Putting a value on your company s financial capacity to take risk

Transcription

1 Putting a value on your company s financial capacity to take risk Session: SRM009 Price Tag This! Day/Date: Tuesday, April 12, 2016 Speakers: Graeme Harper, Senior Vice President - Global Insurance, FIS Richard Michel, Enterprise Solutions Practice Leader, Wells Fargo Insurance

2 Learning Objectives By the end of this session, you will: Learn some premises about risk, opportunity and the capacity to take risk: Uncertainty, randomness and volatility Risk and opportunity are value judgments The value of taking risk Learn some definitions of the following terms: Risk Bearing Capacity Risk Tolerance Risk Appetite Learn to quantify the following: Financial capacity to take risk Impact of strategic and uninsurable risk Surplus risk bearing capacity Intrinsic risk value

3 The Evolution 1996 ERM & Cyber Risk 2004 COSO Model - ERM Strategic, Financial, Operational, Legal/Compliance Traditional Risk Framework Risk identification Risk measurement frequency & severity Techniques to treat avoid, mitigate, transfer, assume Implement and monitor

4 Continued Evolution 2008 Traditional Strategic Companies recognizing importance of ERM But not really embracing it Change in risk importance From traditional WC, GL, Property, Catastrophe To Brand, Technology E-Risk, Compliance, EPLI

5 Evolution to the present 2011 FIS Breach ERM function went from 25 to 440 in 2yrs RISC (Risk, Information Security, Compliance) 1 st Line of defense all employees 2 nd Line RISC department identify transfer to BU owner 3 rd Line Internal Audit 4 th Line Insurance the safety net! 2016 Tradition to Sophisticated Modeling

6 Putting a value on your organization s financial capacity to take risk We make better decisions and create more value for our companies when we have a clear understanding of the organization s financial capacity to take risk or Risk Bearing Capacity (RBC), management s tolerance for risk and their appetite to use available Risk Bearing Capacity when opportunities arise. However, original research WFI did with select members of the Russell 2500 show that less than half (46%) of survey participants formally define RBC and even fewer (42%) formally define risk appetite.

7 The Russell 2500 survey shows: Less than half (46%) of survey participants formally define RBC and even fewer (42%) formally define risk appetite. Company s risk bearing capacity formally defined People making most of the day to day decisions are doing so with a limited understanding of risk appetite. Understanding of risk appetite (Base: total respondents)^ Executive committee (n=49) 6% 4% 18% 71% Board level (n=46) 9% 4% 33% 54% Functional/Staff level (n=48) 13% 19% 50% 19% Operational business unit leaders (n=48) 13% 21% 50% 17% Company s risk appetite formally defined Operational managers in the field (n=48) 25% 35% 29% 10% Sales and marketing (n=48) 25% 38% 29% 8% Other non-management employees (n=47) 45% 38% 15% Not at all/not very well Neutral Somewhat Very well ^ N/A and don t know responses excluded from base

8 Consider the following premises: Risk and opportunity are not observable in nature. Uncertainty, randomness and volatility are all objectively observable phenomena. Risk and opportunity involve value judgments applied to observed or anticipated uncertainty, randomness or volatility and such value judgments can only be made in the context of goals or objectives i.e. a desired outcome that is in question. Therefore, risk and opportunity are always linked around specific goals and objectives. Without risk, there is no opportunity (risk is good!). So, taking risk is an essential need of every organization seeking to profit or achieve some objective of value. An organization s financial capacity to take risk is finite, given its financial condition at any given point in time. As risk bearing capacity is finite, it must first be allocated to those risks for which no risk transfer is possible and then to the opportunities that have the highest potential return to the organization.

9 With these premises in mind, we can offer the following definitions: Risk bearing capacity: An organization s financial capacity to take risk, regardless of tolerance or appetite. Risk tolerance: The maximum limit of risk bearing capacity within which management wishes to operate the business. Risk appetite: Management s willingness to use financial capacity to take risk within the organization s risk tolerance. Impact of strategic and uninsurable/uninsured risk: the aggregate impact of such risks to the organization in any given fiscal period estimated at both expected ( mean ) and at a high confidence interval. Surplus Risk Bearing Capacity: the difference between the potential impact of strategic and other uninsured risks and the company s risk tolerance (if such difference is positive). Intrinsic Risk Value: the cost to retain a given risk, including the cost of capital required to support taking the risk, versus the cost of other available options. Reflects the value to the business of using surplus risk bearing capacity.

10 Quantifying RBC and Risk Tolerance Looking at a series of benchmarks (hypothetical amounts of loss) that, if experienced in a given timeframe, would result in well-defined business consequences, often helps to frame the discussion for senior leaders. It is helpful to begin with the amount of financial loss that would put the organization on the brink of insolvency. This reinforces the idea that RBC is finite. Then, other benchmarks such as violating loan covenants, a downgrade in credit rating, loss of investment grade, or inability to fund strategy as planned can be examined. With this continuum of benchmarks and clear business consequences, a company s senior executives are better able to agree on a level of risk tolerance within which they would manage the business.

11 Potential impact of strategic and uninsurable risk and Surplus RBC $500 Loss Estimate by Confidence Interval vs RBC $450 $400 Surplus RBC $350 $300 $250 $200 10k Risks Client EBITDA Peer EBITDA RBC $150 $100 $50 $0 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% Confidence Interval

12 Virtual Captive (VCap) One way of thinking about risk appetite or valuing risk/reward tradeoffs is to imagine placing risks in a Virtual Captive (VCap). A VCap exists only on paper as a risk management device. Once a company has established a value for surplus Risk Bearing Capacity, this value would be assigned to the VCap as its' underwriting capacity. New risks are then evaluated through the Intrinsic Risk Valuation (IRV) process. Surplus RBC IRV New Risk Efficient Risk Portfolio

13 Intrinsic Risk Value (IRV) The intrinsic value of each risk, or layer of risk, is defined as the company s internal cost to retain, or self-insure the risk at breakeven over time. IRV is calculated as follows: Mean (expected) loss +risk charge (based on Δ high confidence interval estimate of the risk and the Mean ) + a charge for surplus + other out of pocket costs related to assuming the risk The charge for surplus RBC would be based on the amount of capital a captive insurer would have to reserve against the risk at issue, times the rate of return the organization would expect for that capital. The rate of return would depend on the company s weighted average cost of capital (WACC) and the return available from all other competing uses of that capital available to the company. With the intrinsic value established for each risk, companies can evaluate the full range of risk solutions available to them. If a solution is found that is less costly than the intrinsic risk value, implementing it would add economic value to the business versus retaining the risk.

14 Bringing it all together Loss Estimate by Confidence Interval vs RBC $500 $450 Financial Strategic $400 $350 $300 Surplus RBC VCap Operational $250 $200 $150 10k Risks Client EBITDA Peer EBITDA RBC Surplus RBC New Risk $100 $50 IRV $0 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% Confidence Interval Retain IRV is lower than other options Efficient Risk Portfolio IRV/NBA=1 Transfer Other options are lower than IRV Risk A Risk B Risk C Risk D Risk E Risk F Risk G Cost effective Value creating

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