Value and Capital Management E-Book

Thomas C. Wilson

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 1443

Veröffentlichungsjahr: 2015

Beschreibung

A value management framework designed specifically for banking and insurance The Value Management Handbook is a comprehensive, practical reference written specifically for bank and insurance valuation and value management. Spelling out how the finance and risk functions add value in their respective spheres, this book presents a framework for measuring - and more importantly, influencing - the value of the firm from the position of the CFO and CRO. Case studies illustrating value-enhancing initiatives are designed to help Heads of Strategy offer CEOs concrete ideas toward creating more value, and discussion of "hard" and "soft" skills put CFOs and CROs in a position to better influence strategy and operations. The challenge of financial services valuation is addressed in terms of the roles of risk and capital, and business-specific "value trees" demonstrate the source of successful value enhancement initiatives. While most value management resources fail to adequately address the unique role of risk and capital in banks, insurance, and asset management, this book fills the gap by providing concrete, business-specific information that connects management actions and value creation, helping readers to: * Measure value accurately for more productive value-based management initiatives and evaluation of growth opportunities * Apply a quantitative, risk-adjusted value management framework reconciled with the way financial services shares are valued by the market * Develop a value set specific to the industry to inspire initiatives that increase the firm's value * Study the quantitative and qualitative management frameworks that move CFOs and CROs from measurement to management The roles of CFO and CRO in financial firms have changed dramatically over the past decade, requiring business savvy and the ability to challenge the CEO. The Value Management Handbook provides the expert guidance that leads CFOs and CROs toward better information, better insight, and better decisions.

Leseprobe

CONTENTS

Cover

Series Page

Title Page

Copyright

Dedication

List of Abbreviations

Preface

Who Should Read This Book?

Acknowledgments

Colleagues at Work

Colleagues in the Profession

Research and Editorial Support

To My Family

Disclaimer

About the Author

Part One: Introduction

Chapter 1: Why is Value Management Important?

Better Information

Better Insights

Better Decisions

Why Shareholder Value?

Chapter 2: How do CFOs and CROs Add Value?

The Evolution of the Corporate Center as “Shareholder Surrogate”

The Implications for the CFO

The Implications For The CRO

Part Two: Better Information – Measuring Value

Chapter 3: RAPMs – The Industry Standard

What Makes Financial Services Unique?

What Do RAPMs Do And How?

The RAPM (R)Evolution

Three RAPMs For Three Distinct Purposes…

…Linking Directly To Shareholder Value

Insurance Example

Banking Example

Chapter 4: Two Challenges in Using RAPMs

Do RAPMs Influence Strategy?

Do RAPMs Give The Right Signals?

Chapter 5: Valuing Financial Services – The Theory

What Determines Share Value? Market Multiples, Roe And Growth…

…But What Determines Market Multiples?

Why A Market-Consistent Approach?

Value: Where It Comes From and How to Create More of It

Chapter 6: Valuing Financial Services – The Evidence

Evidence From The Insurance Industry1

Evidence From Banking

Is It Just Me Or are Others Thinking the Same Thing?

Chapter 7: Market-Consistent Valuation for Insurers

Introduction to Fair Valuation For Insurers

Calculating Traditional Embedded Value

European Embedded Value

Market Consistent Embedded Value (Mcev)

How is MCEV Calculated in Practice?

From MCEV to MVBS

Final Comments: Whither MCEV?

Part Three: Better Insights – Managing Value

Chapter 8: Property and Casualty Insurance

History And Economic Rationale1

From Principles to Rules of the Game

From Rules to the Valuation of PC Businesses

PC KPIs: Understanding And Managing Value

Chapter 9: Life and Health Insurance

History and Economic Rationale

From Principles to “Rules of the Game”

LH Valuation

Understanding Value Creation: Capital Intensity and Financial Risk Taking

Chapter 10: Banking

History1

Products

Economic Rationale

From Principles To “Rules Of The Game”

From “Rules” To Value

Chapter 11: Achieving Profitable Growth

Rules of the Game and KPIs

Management Actions – Three Horizons of Growth

Horizon 1 – Increasing Sales Productivity

Horizon 1 – Going Multi-Channel

Horizon 1 – Getting More out of Existing Customers; Cross Sell, Big Data and Customer Loyalty

Horizon 1 – Managing the Customer Portfolio Skew

Horizon 2 – Anticipating Mega-trends

Horizon 2 – Exploiting Adjacencies

Horizon 2 – Transformational and Bolt-On Acquisitions

Horizon 3 – Creative Disruptions

Chapter 12: Achieving Operating Efficiency

The Importance of Operating Efficiency

Rules of the Game

Pay Less: Optimize Procurement

Pay less: From Business Process Redesign to Outsourcing

Use Less, But More Effectively: Digitize and Automate

Use Less, But More Effectively: Re-Engineer the Product Portfolio

Case Example

Use Less, But More Effectively: Managing Acquisition Expenses

Part Four: Better Decisions – Capital, Balance Sheet and Risk Management

Chapter 13: Corporate Strategy and Capital Allocation

Corporate Strategy, Capital Allocation and Performance Management

Capital Allocation: The Capital Budget, From Sources to Uses of Capital

Capital Allocation: Optimizing the Corporate Portfolio

Capital Allocation: Aligning Financial Resources within Constraints

Chapter 14: Strategic Planning and Performance Management

What is Strategic Planning?

