ERM and Enterprise Value
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1 ERM and Enterprise Value Timur Gök Audit Committees: Improving Performance Through Compliance CAACM Saint Lucia, June 23rd 24th, 2008
2 Enterprise Risk Management Balancing risk and controls to improve business performance Practical implementation of ERM Getting value for ERM efforts 2
3 Background
4 Evolution of Risk Management Strategic Credit Hazard Market Credit Hazard Operational Financial Hazard 1970s 1980s 1990s 4
5 Focus on Risk Management Corporate Scandals Corporate Programs Risk Management Regulatory Actions Industry Initiatives 5
6 Focus on ERM Corporate Scandals Corporate Programs ERM Regulatory Actions Industry Initiatives 6
7 On the Way to the Forum 2000s ERM, Strategy, and New Questions Late 1990s ERM and Regulators Early 1990s Derivatives Disasters 1980s Brave New World of Derivatives 1970s Foundations 7
8 Today
9 Stock Price Performance C Citigroup; MER Merrill Lynch; BAC Bank of Amer.; JPM JPMorgan Chase; UBS; CFC Countrywide Fin. Corp.; GSPC S&P 500 index; GS Goldman Sachs
10 YES NO? Treasury & Risk, June 2008
11 Enterprise Risk Management Creating Value
12 Conformance versus Performance What is the purpose of ERM? Tool for compliance and control? Tool for strategic decision-making? 12
13 Goal Enterprise-wide integration of risk management techniques Scope firm-wide (vertical and horizontal) Basic extension of audit and regulatory compliance Advanced strategic focus 13
14 Basics Compliance and control may block outright fraud However, aggressive targets and incentives can still lead to excessive risktaking Further, compliance and control will not necessarily lead to good strategic decision-making 14
15 Examples Barings; Societe Generale; Failure of compliance and control Merrill; Citigroup; Aggressive targets and incentives (among other systemic risk management failures) 15
16 First Steps An easy place to start is the organizational structure Instead of having the CRO report dotted line to the CEO have the CRO report solid line As well, create a board risk committee and have the CRO report dotted line 16
17 Substantive Changes Tone for risk management must be set at the top echelons the CEO and the Board How do you get the CEO to focus on risk management? Incentives / pay This where board oversight comes in 17
18 Dancing with the Music CEOs of Citigroup and Merrill, and countless other CEOs, were rewarded handsomely for the risks their firms took When the music stopped, shareholders picked up the bill Incentives/compensation schemes must change Otherwise, heads I win, tails you lose 18
19 Then What? Next comes the really hard part On what kind of risk management do we want to CEO to focus? What is the purpose of ERM? Tool for strategic decision-making? Recall the simple definition of ERM A decision-making discipline that addresses variation in company goals 20
20 Where the Wild Things Are The source of the variation is not just financial, operational or hazard risks Those are under the light-post But, strategic risk 21
21 Strategic Risk [A]rray of external events and trends that can devastate a company s growth trajectory and shareholder value Slywotzky and Drzik (2005) Risk stemming from an inability to adapt to changes in the environment 22
22 Strategic Risks Slywotzky and Drzik, Countering the biggest risk of all, Harvard Business Review, April
23 Risk and Value From 93-98, 10% of Fortune 1000 lost > 25% stockholder value in one month strategic and operating risk led the way Customer Demand Shortfall Competition M&A Problems Products Pricing Loss Customer Source: Chris Duncan Presentation Regulatory R&D Delays Cost Overruns Supplier Accounting Irregularities Management Ineffectiveness Supply Chain Issues Macroeconomics Commodity Prices Interest Rates Lawsuit Natural Disasters Strategic Operational Financial Hazard Source: Marsh/Mercer 24
