Risk Adjusted Performance Measures

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

Bonus Fury

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.

New Decade Resolutions

Here are New Decade Resolutions for firms to adopt who are looking to be prepared for another decade

1. Attention to risk management by top management and the board.  The past decade has been just one continuous lesson that losses can happen from any direction. This is about the survival of the firm.  Survival must not be delegated to a middle manager.  It must be a key concern for the CEO and board.
2. Action oriented approach to risk.  Risk reports are made to point out where and what actions are needed.  Management expects to and does act upon the information from the risk reports.
3. Learning from own losses and from the losses of others.  After a loss, the firm should learn not just what went wrong that resulted in the loss, but how they can learn from their experience to improve their responses to future situations both similar and dissimilar.  Two different areas of a firm shouldn’t have to separately experience a problem to learn the same lesson. Competitor losses should present the exact same opportunity to improve rather than a feeling of smug superiority.
   
4. Forwardlooking risk assessment. Painstaking calibration of risk models to past experience is only valuable for firms that own time machines.  Risk assessment needs to be calibrated to the future. 
   
5. Skeptical of common knowledge. The future will NOT be a repeat of the past.  Any risk assessment that is properly calibrated to the future is only one one of many possible results.  Look back on the past decade’s experience and remember how many times risk models needed to be recalibrated.  That recalibration experience should form the basis for healthy skepticism of any and all future risk assessments.

6. Drivers of risks will be highlighted and monitored.  Key risk indicators is not just an idea for Operational risks that are difficult to measure directly.  Key risk indicators should be identified and monitored for all important risks.  Key risk indicators need to include leading and lagging indicators as well as indicators from information that is internal to the firm as well as external. 
   
7. Adaptable. Both risk measurement and risk management will not be designed after the famously fixed Ligne Maginot that spectacularly failed the French in 1940.  The ability needs to be developed and maintained to change focus of risk assessment and to change risk treatment methods on short notice without major cost or disruption. 
   
8. Scope will be clear for risk management.  I have personally favored a split between risk of failure of the firm strategy and risk of losses within the form strategy, with only the later within the scope of risk management.  That means that anything that is potentially loss making except failure of sales would be in the scope of risk management. 
   
9. Focus on  the largest exposures.  All of the details of execution of risk treatment will come to naught if the firm is too concentrated in any risk that starts making losses at a rate higher than expected.  That means that the largest exposures need to be examined and re-examined with a “no complacency” attitude.  There should never be a large exposure that is too safe to need attention.   Big transactions will also get the same kind of focus on risk. 
   

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.

Coverage and Collateral

I thought that I must be just woefully old fashioned. 

In my mind the real reason for the financial crisis was that bankers lost sight of what it takes to operating a lending business. 

There are really only two simple factors that MUST be the first level of screen of borrowers:

1.  Coverage

2.  Collateral

And banks stopped looking at both.  No surprise that their loan books are going sour.  There is no theory on earth that will change those two fundamentals of lending. 

The amount of coverage, which means the amount of income available to make the loan payments, is the primary factor in creditworthiness.  Someone must have the ability to make the loan payments. 

The amount of collateral, which means the assets that the lender can take to offset any loan loss upon failure to repay, is a risk management technique that insulates the lender from “expected” losses. 

Thinking has changed over the last 10 – 15  years with the idea that there was no need for collateral, instead the lender could securitize the loan, atomize the risk, thereby spreading the specific risk to many, many parties, thereby making it inconsequential to each party.  Instead of collateral, the borrower would be charged for the cost of that securitization process. 

Funny thing about accounting.  If the lender does something very conservative (in terms of current standards) and requires collateral that would take up the first layer of loss then there will be no impact on P&L of this prudence. 

If the lender does not require collateral, then this charge that the borrower pays will be reported as profits!  The Banks has taken on more risk and therefore can show more profit! 

EXCEPT, in the year(s) when the losses hit! 

What this shows is that there is a HUGE problem with how accounting systems treat risks that have a frequency that is longer than the accounting period!  In all cases of such risks, the accounting system allows this up and down accounting.  Profits are recorded for all periods except when the loss actually hits.  This account treatment actually STRONGLY ENCOURAGES taking on risks with a longer frequency. 

What I mean by longer frequency risks, is risks that expect to show a loss, say once every 5 years.  These risks will all show profits in four years and a loss in the others.  Let’s say that the loss every 5 years is expected to be 10% of the loan, then the charge might be 3% per year in place of collateral.  So the banks collect the 3% and show results of 3%, 3%, 3%, 3%, (7%).  The bank pays out bonuses of about 50% of gains, so they pay 1.5%, 1.5%, 1.5%, 1.5%, 0.  The net result to the bank is 1.5%, 1.5%, 1.5%, 1.5%, (7%) for a cumulative result of (1%).  And that is when everything goes exactly as planned! 

