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“Over the past 20 years, TomWilson has been a highly visible risk management practitioner inmajor financial services firms – both banks and insurance companies – as well as in leadingadvisory firms. The discussion of value management in banking and insurance in a singlevolume highlights that one of the major roles of financial services firms is risk-taking, risktransformation and risk management. Tom’s unique experience in both sectors has allowedhim to produce a most welcome integrated handbook.
The clear exposition that risk-taking and strategic management in banking and insurancemust be integrated in a value creation framework provides invaluable tools to addressmanagerial issues such as risk identification, capital allocation, measurement of performanceand risk governance. The sharing of Tom Wilson’s vast experience is a gift to the profession.”
Jean Dermine, Professor of Banking and Finance,Insead, author of Bank Valuation and Value Based Management
“Much has been written on value and capital management, also for the financial servicesindustry. But this handbook is truly different in a number of ways.
First, it provides a solid conceptual basis to understand true value creation in banking andinsurance. This may seem academic, but is indeed highly relevant in practice. As a long-standingpractitioner in both industries, I have seen numerous situationswhere profit generation has beenmistaken for value creation, often leading to the wrong decisions. This book clearly dispels somedeeply embedded valuation myths in both the banking and insurance worlds, some of whichare still being trained today!
Second, it provides a sound basis to understand and manage the value of risk-based,capital intensive businesses using a common set of practical tools, filling a void in the availableliterature.
Third, it covers the entire spectrum of finance and risk activities relevant for the CFO andCRO: From valuation to management information to management action. Real life examplesfrom both banking and insurance are used to illustrate the various tools in practice, be thatefficiency management, asset liability management, risk management, strategic planning, andmany others.
I was forced to learn many of the themes covered in this handbook the hard way overseveral years, and I suspect the author has taken a similar journey. Much could have beeneasier if I had this book at hand earlier.”
Jo Oechslin, CRO, Credit Suisse Group AG
“Tom’s book on risk and capital management is themost comprehensive in the field. It is not onlywell structured and thorough, it is an easy read. I particularly enjoyed the anecdotes throughoutgiving live examples in insurance and banking. Like minded CROs and CFOs will also find thisbook comforting in that it not only supports their beliefs, it conveys they are not alone in trying toget the fundamental point of true value measurement accepted and embedded in their ownorganizations. Lastly I wanted to compliment Tom on his description of the roles of the CFO andCRO in financial institutions. I have too often heard that CROsmust remain fully independent ofbusiness decisions only being able to blow a whistle when there is a problem. The book clearlypoints to the CRO as a vital part of management decision making from strategy to execution andthat CROs must remain objective, leaving independence to audit and supervisors.”
Tom Grondin, CRO, Aegon Insurance
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“The roles of CFOs and CROs in financial services have gone through an enormous transfor-mation over the past decade, driven by external factors such as increasing shareholder andregulatory expectations and the global financial crisis, as well as by the managements’ interest infundamentally improving how they manage value and capital. Tom’s book offers insights at thenexus of aligning risk management, finance and performance management to boost the firm’svalue. A vast piece of work providing a compelling set of tools to understand the indiscernible linkbetween risk and financial metrics and actually using them to better manage the firm.”
Axel P. Lehmann, Zurich Insurance Group Ltd
“The financial services industry still has a surprisingly long way to go to understand andcommunicate how it manages risk and creates value. It is refreshing to read a defence of valuecreation for the shareholder being consistent with running a business for the benefit of allstakeholders. I also welcome insights into how CFOs and CROs can demonstrate and quantifytheir contribution to this value creation and reverse the conglomerate discount that many largegroups suffer from. Tom Wilson offers useful insights based on financial theory and hisrespected experience as a senior executive.”
William Hawkins, Managing Director –
Head of European Insurance Research, Keefe, Bruyette & Woods
“Tom Wilson expertly brings to bear his unique perspective of financial services providers’value and capital management practices in this book. I have encountered Tom serving as riskmanager and risk taker in, and advisor to, many of the world’s leading life insurers, propertycasualty insurers, reinsurers, banks and asset managers. His book mixes theory with theevolution of practice across the sector, and draws on many real life examples. I commendTom’s work to all practitioners in, and observers and students of, financial services.”