Why Does Strategic Planning Fail and What can be Done About It?

Corporate Strategy

Chapter 15: Balance Sheet Management

Balance Sheet Management Activities

The Asset/Liability Committee (ALCO) Mandate and Agenda

The Asset/Liability Management (ALM) Unit

Two Complications to the “Classic” ALM Unit

The Insurer ALM–Investment Value Chain

The Treasury Function

Chapter 16: The Economics of Asset/Liability Management

The Role of ALM Earnings

The Risks: Some Spectacular ALM Failures

The Returns: Are Shareholders Willing to Pay a Premium or a Discount?

Chapter 17: The Practical Aspects of Asset/Liability Management

ALM Performance and Risk Measures

Calculating Funds Transfer Prices (FTPs)

Measuring Alpha

Chapter 18: Cash and Liquidity Management

Managing Funding Liquidity Risk

What Happens If It Goes Wrong?

Measuring Funding Liquidity Risk

Chapter 19: Managing the Capital and Funding Structure

Capital Funding Management

Determining The Optimal Capital Structure

The Empirical Reality: What Determines Capital Structure?

Chapter 20: Risk Management

Enterprise Risk Management

Taking The Right Decisions

The Role Of Culture

Chapter 21: Risk Governance and Organization

Risk Governance Principles

Role of the Board and Management

Three-Line-of-Defense Model

The Risk Function

Chapter 22: Risk Identification and Evaluation

From Risk Identification to Evaluation

Data-Driven Approaches

Evaluation-Based Approaches

Building a Resilient Organization

Chapter 23: Risk Underwriting – Strategy and Governance

Underwriting Context

Underwriting Strategy

Underwriting Governance

Chapter 24: Risk Underwriting – Technical Tools

Retail Segment: “Scoring” Models

Commercial Lines: Leveraging Expert Judgment

Underwriting Structured Solutions

Underwriting Controls, Validation and Learning

Chapter 25: Risk Underwriting – From Technical Pricing to Value Maximization

Technical Production Cost: RAPM Pricing

From Technical Pricing to Optimal Price

Chapter 26: Managing Operational and Reputational Risks

Defining Operational Risk

Managing Operational Risk

Chapter 27: Risk and Limit Controlling

Risk Reporting

An Effective Risk Limit Framework

Final Thoughts on Risk and Limit Reporting

Appendix AMarket Multiple Approaches

Step 1: Define the Peer Group for Comparison

Step 2: Estimate Sectoral Multiples

Step 3: Calculate the Implied Sum-of-Parts Valuation Using the Following Formulae

Appendix BDerivation of Steady-State Valuation Multiples

The Accounting Approach

The Discounted Free Cash Flow Entity Approach

The Market-Consistent Valuation Approach

A Brief Digression on Changing the Accounting Basis

Appendix CValuing Banks and Insurers: The Link Between Value and New Business and Investment RAPM

Valuation of Insurers

Valuation of Banks

Appendix DBeyond Debt and Equity

Sources of Customer and Internal Financing

Unsecured Financing from the Wholesale Markets

Securitized Financing

Hybrid Capital

Glossary

References

Index

End User License Agreement

List of Tables

Table 1.1

Table 3.1

Table 3.2

Table 3.3

Table 4.1

Table 4.2

Table 4.3

Table 4.4

Table 4.5

Table 4.6

Table 4.7

Table 4.8

Table 4.9

Table 5.1

Table 5.2

Table 5.3

Table 5.4

Table 5.5

Table 6.1

Table 6.2

Table 6.3

Table 6.4

Table 6.5

Table 6.6

Table 8.1

Table 8.2

Table 8.3

Table 8.4

Table 8.5

Table 8.6

Table 9.1

Table 9.2

Table 9.3

Table 9.4

Table 9.5

Table 9.6

Table 10.1

Table 10.2

Table 10.3

Table 10.4

Table 10.5

Table 11.1

Table 11.2

Table 11.3

Table 11.4

Table 11.5

Table 15.1

Table 15.2

Table 15.3

Table 15.4

Table 16.1

Table 16.2

Table 16.3

Table 16.4

Table 16.5

Table 17.1

Table 17.2

Table 17.3

Table 17.4

Table 17.5

Table 17.6

Table 17.7

Table 17.8

Table 17.9

Table 18.1

Table 18.2

Table 19.1

Table 19.2

Table 21.1

Table 22.1

Table 22.2

Table 22.3

Table 22.4

Table 23.1

Table 23.2

Table 23.3

Table 24.1

Table 25.1

Table 25.2

Table 26.1

Table 26.2

Table 27.1

Table 27.2

Table 27.3

Table 27.4

Table 27.5

Table A.1

Table B.1

Table B.2

Table C.1

Table C.2

List of Illustrations

Figure 1.1

Figure 1.2

Figure 1.3

Figure 2.1

Figure 2.2

Figure 2.3

Figure 2.4

Figure 3.1

Figure 3.2

Figure 3.3

Figure 3.4

Figure 3.5

Figure 4.1

Figure 5.1

Figure 5.2

Figure 5.3

Figure 5.4

Figure 5.5

Figure 6.1

Figure 6.2

Figure 6.3

Figure 6.4

Figure 6.5

Figure 6.6

Figure 7.1

Figure 7.2

Figure 7.3

Figure 7.4

Figure 7.5

Figure 7.6

Figure 8.1

Figure 8.2(a)

