journal of applied corporate finance - … 21 | number 4 | fall 2009 applied corporate finance...

VOLUME 21 | NUMBER 4 | FALL 2009

APPLIED CORPORATE FINANCEJournal of

A M O R G A N S T A N L E Y P U B L I C A T I O N

In This Issue: Market Efficiency and Risk Management

The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned?

8 Ray Ball, University of Chicago

Contingent Capital vs. Contingent Reverse Convertibles for Banks and Insurance Companies

17 Christopher L. Culp, Compass Lexecon and

University of Chicago

International Insurance Society Roundtable on Risk Management After the Crisis 28 Panelists: Geoffrey Bell, Geoffrey Bell & Company;

Nikolaus von Bomhard, Munich Re; Prem Watsa and

Bijan Khosrowshahi, Fairfax Financial Holdings.

Moderated by Brian Duperreault, MMC

Lessons from the Financial Crisis on Risk and Capital Management: The Case of Insurance Companies

52 Neil A. Doherty, University of Pennsylvania’s Wharton

School of Business, and Joan Lamm-Tennant,

Guy Carpenter & Co. and the Wharton School

The Theory and Practice of Corporate Risk Management 60 Henri Servaes and Ane Tamayo, London Business School,

and Peter Tufano, Harvard Business School

Measuring the Contributions of Brand to Shareholder Value (and How to Maintain or Increase Them)

79 John Gerzema, Ed Lebar, and Anne Rivers,

Young & Rubicam Brands

Creating Value Through Best-In-Class Capital Allocation 89 Marc Zenner, Tomer Berkovitz, and John H.S. Clark,

J.P. Morgan

Using Corporate Inflation Protected Securities to Hedge Interest Rate Risk 97 L. Dwayne Barney and Keith D. Harvey,

Boise State University

The Gain-Loss Spread: A New and Intuitive Measure of Risk 104 Javier Estrada, IESE Business School

Assessing the Value of Growth Option Synergies from Business Combinations and Testing for Goodwill Impairment: A Real Options Perspective

115 Francesco Baldi, LUISS Guido Carli University, and

Lenos Trigeorgis, University of Cyprus

28 Journal of Applied Corporate Finance • Volume 21 Number 4 A Morgan Stanley Publication • Fall 2009

International Insurance Society Roundtable on

Risk Management After the Crisis

IIS 45th Annual Seminar | Amman, Jordan | June 7–10, 2009

29Journal of Applied Corporate Finance • Volume 21 Number 4 A Morgan Stanley Publication • Fall 2009

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around those priority concerns. But this year has been different. In developing the program for the meeting, we were fairly confident about the number one issue on everybody’s mind: the global finan-cial crisis and how to manage through it. As I think we all can appreciate at this point, the current economic downturn has changed the playing field. While some parts of the insurance industry have weathered the financial crisis fairly well, particularly the property and casualty sector, others have faced major challenges and are looking for a way forward.

For both groups of companies, how-ever, the financial crisis is clearly something to be reckoned with. Even in the stron-gest and best-run companies, the crisis has forced managements to reevaluate industry benchmarks and tried-and-tested methodologies. As with any challenge, we should use this as an opportunity to learn from past mistakes and, where called for, to improve or redefine our standards. By so doing, we can come out of this with companies that are both more efficient and have the risk management knowl-edge and methods to ensure stability and continuity.

At this meeting, we have brought together three leaders of insurance com-panies representing three continents to discuss their views on managing through these challenging times, and on find-ing and capitalizing on opportunities in crisis. Our panelists bring both a wealth of experience and unique perspectives to this discussion—and each, I should add, represents a company that has not only weathered the current storm, but improved its competitive position.

But before turning to these three executives, we have asked Geoffrey Bell, a

Brian Duperreault: Good morning, and welcome to this annual meeting of the International Insurance Society. I’m Brian Duperreault, president and CEO of MMC as well as the current Chairman of the IIS. The IIS, as you all know, is the world’s largest association of global insurance companies. And I thought you might like to know that of the more than 900 members representing the 90 companies now enrolled in our organization, more than 350 are attending this year’s meetings. And for those of you who are attending these meetings for the first time, let me just repeat that our mission is to provide education and information about the global industry as well as networking opportunities for people and companies looking for cross-border exchanges and contacts.