Rob Jones, Former Managing Director at Standard& Poor’s Financial Services Ratings
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Value and CapitalManagement
A Handbook for the Finance and RiskFunctions of Financial Institutions
THOMAS C. WILSON
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This edition first published 2015 2015 John Wiley & Sons Ltd
Registered officeJohn Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom.
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Library of Congress Cataloging-in-Publication Data
Wilson, Thomas C.,Value and capital management : a handbook for the finance and risk functions of financial institutions /
Thomas C. Wilson.—1pages cm.—(The Wiley finance series)
Includes bibliographical references and index.ISBN 978-1-118-77463-2 (hardback)1. Banks and banking. 2. Financial services industry. 3. Risk management. I. Title.HG1601.W558 2015332.1068´1—dc23 2015013221
A catalogue record for this book is available from the British Library.
ISBN 978-1-118-77463-2 (hardback) ISBN 978-1-118-77438-0 (ebk)ISBN 978-1-118-77462-5 (ebk) ISBN 978-1-118-77435-9 (obk)
Cover Design: WileyCover Image: Iaroslav Neliubov/Shutterstock
Set in 10/12pt TimesLTStd-Roman by Thomson Digital, Noida, IndiaPrinted in Great Britain by TJ International Ltd, Padstow, Cornwall, UK
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To Kurt and Arlyn, with love and gratitude
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Contents
List of Abbreviations xiii
Preface xvii
Acknowledgments xix
About the Author xxiii
PART ONEIntroduction 1
CHAPTER 1Why is Value Management Important? 3
Better Information 3Better Insights 6Better Decisions 8Why Shareholder Value? 12
CHAPTER 2How do CFOs and CROs Add Value? 15
The Evolution of the Corporate Center as “Shareholder Surrogate” 15The Implications for the CFO 20The Implications for the CRO 24
PART TWOBetter Information – Measuring Value 29
CHAPTER 3RAPMs – The Industry Standard 31
What Makes Financial Services Unique? 31What do RAPMs do and How? 34The RAPM (R)evolution 37Three RAPMs for Three Distinct Purposes . . . 41. . . Linking Directly to Shareholder Value 46
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Insurance Example 49Banking Example 50
CHAPTER 4Two Challenges in Using RAPMs 51
Do RAPMs Influence Strategy? 51Do RAPMs Give the Right Signals? 55
CHAPTER 5Valuing Financial Services – The Theory 71
What Determines Share Value? Market Multiples,RoE and Growth . . . 71
. . . But What Determines Market Multiples? 73Why a Market-Consistent Approach? 77Value: Where it Comes from and How to Create More of it 80
CHAPTER 6Valuing Financial Services – The Evidence 85
Evidence from the Insurance Industry 85Evidence from Banking 96Is it Just me or are Others Thinking the Same Thing? 98
CHAPTER 7Market-Consistent Valuation for Insurers 101
Introduction to Fair Valuation for Insurers 101Calculating Traditional Embedded Value 104European Embedded Value 106Market Consistent Embedded Value (MCEV) 109How is MCEV Calculated in Practice? 115From MCEV to MVBS 120Final Comments: Whither MCEV? 122
PART THREEBetter Insights – Managing Value 125
CHAPTER 8Property and Casualty Insurance 127
History and Economic Rationale 127From Principles to Rules of the Game 133From Rules to the Valuation of PC Businesses 135PC KPIs: Understanding and Managing Value 140
CHAPTER 9Life and Health Insurance 151
History and Economic Rationale 151From Principles to “Rules of the Game” 163
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LH Valuation 167Understanding Value Creation: Capital Intensityand Financial Risk Taking 171
CHAPTER 10Banking 189
History 189Products 195Economic Rationale 197From Principles to “Rules of the Game” 199From “Rules” to Value 201
CHAPTER 11Achieving Profitable Growth 211
Rules of the Game and KPIs 211Management Actions – Three Horizons of Growth 217Horizon 1 – Increasing Sales Productivity 218Horizon 1 – Going Multi-channel 221Horizon 1 – Getting More out of Existing Customers;cross sell, big data and customer loyalty 224
Horizon 1 –Managing the Customer Portfolio Skew 228Horizon 2 – Anticipating Mega-trends 230Horizon 2 – Exploiting Adjacencies 232Horizon 2 – Transformational and Bolt-on Acquisitions 234Horizon 3 – Creative Disruptions 238