Figure 8.2(b)

Figure 8.3

Figure 8.4(a)

Figure 8.4(b)

Figure 8.5

Figure 9.1

Figure 9.2

Figure 9.3

Figure 9.4

Figure 9.5

Figure 9.6(a)

Figure 9.6(b)

Figure 9.7(a)

Figure 9.7(b)

Figure 9.8(a)

Figure 9.8(b)

Figure 9.9

Figure 10.1

Figure 10.2

Figure 10.3

Figure 10.4

Figure 11.1

Figure 11.2

Figure 11.3

Figure 11.4

Figure 11.5

Figure 12.1

Figure 12.2

Figure 12.3

Figure 12.4

Figure 12.5

Figure 12.6

Figure 13.1

Figure 13.2

Figure 13.3

Figure 13.4

Figure 13.5

Figure 13.6

Figure 13.7

Figure 13.8

Figure 14.1

Figure 14.2

Figure 14.3

Figure 14.4

Figure 14.5

Figure 14.6

Figure 14.7

Figure 14.8

Figure 15.1

Figure 15.2

Figure 15.3

Figure 15.4

Figure 15.5

Figure 15.6

Figure 15.7

Figure 15.8

Figure 16.1

Figure 16.2

Figure 16.3

Figure 16.4

Figure 16.5

Figure 16.6

Figure 16.7

Figure 17.1

Figure 17.2

Figure 17.3

Figure 17.4

Figure 17.5

Figure 17.6

Figure 17.7

Figure 17.8

Figure 17.9

Figure 17.10

Figure 17.11

Figure 17.12

Figure 17.13

Figure 18.1

Figure 18.2

Figure 18.3

Figure 18.4

Figure 19.1

Figure 20.1

Figure 20.2

Figure 20.3

Figure 20.4

Figure 21.1

Figure 21.2

Figure 22.1

Figure 22.2

Figure 23.1

Figure 23.2

Figure 23.3

Figure 23.4

Figure 24.1

Figure 25.1

Figure 25.2

Figure 25.3

Figure 25.4

Figure 25.5

Figure 25.6

Figure 25.7

Figure 26.1

Figure 26.2

Figure 27.1

Figure 27.2

Figure 27.3

Guide

Cover

Table of Contents

Begin Reading

Part 1

Chapter 1

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“Over the past 20 years, Tom Wilson has been a highly visible risk management practitioner in major financial services firms – both banks and insurance companies – as well as in leading advisory firms. The discussion of value management in banking and insurance in a single volume highlights that one of the major roles of financial services firms is risk-taking, risk transformation and risk management. Tom’s unique experience in both sectors has allowed him to produce a most welcome integrated handbook.

The clear exposition that risk-taking and strategic management in banking and insurance must be integrated in a value creation framework provides invaluable tools to address managerial issues such as risk identification, capital allocation, measurement of performance and 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 services industry. 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 and insurance. This may seem academic, but is indeed highly relevant in practice. As a long-standing practitioner in both industries, I have seen numerous situations where profit generation has been mistaken for value creation, often leading to the wrong decisions. This book clearly dispels some deeply embedded valuation myths in both the banking and insurance worlds, some of which are 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 available literature.

Third, it covers the entire spectrum of finance and risk activities relevant for the CFO and CRO: From valuation to management information to management action. Real life examples from both banking and insurance are used to illustrate the various tools in practice, be that efficiency management, asset liability management, risk management, strategic planning, and many others.

I was forced to learn many of the themes covered in this handbook the hard way over several years, and I suspect the author has taken a similar journey. Much could have been easier if I had this book at hand earlier.”

Jo Oechslin, CRO, Credit Suisse Group AG

“Tom’s book on risk and capital management is the most comprehensive in the field. It is not only well structured and thorough, it is an easy read. I particularly enjoyed the anecdotes throughout giving live examples in insurance and banking. Like minded CROs and CFOs will also find this book comforting in that it not only supports their beliefs, it conveys they are not alone in trying to get the fundamental point of true value measurement accepted and embedded in their own organizations. Lastly I wanted to compliment Tom on his description of the roles of the CFO and CRO in financial institutions. I have too often heard that CROs must remain fully independent of business decisions only being able to blow a whistle when there is a problem. The book clearly points to the CRO as a vital part of management decision making from strategy to execution and that CROs must remain objective, leaving independence to audit and supervisors.”

