Transcript Using Enterprise Risk Management to Maximize Shareholder Value William H. Panning Executive Vice President Willis Re CAS/SOA Enterprise Risk Management Symposium, Washington, D.C., 2003 Making better decisions… © Copyright 2003

Using Enterprise
Risk Management
to Maximize
Shareholder Value
William H. Panning
Executive Vice President
Willis Re
CAS/SOA Enterprise Risk Management
Symposium, Washington, D.C., 2003
Making better decisions…
© Copyright 2003 Willis Limited all rights reserved.
Agenda
1.
Introduction: Enterprise Risk Management (ERM) as a discipline
2.
The components of shareholder value
3.
Risk, capital, and shareholder value
4.
The importance of strategy to shareholder value
5.
Conclusions: How ERM adds shareholder value
6.
Appendix: Sources of further information
•
My focus will be on Property-Casualty insurers
•
I will avoid technical details (equations)
Making better decisions…
2
1. Enterprise Risk Management as a Discipline
• Enterprise Risk Management (ERM) is a way of thinking,
measuring, and managing that enables managers to maximize the
value of their firms to shareholders.
• ERM has three dimensions:
• Thinking  Conceptual and Cultural
• Measuring  Technological
• Managing  Behavioral
• What and how we think about ERM  what and how we measure
• What and how we measure  what and how we manage
• What and how we manage  the value of our organization
• Getting the conceptual framework right is crucial to the success of
ERM
Making better decisions…
3
2. The components of shareholder value
• The shareholder value of a firm has two components:
• Adjusted current surplus: The value of its current surplus, adjusted
for differences between economic and book value
• Franchise value: The expected value of future business profits,
including business not yet written, adjusted for optionality and risk
Making better decisions…
4
2a. Adjusted Current Surplus
• Adjusted current surplus equals reported surplus . . .
• (+) reserve discount: the difference between nominal and
discounted future loss payments
• (+) equity in the unearned premium reserve: the expected profit
embedded in the unearned premium reserve
• (+ or -) the difference between the market and book value of
invested assets
• (-) discount for credit risk of receivables and recoverables
• (-) adjusted for the risk of adverse loss development
Making better decisions…
5
2b. Franchise Value
• Franchise Value itself has two components, both adjusted for
risk:
• Expected future profits from probable renewals of existing
policies
• Expected future profits from new business not yet written
• Franchise value typically comprises 20% to 75% of a firm’s
value.
• In contrast to adjusted current surplus, which reflects the
profits from past decisions, Franchise Value is the only
component of a firm’s value that can be actively managed
Making better decisions…
6
2c. ERM and Franchise Value
• For many firms, Franchise Value is a significant component of
their market capitalization (number of shares x share price)
• Example: an auto insurer with assets of 12 billion, liabilities of 9
billion, and therefore surplus of 3 billion, but a market
capitalization of 14 billion!
• In this case, franchise value comprises more than 3/4 of the
firm’s market value
• Franchise value is real, and is reflected in the business
rationale of directly marketed auto insurance
• ERM that ignores Franchise Value is seriously flawed
Making better decisions…
7
3. Risk, capital, and shareholder value
• Both components of shareholder value are subject to risk
• Adjusted current surplus is subject to
• Investment risk: changes in interest rates
• Credit risk: changes in credit spreads
• Liability risk: adverse loss reserve development
• In principle, these risks can be hedged
• Control asset-liability duration mismatch to limit investment risk
• Use diversification and credit default swaps to limit credit risk
• Use reinsurance or loss portfolio transfers to limit or avoid adverse
reserve development
Making better decisions…
8
3a. Shareholder value at risk
• Franchise risk is subject to
• Interest rate risk: future premium and loss CFs are mismatched
• Industry pricing risk: future profits follow the underwriting cycle
• Solvency risk: capturing future profits requires sufficient capital
• In principle, these risks can also be hedged, at least partly:
• The interest rate risk of future profits can be controlled by
appropriately adjusting the duration of the current asset portfolio
• Industry pricing risk can be partially controlled by managing the
firm’s yearly growth rate
• Solvency risk can be controlled by altering underwriting and
financial leverage and/or by purchasing reinsurance
Making better decisions…
9
3b. The need for improved measures of risk
• Current measures of risk are inappropriate for measuring the
risk to shareholder value
• Value at Risk and Tail Value at Risk are cross-sectional
measures: they measure the distribution of outcomes at a
particular time in the future: the time horizon
• Cross-sectional measures of risk underestimate shareholder
value at risk (“so far so good”)
• The expected future profits that comprise franchise value, and
the risks that affect them, are longitudinal: they span the whole
future. There is no “time horizon” for shareholder value.
Making better decisions…
10
3c. Implications of longitudinal measures of risk
• Longitudinal analysis of risk reveals important connections
between adjusted current surplus and franchise value.
