Recognising Risk in Financial Decision Making€¦ · Business risk any other unexpected reduction...
Transcript of Recognising Risk in Financial Decision Making€¦ · Business risk any other unexpected reduction...
© 2007 Towers Perrin
Recognising Risk in
Financial Decision Making
Tim Gorst and Anton Kapel
© 2007 Towers Perrin 2
There are a number of steps that should be followed in
order to appropriately recognise risk in financial
decision making
Section 4.1 -
U nderstand
O rganisational
R isk Appetite
Section 3.3 -
N om inate C ash
F lows to R isk
Adjust
Value C ash
F lows at R isk
Free R ate
Section 2 -
C onduct R isk
Assessm ent
Section 3.1 -
M odel Best
Estim ate C ash
F lows
Section 3.4 -
M odel C apita l
R equirem ent
AN D / O R
Section 3.4 -
Value C apita l
R equirem ent at
Suitable R D R
Section 4.2 -
C om m unicate
R isk Adjusted
Value O utcom es
N om inate C ash
F lows N ot To
Be R isk
Adjusted
Section 3.5 -
Value C ash
F lows w ith a
Suitable R D R
© 2007 Towers Perrin 3
Understanding the organisation’s risk appetite and
attitudes is critical context to financial decision
making ...
T AB LE 2
Exam ple Risk Appetite Statem ent – Key Capital M etrics
Total
B usiness
B usiness
U nit A
B usiness
U nit B
B usiness
U nit C
C ash Earn ings $ $ $ $
End of Year B ook C apita l (“E”) $ $ $ $
End of Year R egulatory C ap ita l (“R C ”) $ $ $ $
End of Year R isk C apita l
- Econom ic C apita l (@ 99.95% *) $ $ $ $
- Severe D ow nturn (@ 95 % *) $ $ $ $
- M oderate D ow nturn (@ 80% *) $ $ $ $
R eturn on A verage C apita l
- R O E (Book C apita l) % % % %
- R O R C (R egula tory C ap ita l) % % % %
- R O EC (E conom ic C apita l) % % % %
* R isk cap ita l confidence in terva ls are genera lly a function o f the organisation ’s target debt ra ting .
© 2007 Towers Perrin 4
... where risk capital corresponds to agreed
points on the aggregate loss distribution
* Economic capital confidence interval is generally a function of the organisation’s target debt rating
Expected Loss
Amount of Loss
Probability
Economic Capital (99.95%
Percentile)
Severe Downturn (95% Percentile)
Moderate Downturn (80% Percentile)
© 2007 Towers Perrin 5
A risk assessment will assess the potential risks
associated with a decision across relevant risk
classes, and time horizon
T AB LE 1
Exam ple – A G eneric R isk Type Fram ew ork
R isk T ype As defined by the chance that, over the re levant tim e horizon, losses
result from :
M arket risk the business be ing exposed to adverse m arket m ovem ents
C red it risk a payee ’s (or borrow er ’s) fa ilu re to m eet the term of any contract
O perationa l risk inadequate or fa iled in terna l processes, people and system s or from externa l events
Insurance risk an unforeseen increase to insurance cla im s, that cannot be o ffset by a corresponding tim ely
increase in insurance prem ium s
L iqu id ity risk an inab ility to rea lise assets w ith in a requ ired tim e horizon
Funding risk an inab ility to ra ise requ ired bus iness cap ita l, on appropria te term s, w ith in a requ ired tim e horizon
S tra teg ic risk poor stra teg ic cho ices
R eputation R isk reputation / brand dam age
Business risk any o ther unexpected reduction in revenue that cannot be o ffset by a corresponding tim ely
decrease in expenses
© 2007 Towers Perrin 6
Base cash flows should reference the “mean”, not
mode, and be suitably adjusted for implementation risk
Y1 Y2 Y3 Y4 Y5
cash
flows
im plem entation costs
cash flows (adjusted for im plem entation risk )
effect of a 50% im plem entation risk on future cash flows
Expected Loss
Am ount of Loss
Probability
Econom ic Capital
Most Com m on Observation (Mode)
Expected Loss
Am ount of Loss
Probability
Econom ic Capital
Most Com m on Observation (Mode)
Recognising
implementation risk
© 2007 Towers Perrin 7
Cost of Capital should be recognised:
* primarily through a risk-based Economic Capital lens
* by forecasting an explicit annual “Capital Charge”
Some “secondary” capital lenses through which to
consider the financial decision might include:
regulatory
physical book
target
liquid
etc.
© 2007 Towers Perrin 8
Example: same cash flow but different risk adjusted value
A B
Cash Flow 1 pa 1 pa
Economic Capital 2.3 5.5
Discount Rate (RDR) LOWER HIGHER
Valuation HIGHER LOWER
Value is reduced through the impact
of the initiative risk, and risk attitudes
of decision makers, to increase both
the capital charge, and the risk
adjusted discount rate
© 2007 Towers Perrin 9
Where cash flows are adjusted for risk, then the
appropriate RDR for these cash flows would be the risk
free rate
Section 4.1 -
U nderstand
O rganisational
R isk Appetite
Section 3.3 -
N om inate C ash
F lows to R isk
Adjust
Value C ash
F lows at R isk
Free R ate
Section 2 -
C onduct R isk
Assessm ent
Section 3.1 -
M odel Best
Estim ate C ash
F lows
Section 3.4 -
M odel C apita l
R equirem ent
AN D / O R
Section 3.4 -
Value C apita l
R equirem ent at
Suitable R D R
Section 4.2 -
C om m unicate
R isk Adjusted
Value O utcom es
N om inate C ash
F lows N ot To
Be R isk
Adjusted
Section 3.5 -
Value C ash
F lows w ith a
Suitable R D R
© 2007 Towers Perrin 10
Where cash flows are adjusted for risk, then the
appropriate RDR for these cash flows would be the risk
free rate
However this requires:
decomposing revenue and cost cash flows into
components that are affected by each individual
underlying risk type
deriving or assuming a statistical distribution for
each risk type
understanding the correlations that might exist
between these various risk types
© 2007 Towers Perrin 11
Communicating results of the financial assessment of
initiative(s) should provide transparency around the
manner in which adjustments for risk have been made
T AB LE 4
Exam ple – “Base Case” NPV of a Pipeline of Alternative In itiatives
In itiative A In itiative B In itiative C
N PV of C ash F low s
- Im plem entation Investm ent R equired (if app licab le) $ $ $
- Best Estim ate (M ean) C ash F low s $ $ $
- Im plem entation R isk Ad justm ents to C ash F low s $ $ $
- In troduced R isk Adjustm ents to C ash F low s $ $ $
Less N PV of C ost o f Econom ic C apita l B y K ey Type
- M arket R isk $ $ $
- C red it R isk $ $ $
- O perationa l R isk $ $ $
- e tc …
Total N PV $ $ $
C hosen D iscount (H urd le) R ate % % %
IR R (if app licab le) % % %
© 2007 Towers Perrin 12
CONCLUSION - The 7 Deadly Sins
1. rigidly applying a fixed discount rate irrespective of risk to
decide on “yes/no” investment decisions
2. undisciplined ad hoc adjustments to get to the NPV that “feels
right”
3. over reliance on recent history to define future losses
4. over aggressive revenue forecasts
5. an “ad hoc” risk assessment process
6. ignoring implementation risk
7. inconsistent application of time horizon and terminal values
to financial assessment