Tom Grondin, CRO, Aegon Insurance

“The roles of CFOs and CROs in financial services have gone through an enormous transformation over the past decade, driven by external factors such as increasing shareholder and regulatory expectations and the global financial crisis, as well as by the managements’ interest in fundamentally improving how they manage value and capital. Tom’s book offers insights at the nexus of aligning risk management, finance and performance management to boost the firm’s value. A vast piece of work providing a compelling set of tools to understand the indiscernible link between 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 and communicate how it manages risk and creates value. It is refreshing to read a defence of value creation for the shareholder being consistent with running a business for the benefit of all stakeholders. I also welcome insights into how CFOs and CROs can demonstrate and quantify their contribution to this value creation and reverse the conglomerate discount that many large groups suffer from. Tom Wilson offers useful insights based on financial theory and his respected 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 risk manager and risk taker in, and advisor to, many of the world’s leading life insurers, property casualty insurers, reinsurers, banks and asset managers. His book mixes theory with the evolution of practice across the sector, and draws on many real life examples. I commend Tom’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

Value and Capital Management

A Handbook for the Finance and Risk Functions of Financial Institutions

Thomas C. Wilson

This edition first published 2015

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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.—1

pages 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 2015

332.1068′—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: Wiley

Cover Image: © Iaroslav Neliubov/Shutterstock

Dedication

To Kurt and Arlyn, with love and gratitude

List of Abbreviations

ABC

Activity-Based Costing

ADM

Application Development and Maintenance

AEP

Aggregate Exceedance Probability

ALCO

Asset Liability Committee

ALM

Asset/Liability Management

APE

Annualized Premium Equivalent

ATE

Absolute Tracking Error

AUM

Assets Under Management

BPO

Business Process Outsourcing

BPR

Business Process Re-engineering

CAPM

Capital Asset Pricing Model

CER

Capital Efficiency Ratio

CFO

Chief Financial Officer

CIO

Chief Investment Officer

CIR

Cost Income Ratio

CLV

Customer Lifetime Value

CNHR

Cost of Non-Hedgeable Risks

COC

Cost of Capital

CoR

Combined Ratio

CRM

Customer Relationship Management

CRO

Chief Risk Officer

CUO

Chief Underwriting Officer

DAC

Deferred Acquisition Costs

DJSI

Dow Jones Sustainability Index

EaR

Earnings at Risk

EC

Economic Capital

ECI

Economic Capital Intensity

EDP

Electronic Data Processing

EEV

European Embedded Value

EIA

Equity Indexed Annuity

EP

Economic Profit

EPS

Earnings Per Share

ERM

Enterprise Risk Management

ESG

Economic Scenario Generator

ESG

Environmental, Social and Governance

FASB

Financial Accounting Standards Board

FCF

Free Cash Flow

FCReC

Frictional Costs of Required Capital

FNAV

Fair Net Asset Value

FS

Free Surplus

FSB

Financial Stability Board

FTP

Funds Transfer Pricing

GAAP

Generally Accepted Accounting Principles

GIC

Guaranteed Investment Contract

GMAB

Guaranteed Minimum Accumulation Benefit

GMDB

Guaranteed Minimum Death Benefit

GMIB

Guaranteed Minimum Income Benefit

GMWB

Guaranteed Minimum Withdrawal Benefit

G-SIFI

Globally Systemically Important Financial Institutions

HRO

High-Reliability Organization

IBES

Institutional Brokers' Estimate System

IC

Invested Capital

ICT

Information and Communications Technology

IDR

Implied Discount Rate

IFRS

International Financial Reporting Standards

ILS

Insurance-Linked Securities

IRR

Internal Rate of Return

ITO

Information Technology Outsourcing

IV

Intrinsic Value

KPI

Key Performance Indicator

KRI

Key Risk Indicator

LCR

Liquidity Coverage Ratio

LH

Life and Health insurance business

Libor

London inter-bank offered rate

LLPO

Limited Liability Put Option

LTP

Liquidity Transfer Pricing

MBR

Monthly Business Review

MC

Market Capitalization

MCEV

Market-Consistent Embedded Value

MIS

Management Information System

MPL

Maximum Probable Loss

MREL

Minimum Required Eligible Liabilities

MVBS

Market Value Balance Sheet

MVE

Market Value of Earnings

NAV

Net Asset Value

NBM

New Business Margin

NDM

Net Deposit Margin

NFCL

Non-Financial Component of Liabilities

NI

Net Income

NII

Net Interest Income

NLM

Net expected Loan Margin

NOPLAT

Net cash Operating Profit Less Adjusted Taxes

NPS

Net Promoter Score

NSFR

Net Stable Funding Ratio

OAS

Option-Adjusted Spreads

OCF

Operating Cash Flow

OCI

Other Comprehensive Income

PAYD

Pay As You Drive

PC

Property and Casualty insurance business

PRE

Policyholder Reasonable Expectations

PVFP

Present Value of Future Premium

PVIF

Present Value In-Force business

PVNBP

Present Value of New Business Premium

QBR

Quarterly Business Review

RAC

Risk-Adjusted Capital

RAG

Red, Amber, Green

RAPM

Risk-Adjusted Performance Measures

RAROA

Risk-Adjusted Returns on Assets

RAROC

Risk-Adjusted Return on Capital

RARORAC

Risk-Adjusted Return on Risk-Adjusted Capital

RC

Required Capital

RCSA

Risk Control Self-Assessment

ROE

Return on Equity

ROIC

Return on Invested Capital

RoMVS

Return on Market Value Surplus

RORAA

Return on Risk-Adjusted Assets

RORAC

Return on Risk-Adjusted Capital

SLA

Service Level Agreement

SML

Securities Market Line

TDIs

Top-Down Indicators

TEV

Traditional Embedded Value

TNAV

Tangible Net Asset Value

TOM

Target Operating Model

TRA

Top Risk Assessment

TSR

Total Shareholder Return

TVA

Total Value Added

TVOG

Time Value of Financial Options and Guarantees

UL

Unexpected Loss

UL

Unit Linked investment product

VaR

Value at Risk

ViF

Value in Force

VNB

Value of New Business

VOBA

Value of Business Acquired

WACC

Weighted Average Cost of Capital

Preface

Creating value is challenging in any highly competitive industry, a daily battle to capture market share, defend margins and improve expenses. Managing value in financial services is even more challenging due to the unique role that risk and capital play in the economics of the business: whereas most industrial corporations actively avoid risk, there can be no return to shareholders – and no satisfied customers – if banks and insurers avoid risk, and taking risks requires capital. In banking and insurance, risk and capital management and value management are synonymous.