Given the global scope and aims of this organization, let me also say how pleased we are to be holding these meet-ings in Jordan. In the past few days, I’ve had the chance to meet with both gov-ernment officials and executives from a wide range of industries. When combined with the reports I’ve read about the region, my impression from these meetings and discussions is that Jordan is not only one of the two most productive econo-mies in the Middle East, but one of the most promising in the entire developing world. My sense is that these companies and this economy have done a great job of weathering the global crisis, and are on the verge of achieving some impressive gains in growth and profitability.

In the past, we have planned these meetings by asking our member com-panies what they think are the top issues facing the insurance industry. We then take that information and build a program

well-known adviser to governments and central banks on a wide range of financial and economic issues, to start the discus-sion by commenting on the aftermath of the crisis and the various proposals for reforming the international financial sys-tem. Following Geoff’s presentation, we will ask our other panelists to react in an open-dialogue format. And before I intro-duce Mr. Bell, let me say a bit about each of our panel of distinguished executives.

Nikolaus von Bomhard is chairman of the board of management of Munich Re in Germany. Dr. von Bomhard joined Munich Re’s graduate training program in 1985, and over the past 20 years has held a number of management positions before being named to his current role in 2004. During this 20-year period, and thanks in significant part to Nikolaus’s efforts, Munich Re has used its combination of financial strength and risk management expertise with an integrated insurance business model—a model that spans the entire value chain from insurance through reinsurance—to become one of the world’s leading risk carriers. Nikolaus has also played a big role in driving the Sol-vency II risk-based capital initiative in the European Union. And we look forward to hearing much more from him about Solvency II, and about Munich Re’s ability to remain both competitive and profitable in this environment.

Prem Watsa is chairman and CEO of Fairfax Financial Holdings in Canada, a position he has held since he created the company in 1987. Prem is also vice presi-dent of the Hamblin Watsa Investment Council, chairman of Odyssey Re, and chairman of the board of Northbridge Financial Corporation, all subsidiaries of Fairfax. Through its subsidiaries, Fair-


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fax has been engaged in P&C insurance, life insurance, reinsurance, investment management, and insurance claim man-agement. Under Prem’s leadership, Fairfax continues to thrive and maintain a leading position in the marketplace.

Our third panelist, Bijan Khosrow-shahi, is also an executive of Fairfax, having joined the company as the presi-dent and CEO of Fairfax International just a week ago. During the five years before joining Fairfax, Bijan was presi-dent and CEO of Fuji Fire & Marine in Japan, one of the largest Japanese insurance companies. And before join-ing Fuji Fire & Marine in 2004, Bijan spent 20 years with AIG, a tenure that included posts in North America, Tur-key, and South Korea. I should also add that when he was named CEO in 2004, Bijan was the first “expatriate” to lead a Japanese insurer. And judging from the success of Fuji Fire & Marine during his tenure, and throughout the crisis, Bijan has demonstrated tremendous expertise in navigating the Japanese marketplace, thereby adding to his solid track record in global markets.

Now, a bit more about our f irst speaker this morning. Geoffrey Bell is president of Geoffrey Bell & Company, an international adviser that specializes in international reserve and asset-liability management programs, and in capital market transactions and economic, finan-cial, and country risk analysis. Geoff has acted as a financial adviser to the Central Bank of Venezuela for over 25 years, the government of Barbados for more than 20 years, and the government of Jamaica for almost a decade. Educated at the London School of Economics, he joined the U.K. Treasury after graduation. He was chair-

man of Guinness Mahon Holdings, one of London’s oldest merchant banks, from 1987 to 1993, and held a leadership posi-tion at London’s leading merchant bank, J. Henry Schroder Bank. He was a visiting scholar with the Federal Reserve System, and later lectured on monetary economics at the LSE prior to becoming an economic adviser to the British Embassy in Wash-ington. He has worked closely on issues related to the Basel Banking Committee, and is the founder as well as a member of the Board of Directors of the consult-ing group of international economic and monetary affairs known as the “Group of 30.” His book, The Eurodollar Market and the International Financial System, has been published in three languages.