24 Root Causes of Revenue Stalls Source: Corporate Strategy Board research Corporate Executive Board.
25 Stacked Odds Growth Experience of Fortune 100-Sized Sample Source: Corporate Strategy Board research Corporate Executive Board. 26
26 What were Kmart, Sears and Target doing over this period? 27 Holmes (2008)
27 Case Study Banking
28 Case Study: Banking Measure of total bank risk Earnings volatility Components of risk Market Credit Asset/liability Operational Business (strategic) Kuritzkes and Schuermann (2007) 29
29 K - u - U Flavors of risk Known (K) identified and quantified Unknown (u) identified, but not meaningfully quantified Unknowable (U) existence of risk(s) not predictable ex ante, let alone quantifiable Kuritzkes and Schuermann (2007) 30
30 Taxonomy of Bank Risks Kuritzkes and Schuermann (2007) 31
31 Risk Taxonomy & Risk Contribution Kuritzkes and Schuermann (2007) 32
32 Risk Management Process
33 Risks According to Drucker Unavoidable risks inherent to business Risk one can afford to take Risk one cannot afford to take Risk one cannot afford not to take 34
34 Risk Management Retain Avoid Reduce Transfer Increase How does one decide? R.I. Mehr and B.A. Hedges, Risk Management in the Business Enterprise, Homewood, IL: R.D. Irwin,
35 Risk Capital How does an enterprise create value? By generating cash (not earnings!) What generates cash? Assets do An enterprise needs capital to acquire assets Value is created so long as cash receipts cover the opportunity cost of capital 36
36 Capital Management Capital management the key to maximizing value Have adequate capital Maximize the return on capital Minimize the cost of capital 37
37 Capital Adequacy Manage Capital Capital Allocation Maximize Return on Capital EVA Minimize Cost of Capital Capital Structure EVA TM Economic Value Added J. Lamm-Tennant, ERM: Issues and Applications, June 28, 2007.
38 Risk and Capital Structure C. Culp, Catastrophic risk and risk capital, June 5,
39 Case Study Insurance Companies
40 Insurance Industry The insurance industry has been an early adopter Quantifiable risks Right (quantitative/actuarial) skill-set Regulatory and rating agency requirements 41
41 Enterprise Measures of Risk E c o n o m i c F a c t o r s Individual Assets Individual Loss Events Catastrophe Event Tables Asset Proxy (Duration/ Convexity/Credit) Fit Frequency and Severity Distributions Aggregated Losses C O R R E L A T I O N S I M U L A T I O N Enterprise Risk/Return Economic Capital Operational Risk Event Tables Aggregated Losses J. Lamm-Tennant, ERM: Issues and Applications, June 28,
42 Enterprise Measures of Risk Simulation gives us a new measure of risk Capital-at-Risk CaR is the probability of a decline in capital for example, the probability of a 20% decline in capital is 10% (a 1 in 10 year event) Mean 10% of the simulations resulted in capital falling 20% or more -40% -20% +5% (Mean) +25% % Change in Capital J. Lamm-Tennant, ERM: Issues and Applications, June 28,
43 Case Study ERM at Allstate
44 Evolution of ERM at Allstate Early 1990 s 1995/96 Allstate expands Investment 1995 Allstate quantitative risk introduces AIR analytics and RMS cat models 1995/96 A.M. Best and S&P introduce Risk adjusted capital measures 2002 Allstate develops ERM Framework and Strategic Vision with Tillinghast 2003 AF makes Strategic ALM Investment 2004 Allstate initiates enhanced Legal Risk Management 2004 Allstate Identifies Potential Key Risks with Enterprise Risk Survey Allstate enhanced state reinsurance contracts 2005 Allstate discloses ERM in MD&A 2005 Allstate Financial ALM develops GAAP EaR model 2006 Allstate announces new countrywide reinsurance agreements Enterprise Economic Capital model and analytics Today Future Banking Industry adopts Risk Adjusted Capital measures (Basel I) 1997 Allstate Financial develops internal capital formula incorporating credit, mortality, and interest rate risks 2001 Allstate begins to develop P/C Economic Capital Model Allstate begins hedging portion of VA DBs Allstate hedges Accumulation and Withdrawal Benefits in VA contracts 2003 Allstate forms Enterprise Risk Council 2004 Allstate Protection begins utilizing Economic Capital Measures 2004 Allstate appoints CRO and forms ERM Function 2004 Capital management actions partially based on economic capital 2004 Allstate Implements Enterprise Risk Dashboard 2005 Allstate Protection Implements Economic Capital in Strategic Plan 2005 Allstate develops Protection model enhancements and efficiencies 2005 Begin Allstate Financial economic capital model prototype 2005 Allstate Protection adjusts interest rate limits and duration Implement Long-term Catastrophe Management Solutions Basel II Solvency II Framework and Standards A. Wunsch, Enterprise Risk Management: A Case Study, March 13, 2007.
45 Allstate s ERM framework Michael E. Bond, Jeanne M. Hollister and J. David Dean, Allstate: An ERM Case Study, The Actuary Magazine, December
46 Michael E. Bond, Jeanne M. Hollister and J. David Dean, Allstate: An ERM Case Study, The Actuary Magazine, December 2006.