CHAPTER 12Achieving Operating Efficiency 241
The Importance of Operating Efficiency 242Rules of the Game 248Pay Less: Optimize Procurement 249Pay Less: From Business Process Redesign to Outsourcing 250Use Less, But More Effectively: Digitize and Automate 253Use Less, But More Effectively: Re-engineer the Product Portfolio 254Use Less, But More Effectively: Managing Acquisition Expenses 257
PART FOURBetter Decisions – Capital, Balance Sheet and Risk Management 261
CHAPTER 13Corporate Strategy and Capital Allocation 263
Corporate Strategy, Capital Allocation and Performance Management 263Capital Allocation: The Capital Budget, from Sources toUses of Capital 265
Capital Allocation: Optimizing the Corporate Portfolio 273Capital Allocation: Aligning Financial Resources within Constraints 278
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CHAPTER 14Strategic Planning and Performance Management 285
What is Strategic Planning? 285Why does Strategic Planning Fail and What can be done About it? 295Corporate Strategy 302
CHAPTER 15Balance Sheet Management 311
Balance Sheet Management Activities 311The Asset/Liability Committee (ALCO) Mandate and Agenda 314The Asset/Liability Management (ALM) Unit 323The Insurer ALM-Investment Value Chain 330The Treasury Function 339
CHAPTER 16The Economics of Asset/Liability Management 345
The Role of ALM Earnings 345The Risks: Some Spectacular ALM Failures 349The Returns: Are Shareholders Willing to Pay a Premium or a Discount? 361
CHAPTER 17The Practical Aspects of Asset/Liability Management 371
ALM Performance and Risk Measures 372Calculating Funds Transfer Prices (FTPs) 385Measuring Alpha 406
CHAPTER 18Cash and Liquidity Management 413
Managing Funding Liquidity Risk 413What Happens if it Goes Wrong? 416Measuring Funding Liquidity Risk 420
CHAPTER 19Managing the Capital and Funding Structure 431
Capital Funding Management 431Determining the Optimal Capital Structure 436The Empirical Reality: What Determines Capital Structure? 446
CHAPTER 20Risk Management 451
Enterprise Risk Management 451Taking the Right Decisions 460The Role of Culture 463
CHAPTER 21Risk Governance and Organization 477
Risk Governance Principles 477
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Role of the Board and Management 478Three-Line-of-Defense Model 480The Risk Function 484
CHAPTER 22Risk Identification and Evaluation 491
From Risk Identification to Evaluation 491Data-Driven Approaches 497Evaluation-Based Approaches 499Building a Resilient Organization 507
CHAPTER 23Risk Underwriting – Strategy and Governance 513
Underwriting Context 513Underwriting Strategy 518Underwriting Governance 522
CHAPTER 24Risk Underwriting – Technical Tools 527
Retail Segment: “Scoring”Models 527Commercial Lines: Leveraging Expert Judgment 535Underwriting Structured Solutions 541Underwriting Controls, Validation and Learning 542
CHAPTER 25Risk Underwriting – From Technical Pricing toValue Maximization 549
Technical Production Cost: RAPM Pricing 549From Technical Pricing to Optimal Price 558
CHAPTER 26Managing Operational and Reputational Risks 571
Defining Operational Risk 571Managing Operational Risk 581
CHAPTER 27Risk and Limit Controlling 589
Risk Reporting 589An Effective Risk Limit Framework 601Final Thoughts on Risk and Limit Reporting 606
Appendices
Appendix A: Market Multiple Approaches 609
Appendix B: Derivation of Steady-State Valuation Multiples 613
Contents xi
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Appendix C: Valuing Banks and Insurers: The Link BetweenValue and New Business and Investment RAPM 621
Appendix D: Beyond Debt and Equity 629
GLOSSARY 641
REFERENCES 653
Index 675
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List of Abbreviations