My hope is that, with such an impressive set of credentials and accom-plishments, Mr. Bell will guide and inspire us toward financial recovery.

The Financial Crisis and Prospects for Regulatory ChangeGeoffrey Bell: Thank you for the kind words, Brian, and for allowing me to share some ideas with you and this accomplished group of panelists. I’ve been asked to talk about the aftermath of the financial crisis, and what it means for all of us. And I’d like to give you a few of my impressions of what’s going on.

Now, everybody in the room will have heard that this is the worst financial crisis since the Great Depression. For the first time since the Second World War, we have experienced a situation in which the United States, the United Kingdom, con-tinental Europe, and Japan have all been in recession at the same time. The IMF, in the World Economic Outlook series it started late last year, revised its forecast

for global growth downward once again in April, and they’re now predicting that output will fall 1.3% this year.

But before we go any farther, let’s go back to the Great Depression and see if the comparison is a just or sensible one. During the Great Depression, which lasted from October 1929 to the end of 1933—and was followed by an up-and-down recovery—output in the U.S. fell by 30% and the rate of unemployment rate rose to 25%. The stock market lost almost 90% of its value—and it took until 1954, or some 25 years, for the Dow Jones to get back to that peak in October 1929. What’s more, from the peak to the trough of the market lasted about three and a half years. That was a very long fall, and a big, big turn for the economy.

Now that’s very different from the length of the average recession in the U.S., which has been 11 months. As a general rule, the economy goes down and then comes back very quickly. But there have been two exceptions: the oil crisis of 1973-75, when both oil prices and infla-tion increased sharply; and the “Volcker recession” of 1980-82, when interest rates went so high. But, again, the average reces-sion has lasted about 11 months, output has fallen a little under 2%, and the stock market has fallen about 20%.

What this tells us, then, is that we are not experiencing an average reces-sion. The recession has now lasted about 18 months, and will probably turn out to run about two years. Output will likely fall about 4% in the U.S., and a bit more in other parts of the world. The stock market, which is now recovering, had fallen in March by over 50%, again a much larger than average drop. And on the basis of these numbers, it’s fair to


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fourth. My best guess is that it will end in the U.S. sooner than in Western Europe, and sooner in Europe than in Japan. But whether sooner or later, the end will come. As the economist Herbert Stein once put it, “If something isn’t sustainable, it will eventually come to an end.”

But the big question here is not whether or when it’s going to stop, but what the recovery is going to look like? Will it be a “V”-shaped recovery, like so many others during the post-war period. Will it be an extended “L” where we level off and then go sideways for a number of years? Or will it be a Nike “swoosh” of the kind sported by Mr. Woods, in which we move up and down over time?

My guess, which may well be wrong, is that we’re going to have a very slow recovery. And the reasons I believe we’re going to have a slow recovery start with the fact that the U.S., along with the rest of the world, is saving more. Savings rates in the U.S. were actually negative for a

say that we are now living through the Great Recession of the post-war period. But without minimizing the hardship, it’s also important to keep in mind that the losses have been on a much smaller scale than those of the Great Depression. On the other hand, it’s been consider-ably larger and more destructive than the small subprime problem confined to the U.S. that was originally diagnosed by Dr. Bernanke—very different from what most economists were forecasting.

Now, why did this happen, and when are things likely to turn around? We appear to be seeing more signs of recov-ery, more “green shoots” if you will. And a skeptic might suggest that some of these green shoots have been reported by people who are strongly predisposed to see them, notably politicians. But most economists are optimistic as well, and I think it’s only a matter of time before this recession comes to an end—a question of whether it ends in the third quarter or the

time; in 2005-2006, they were reported as minus 2% of GDP. As of last month, savings had increased to 6%. That’s a very big increase, and the explanation is clear: if you’re nervous about the future, you tend to save more.

