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5.3: Risk Management and the Firm’s Financial Statement—Opportunities within the ERM

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    Learning Objectives

    • In this section you will learn the tasks of the enterprise risk managers (ERM) function as it relates to the balance sheet of the firm annual statement.
    • The ERM function manages and ensures sustainability by preventing losses and providing opportunities within the risk matrix.
    • Using hypothetical balance sheets, the student learns the actual ERM functions of both financial and nonfinancial firms.
    • Our exploration of financial firms uncovers some of the causes of the 2008–2009 financial crisis.

    The enterprise risk manager or CRO must understand the risks inherent in both sides of the balance sheet of the firm’s financial statements. A balance sheet provides a snapshot of a firm’s assets and liabilities. We show a balance sheet for a nonfinancial firm in Table 5.3. Table 5.5 then shows a balance sheet for an insurance company. Firms must produce annual financial reports including their balance sheets and income statements. Together, we call income statements and balance sheets financial statements. While we focused in the section above on a simplified hypothetical income statement, now we focus on the assets and liabilities as they appear at a certain point. With this ammunition at hand, we will be able to explain why financial institutions created so many problems during the 2008–2009 credit crisis. You will be able to explain AIG’s major problems and why the government ended up bailing it out, along with many other financial institutions. The question that you will be able to answer is, “What side of the balance sheet did AIG fail to manage appropriately?”

    Nonfinancial Firm

    First, we will work with a hypothetical, small, nonfinancial institution, such as a furniture manufacturer or high-tech hardware and software company. Table 5.3 shows the hypothetical assets, liabilities, and equity of this business.

    Table 5.3 Hypothetical Retail and Wholesaler Fashion Apparel Balance Sheet—(Risks and ERM)
    Assets Liabilities and Owners’ Equity
    Cash (loss of use risks) $8,000 Liabilities
    Accounts Receivable (customers quality, foreign exchange and interest rate risks) $28,000 Notes Payable (cash flow, foreign exchange and interest rate risks) $50,000
    Accounts Payable and the mortgage on the building (real estate crisis, cash flow, and interest rate risks) $90,000
    Buildings (asset risk) $100,000 Total liabilities $140,000
    Tools, furniture, inventory, and equipment (asset risk and opportunity asset risk in store design) $27,000 Owners’ equity
    Capital Stock $17,000
    Retained Earnings $6,000
    Total owners’ equity $23,000
    Total $163,000 Total $163,000

    Based on Table 5.3, we can list some areas for which enterprise risk managers (ERMs) need to involve themselves for risk mitigation. Note, these loss risks do not. As part of the executive team, enterprise risk managers regard all activities, including any involvement in opportunity risks that carry the potential of gains as discussed in "1: The Nature of Risk- Losses and Opportunities".

    Examples of ERM activities generated from the assets and the liabilities on the balance sheet are as follows:

    • Building risk: The ERM or CRO has to keep all company buildings safe and operational. Most, if not all, companies carry insurance on all real property. We will discuss the reasons later in the text. However, this represents only part of the CRO’s activities. The risk management manual should give directions for how to take care of weather-related potential damages, or losses from fires or other perils. Furthermore, the risk manager should be involved in any discussions of how to convert some building parts into income–producing opportunities. This will entail carefully assessing potential cash flow streams from reliable and careful tenants, not only from their capacity to pay potential, but also from their capacity to keep losses at an absolute minimum. The CRO or ERM takes on the capital budgeting function and computes net present values with the appropriate risk factors, as shown in "4: Evolving Risk Management - Fundamental Tools" with the example of the safety belts. They need to include some risk factors to measure tenant quality in terms of both paying the rent and maintaining the properties properly.
    • Accounts Receivables and Notes Due: ERMs and CROs must create procedures to ensure that the accounts receivables can be collected and remain in good standing. This is key to sustainability—the ability to maintain expected cash flows. In addition, since the Fashion Apparel’s customers are from other countries, the decision of what currency to use is very important. As far as currency risk is concerned, the risk officer must negotiate with the suppliers and designers to set a mutually beneficial currency. This mutually beneficial currency will provide a very important means to pay the firm’s suppliers and global designers. The risk manager can use currency derivatives to hedge/mitigate the currency risk. Also, if the company uses credit to maintain inventory for the long term, the ERM procedures should include ways to handle interest rate risk on both sides. Such interest rate risk would affect both receivables and payments to vendors, designers, and suppliers. To ensure liquidity, many companies create interest-bearing credit lines from banks—as long as the interest rates are in line with what can be collected in the accounts receivable. The firm has to borrow money to create the cash flows to pay salaries and buy new inventory. At the same time, the firm receives interest from clients. These transactions create a need for interest-rate management while it is receiving interest from clients, there needs to be interest risk management, such as using swaps, which is explained in detail with an example in the next section of this chapter.
    • If used correctly, the swap derivative can act as insurance to mitigate interest rate risk. The interest rate used for borrowing and lending must make sense in terms of the management of accounts receivable and notes due on the liabilities side of the balance sheet. See Figure 5.1.1 showing the gains and losses that can occur because of interest rate and currency risks. They can also provide opportunities if handled with appropriate risk management. Note that the ability to obtain lines of credit from banks and suppliers and extend credit to customers is an integral part of the working of the cash flow of the firm. Indeed the credit crisis of 2008–2009 occurred in part because banks and other creditors lost confidence in the counterparty’s ability to pay, and the credit markets “froze.” This led to insolvencies, declines in stock value, and a general recession.
    • Tools, furniture, and inventory: ERMs must take account of the traffic flow in the show room because they will want to establish sustainability and opportunities to make money. They must ensure that halls provide safety designs as well as fashion statements and innovative and creative designs to enhance visibility of the merchandise. Thus, while the risk manager is involved in avoiding or reducing losses, he/she is also involved in the opportunities. For example, it may be risky to hang some of the merchandise from the ceilings with wind tunnels that accentuate the flow of the fabrics, but it may also increase sales dramatically if the right effects are achieved. CROs must manage the opportunity risk (the chance to make money) with the appropriate risk factors as they compute the capital budget.
    • Accounts Payable including the Mortgage on the Buildings → Capital Structure: Until the real estate crisis of 2008, real estate investments were stable. However, the CRO, working with other managers, must decide whether to purchase large assets with debt or equity from investors. The financing method is very important and it is regarded as the capital structure of the firm—the choice between debt and equity. In this company, the Apparel Designer, the building was purchased with a large mortgage (debt). The mortgage amount due is not subject to reduction unless paid. But, the buildings can decline in value, and at the same time the company’s net worth can be in jeopardy, with potentially catastrophic consequences. If our hypothetical example was a publicly traded company, it would have to show at the end of each year the true value of buildings—the market value. Under this scenario, with so much debt and so little owner’s equity, the balance sheet can show the firm as insolvent. The CRO or risk manager must address the company’s capital structure issue and point out the risks of taking large mortgages on buildings, since the properties may lose their value. The capital structure decision creates a need for managers to choose between financing property with debt versus equity. This tradeoff is a tricky one to negotiate. If the firm uses equity, it may be underinvested. If it uses debt, it runs the risk of insolvency. For example, we know that before the 2008 financial crisis, many firms used too much debt, leading to sustainability issues and liquidation, such as Circuit City.Circuit City announced its liquidation in the middle of January 2009 after they could not find a buyer to salvage the company that specialized in electronics.

    Capital structure decisions as well as the nature of debt and its covenants (the details of the contracts and promises between the debt contract parties), accounts receivables, and notes have been under the domain of the finance or treasury department of companies with a new breed of financial risk managers. These risk managers are responsible for managing the risk of the investments and assets of the firms using tools such as Value at Risk (VaR; discussed in "2: Risk Measurement and Metrics") and capital markets instruments such as derivatives as explained in "2: Risk Measurement and Metrics" and will be detailed in the next section of this chapter. Currently, the trend is to move financial risk management into the firm-wide enterprise risk management.