ABC Activity-Based CostingADM Application Development and MaintenanceAEP Aggregate Exceedance ProbabilityALCO Asset Liability CommitteeALM Asset/Liability ManagementAPE Annualized Premium EquivalentATE Absolute Tracking ErrorAUM Assets Under ManagementBPO Business Process OutsourcingBPR Business Process Re-engineeringCAPM Capital Asset Pricing ModelCER Capital Efficiency RatioCFO Chief Financial OfficerCIO Chief Investment OfficerCIR Cost Income RatioCLV Customer Lifetime ValueCNHR Cost of Non-Hedgeable RisksCOC Cost of CapitalCoR Combined RatioCRM Customer Relationship ManagementCRO Chief Risk OfficerCUO Chief Underwriting OfficerDAC Deferred Acquisition CostsDJSI Dow Jones Sustainability IndexEaR Earnings at RiskEC Economic CapitalECI Economic Capital IntensityEDP Electronic Data ProcessingEEV European Embedded ValueEIA Equity Indexed AnnuityEP Economic ProfitEPS Earnings Per ShareERM Enterprise Risk ManagementESG Economic Scenario GeneratorESG Environmental, Social and GovernanceFASB Financial Accounting Standards Board
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FCF Free Cash FlowFCReC Frictional Costs of Required CapitalFNAV Fair Net Asset ValueFS Free SurplusFSB Financial Stability BoardFTP Funds Transfer PricingGAAP Generally Accepted Accounting PrinciplesGIC Guaranteed Investment ContractGMAB Guaranteed Minimum Accumulation BenefitGMDB Guaranteed Minimum Death BenefitGMIB Guaranteed Minimum Income BenefitGMWB Guaranteed Minimum Withdrawal BenefitG-SIFI Globally Systemically Important Financial InstitutionsHRO High-Reliability OrganizationIBES Institutional Brokers’ Estimate SystemIC Invested CapitalICT Information and Communications TechnologyIDR Implied Discount RateIFRS International Financial Reporting StandardsILS Insurance-Linked SecuritiesIRR Internal Rate of ReturnITO Information Technology OutsourcingIV Intrinsic ValueKPI Key Performance IndicatorKRI Key Risk IndicatorLCR Liquidity Coverage RatioLH Life and Health insurance businessLibor London inter-bank offered rateLLPO Limited Liability Put OptionLTP Liquidity Transfer PricingMBR Monthly Business ReviewMC Market CapitalizationMCEV Market-Consistent Embedded ValueMIS Management Information SystemMPL Maximum Probable LossMREL Minimum Required Eligible LiabilitiesMVBS Market Value Balance SheetMVE Market Value of EarningsNAV Net Asset ValueNBM New Business MarginNDM Net Deposit MarginNFCL Non-Financial Component of LiabilitiesNI Net IncomeNII Net Interest IncomeNLM Net expected Loan MarginNOPLAT Net cash Operating Profit Less Adjusted TaxesNPS Net Promoter Score
xiv LIST OF ABBREVIATIONS
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NSFR Net Stable Funding RatioOAS Option-Adjusted SpreadsOCF Operating Cash FlowOCI Other Comprehensive IncomePAYD Pay As You DrivePC Property and Casualty insurance businessPRE Policyholder Reasonable ExpectationsPVFP Present Value of Future PremiumPVIF Present Value In-Force businessPVNBP Present Value of New Business PremiumQBR Quarterly Business ReviewRAC Risk-Adjusted CapitalRAG Red, Amber, GreenRAPM Risk-Adjusted Performance MeasuresRAROA Risk-Adjusted Returns on AssetsRAROC Risk-Adjusted Return on CapitalRARORAC Risk-Adjusted Return on Risk-Adjusted CapitalRC Required CapitalRCSA Risk Control Self-AssessmentROE Return on EquityROIC Return on Invested CapitalRoMVS Return on Market Value SurplusRORAA Return on Risk-Adjusted AssetsRORAC Return on Risk-Adjusted CapitalSLA Service Level AgreementSML Securities Market LineTDIs Top-Down IndicatorsTEV Traditional Embedded ValueTNAV Tangible Net Asset ValueTOM Target Operating ModelTRA Top Risk AssessmentTSR Total Shareholder ReturnTVA Total Value AddedTVOG Time Value of Financial Options and GuaranteesUL Unexpected LossUL Unit Linked investment productVaR Value at RiskViF Value in ForceVNB Value of New BusinessVOBA Value of Business AcquiredWACC Weighted Average Cost of Capital
List of Abbreviations xv
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Preface
C reating value is challenging in any highly competitive industry, a daily battle to capturemarket share, defend margins and improve expenses. Managing value in financial services
is evenmore challenging due to the unique role that risk and capital play in the economics of thebusiness: whereas most industrial corporations actively avoid risk, there can be no return toshareholders – and no satisfied customers – if banks and insurers avoid risk, and taking risksrequires capital. In banking and insurance, risk and capital management and value managementare synonymous.