Another important factor in my fore-cast is that the unemployment rate is rising around the world. Last week, the U.S. unemployment rate for May was reported to have jumped to 9.4%. There’s no ques-tion in my mind that we’re going to see a 10% unemployment rate in the U.S. before this year is out, and it may be higher in 2010. So, if people are saving more, and unemployment is expected to keep rising, then consumption is going to be slow.

The third factor in my analysis is that the banks have finally gotten religion. For years they were very profit-oriented and eager to lend. If you wanted to bor-row, you could borrow. Interest rates were also very low. And the net result was that you could borrow very large amounts of

Models have been very important, and they will continue to be very important. In fact, they are essential to keeping economies going. But models are not economic reality, of course, and you have to be very careful in how you use them; you have to recognize their limitations. We went far too far with the idea that a model can tell you how much capital you need, with little or no need for judgment.

Geoffrey Bell


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money. That’s how you get negative sav-ings rates. But today, of course, banks have begun to say, “Well, if you want to borrow, unless you’re already got a lot of money, we don’t want to lend.” The banks have become much more cautious, and loans for both companies and individuals are much harder to get.

So, mainly for those three reasons, my guess is that we’re going to have a slow recovery. At the same time, governments in general have decided to revert back to their earlier “Keynesian” approach. Until very recently, the Keynes who wrote The General Theory was considered to be have become passé, largely irrelevant to modern-day economists and government policymakers. The proper objectives of policymakers and governments were thought to be balanced budgets and low inflation. But, as policymakers watched their economies spiraling downward, they very quickly decided to provide a major Keynesian stimulus to the economy while concerns about budget deficits and infla-tion have been pushed backstage, if not completely forgotten.

Now, it’s very difficult to calculate just how much money has been pushed into the world economy, but it’s a matter of trillions of dollars. At the same time, the central banks have decided that the only way to get the economy moving again is to lower interest rates. And so in most economies, interest rates are very close to zero. And it’s interesting to me that the chairman of the Federal Reserve—who is a student of the Great Depression, with a Ph.D. dissertation and several monographs on that subject to his credit—decided that when interest rates in the U.S. got down to zero, the government had to take an additional measure called “quantitative

easing,” which meant having the gov-ernment buy more of its own securities, thereby putting even more money into the economy.

And this brings me to one other reason why I believe we’re going to have a slow recovery. As more money is pushed into the economy, the U.S. is going to have a budget deficit this year on the order of 14% of GDP, a level unheard of in the past—and the U.K. will have deficits of about the same size. With such deficits, and with the increase in the U.S. central bank’s balance sheet from $800 billion last October to well over $2 trillion today, interest rates have started to move up again. For example, the 10-year rate, which was 2.25% on the last day of 2008, is now 3.90% and rising. And I see ris-ing interest rates as another force that will help slow the recovery.

So my conclusion from this is that the world economy is going to go through a period of slow growth, and the difficulties are going to be greatest in the industrial world—in the United States, Western Europe, United Kingdom, and Japan. At the same time, I believe that China, India, Brazil, and the emerging markets are going to recover more quickly, though they’re not going to return to the remarkable growth rates of the years just prior to the crisis. For example, in 2007, China’s GDP rose by 12%, and I think it will be some time before we see that number again. So a relatively slow period of growth for all countries, but especially in the most devel-oped economies.

Before we start talking about solutions to our current problems, let’s spend a few moments thinking about what has hap-pened? Why did everything suddenly go so wrong? And why did it come as such

a shock; why were so many people taken by surprise? I can assure you that most central bankers, and most economists, did not realize that we were sitting on a bubble that was about to burst and become the Great Recession.

The trouble started, as we all know, with the housing bubble. People every-where were saying to themselves, “We’re not building any more land. Housing prices can go only in one direction—up.” So housing prices began to rise; and when people then took advantage of low interest rates and borrowed a great deal, housing prices continued to rise.

But let me assure you that bubbles are not new; they have a long and venerable past. One of the most famous episodes was the South Sea Bubble of the 18th century. In that case, the great physicist Isaac Newton lost money because he felt that prices could only go up. At the height of the South Sea Bubble, one company even succeeded in raising capital from the public without disclosing its “purpose.” Its intended use of the funds was to be revealed at a later stage, somewhat like today’s SPACS. So, it was an era in which everybody was feeling optimistic—and the same was true in the last few years.

