Enterprise Risk Management:
Risk, Capital, and Value
Bill Panning, EVP, Willis Re
The Argument in Brief
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For Enterprise Risk Management (ERM) to be a practical
discipline, it must address three crucial questions:
1. How much risk are we taking as a firm?
2. How much capital (surplus + reinsurance) should we have, given
our risk?
3. Are there practical and effective ways to enhance the value of
our firm by changing our risk-capital balance?
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As typically presented and practiced, ERM addresses only
the first of these three questions. It therefore lacks relevance
to a firm’s strategic decisions and its value to stakeholders.
The Argument in Brief (continued)
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At Willis Re we have developed a value-based approach to
capital management and reinsurance that specifically focuses
on practical strategic decision making.
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Our value-based approach specifically explains what is
typically assumed but rarely described: how “better”
information about risk can be used to make “better” strategic
decisions that make the firm more valuable.
•
ERM will survive only if it becomes a practical way to deliver
measurable value to those who implement it.
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Part I
How much risk are we taking as a firm?
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So where are the numbers?
Advice from my first boss:
• An insurance company gets paid for assuming risk from clients
• The key to success is making sure that the price is adequate
• Successful insurers are the ones that maintain the right balance
between risk and return, between the risk that they assume and
the return that they obtain from doing so.
My question to my first boss:
• I’ve seen numerous reports, spreadsheets, meetings, etc. that
analyze our profits
• Where are the reports, spreadsheets, meetings, etc. that analyze
our risks?
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What happens when we don’t have numbers (risk measures)
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We focus far more on return than on risk
We don’t really measure risk we can’t compare different risks
And we can’t compare the same risk over time
Therefore we can’t really manage risk, since we lack feedback
• Lack of measurement also means that we become very
susceptible to potentially distorted perceptions of risk
• We also become complacent, and readily attribute high profits
(from low losses) to skill rather than luck
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The key event in the evolution of ERM
• 1989: Dennis Weatherstone, CEO of J. P. Morgan, asks for a
report, to be delivered to him daily at 4:15 pm, that answers
the following question:
How much could we lose if tomorrow turns out to be a relatively
bad day?
• Why 4:15? Because if the number was larger than he was
comfortable with, there was still time to do something about it
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Why this is a great question
How much could we lose if tomorrow turns out to be a
relatively bad day?
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It is short and clear. Everyone can understand it.
It provides an alternative to standard deviation as a risk measure
It defines risk as the potential for loss
It focuses on a specific time horizon
It focuses on the firm as a whole (the “enterprise”) and not on
numerous individual trading desks
• other reports did indeed focus on trading desks (where is our risk?)
• Its objective was managing risk, not just measuring it (4:15)
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What is a relatively bad day?
• Analogy to weather: how cold could it get on a relatively cold
day?
• We could answer by specifying a percentile: “95% of the time
(days) the temperature stays above zero”
• Value at Risk (VaR): “95% of the time our losses will be less
than $125 million”
• $125 million is therefore the 95% VaR
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Benefits of having a measure of risk – VaR or otherwise
• We can track risk over time
• We can compare different risks to one another
• We can determine a reward to risk ratio for different risks
• Value of measuring risk in dollars, as in VaR
• We can use the number to inform strategic decisions
• Mix of business
• Investment versus underwriting
• Reinsurance decisions
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Some limitations of Value at Risk
It is not clear how to pick a percentile (or several)
• Pick more than one (we are trying to manage a distribution,
not just one point on a distribution)
• Pick the number, then determine the percentile
• Example, instead of reporting the 95th percentile loss (95%
VaR), determine the magnitude of the loss that would bring
about some key event (e.g., a one-notch downgrade) and
report the probability of that happening. Then track that
number.
• This translates VaR into something meaningful to managers
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Some limitations of Value at Risk, continued
A technical problem: “coherence” and subadditivity
• The basic problem: VaR measures can sometimes indicate
that the combination of two portfolios is more risky than either
one taken separately. This should not happen.
However,
• It’s not at all clear that this is a big problem in practice. The
examples that illustrate this problem are highly contrived.
• Comprehensibility and relevance are offsetting benefits
• There is no reason to rely on a single risk measure.