The role of the Chief Financial Officer (CFO) and Chief Risk Officer (CRO) has evolved and adapted to this economic reality. Modern finance and risk functions now have substantial influence on the strategy, operations and, ultimately, the value of their firms. This influence comes in part from being a business partner and in part through the financial and risk management activities directly within their responsibility.

This Handbook is intended as a practical but theoretically grounded reference for finance and risk professionals interested in managing value. The Handbook consists of three main sections.

Better information – Measuring value. What gets measured, gets managed. Accurately measuring 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 framework clearly links management actions to shareholder value creation and is the foundation for internal, value-based management initiatives.

Better insights – Managing value. Better information may be a necessary condition, but it is not a sufficient condition: ultimately, the “right” decisions have to be taken. Allocating capital to existing businesses and exploiting new growth opportunities requires insights beyond risk and capital; it also requires an understanding of the markets, the drivers of operating performance 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 is designed to give CEOs, CFOs and CROs concrete ideas for increasing the value of the individual businesses as well as the corporate portfolio.

Better decisions – Capital, balance sheet and risk management. In addition, CFOs and CROs contribute directly to value creation through their own areas of responsibility, especially through strategic planning and capital allocation; balance sheet, liquidity and asset/liability management; risk underwriting and risk management. This section provides insights into how CFOs and CROs can actively create value in these areas.

Who Should Read This Book?

This Handbook provides an accessible reference for professionals working within and around the financial services industry, targeted toward

CFOs, CROs and other finance and risk professionals in banks and insurance who are interested in increasing the value of their company, especially those active in strategic planning and performance management; capital management, Treasury, balance sheet, liquidity management and asset/liability management; risk underwriting and risk management.

CEOs and business unit heads who want to understand how the business and value creation look “through a finance and risk lens.”

Analysts who cover banks and insurers from a value and solvency perspective, including buy- and sell-side equity analysts, as well as analysts in rating agencies, regulators and supervisors.

Graduate students in business, economics and finance who are interested in bridging the gulf between financial theory and the practical realities of managing value in banks and insurance companies.

Acknowledgments

The intellectual foundations for this Handbook have been laid over the past 20 years while working 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 Perlet for bringing me on board and supporting me in building a world-class risk function. I would also especially like to thank Dieter Wemmer for reinforcing active capital management within the 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, Christoph Mascher, Jay Ralph, Axel Theis and Werner Zedelius for valuable business discussions.

For challenging my thinking, special thanks to Peter Etzenbach, Kamesh Goyal, Burkhard Keese, Thomas Naumann, Walter Reinl, Giulio Terzariol and Renate Wagner in Finance and Strategic Planning; Dirk Diederich and Stephan Theissing in Treasury and Capital Management; Oliver Schmidt in Investor Relations; Michele Gaffo, Andreas Gruber, Günther Thallinger and Axel Zehren in Investment Management. Also, to my Global Risk team at Allianz, especially Larisa 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 I consider as friends and mentors. Within the ING Risk team, thanks to Doug Caldwell, Bill Cokins, Emmanuel van Grimbergen and Francis Ruijgt in particular for challenging my thinking.

At Oliver Wyman and Company, special thanks to John Drzik, Thomas Garside, Andy Kuritzkes, John Paul Pape and Dylan Roberts, who challenged me to merge finance and risk into 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 to understand the power of linking strategy, performance and incentives in changing the culture and, ultimately, the performance of a company.

At Swiss Re, special thanks to Walter Kielholz, John Fitzpatrick and Bruno Porro for giving 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 helping me to make the theoretical, practical.

At McKinsey & Company, special thanks to Peter Wuffli, whose good common sense and mentorship 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 Are Lyso and Thomas Poppensieker for helping me to build the risk management practice so many years ago. Finally, to Tom Copeland for providing me with an early “apprenticeship” in valuation 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 you what time it is…and then charges you for the ‘service’!” While I believe my former clients will find much humor and little truth in this cliché, it is nonetheless fair to say that I have learned significantly from former clients and other industry professionals and professional bodies.