    Financial Firm—An Insurer

    Next, we move to the risk management function with regard to the balance sheet of financial institutions. We delve into an example of a hypothetical life insurance company. As you will see in the coming chapters, insurance companies are in two businesses: the insurance and investment businesses. The insurance side is the underwriting and reserving liabilities. Underwriting is the process of evaluating risks, selecting which risks to accept, and identifying potential adverse selection. Reserving liabilities involves the calculation of the amount that the insurer needs to set aside to pay future claims. It’s equivalent to the debt of a nonfinancial firm. The investment side includes decisions about asset allocation to achieve the best rate of return on the assets entrusted to the insurer by the policyholders seeking the security. Asset allocation is the mix of assets held by an insurer; also, the allocation of assets is necessary to meet the timing of the claims obligations. This activity is called asset-liabilities matching. The matching is, in essence, to ensure liquidity so that when claims come due the firm has available cash to pay for losses.

    When reviewing the asset portfolio, also referred to as the investment portfolio or asset allocation of an insurer, we see the characteristics of the assets needed to support the payment of claims of the specific insurer. Asset allocation is the mix of assets held by an insurer. A property or health insurer needs a quick movement of funds and cannot invest in many long-term investments. On the other hand, insurers that sell mostly life insurance or liability coverage know that the funds will remain for longer-term investment, as claims may not arrive until years into the future.

    The firm maintains liability accounts in the form of reserves on balance sheets to cover future claims and other obligations such as taxes and premium reserves. The firm must maintain assets to cover the reserves and still leave the insurer with an adequate net worth in the form of capital and surplus. Capital and surplus represent equity on the balance sheet of a nonfinancial firm. We calculate the firm’s net worth by taking the asset minus liabilities. For students who have taken a basic accounting course, the balance sheet of a firm will be very familiar. Table 5.4 provides the two sides of the balance sheet of an insurer in insurance terminology.

    Table 5.4 Balance Sheet Structure of an Insurer
    Assets Liabilities
    Portfolio of invested assets Liabilities including reserves
    Premiums, reinsurance, and other assets Capital and surplus

    The following is Table 5.5, which shows the investment portfolio or the asset allocation of a hypothetical life insurer within its balance sheet. The asset mix reflects the industry’s asset distribution. Table 5.5 also shows the liabilities side of that insurer.

    Table 5.5 A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM
    Assets Liabilities and Capital and Surplus
    Bonds: risks of junk bonds and nonperforming, mortgage-backed securities. $1,800 Loans and advances $10
    Stocks: risks of the market fluctuations 990 Life insurance and annuities reserves [risk of catastrophes and miscalculations by actuaries (longevity risk) and lack of underwriting 950
    Mortgages: risk of nonperforming mortgages, no liquidity 260 Pension fund reserves: risk of inability to keep the promises of the guarantees 1,200
    Real Estate: risks of real estate collapse and lack of liquidity 50 Taxes payable 25
    Policy Loans: risk of inability of policyholders to pay 110 Miscellaneous liabilities 650
    Miscellaneous 120 Total Liabilities 2,835
    Capital and Surplus $495
    Total 3,330 Total $3,330

    The hypothetical life insurer in Table 5.5 represents a typical insurer in the United States with a larger percentage of investment in bonds and mortgages and less investment in stocks. The ERM joins the executive team and regards all activities, including firm undertakings in opportunity and financial risks. Therefore, the risk manager works also as a financial risk manager on the side of the insurer’s asset allocation and capital structure questions. Examples of ERM activities generated from the assets and liabilities on the balance sheet are as follows:

    • Risks from the liabilities: The liabilities comprise mostly reserves for claims on the products sold by the life insurer. The products here are life and annuities (this insurance company does not sell health insurance). Most of the reserves are for these products. The reserves are computed by actuaries, who specialize in forecasting the losses and developing the losses’ potential future impact on the insurers. Actuaries use mortality tables and life expectancy tables to estimate the future losses that the insurer must pay. Mortality tables indicate the percent of expected deaths for each age group. Life expectancy shows the length of life expected for people born in each year. "1: The Nature of Risk - Losses and Opportunities" delves into this topic in detail. Usually, life insurance firms maintain a high level of expertise in selling products to people and categorizing them in similar risk levels. Insurance underwriters develop specialized expertise to ensure that the insurer does not sell the products too cheaply for the risks that the insurer accepts. As such, the enterprise risk manager depends on the actuarial and underwriting expertise to ensure the liabilities side of the business is well managed. If the reserve calculations miss the mark, the insurer can become insolvent very quickly and lose the capital and surplus, which is its net worth.Insurers have a special accounting system called statutory accounting. Only insurers that are publicly traded are required to show the market value of their assets in a separate accounting system, called GAAP accounting (Generally Accepted Accounting Procedures). The assets and liabilities shown in Table 5.5 are based on the statutory accounting and the assets are booked at book value, rather than market value, except for the stocks. The differences between the two accounting systems are beyond the scope of this textbook. Nevertheless, the most important differences have to do with accrued liabilities and mark-to-market values of the assets. Statutory accounting does not require market values of bonds.
    • Risks from the asset mix: The enterprise risk manager or CRO should ensure that the insurer’s investment portfolio or asset mix can perform and sustain its value. Our hypothetical life insurer posted $1,800 million in bonds. The mix of these bonds is critical, especially during the recent 2008–2009 global crisis (described in "1: The Nature of Risk - Losses and Opportunities"). The amount of mortgage-backed securities (MBS) within the bonds is very critical, especially if these MBS are nonperforming and lose their value. As it turns out, the balance sheet we provided above represents a time before the credit crisis of 2008. This hypothetical insurer held 10 percent of its bonds in MBS and half of them turned into nonperforming assets by the end of 2008. This translates into $90 million of lost assets value in 2008. In addition, the stock market collapse took its toll and the 2008 market value of the stocks decreased by 30.33 percent. Investment professionals worked with a CRO to ensure a much lower decrease than the market indexes. They ensured that the stock portfolio was more conservative. If we assume that all other liabilities and assets did not suffer any additional loss, the capital and surplus of this hypothetical insurer will be almost wiped out at the end of 2008.This was reflected in the stock market with insurers such as Hartford Life, Genworth Life, and AIG life insurance, for example. This decline, without a decline in the liabilities, lowered the capital amount of these insurers.

    $495-90-330=$75 worth of capital and surplus

    As an insurer, the firm faces an outcome to the ERM function, since underwriting is a critical component for the insurer’s sustainability. Here, the balance sheet would show that the insurer invested in mortgage-backed securities (MBS), not doing its underwriting work itself. The insurers allowed the investment professionals to invest in financial instruments that did not underwrite the mortgage holders prudently. If the CRO was in charge completely, he would have known how to apply the expertise of the liabilities side into the expertise of the assets side and would have demanded clear due diligence into the nature of MBS. Warren Buffet, the owner of insurance companies, said he did not trust MBS and did not invest in such instruments in his successful and thriving businesses. Due diligence examines every action and items in the financial statement of companies to ensure the data reflect true value.

    Key Takeaways

    In this section you learned the following:

    • How the ERM function has to consider both sides of the balance sheet: assets and liabilities
    • How the ERM function ensures the survival of the firm and its net worth
    • How the ERM function can help in the due diligence for sustainability
    • The differences between the ERM function of a nonfinancial firm and a financial firm

    Discussion Questions

    1. Find the balance sheet of a company such as Best Buy and analyze all the risk and ERM from the assets side and from the liabilities side. Create a list of actions for the ERM function.
    2. Find the balance sheet of Bank of America from 2006 or 2007 and analyze all the risk and ERM from the assets side and from the liabilities side. Create a list of actions for the ERM function.
    3. Introduce the 2008–2009 credit crisis to both companies in questions 1 and 2. Explain the impact on the net worth of these companies. What actions you would suggest to incorporate in the ERM function?