The role of the Chief Financial Officer (CFO) and Chief Risk Officer (CRO) has evolvedand adapted to this economic reality. Modern finance and risk functions now have substantialinfluence on the strategy, operations and, ultimately, the value of their firms. This influencecomes in part from being a business partner and in part through the financial and riskmanagement activities directly within their responsibility.
This Handbook is intended as a practical but theoretically grounded reference for financeand risk professionals interested in managing value. The Handbook consists of three mainsections.
Better information – Measuring value. What gets measured, gets managed. Accuratelymeasuring value is a necessary precondition for managing it. This section develops a risk-adjusted valuation and performance measurement framework tailored to banks and insurers,reconciled with the way that our shares are actually valued by the market. The frameworkclearly links management actions to shareholder value creation and is the foundation forinternal, value-based management initiatives.
Better insights –Managing value. Better information may be a necessary condition, but itis not a sufficient condition: ultimately, the “right” decisions have to be taken. Allocatingcapital to existing businesses and exploiting new growth opportunities requires insights beyondrisk and capital; it also requires an understanding of the markets, the drivers of operatingperformance and the sources of profitable growth. This section presents corporate and segment-specific “rules of the game” (or strategies) as well as Key Performance Indicators (KPIs)tailored to banking and insurance and gives examples of value-enhancing initiatives. It isdesigned to give CEOs, CFOs and CROs concrete ideas for increasing the value of theindividual businesses as well as the corporate portfolio.
Better decisions – Capital, balance sheet and risk management. In addition, CFOs andCROs contribute directly to value creation through their own areas of responsibility, especiallythrough strategic planning and capital allocation; balance sheet, liquidity and asset/liabilitymanagement; risk underwriting and risk management. This section provides insights into howCFOs and CROs can actively create value in these areas.
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WHO SHOULD READ THIS BOOK?
This Handbook provides an accessible reference for professionals working within and aroundthe financial services industry, targeted toward
■ CFOs, CROs and other finance and risk professionals in banks and insurance who areinterested in increasing the value of their company, especially those active in strategicplanning and performance management; capital management, Treasury, balance sheet,liquidity management and asset/liability management; risk underwriting and riskmanagement.
■ CEOs and business unit heads who want to understand how the business and valuecreation look “through a finance and risk lens.”
■ Analysts who cover banks and insurers from a value and solvency perspective, includingbuy- and sell-side equity analysts, as well as analysts in rating agencies, regulators andsupervisors.
■ Graduate students in business, economics and finance who are interested in bridging thegulf between financial theory and the practical realities of managing value in banks andinsurance companies.
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Acknowledgments
T he intellectual foundations for this Handbook have been laid over the past 20 years whileworking with bank and insurance professionals in finance and risk. While too numerous to
acknowledge individually, some warrant special mention.
COLLEAGUES AT WORK
At Allianz, a special note of thanks to Michael Diekmann, Oliver Baete and Dr Helmut Perletfor bringing me on board and supporting me in building a world-class risk function. I wouldalso especially like to thank Dieter Wemmer for reinforcing active capital management withinthe Group. In addition, thanks to Max Zimmerer for discussions on asset/liability management;to Clem Booth for discussions on underwriting; and to Manuel Bauer, Helga Jung, ChristophMascher, Jay Ralph, Axel Theis and Werner Zedelius for valuable business discussions.
For challenging my thinking, special thanks to Peter Etzenbach, Kamesh Goyal, BurkhardKeese, Thomas Naumann, Walter Reinl, Giulio Terzariol and Renate Wagner in Finance andStrategic Planning; DirkDiederich and Stephan Theissing in Treasury andCapitalManagement;Oliver Schmidt in Investor Relations; Michele Gaffo, Andreas Gruber, Günther Thallinger andAxel Zehren in Investment Management. Also, to my Global Risk team at Allianz, especiallyLarisa Angstenberger, Blaise Bourgeois, Violeta Bondoc,Michael Buttstedt, Jean-Marc Cornet,Wolfgang Deichl, Doug Franklin, Marco Hauck, Andreas Graser, Erick Holt, Pierre Joos,Kathrin Meier, Sebastian Pichler, Sigurd Volk, Terry Watson and Andreas Wilhelm.