While too numerous to name individually, a special debt of gratitude is owed to Mark Abbot, Guardian Financial; Martin Blessing, Commerzbank; Michel Crouhy, CDC-Ixis; Ron Denbo, Algorithmics; Philipp Halbherr, Zuercher Kantonalbank; Tobias Guldimann, Credit Suisse Group; Tom Grondin, Aegon; Robert Gumerlock, Swiss Bank Corporation; Will Hawkins, KBW; Philipp Keller, Deloitte; Martin Kauer, Converium; Arno Kratky, Commerzbank; Bob Mark, Black Diamond; Dan Marinangelli, Toronto Dominion; Chris Matten, KPMG; Jean-Christoph Meniuex, AXA; Charles Monet, Morgan Stanley; Per-Göran Persson, 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 a platform 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 and Verena Jaeger and the students in the Ludwig Maximillian University 2014–15 Masters' Seminar on Managing Value in Financial Institutions who provided me with critical comments and challenged me to make the messages clearer. Thanks also to Yoanna Histrova, Master's Student at LMU, for research assistance on the value relevance of market-consistent approaches. Thanks to Jean-Fredrick Breton for illustrative calculations.

Further thanks to Tom Copeland, Mark Wagner, Jean-Fredrick Breton and Tom Grondin for reviewing an earlier draft, as well as to the editors at John Wiley who helped to bring this book 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 and support 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 being the sweetest, most caring and special person I know. To my brothers, Marc and Kurt Wilson, 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 errors and omissions. In addition, the opinions and views expressed in this Handbook are mine alone and do not represent the opinions or views of any other individual or institution that I have worked with now or in the past.

About the Author

Thomas C. Wilson has over 20 years' experience in finance and risk with world-class financial institutions and advisory firms.

Since 2008, Tom has been the CRO for Allianz SE, one of the largest insurance companies and asset managers in the world. During the financial crisis of 2008, Tom also held the dual role of 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 Management rating by Standard & Poor's in 2013 and was recognized as the Insurance Chief Risk Officer of the 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. During his tenure, Tom helped ING to achieve the highest possible Enterprise Risk Management rating granted by Standard & Poor's in 2007 and was recognized as the Insurance Chief Risk Officer of 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 at Oliver Wyman & Company (OWC), a consulting firm specializing in serving banks and insurers in risk, strategy and organization. This newly created position was designed to leverage and expand OWC's traditional risk expertise into an equivalent strength in finance and serving the CFOs of financial services firms.

Prior to joining OWC in 2002, Tom was the CFO of Swiss Re New Markets (SRNM), the alternative 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, Tom was Global Head of the Risk Management Practice at McKinsey & Company. Tom is credited as being the founder of McKinsey's risk management practice, making substantial contributions to the industry and clients in risk management and governance.

Tom began his career at the Union Bank of Switzerland (UBS) in Zurich as a swap and swap option trader.

Tom is a former Chair of the CRO Forum and on the Blue Ribbon Advisory Panel of PRMIA, the Professional Risk Management International Association.

Tom earned a BSc in Business Administration with honors from the University of California at Berkeley and a PhD in Economics from Stanford University.

Tom was born in San Francisco and has lived and worked in Munich, Amsterdam, New York, London and Zurich. Tom is a dual American/Swiss citizen.

Part OneIntroduction

Chief Financial Officers (CFOs) and Chief Risk Officers (CROs) have significant potential to influence 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 corporate strategy and capital allocation, balance sheet management and risk management.

These three levers are so important for managing the value of banks and insurers that they form the organizing framework for this Handbook, illustrated in the figure below.

Figure P1.1 Managing for value from the finance and risk perspective

These responsibilities are also relatively new, representing an evolution in the roles of the CFO and CRO over the past 20 to 30 years. As banks and insurance companies evolved into larger, more complex, internationally diversified financial services groups, the roles of the CFO and CRO evolved in parallel. The result is a finance and risk “backbone” that helps diversified groups get the most from their corporate portfolio through strategic planning, performance management, capital allocation and balance sheet management. In order to understand the role of the modern CFO and CRO within a diversified financial services firm, you first have to understand how and why their roles have evolved in parallel.

The remainder of this Part I of the Handbook motivates the three levers – better information, better insights and better decisions – and the unique role of the CFO and CRO in applying them toward value creation.

Chapter 1Why is Value Management Important?

CFOs and CROs have significant potential to influence the value of their firm through three channels.

First, by providing

better information

in the form of RAPMs,

1

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 corporate strategy, capital allocation, balance sheet management and risk management.

This chapter motivates the importance of these three levers in managing the value of the company from a CFO and CRO's perspective.

Better Information

The first objective of this Handbook is to develop a value and performance measurement framework 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, illustrated below, splits the value of the firm between its current net asset value (or the market value of its current assets less its liabilities) and its franchise value (reflecting future, profitable new business).

Figure 1.1 is used throughout the Handbook to represent the three value levers available to CFOs and CROs – better information, better insights and better decisions.

Figure 1.1 Better information – What gets measured, gets managed

The top part of the figure represents better information in the form of a valuation framework suitable for risk-based, capital-intensive businesses. This framework explicitly links management actions to both traditional value drivers – including profitable growth and operating efficiency – and value drivers unique to banking and insurance – including underwriting effectiveness, capital efficiency and financial returns from asset/liability mismatches. Better information is covered in Part II of the Handbook.

The rows in the figure represent better insights, representing the strategies and core skills needed to create value in each business segment. It suggests, for example, that sales effectiveness 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 and banking. Better insights is the theme of Part III of the Handbook.

