insurance) have consistently  found that approximately two-thirds of these transactions yielded unsatisfactory results. One could observe that this is not surprising, as there are so many steps along the way that can turn into insurmountable roadblocks. Considering the myriad of factors that must be performed well, it is clear than sound, pragmatic risk management throughout the process and beyond is critical in order for acquisition activity to succeed

No Thanks, I have enough “New”

It seems sad when 75 year old businesses go bust.  They had something that worked for several generations of managers, employees and investors.  And now they are gone.  How could that be?

There are two ways that old businesses can come to their demise.  They can do it because they stick to what they know and their product or service  (usually) slowly goes out of fashion.  Usually slowly, because all but the most ossified large successful companies can adapt enough to keep going for quite some time, even when faced by competition with a better business model/product or service.  Think of the US auto industry slowly declining for 40 years.

The second way is a quick demise. This usually happens after the old company chooses to completely embrace something completely new.  If their historic business is in decline, many large old firms are on the look out for that new transformational thing.  The mistake that they sometimes make is to be in much too much of a hurry. They want to apply their size advantage to the new thing and start getting economies of scale in addition to early adopter advantages.

The failure rate of new business is very, very high.  A big business that jumps to putting a large amount of its resources into the new business will be transforming a solid longstanding business effectively into a start-up.  But rarely do the big businesses in restart mode deliver anything like start-up returns.  So investors bare the risks of of the start-up with the returns only slightly higher than long term averages.

This is a clear example of when the CEO needs to be the risk manager.  The established firm needs to have a limit for “New” businesses.  The plan for the new business should reflect an orderly transition between the franchise business and what MAY become the new franchise.  This requires the CEO to have a time frame in mind that is appropriate for a business that may have existed before he/she was born and that, if the risks are managed well, should exist long after they are gone.

There are good underlying reasons why the “New” needs to be limited for a company with long term survival plans.  “New” involves several risks that a well established firm may have mastered a generation ago and have relegated to the corporate unconscious.

The first is execution risk.  The established firm will doubtless be excellent at execution of its franchise business.  But the “New” will doubtless require different execution.  An example of this from the insurance industry, when US Life Insurers started into the equity linked products, man of them experienced severe execution problems.  Their traditional products involved collecting cash and putting it into their general fund.  They only provided annual information to their customers if any.  Their administrative systems and procedures were set up within an environment that was not particularly time sensitive.  The money was in the right place, their accounting could catch up “whenever”.   With the new equity linked products, exacting execution was important.  Money was not left in the general fund of the insurer but needed to be transferred to the investment manager within three days of receipt.  So insurers adapted to this new world by getting to the accounting and cash transfers “whenever” but crediting the customer with the performance of their chosen equity fund within the legal 3 day limit.  This worked out fine with small timing delays creating some small gains and some small losses for the insurers.  But the extended bull market of the late 1990’s made for a repeated loss because the delay of processing and cash transfer meant that the insurer was commonly backdating to a lower purchase price for the shares than what they paid.  Some large old insurers who had jumped into this new world with both feet were losing millions to this simple execution risk.  In addition, for those who were slow to fix things, they got hit on the way down as well.  When the Internet bubble popped, there were many, many calls for customer funds to be taken out of the equity funds.  Slow processing meant that they paid out at a higher rate than what they received from their delayed transactions with the investment funds.

The insurers had a well established set of operational procedures that actually put them at a disadvantage compared to start-ups in the same business.

The second is the “unknown” risk.  A firm that has been operating for many years is often very familiar with the risks of its franchise business.  In fact, their approach to risk management for that business may well be so ingrained, that it is no longer considered a high priority.  It just happens.  And the risk management systems that have been in place may work well with little active top management attention.  These organizations are usually not very well positioned to be able to notice and prepare for the new unknown risks that the new business will have.