At ING, thanks to Cees Maas and especially John Hele and Koos Timmermans whom Iconsider as friends and mentors. Within the ING Risk team, thanks to Doug Caldwell, BillCokins, Emmanuel van Grimbergen and Francis Ruijgt in particular for challenging mythinking.
At Oliver Wyman and Company, special thanks to John Drzik, Thomas Garside, AndyKuritzkes, John Paul Pape and Dylan Roberts, who challenged me to merge finance and riskinto a coherent, value-oriented framework and supported my practice-building and client-oriented work. At Mercer Human Resources, thanks to Vicki Elliott, who helped me tounderstand the power of linking strategy, performance and incentives in changing the cultureand, ultimately, the performance of a company.
At Swiss Re, special thanks to Walter Kielholz, John Fitzpatrick and Bruno Porro forgiving me the opportunity to develop and implement many of the ideas for the first time in a“line capacity.” In addition, thanks to Paul Huber, Adam Litke and Christoph Menn for helpingme to make the theoretical, practical.
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At McKinsey & Company, special thanks to Peter Wuffli, whose good common sense andmentorship during my early years encouraged me to dedicate myself to finance and risk.Thanks also to Kevin Buehler, Christian Casal, Arno Gerken, Wolfgang Hammes, Nils AreLyso and Thomas Poppensieker for helping me to build the risk management practice so manyyears ago. Finally, to Tom Copeland for providing me with an early “apprenticeship” invaluation and value-based management.
COLLEAGUES IN THE PROFESSION
There is an old cliché, “A consultant is someone who borrows your watch in order to tell youwhat time it is . . . and then charges you for the ‘service’!” While I believe my former clientswill findmuch humor and little truth in this cliché, it is nonetheless fair to say that I have learnedsignificantly from former clients and other industry professionals and professional bodies.
While too numerous to name individually, a special debt of gratitude is owed to MarkAbbot, Guardian Financial; Martin Blessing, Commerzbank; Michel Crouhy, CDC-Ixis; RonDenbo, Algorithmics; Philipp Halbherr, Zuercher Kantonalbank; Tobias Guldimann, CreditSuisse Group; Tom Grondin, Aegon; Robert Gumerlock, Swiss Bank Corporation; WillHawkins, KBW; Philipp Keller, Deloitte; Martin Kauer, Converium; Arno Kratky,Commerzbank; Bob Mark, Black Diamond; Dan Marinangelli, Toronto Dominion; ChrisMatten, KPMG; Jean-Christoph Meniuex, AXA; Charles Monet, Morgan Stanley; Per-GöranPersson, UBS; Jo Oechslin, Credit Suisse; Bruno Pfister, Swiss Life; Professor Stuart Turnbull,University of Texas at Austin; Martin Senn, Zurich Financial Services; Walter Stuerzinger,Union Bank of Switzerland; Johnny Vo, Royal Bank of Canada; Bob Yates, Fox-Pitt, Kelton.
In addition, I would like to thank the European CRO Forum and PRMIA for creating aplatform for the exchange of ideas and best practices between industry professionals.
RESEARCH AND EDITORIAL SUPPORT
I would like to thank Professor Andreas Richter, PhD candidates Dominik Lohmaier andVerena Jaeger and the students in the Ludwig Maximillian University 2014–15 Masters’Seminar on Managing Value in Financial Institutions who provided me with critical commentsand challenged me to make the messages clearer. Thanks also to Yoanna Histrova, Master’sStudent at LMU, for research assistance on the value relevance of market-consistentapproaches. Thanks to Jean-Fredrick Breton for illustrative calculations.
Further thanks to Tom Copeland, Mark Wagner, Jean-Fredrick Breton and Tom Grondinfor reviewing an earlier draft, as well as to the editors at John Wiley who helped to bring thisbook to completion.
TO MY FAMILY
Finally, I would like to thank my family who supported and encouraged me. First and foremost,to my parents, Kurt and Arlyn Wilson, to whom I dedicate this book – their continued love andsupport through good weather and stormy seas provided a safe harbor. Second, to my wife,Nontaya Ekmonachai, for having the patience to see this project through to the end and for
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being the sweetest, most caring and special person I know. To my brothers, Marc and KurtWilson, for always being there when I needed them. Finally, with special love to my children,Paige, Christian and Lucas, who continually make me both very happy and very proud.