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What risk measurement does NOT tell us
How do we use risk measures to make good strategic decisions?
• Example: how did Weatherstone determine when his firm was
taking too much risk?
Are we using risk measures that are the most appropriate ones,
given our objectives?
• Example: VaR focuses on losses that occur in a specific period.
But it ignores additional consequences in later periods.
• For a going concern, there is no “horizon,” since the firm’s whole
future matters, as we will see.
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Part II
How much capital should we have, given our risk?
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How do firms answer this question in practice?
• Peer comparison: maintain financial ratios similar to peers
• Ratings: maintain ratios needed to sustain a target rating
• Risk tolerance: adopt guidelines that reflect chosen risk limits
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Some limitations of current practices
• Peers: what are appropriate peer comparisons?
• What companies?
• What ratios?
• Implicit assumption that other firms have gotten it right?
• Ratings: what is the best rating to have?
• Do rating agencies have it right?
• Risk tolerance: what is it? Who decides?
• Does that person or group have it right?
• And what do we mean by “right”?
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How much capital should we have, given our risk?
Willis Re’s approach: manage risk and capital (surplus +
reinsurance) so as to maximize the value of the firm
We call our approach “Value-based Capital Management”TM
One of its components is “Value-based Reinsurance”TM
What’s crucial: we make these practical realities, not just
slogans
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To achieve this objective we need to measure value
• We begin by creating a valuation model with observable
parameters that are understandable and measurable (unlike
“risk appetite”)
• This model specifies how value is to be measured
• It incorporates measures of risk and measures of return
• It is explicit and transparent (unlike “risk tolerance”)
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The components of firm value: (1) Liquidation value
• The value of the firm has two components: the first is
liquidation value: the net present value (NPV) achieved by
placing the firm in runoff
• This is the market value of assets, less the present (discounted)
value of liabilities, that exist on the firm’s current balance sheet
• These include future cash flows from business now on the books
• It is the result of decisions made in the past
• Apart from claims handling, liquidation value cannot be managed
• Ironically, this is typically the focus of management reporting
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The components of firm value: (2) Franchise value
• The second component is franchise value, which is the
impairment-risk-adjusted present value of expected earnings
or cash flows from future business not yet written
• Practically speaking, modeling earnings is more transparent to
senior management than modeling cash flows
• Like cash flows, future earnings must be discounted for time value
• For firms with high growth rates, future earnings must also be
adjusted to reflect decreasing sustainability of high growth
• There are important judgments here; managerial input is crucial
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The components of firm value: (2) Franchise value (cont.)
• Future earnings must also be adjusted to reflect the possibility
of impairment: the likelihood that they may not occur, or may
be reduced, by events that occur between now and then
• Impairment is a reduction in the ability of a firm to produce
future earnings. It does not necessarily imply default, but
does imply that the flow of net income is reduced or stopped.
• There are important examples of impairment in which firms
remain solvent but are unable to recapitalize or obtain ratings
that enable them to continue writing business. Their earnings
capacity is crippled.
• Adverse ratings changes are one type of impairment; they
reduce the ability of a firm to produce a given level of earnings
• Here again, managerial input is crucial
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More about franchise value
• In contrast to liquidation value, franchise value presents the
value obtained by operating the firm in the future, as a going
concern
• Franchise value is therefore the only portion of the firm’s
value that can truly be managed
• There are important tradeoffs between net income and
franchise value (and therefore stakeholder value) that should
be incorporated in a valuation model
• Publicly traded firms with significant franchise value have a
market-to-book ratio that significantly exceeds 1.0
• For most firms, franchise value is invisible, since it is not
included in managerial reports or accounting statements
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How ratings and regulation affect franchise value
• The EU, UK, and USA all face a common emerging
environment: rating agencies (US) and regulatory rules
(Solvency II) impose specific criteria for evaluating an insurer’s
capital adequacy.