• Franchise value requires adequate current surplus:
• There may be regulatory restrictions on underwriting leverage
• Current investment may be necessary to capture future business
• Current surplus may be necessary to absorb unanticipated losses
• Impairments to current surplus – now or in the future – may limit
the ability of a firm to fully capture its potential franchise value
Making better decisions…
11
3d. Tradeoffs between surplus and franchise value
• Increasing a firm’s surplus increases its ability to withstand
unexpected losses and thus increases the probability that it will
survive (remain solvent) in order to capture franchise profits
• This can be achieved by increasing the firm’s capital (surplus) or
by purchasing reinsurance. Both are costly.
• The effect of increasing capital or purchasing reinsurance is
curvilinear. Initially, these actions increase shareholder value, but
the effect gradually decreases and eventually becomes negative.
Having too much equity or too much reinsurance reduces the
profitability of future business.
• There is an optimal risk/capital relationship that maximizes
shareholder value. (Risk “appetite” is irrelevant.)
Making better decisions…
12
4. How strategy affects shareholder value
• The volume and profitability of future business depends upon
business conditions and on management’s response to them.
• Different strategies for responding to changing business
conditions have a substantial impact on the value of future
business and on the shape of the firm’s distribution of returns
Making better decisions…
13
4a. The effect of strategy on risk and capital: an example
• Investment Strategy: Three portfolio managers all start out at
the same time with portfolios of 50% stocks and 50% bonds,
but follow different strategies:
• Buy-and-hold (B&H)
• Buy low & sell high (BL-SH)
• Momentum: buy as stocks rise, sell as they fall (MOM)
• The results are as follows:
Strategy
MOM
B&H
BL-SH
Return
8.4%
7.9%
7.4%
Std Dev 95%Loss 99%Loss WC Loss
14.0%
5.3%
6.2%
7.1%
10.2%
6.6%
11.8%
14.5%
7.9%
8.4%
18.7%
24.7%
Note that Std Dev decreases going down, but other measures
increase
Making better decisions…
14
4b. Results from a Buy and Hold Strategy
Results of Buy & Hold Strategy
Ending Value of Portfolio
200
180
160
140
120
100
80
60
60
80
100
120
140
Ending Stock Price
Making better decisions…
15
160
180
200
4c. Results from a Momentum Strategy
Results of Momentum Strategy
Ending Portfolio Value
200
180
160
140
120
100
80
60
60
80
100
120
140
Ending Stock Price
Making better decisions…
16
160
180
200
4d. Results from a Buy-Low-Sell-High Strategy
Results of Buy-Low-Sell-High Strategy
Ending Value of Portfolio
200
180
160
140
120
100
80
60
60
80
100
120
140
Ending Stock Price
Making better decisions…
17
160
180
200
4e. Return Distributions from the three strategies
Return Distributions for Alternative Strategies
Buy & Hold
16%
14%
Probability
Buy Low ,
Sell High
Mom entum
Strategy
12%
10%
8%
6%
4%
2%
0%
80
90
100
110
120
130
Ending Value of Portfolio
Making better decisions…
18
140
150
160
4f. The Importance of Strategy: Implications
• Strategy has a significant impact on the return distribution
• Risk measures like standard deviation can be misleading, since
they fail to reflect differences in the shape of the return
distribution. They fail to differentiate between upside and
downside potential.
• Strategy has a significant impact on the amount of capital needed
by the firm
• Strategy therefore affects both components of shareholder value
• For simplicity, this example focused on investment. But similar
considerations apply to strategies for managing the firm’s growth
options in underwriting
Making better decisions…
19
Conclusion: How ERM can add shareholder value
• ERM can help managers increase shareholder value by quantifying
what is otherwise invisible to them
• Managers manage only what they can see and quantify
• Typically they see and quantify only accounting values: current
surplus
• ERM can help managers add value in several ways:
•
•
•
•
By quantifying franchise value, so that feedback is possible
By measuring the risks to franchise value
By helping managers recognize ways to increase franchise value
By helping managers recognize ways to protect franchise value
Making better decisions…
20
Conclusion: How ERM can add value
• ERM can assist managers in identifying the combination of
risk and surplus that maximizes shareholder value
• This optimal combination has direct implications for
underwriting and financial leverage and for business mix
• ERM can identify strategies that increase shareholder value by
modifying the risk-return relationship
Making better decisions…
21
Some sources of further information:
• William Panning, ALM for a Going Concern, in Edward Altman
and and Irwin Vanderhoof, eds., Financial Dynamics of the
Insurance Industry. Dow Jones-Irwin, 1994.
• William Panning, The Strategic Uses of Value at Risk: Long
Term Capital Management for Property-Casualty Insurers,
North American Actuarial Review, 3:2, April 1999.
•
•
•
•
•
•
Harnessing the Elusive Risk Factor, Best’s Review, June 2001
The Virtues of Value at Risk, Best’s Review, September 2001
Rethinking Retention, Best’s Review, November 2001
Adding up the Skills, Best’s Review, September 2002
Changing the Answers, Best’s Review, January 2003
Managing the Invisible, Best’s Review, June 2003
Making better decisions…
22