DISCLAIMER
Acknowledging my intellectual debts does not absolve me of the responsibility for any errorsand omissions. In addition, the opinions and views expressed in this Handbook are mine aloneand do not represent the opinions or views of any other individual or institution that I haveworked with now or in the past.
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About the Author
Thomas C.Wilson has over 20 years’ experience in finance and risk with world-class financialinstitutions and advisory firms.
Since 2008, Tom has been the CRO for Allianz SE, one of the largest insurance companiesand asset managers in the world. During the financial crisis of 2008, Tom also held the dual roleof CRO for Dresdner Bank, then an Allianz subsidiary and the third largest bank in Germany,until it was sold. Tom helped Allianz earn the highest possible Enterprise Risk Managementrating by Standard & Poor’s in 2013 and was recognized as the Insurance Chief Risk Officer ofthe Year by Risk Magazine in 2009 and Life & Pensions Magazine in 2009.
Prior to joining Allianz, Tom was the CRO for ING’s global insurance operations. Duringhis tenure, Tom helped ING to achieve the highest possible Enterprise RiskManagement ratinggranted by Standard & Poor’s in 2007 and was recognized as the Insurance Chief Risk Officerof the Year by Risk Magazine in 2006 and Life & Pensions Magazine in 2007.
Prior to joining ING in 2005, Tom was Global Head of the Finance & Risk Practice atOliver Wyman & Company (OWC), a consulting firm specializing in serving banks andinsurers in risk, strategy and organization. This newly created position was designed toleverage and expand OWC’s traditional risk expertise into an equivalent strength in finance andserving the CFOs of financial services firms.
Prior to joining OWC in 2002, Tom was the CFO of Swiss Re New Markets (SRNM), thealternative risk transfer and capital markets division of Swiss Reinsurance. While at SRNM,Tom was responsible for strategic planning, financial and management reporting, Treasury,back-office operations and risk management.
Prior to joining SRNM in 1998, Tomwas Global Head of the RiskManagement Practice atMcKinsey & Company. Tom is credited as being the founder of McKinsey’s risk managementpractice, making substantial contributions to the industry and clients in risk management andgovernance.
Tom began his career at the Union Bank of Switzerland (UBS) in Zurich as a swap andswap option trader.
Tom is a former Chair of the CRO Forum and on the Blue Ribbon Advisory Panel ofPRMIA, the Professional Risk Management International Association.
Tom earned a BSc in Business Administration with honors from the University ofCalifornia at Berkeley and a PhD in Economics from Stanford University.
Tom was born in San Francisco and has lived and worked in Munich, Amsterdam, NewYork, London and Zurich. Tom is a dual American/Swiss citizen.
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PART
OneIntroduction
C hief Financial Officers (CFOs) and Chief Risk Officers (CROs) have significant potential toinfluence the value of their firm through three channels.
■ First, by providing better information in the form of Risk-Adjusted Performance Metrics(RAPMs), which link management actions directly to shareholder value.
■ Second, by challenging businesses to higher levels of performance through better insights,including segment-specific strategies and management actions.
■ Third, by taking better decisions in their own areas of responsibility, especially corporatestrategy and capital allocation, balance sheet management and risk management.
These three levers are so important for managing the value of banks and insurers that theyform the organizing framework for this Handbook, illustrated in the figure below.
These responsibilities are also relatively new, representing an evolution in the roles of theCFO and CRO over the past 20 to 30 years. As banks and insurance companies evolved intolarger, more complex, internationally diversified financial services groups, the roles of the CFOand CRO evolved in parallel. The result is a finance and risk “backbone” that helps diversifiedgroups get the most from their corporate portfolio through strategic planning, performancemanagement, capital allocation and balance sheet management. In order to understand the roleof the modern CFO and CRO within a diversified financial services firm, you first have tounderstand how and why their roles have evolved in parallel.
The remainder of this Part I of the Handbookmotivates the three levers – better information,better insights and better decisions – and the unique role of the CFO and CRO in applying themtoward value creation.
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• How to value risk-based, capital intensive businesses?• How to link management actions, risk adjusted performance measures (RAPMs) and other, Key Performance Indicators to value?