• Low scores on these measures make it more difficult for an
insurer to maintain revenues and profits, since potential clients
will see impairment of some sort – mild or severe – as likely
• Additional surplus or reinsurance is costly, but lowers the risk
of a significant fall in an insurer’s capital adequacy measure
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Value-based Capital ManagementTM
• Value-based Capital ManagementTM necessarily focuses on
both components of a firm’s total value: liquidation value and
franchise value
• But the emphasis is necessarily on franchise value, since
liquidation value is fixed
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Value-based Capital ManagementTM: how it works
• Suppose a firm has very little capital relative to its risk exposure
• Suppose also that it is being appropriately paid for taking risk
• If its capital is low relative to its risk, then impairment is probable
• Its expected earnings stream is high, but likely to be short or quickly
reduced
• Let’s agree that additional surplus and reinsurance are costly
• Even so, increasing its surplus or increasing its reinsurance may
increase the value of a firm, by reducing impairment probabilities
• However, beyond some critical point, adding surplus or
reinsurance actually lowers the value of the firm, by making it
over-capitalized or over-reinsured.
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Critical implications of Value-based Capital ManagementTM
• There is an optimal relationship between a firm’s risk exposure
and its capitalization, between risk and capital, consisting of its
surplus plus reinsurance
• Getting this relationship right maximizes the value of a firm to
its stakeholders
• Critical implication: decisions about surplus and
reinsurance should focus on the franchise value that is at
risk, and not just on the current-year earnings that might
be lost (VaR).
• VaR looks at potential losses within a specified limited horizon
• Near-term earnings at risk are often dwarfed by the consequent
potential loss of subsequent earnings
• Value-based Capital ManagementTM focuses on the franchise
value of a going concern, which has a potentially infinite horizon
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The value of adding capital
Effect of Surplus on Value Added
Value.Added
70
60
50
40
30
20
0
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25
50
75
100
Surplus
125
150
175
200
Why “Value-added”?
• The horizontal axis in the preceding graph is the absolute amount of
capital added to a hypothetical firm with real parameters, starting
from a base of zero surplus.
• The vertical axis is value added: the increase in the value of the firm,
less the capital added to the firm.
• Why value-added rather than value? Because adding capital to a
firm always increases its value, even if most of that capital is wasted.
• Example: if investing an additional $100 increases the value of the firm
by, say, $50, that is still a net increase in value. But value added is
negative.
• The appropriate objective is to invest additional funds in the firm when
doing so adds value in excess of the investment; if adding $100
increases firm value by $150, then value-added is $50.
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Part III
Are there practical and effective ways to enhance the
value of our firm by changing our risk-capital balance?
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Some specific applications of our approach
Identifying actions that can increase value:
• Increasing or decreasing surplus or reinsurance, as described
• Altering the firm’s mix of business
• Shifting reinsurance among lines of business
• Changing attachments and/or limits on reinsurance
• Changing the structure of the firm’s reinsurance program
• Evaluating loss portfolio transfers
• Changing the firm’s asset mix
• Purchasing equity or credit hedges
• Hedging interest rate or FX exposure
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An illustrative application of our approach
• A new client, which provided liability insurance to medical
institutions, and had grown substantially over 30 years
• Early on it purchased per risk reinsurance that attached at $1
million and went up to the firm’s $20m limit of liability
• As it grew, it increased its attachment to the current $3m
• Our Value-based Capital ManagementTM model revealed that
the client’s reinsurance strategy was suboptimal
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• It protected the firm from extremely severe losses
• But as the firm grew and had more claims, severity risk became
more diversified; its current risk was principally from frequency.
• So we recommended raising its attachment, and using the savings
to purchase an aggregate stop loss that protected the firm from
excessive loss frequency.
• The result: an increase in the value of the firm.
Key Issues
• Modeling a complex firm is nontrivial
• On the other hand, almost every decision made at a firm
relies on some model of its value, whether implicit or explicit
• It is better to have an explicit and testable model of a firm’s
value than to have an implicit model that is unexamined
• The model just outlined has been implemented at
several of the top ten firms in the US
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Conclusion: POV is worth 80 IQ points
• Alan Kay, a computer science pioneer, got it right: adopting the
right point of view helps us to make more intelligent decisions
• Think about multiplying 12 x 12 in our current number system as
contrasted to doing so in Roman numerals
• Value-based Capital ManagementTM is a point of view that
has the same effect on the way you think about your business
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For questions, comments, discussion, contact me at
Bill.Panning@willis.com
Cell: 502-387-5411
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