The third is the “Unknowable”.  For a new activity, product or business, you just cannot tell what the periodicity of loss events or the severity of those events.  That was one of the mistakes in the sub prime market  The mortgage market has about a 15 year periodicity.  Since a large percentage of people operating in the sub prime space were not in that market the last time there was a downturn, they had no personal experience with the normal cycle of losses in the mortgage market.  Then there was the unknowable impact of the new mortgage products and the drastic expansion into sub prime.  It was just unknowable what would be the periodicity and severity of losses in the “new” mortgage market.

So the point is that these things that are observed about the prior “new” things can be learned and extrapolated to future “new” things.

But the solution is not to never do anything “new”, it is to keep the “new” reasonable in proportion to the rest of the organization, to put limits on “new” just like there are limits on any other major aspect of risk.

Project Risk Management

A Guest Post from Johann Meeke

Why do most projects overrun on time or cost?

Perhaps it’s because sane people are involved. One of the components of sanity is optimism. (It’s why we are happy to get out of bed each morning – because we think things will be okay). Sane people, trying to anticipate the problems ahead, on a new venture, will most often believe things will be good … and that bad things can be dealt with!

When is a risk a threat and when is it an opportunity?

Imagine you commissioned a new bridge. The week before opening the constructor tells you that it needs to be delayed by 48 hours. Do you cancel the whole project … or just wait 48 hours?  What happens if they come to you and say they can open it early by 24 hours. Do you declare the project a failure? Of course not. But this is the point about project risk. The very essence of what we mean by risk needs to be reflected on. Now the nature of risk is much more uncertain.

Contrast this to an incident where the bridge is built but collapses through poor workmanship. Now there is no doubt about the nature of risk. It’s very clear.

Projects present a particular form of challenge to the risk manager. Firstly, the definition of risk needs to more balanced. Secondly, the processes used to identify and evaluate risk need to be specifically considered and finally the risk mitigation techniques require tailored consideration.

Typically projects have three main risk variables:

• Price – will you make a profit by building/delivering for less cost that you can eventually sell it for. (Or will you be on budget).
• Performance – will it work to customer specification, over its entire life (or life of contract obligations)
• Programme – will you complete on time.

All these variables interact in a positive and negative way. You could deliver early but might have to sacrifice performance and price (by compromising spec or putting more resource, i.e. cost, into the project). You could delay the programme (a negative) by reducing costs (normally a positive).

What is actually happening is a trade-off between threat and opportunity in a manner that’s doesn’t happen so directly in most others areas of risk management.

For example, installing automatic sprinklers in a factory doesn’t provide a direct opportunity to earn more profit. It might protect the profit you have projected. But as can be seen above, trading off programme and performance risk, on a project, might lead to directly increased profits (because costs have been reduced through less overtime working for example).

The reason this point has been concentrated on is because there is a strong tendency to assume project risk management is just like any other form of risk management – with just a few more time and cost constraints.

So what are the main differences in managing risk?

Well, for this article we will ignore those risks that can be subject to some form of preconception e.g. building site health and safety where normal safeguards should be applied. Let’s instead focus on the unique aspects.

Risk identification

By definition a project is a new thing. Whether developing a new product, building a new factory or installing a new IT system – it will never have been done before, under quite the same circumstances. You may have built a similar factory nearby, but the ground conditions will be different, the neighbours, the weather, key staff might have left and so it goes on.

In short, you can learn from the past but the future consists of potentially significant new elements. Therefore, whilst you can rely on checklists and lessons learned you will also have to consider the unknowns that have never been encountered in quite the permutation you will come across. For this reason, some form of multi-disciplinary “brainstorming” or scenario envisaging should take place. This will allow you to comprehensively explore the future and how it might manifest itself. The multidisciplinary approach allows quick identification of risks that arise through a combination of circumstance or that might fall through gaps.