The columns in the figure represent better decisions taken by the finance and risk functions, focusing on strategic planning and capital allocation; risk management and underwriting; balance sheet and liquidity management; asset/liability management. The topic of better 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 the story of the chandelier factory in the old Soviet Union, where the Party had set production targets in gross tons of chandeliers. What did they get? Consistent with the incentives, the factory produced a dozen chandeliers, each weighing the equivalent of a small bus and capable of pulling down the roof of any building were they ever to be installed. The result: many tons of chandeliers, all twelve of them, but no light.

If we want to manage shareholder value and performance, we first need to measure it. If a company 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 or growth create value? Not always. The international expansion of Japanese commercial banks and German Landesbanken in the 1990s illustrates strategies which arguably focused on growth but sacrificed shareholder value.

Similarly, a company focusing on risk-adjusted returns will achieve a higher return on capital if successful. But do higher percentage returns always translate into higher shareholder value? Even if the capital deployed is decreasing? Returns below the cost of capital obviously destroy value, but investing less and less capital at marginally higher risk-adjusted returns also represents an opportunity cost to shareholders.

Growth without adequate returns or risk-adjusted returns without growth. Both are bad strategies. Ultimately, the trade-off between growth, risk and returns needs to be understood and evaluated so that the right path can be taken. Providing clarity is one of the key levers that CFOs and CROs can “pull” to help create value.

Why It is Challenging

Measuring the performance of financial services firms is inherently difficult given the duration, complexity and risks inherent in their products. How to measure the value created by products with highly uncertain cash flows far into the future? Although the standard corporate finance mantra “Cash is King!” works well for industrial corporations, anyone who has had to wade through the complexities of insurance and bank financial accounts knows how difficult it is to go from financial reporting to cash and from cash to value.

In response, banks and insurers have converged on internal RAPM and Economic Profit (EP) frameworks, which make the returns and risks of very different, highly complex financial businesses directly comparable. Unfortunately, RAPM frameworks can be complex, reflecting the complexity of the business, and in spite of the complexity, not all of them provide the “right” answer.

In addition, the inherent complexity can make the link between RAPMs and shareholder value seem so tenuous to senior managers that they revert to a simpler paradigm to manage value – one of accounting earnings, earnings growth and P/E (price/earnings) multiples – even though, by ignoring capital and risk, the simpler approaches will lead almost certainly to the wrong decisions.

I remember a conversation that I had with the CFO of a large bank in North America while conducting a survey on the role of the CFO and CRO (OWC, 2003). We quickly established that the bank used RAROC to evaluate individual credits and business unit strategies, that RAROC was accepted by management and used to set targets and incentivize performance.

“At last!” I thought to myself. “Here is the poster child for value management that I have been searching for!” And so, with growing enthusiasm and great expectations, I (naively) asked my final question of the interview, “So, RAROC has had a strong influence in terms of shaping your corporate strategy?”

The answer was dumbfounding: “Shaping corporate strategy? But why? The CEO and I drive strategy by looking at earnings, earnings growth and a P/E multiple – from a shareholders' perspective, isn't that all that we need to set the strategy of the bank?”

A lot of questions ran through my head: If the bank's internal metrics don't link to value and are not used to set corporate strategy, then why go through the effort? Looking at it from another angle, if P/E or M/B (market-to-book) ratios accurately reflect value, then what determines them? Why do some firms enjoy an M/B multiple of 2× tangible equity and others only 1× or less? And finally, isn't ignoring risk and capital, as P/E and M/B multiples seem to do, asking for trouble when managing risk-based, capital-intensive businesses?

During the remaining interviews, I asked the same question of other CFOs and CROs. A consistent picture emerged: even in the most “advanced” institutions, senior management relied more on a combination of revenue and earnings growth and market multiples to set strategy, ignoring internal performance metrics which were developed over many years and with great effort. This is not to say that RAPMs and EP didn't have an impact at the tactical and transaction level, just that they more often failed to impact the strategy of the firm.

The reasons cited most often were the complexity of the internal metrics, combined with lingering concerns regarding stability and accuracy. From my experience, however, the real issue was simpler: most CEOs, business unit heads and CFOs saw no clear link between the complex internal metrics and the external valuation multiples used in practice. During my career, I have seen more CEOs sketch their corporate strategy on the “back of an envelope” for equity analysts using P/E multiples than I have seen using RAPMs and EP!

Fortunately, there is a way to salvage RAPM frameworks, correcting the flaws and allowing them to be understood and more closely aligned with value creation. These are the themes developed in the more technical Part II of this Handbook.

Better Insights

Better information is necessary but not sufficient; ultimately, strategic and operational decisions have to be taken, including the allocation of capital, and this requires an in-depth understanding of the marketplace as well as business strategies, core competencies and management actions which can be implemented. See Figure 1.2.

Figure 1.2 Better insights

Why It is Important

An interview with the CFO of a mid-sized European bank illustrated the importance of better insights in terms of both business challenge and capital allocation. Like many of his peers, the CFO's role had evolved over time from the Head of Accounting and Reporting to a modern CFO, including responsibility for the strategic planning process.

Focusing on strategic planning, he explained the steps already taken in supplementing accounting information with an economic value framework and moving from a bottom-up, revenue- and expense-budgeting exercise to a process emphasizing strategy.