47 Case Study Airlines
48 Hedging and Higher Firm Value Reduce taxes Lower costs of financial distress Maintain financial flexibility 49
49 US Passenger Airline Cost Index 2007Q3 50
50 Jet Fuel Prices 51
51 Labor and Fuel Costs 52
52 Jet Fuel Hedging at Airlines J. Bailey, An airline shrugs at oil prices, New York Times, June 9,
53 Fuel Cost Advantage Wikinvest, June 9,
54 Earnings and the Price of Oil Wikinvest, June 9,
55 Advantage Southwest! Wikinvest, June 9,
56 U.S. Domestic Enplanements 2007 Rank Carrier 2007 Enplaned Passengers 2006 Enplaned Passengers Pct. Change Enplaned Passengers Pct. Change Enplaned Passengers Pct. Change Rank 1 Southwest American Delta United Northwest US Airways* Continental AirTran Sky West JetBlue Source: Bureau of Transportation Statistics, T-100 Domestic Market 57
57 Concluding Remarks
58 Would you rather manage risk or manage a crisis?
59 Implementing ERM Perspective Aspect Must Do Compliance Basic Want to Do Intermediate Advanced Responsibility Governance Risk Strategy Alignment Infrastructure People Modeling Information management Pol. & Proc. Fit / Proper Role clarity Learning Regulatory Fewer surprises through mgmnt of key risks Greater share der confidence & improved risk mitigation strategy Risk adjusted strategy, perf. evaluation and capital allocation Culture Frequency Reporting Content Integration A. Halpert, ERM Essentials for Decision Makers, ERM Symposium, Chicago, March
60
61 Computers are useless, they can only give answers. Pablo Picasso
62 There is nothing new except what is forgotten. Mlle. Rose Bertin
63 Appendix Scientific Evidence
64 Risk Management Risk management can increase firm value: Decrease the PV of bankruptcy costs and costs of financial distress Enable firms to make it more likely that they can take advantage of the positive net present value opportunities available to them Enable firms to provide better incentives to managers Decrease the present value of taxes paid 65
65 Risk Management The purpose of risk management is to avoid costly lower-tail outcomes Companies should manage risk in such a way that makes financial distress highly unlikely and, in so doing, preserves the financing flexibility necessary to carry out their investment strategies * * R. Stulz, Rethinking risk management, JACF, Fall
66 Risk Management Risk management and equity capital as direct substitutes Risk management and capital structure decisions should be made jointly Manage risk insofar as equity is more expensive than debt 67
67 Costs of Financial Distress Hedging can reduce earnings volatility and probability of distress, and increase firm value Reduce the present value of bankruptcy costs Increase the present value of the tax shield of debt Preserve financing flexibility to invest 68
68 Empirical Evidence Does RM increase the value of the firm? 1. Is financial risk reflected in share price behavior? 2. Is the use of risk management tools (derivatives) associated with reduced risk 3. Is cash flow volatility related to firm value? 4. Is there a relationship between the use of risk management and the value of the firm? Smithson and Simkins (2005) 69
69 Financial Risk & Stock Prices 1. Stock returns of financial institutions are sensitive to interest rate changes 2. Hedging FX and/or interest rates increases firm value by 1.1% through increased debt capacity and tax benefits 3. Link between volatility and lower investment 4. Link between volatility and lower value 70
70 Commodity Price Risk Commodity price risk management Commodity users Commodity producers Whether or not risk management adds value depends on whether the company is a user or producer of the commodity Positive for users Either no effect or negative effect for producers 71
71 Airlines Fuel price hedging by airlines associated with significantly higher firm values 29 U.S. airlines over Stock prices of all airlines sensitive to fuel prices 12-16% premium for airlines that hedge over those that don t Carter, D., D. Rogers, and B. Simkins, 2004, Does Fuel Hedging Make Economics Sense? The Case of the U.S. Airline Industry, WP, Oklahoma State University and Portland State University. 72
72 Financial Risk & Stock Prices Conclusions Financial price risks can affect the expected returns on stocks and hence stock prices themselves The resulting reduction in cash flow volatility reduces the likelihood that the company will become financially distressed or be forced to pass up valuable investment opportunities 73
73 Timur Gök Regional Director, PRMIA Chicago Department of Finance Northern Illinois University DeKalb, IL /
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