Risk Assessment

Determining downside threat without also calculating upside opportunity would make a project risk management exercise like a car with brakes but no engine. For example, considering the costs of project overrun will give one view of management action – however, looking at the potential benefits of delivering early (e.g. improved cash flow, availability of staff for other projects, project bonuses etc.) will give a completely different emphasis. Blending the upside/downside trade-offs between performance, programme and price is the very essence of good project management.

Risk  Treatment or Mitigation

Dealing with risk here is more than ensuring compliance. It is about having the correct upside and downside KPI’s. it’s about integrated contract negotiation with proper project monitoring. It is about mitigation that starts at the bid phase with clear contracts and a thorough understanding of what needs to be done, by whom and by when. It’s about having the right staff and material, when and where needed. In short, it’s a whole world of complex interactions requiring experience and skill, underpinned by robust processes.

Some concluding thoughts

How does one tell a good project risk management process from a mediocre one?

Perhaps the most obvious indicator is where the risk management starts when the project starts. In reality it should have started at the bid or inception phase.

On other occasions it has actually occurred at the bid phase – but has never been integrated into the project plan after contract start.

But perhaps the best indicator of all is a bit more personal. Most project risk assessments are de-humanised. It’s the modern way as we search for the commanding heights of objectivity. But imagine the effect of an excellent project manager versus an average one. Would it affect timings, costings, relationships. You bet. If your project risk management hasn’t even assessed this most obvious of risks then I suggest it is back to the drawing board.

Animal Spirits Eating Green Shoots

Guest Post from David Merkel

http://alephblog.com/2009/09/01/animal-spririts-eating-green-shoots/

I have never liked Keynes concept of “animal spirits.” (I reread that piece, and though it is long, I think it is worth another read.  I try not to say that about my own stuff too often.)  Businessmen are generally rational, and take opportunities when they see them.  As for those that invest in the stock market, perhaps the opposite is true — panicking near bottoms, and buying near tops.

Most businessmen are risk-averse.  They do what they can to avoid insolvency.  But debt capital is cheap during the boom phase of an economic cycle, and businessmen load up on it then.  During the bear phase of the cycle, overly indebted businessmen pull in their horns and try to survive.  At bottoms, deals are too attractive for businessmen with spare cash to ignore — businessmen are rational, and seek deals that offer profitability with reasonable probability.

Unlike this article, I’m not convinced that the news does that much to affect behavior.  Movements in asset values are self-reinforcing not because of crowd opinion, but because of the accumulation and decumulation of debt and other financial claims.  As businessmen get closer to insolvency, they trim activity.  As their financial constraints get looser, they are willing to consider more investments with free cash.

As for the current situation, I am less confident of the “green shoots.”  Yes, inventory decumulation has slowed down.  So has the increase in unemployment, maybe.  Yes, financing rates have fallen.  We still face a situation where China is force feeding loans for non-economic reasons into its economy, and where the financial sector of the US is still weak due to commercial real estate loans, bank loans to corporations, and weak financial entities propped up by the US government.  Even residential real estate is not done, because of the number of properties that are inverted, and the increase in unemployment, which I think is likely to get worse.

Applications: I think it is more likely than not that there will be another crisis with the banks, and another round of monetary rescue from the government.  I also think that many speculative names like AIG have overshot, and the advantage now rests with the shorts for a little while.  Real money selling is overcoming day traders.

Be cautious in this environment.  After I put out my nine-year equity management track record, the next project is to dig deeper in the risks in my own portfolio, and make some changes.

Disclosure

This post is produced by David Merkel CFA, a registered representative of Finacorp Securities as an outside business activity. As such, Finacorp Securities does not review or approve materials presented herein. By viewing or participating in discussion on this blog, you understand that the opinions expressed within do not reflect the opinions or recommendations of Finacorp Securities, but are the opinions of the author and individual participants. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security or other instrument. Before investing, consider your investment objectives, risks, charges and expenses. Any purchase or sale activity in any securities instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Finacorp Securities is a member FINRA and SIPC.