Even with this progress, the results were unsatisfactory: the plans, derived bottom-up, were anything but “strategic,” being better characterized as “business as usual” or “last year plus 5%.”

The firm had more than adequate information and a clearly defined planning process supported by extensive Gantt charts,2 taking up significant resources and delivering a bulky end product. In spite of these, the CFO and CEO were left feeling that the company was missing opportunities which would have required a more fundamental rethink of where capital was allocated and that the business units should have – and could have – committed to much more in terms of results and tangible actions to address the real issues. Unfortunately, these commitments were simply not forthcoming and the businesses were allowed to grow, and capital was allocated, based on momentum and not on their potential.

This was frustrating, because the CFO and CEO (as well as the market!) knew that competitors were more aggressively re-dimensioning their commercial loan portfolio, building more profitable private client businesses and adjusting their cost base. As a consequence, the bank's share price lagged behind those of its peers, and analysts were playing Monday morning quarterback during every conference call, letting the CFO know what plays they should have run after the fact.

Why It is Challenging

The portfolio of businesses in a large, diversified financial services firm is increasingly complex and international, limiting the effectiveness of market discipline on capital allocation decisions. The role of market discipline falls naturally on the corporate center, comprising the group's CEO, CFO and CRO: it is the corporate center's responsibility to allocate capital between competing interests and challenge business strategies based on an in-depth understanding of the marketplace, competitors' strategies and relative business performance.

Returning to the interview, the CFO described how, working together with the CEO, they altered the role of the corporate center from that of a “financial investor” (focused on providing capital and consolidated financial reporting) to that of a “private equity firm,” focusing relentlessly on value creation through a deeper understanding of the businesses and proactive capital management.

One important step was the creation of an “equity analyst” group within the finance function, which regularly performed a sum-of-parts valuation of the firm, defining and benchmarking key value drivers for each business and evaluating peer strategies. The end result was a clear understanding of which businesses were under- and over-performing and the value of the “performance gaps” in terms of potential share price appreciation.

As he explained it, these insights were fundamental in reshaping the dialog between the corporate center and the business units: during the next planning round it was much easier to set tougher targets, initiate greater change, reallocate capital and ultimately shake the business units out of their strategic inertia, especially in areas where the company was producing bottom quartile results.

The interview reinforced the observation that better insights – with respect to markets, competitors and strategies – are critical for the CFO as a value manager.

Part III of this Handbook provides segment-specific insights into business strategies (or “rules of the game”), core competencies and management actions used by successful banks and insurers. It then continues by outlining strategies for profitable growth and operating efficiency applicable to all segments. It is useful for CEOs and business leaders when taking strategic and operational decisions as well as for the finance and risk functions when allocating capital and challenging line managers from a shareholder value perspective.

Better Decisions

CFOs and CROs also take important decisions in their own areas of responsibility. From a value management perspective, the most important decisions include corporate strategy and capital allocation; balance sheet, liquidity and asset/liability management; as well as underwriting and risk management. The third objective of this Handbook, highlighted in Figure 1.3, is to help CFOs and CROs take decisions in these three important areas.

Figure 1.3 Better decisions

Corporate Strategy and Capital Allocation: Why It is Important and Challenging

Capital allocation is the tool used to implement corporate strategy, clearly defining which businesses you will harvest for cash, which you will invest in for profitable growth, which you will fix or exit and how much remaining capital will be returned to shareholders. These are the most important decisions taken at the corporate center from a value management perspective. Getting it wrong represents at best a serious opportunity cost; in the worst case, it can destroy shareholder value.

An Anecdote from Banking

Consider another interview, this time with the CFO of a regional bank in North America. During the meeting, he outlined the corporate goal of doubling the share price in 5 years. Observing that “the P/E multiples for retail and commercial banking are relatively similar,” they set the bank's 5-year strategy to invest retained earnings in commercial banking (which was easier to expand organically) at roughly 4× the rate in retail banking (which was more difficult to expand organically). For this company, earnings, earnings growth and the P/E multiple drove the bank's strategy to shift from retail to commercial banking.

Unfortunately, from a shareholder's perspective, the retail bank required significantly less capital per dollar of earnings, offering a 20% RoE (Return on Equity) and an implied M/B valuation multiple of 2× invested capital even without the prospect of significant growth. This was in contrast to the commercial bank, whose 10% RoE only just covered its cost of capital, generating an implied 1× M/B valuation multiple, with or without growth.

While each dollar of earnings from the retail and commercial bank were “worth” about the same based on the segment P/E multiples, the retail bank was throwing off more earnings per unit of invested capital. Given that both businesses required capital to grow, the opportunity cost of the bank's strategy was tremendous: there was an extra dollar of share value foregone for every dollar invested in the commercial bank rather than the retail bank.

An Anecdote from Insurance

LH and Property and Casualty (PC) P/E multiples can also be similar in mature markets. Looking only at P/E multiples, there may have been an historical bias to focus on LH businesses which can grow faster in a bull market, driven by higher account balances and higher investment margins.

This may be the wrong decision, however: even if P/E multiples are comparable, LH RoE and M/B multiples can lag those of a well-run retail PC franchise. The difference is due in part to the higher capital tied up over longer periods to support LH retirement and savings businesses and in part to the quality of earnings, with LH more dependent on investment margins than operating performance.