Along with—and partly as a result of—this general confidence, we had the phenomenon of high leverage. It’s very difficult to understand just how much leverage was pumped in the system during the last few years. It started with housing, but it went elsewhere. Collateralized debt obligations, or CDOs, became very popu-lar; and then came CDO2s and CDO3s, each of which involved piling still more leverage on already leveraged assets. Secu-ritization became very, very popular at financial institutions. In the past, banks


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That’s when the governments started to pump money into their systems. The central banks, particularly the U.S. cen-tral bank, brought interest rates down; and thanks to this lowering of rates, the infusion of capital into the banks, and other actions designed to inject liquidity into the systems, we’re now seeing signs of recovery.

But it has been a very turbulent and trying period indeed. And central bankers, regulatory supervisors, and governments around the world have all decided that this must never happen again. The bank-ers who were masters of the universe for such a long time are no longer going to be masters of the universe. The message I’m hearing from all the people I speak to around the world involved in supervision is that “the world economy is too impor-tant to be left to bankers.”

Now, the details of how regulatory supervision is going to change vary from country to country. There are three important reports in this area that are well worth reading. The first is what is gener-ally known as “the Volcker Report,” which was undertaken by the Group of 30 and came out in late December of last year. The Volcker Report, which sets out a blue-print for how supervision may look over the next several years, has turned out to be the Group of 30’s version of The Da Vinci Code. We normally define success as distributing 800 copies of any of our monographs. In this case, they’ve distrib-uted 32,000 copies and had two million hits on their website, and the demand keeps rising.

The second report is the De Larosiere Report, which sets out a blueprint for reform in the European Union. The third report, which came out a few weeks ago,

made loans mainly with the intent of keeping them on their books. But when they found that they could bundle and sell some of them to other banks and investors, they ended up selling off as much of the exposure as they could, in many cases all of it. By so doing, the banks could collect their fees and lay off both the interest risk and the credit risk on somebody else—and they could keep originating new loans without exhausting their balance sheets. So, while securitization started with the originating banks selling off 20% of the security, that quickly became 30%, then 40%—a process that continued until the model eventually became originate-and-distribute-as-much-as-you can, and moral hazard be damned.

So, leverage was really the critical development in the past few years, and the key contributor to the crisis. For example, when Bear Stearns failed, it was found to have a leverage ratio of 30-odd times its capital. When Lehman Brothers failed, it had a leverage ratio of 40 times its capital. And there were many banks around the world, particularly in Switzerland, where the leverage ratios were even higher.

But this all came to an abrupt halt with the decision to allow Lehman Broth-ers to go into bankruptcy. At that point, people began to fear, “What next?”—and the banks refused to lend to each other, which is exactly what happened in the 1930s. And the economies went into freefall. The U.S. economy fell 6.3% in the fourth quarter of last year, a rate that has never been seen before—or since—the 1930s. Then, in the first quarter of this year, the U.S. economy fell 5.7%—while the Japanese economy fell 16%! And the drop in the Western European economies was somewhere in between.

was put out by Lord Turner, the chair-man of the Financial Services Authority, or FSA, in the U.K. In addition to these three reports, the U.S Treasury is going to come out with a set of recommendations in the next three weeks.

Now, although there may be some notable differences in the prescriptions, or perhaps mainly just in emphasis, I can think of three changes that are certain to be part of each of these documents.

The first is that financial institutions—and this includes the insurance companies represented at this meeting as well as the banks—are going to be required to have more capital. This will be true of not only banks and insurance companies, but all institutions that are deemed by regulators to be “systemically important.”

What do we mean by systemically important? Was Bear Stearns systemically important? With about $30 billion in total assets, Bear Stearns wasn’t that big. What was important was its trillions of dollars in credit default swaps and other deriva-tives linking it to many other players in the financial system. And so Bear Stearns was viewed as systemically important.

The Volcker Report also proposes that if you are regarded as systemically impor-tant, you will not only have higher capital requirements, you will also be supervised to a much greater degree than in the past. We have just been through a period of lax supervision, thanks in part to Dr. Greenspan’s dismissive view of regula-tion. But that’s clearly about to change, given the very different world we now find ourselves in.