Better Information – What gets measured, gets managed
• What “rules of the game” (or generic strategies) create value in each business segment?• What core skills are required in each segment?
Better Insights – How to create value through operations
• Strategic planning and capital allocation• Balance sheet, asset/liability and liquidity management• Risk management and risk underwriting
Better Decisions – How Finance & Risk creates value
FIGURE P1.1 Managing for value from the finance and risk perspective
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CHAPTER 1Why is Value Management Important?
C FOs and CROs have significant potential to influence the value of their firm through threechannels.
■ First, by providing better information in the form of RAPMs,1 which link managementactions directly to shareholder value.
■ Second, by challenging businesses to higher levels of performance through better insights,including segment-specific strategies and management actions.
■ Third, by taking better decisions in their own areas of responsibility, especially corporatestrategy, capital allocation, balance sheet management and risk management.
This chapter motivates the importance of these three levers in managing the value of thecompany from a CFO and CRO’s perspective.
BETTER INFORMATION
The first objective of this Handbook is to develop a value and performance measurementframework which can be used by managers at all levels to set strategy and steer risk-based,capital-intensive banking and insurance businesses. The valuation framework, illustratedbelow, splits the value of the firm between its current net asset value (or the market valueof its current assets less its liabilities) and its franchise value (reflecting future, profitable newbusiness).
Figure 1.1 is used throughout the Handbook to represent the three value levers available toCFOs and CROs – better information, better insights and better decisions.
The top part of the figure represents better information in the form of a valuationframework suitable for risk-based, capital-intensive businesses. This framework explicitlylinks management actions to both traditional value drivers – including profitable growth andoperating efficiency – and value drivers unique to banking and insurance – including
1Banks and insurers use different risk-adjusted metrics in practice, including RAROC (Risk-AdjustedReturn On Capital), RORAC (Return On Risk-Adjusted Capital) and even RARORAC. By definition, notall of them will lead to the “right” answer. This Handbook defines RAPMs consistent with shareholdervalue.
3
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underwriting effectiveness, capital efficiency and financial returns from asset/liability mis-matches. Better information is covered in Part II of the Handbook.
The rows in the figure represent better insights, representing the strategies and core skillsneeded to create value in each business segment. It suggests, for example, that saleseffectiveness and operating efficiency are critical for all segments, but that managing “alpha”through asset/liability management is core only for Life and Health (LH) insurance andbanking. Better insights is the theme of Part III of the Handbook.
The columns in the figure represent better decisions taken by the finance and riskfunctions, focusing on strategic planning and capital allocation; risk management and under-writing; balance sheet and liquidity management; asset/liability management. The topic ofbetter decisions is covered in Part IV of the Handbook.
Why It Is Important
There is an old saying, “What gets measured, gets managed.” It is colorfully illustrated by thestory of the chandelier factory in the old Soviet Union, where the Party had set productiontargets in gross tons of chandeliers. What did they get? Consistent with the incentives, thefactory produced a dozen chandeliers, each weighing the equivalent of a small bus and capableof pulling down the roof of any building were they ever to be installed. The result: many tons ofchandeliers, all twelve of them, but no light.
If we want to manage shareholder value and performance, we first need to measure it. If acompany measures performance in terms of market share or sales growth then, guess what,market share and sales growth will be what it gets if successful. But does higher market share orgrowth create value? Not always. The international expansion of Japanese commercial banksand German Landesbanken in the 1990s illustrates strategies which arguably focused ongrowth but sacrificed shareholder value.
LHInsurance
CorporateStrategy
CapitalAllocation
PerformanceManagement
Banking
AssetMgmt
PCInsurance
1. Better information – What gets measured, gets managed.
How to measure value in risk-based,capital-intensive businesses?
GrowthOperatingEfficiency
CapitalEfficiency
FinancialMarket Alpha
Bal
ance
She
et /
Liqu
idity
Man
agem
ent
Ass
et /
Liab
ility
Man
agem
ent
Cap
ital A
lloca
tion
& S
trat
egic
Pla
nnin
g
Ris
k U
nder
writ
ing
/ Ris
k M
anag
emen
t
Core skills
Net AssetValue
=Franchise multiple driven by operating performance
Share Value +
1
UnderwritingEffectiveness
FIGURE 1.1 Better information – What gets measured, gets managed
4 VALUE AND CAPITAL MANAGEMENT