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.
Conclusion
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
jpberliet@att.net
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