The second certainty is that there’s going to be much more attention paid to liquidity. In 2007, the U.K. saw the fail-ure of the bank Northern Rock. Northern


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Rock distinguished itself from its competi-tors by securing only 25% of its funding from local depositors, while the other 75% came from the international capital markets. The Bank of England had looked at this in the past and expressed its reser-vations—and the FSA would later look at it, too. But nobody intervened, and there was a failure. People began to be nervous, and there was a run on the bank—the first one, by the way, since the Overend Gurney crisis of 1866, when a London discount bank (or “banker’s bank”) collapsed when owing 11,000 pounds. In response to the run on Northern Rock, the Chancellor of the Exchequer was obliged to step forth and say, “We guarantee all deposits. Your deposit is safe.” So, one of the lessons that we’ve learned from recent events is that companies—and not just banks, but industrial companies as well—need to pay more attention to liquidity and liquidity management.

A third constant in these reports is the need for banks and other financial institu-tions to find and attract better-qualified boards of directors—directors that actu-ally know something about banking and finance—and otherwise strengthen their governance systems. Take the case of money-market funds, which became very popular in the last decade or so and accounted for some $4 trillion in the United States alone. Money market funds promised that if you put a dollar in, you got a dollar back. But, as things turned, some of the funds couldn’t make good on that promise because they’d invested in Lehman Brothers, and Lehman of course failed.

From this experience, we have been forced to recognize that the funds need better supervision. The Volcker report has

gone so far as to recommend that those mutual funds that promise to repay a dol-lar on the dollar be regulated as if they were banks. Now, I don’t believe that’s going to happen, because Mr. Geithner and the Treasury have slightly different views. But it’s clear to me that the money market funds are going to be registered and more tightly supervised.

There’s also no question that hedge funds around the world are going to be registered and, for those above a certain size, supervised by regulators. If you have a hedge fund larger than, say, $2 billion, then you’re going to be subject to regula-tory supervision. It’s already true in the U.K., but it’s going to happen in the U.S. as well.

And in an equally important break with the past—and this applies to insur-ance companies as well as to banks—the regulated institutions are no longer going to be able to find loopholes by being allowed to choose their regulator. AIG, for example, was able to get into credit derivatives, amassing a portfolio of some $440 billion, because it chose the Office of Thrift Supervision as its regulator. But, as Mr. Geithner told the U.S. Congress just the other day, “It won’t be the insti-tution that chooses the regulator. It will be the regulators that decide what body will regulate the institution, whether it be the Federal Reserve, the OCC, or the FDIC.”

Now the exact details of this regula-tory change are still being discussed. Mr. Geithner, for example, has proposed that the Federal Reserve function as a kind of “super-regulator” in the U.S., much as the FSA now functions in the U.K. But my sense is that the most likely outcome in the U.S. is not a single super-regulator,

but rather a council of regulators with the heads of the Federal Reserve, the OCC, and the FDIC each playing important roles. I should also tell you that, in the U.K. today, there is a movement to nar-row the regulatory authority of the FSA and put supervision back to the Bank of England. I don’t think that’s going to happen, but it just shows how things have changed.

In the case of the EU, the De Larosiere Report recommends that the European Central Bank become the supervisor for financial stability—a proposal that I will believe will go through.

So, to sum up, there is no question that we are about to see major changes in the regulation of U.S. financial institutions. We should expect to see tighter supervi-sion and higher capital requirements. And the same will be true in the EU, and defi-nitely in the UK. As I said before, there is a widespread conviction that we can’t risk having another crisis of the order that we’ve just been through, and to prevent it we must have greater supervision.

What does this mean for insurance companies? I’m not an insurance expert; you all know a great deal more about insurance than I do. But let me start by saying that Solvency II—the proposed set of risk-based regulatory capital guidelines for insurance companies in the EU that is set for adoption next year—appears to be a good start, at least as far as it goes. I would also point out that Solvency II seems to have benefited from being able to see and correct some problems with Basel II. In fact, many people refer to Solvency II as “the Basel II for insurance companies.”