Who is looking out for the shareholders here?  Clearly the deck is stacked very well in favor of the employees! 

What it took to make this look o.k. was an assumption of independence for the loans.  If the losses are atomized and spread around eliminating specific risk, then there would be a small amount of these losses every year, the negative net result that is shown above would NOT happen because every year, the losses would be netted against the gains and the cumulative result would be positive. 

Note however, that twice above it says that the SPECIFIC risk is eliminated.  That leaves the systematic risk.  And the systematic risk has exactly the characteristic shown by the example above.  Systematic risk is the underlying correlation of the loans in an adverse economy. 

So at the very least, collateral should be resurected and required to the tune of the systematic losses. 

Coverage… well that seems so obvious it doed not need discussion.  But if you need some, try this.

Who wins with leverage?

Leverage increases apparent returns in best of times but Increases risk considerably in worst of times. Investors do not benefit from leverage over time. Managers benefit greatly from leverage. Derivatives are highly levered. Traders think that it is silly to spend any time thinking about notional amounts of derivatives. Insurers should learn that they need to pay attention to the notional amount of their insurance contracts. Owners of now highly diluted shares of banks (and AIG) now know that the leverage of those organizations did not in the end create value. Insurers, like banks, are by their fundamental nature highly leveraged with capital a tiny fraction of gross obligations. Insurers should take extreme caution when considering activity that increases leverage. And they should make an analysis of the true amount of leverage in their activities an important activity before entering a new activity and periodically as the world turns.

For example, if one investor puts his money in a 2/20 hedge fund that is 10 for 1 levered and that pays 10% interest on its funds. If the returns for the first four years are 20% per year, After 4 years, the investor is up over 400%! The hedge fund manager has been paid over 150% of the original investment and the debtholder has been paid 400%. But then in year 5, the investment loses 20%, giving back just one of those four years of outsized gains. All of a sudden, the investor is down to an 8% cumulative gain!!! while the manager and lender have slightly higher gains than after the four fat years.

The sister of this investor had the same amount of money to invest, but put it into an unlevered fund with the same types of investments and without the 20% profit share for the manager. After four fat years of 10% gains, the sister is up over 35% and the manager has been paid only 7% of the original fund value. Now the market drop hits sis’ fund with a 10% loss and she ends the five years up a respectable 19%. The fund manager gets about 9% of the original fund for his five years of work.

Leverage Illustration

Of course, the illustration can be manipulated to make anyone the supreme winner. But this scenario seems pretty telling. Leverage primarily benefits the fund manager, not the investor in this scenario. In many scenarios they both benefit, but there are no scenarios where the manager does poorly on a leveraged investment fund.

So when you die, pray to come back as a leveraged hedge fund manager.

ERM only has value to those who know that the future is uncertain.

Businesses have three key needs.

First they need to have a product or service that people will buy. They need revenues.

Second they need to have the ability to provide that product or service at a cost less than what their customers will pay. They need profits.

Once they have revenues and profits, their business is a valuable asset. So third, they need to have a system to avoid losing that asset because of unforeseen adverse experience. They need risk management.

So Risk Management is the third most important need of a firm.

And there is often a conflict between risk management and the other two goals. Risk management will sometimes say that a business activity that produces revenue is too risky and must be curtailed or modified in such a way that it produces less revenues. Risk Management often costs money or otherwise depresses profits. For example, an insurance policy covering fire of a building owned by the firm will cost money and depress profits.

So Risk Management needs to defend its value to the firm. Many risk management proponents have been asked to tell the value added of their activities. This is difficult to explain. Not because risk management does not have a value, but because the cost of risk management in terms of reduced revenues or increased costs are usually tangible and definite, while the benefits are probabilistic. Often the person asking the question is looking for a traditional spreadsheet answer that shows two columns adding up and perhaps the difference between the two is the benefit of risk management.

It does not work that way. For Risk Management to have value, one must understand that the future is uncertain. The value of risk management comes from the way that it shapes that uncertainty.

The next time you are asked about the value of risk management, ask the questioner what value they would put on the airbags and seat belts in their car. If they have no uncertainty about their ability to avoid accidents, then they will put a zero value on the safety devices – the personal risk management systems. If they resist answering, ask them if they will agree to have them removed for $20? Or for $2000? What value do they place on that risk management?

Most people will agree that the demise of a company is less serious than the demise of a person, but it is not difficult to see that there is some value to activities that increase the chance that a company will not expire in the next business cycle or windstorm.

So risk management decreases the uncertainty about the survival of the firm. There is a way to quantitatively value that reduction in uncertainty and compare it to the reduced revenues or increased costs of the risk management activities.