The first so-called pillar of Basel II, as some of you may recall, was that institu-tions could meet their capital requirements


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the Colonial Life Insurance Company. Its troubles have led to problems in Trinidad, Barbados, the Bahamas, and Guyana. And this problem of “global in life, national in death” is a very serious one.

What’s required, of course, is some degree of coordination of the regulatory supervision of international institutions, whether they’re called banks or insurance companies. One proposed approach is “burden-sharing according to means”—the idea that if some country has a problem, all countries in the system will contribute, and the wealthiest countries will contrib-ute the most. But that approach is not going to work. And the resulting failure of coordination is going to reinforce the determination of supervisors to insist on more capital for financial companies of all kinds, regardless of what they are called. The great concern, as I said, is to prevent a repetition of what we’ve have just been through. And I don’t think the regulators will hesitate to demand more capital to protect depositors or policyholders.

With the financial world going through such turmoil and changes, I believe there will also be a major effort to change how the International Monetary Fund is oper-ated and governed. The G20 is becoming more important and, along with it, The Financial Stability Forum. The Financial Stability Forum, which is now called the “Financial Stability Board,” has increased its membership to include the largest developing countries. And the IMF also clearly needs countries like China, India, and Brazil to have a bigger role in its gov-ernance.

Along with and as part of these changes, we’re going to see greater attention to anticipating developing problems such as asset bubbles. Such efforts are now under-

while using their own asset pricing models to value their assets and liabilities. Well, that version of self-regulation has clearly gone out with the crisis of last year. As one of my friends likes to say, “When people keep telling you that their models view something as a ‘once-in-a-250-year event’ and the event in question happens week after week, I say it’s time to get another model.”

So, regulators are no longer going to rely on the models produced by the regu-lated institutions. But that doesn’t mean that the institutions themselves are going to throw out all their models. Under the new approach, financial planning and capital adequacy decisions will continue to be guided by models. But, at the end of the day, the supervisors will say, “Your model says that you need X dollars of capital, but we think you need more, if only to provide a cushion against sources of uncertainty that are not captured by your model.” And so levels of capital are going to go up. That’s the second pillar of the new regulatory order, and I think we’re going to get a change in Basel II that reflects this perceived limitation of finan-cial modeling and the resulting need for more capital.

But there is another important real-ity to be reckoned with here. Institutions like insurance companies and banks, while international or global in life, become very much national or domestic in death. If something goes wrong, it is the local supervisor that has to pick up the pieces. In other words, if Lehman Brothers goes into bankruptcy, it’s not the U.S. regu-lator, but the U.K. regulator that has to deal with all the consequences of Lehman’s failure in the U.K. Or take an insurance company in the Caribbean like CLICO, or

way at the Financial Stability Forum and the G20. Alan Greenspan did not believe in dealing with bubbles; his approach was to deal with the aftermath. But that view has pretty much disappeared. The current regulatory view is that, if you see a bubble developing, do something about it. You can’t leave interest rates too low for very long.

Last but not least, I suspect we’re about to see a change in the role of the dollar in the international monetary system. Today the dollar accounts for about 61% of international reserves, while the U.S. accounts for between 20% and 25% of the world economy, depending on how you measure it. My guess is that, bit by bit, the role of the dollar will diminish somewhat—and the role of the yuan will expand.

So, my conclusion is that the biggest global recession since the 1930s is going to lead to regulatory change. Within a few years, banks and other institutions will be fighting back and saying, “There’s too much regulation, we’ve got to grow again.” But I think it will be a long time before banks and financial institutions account for 40% of the profits of the S&P 500. They accounted for just 10% of the prof-its in 1980. And I suspect that, when the dust settles, the banks’ profits are going to wind up accounting for closer to 10% than 40% of corporate profits.

And for those of you with sons and daughters looking for jobs, let me just say that supervision and risk analysis are the growth areas in finance. As for those people seeking a future in financial engineering—in designing CDO2s and CDO3s—I suspect they’re going to be looking for jobs for some time to come. Thank you very much.


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The Corporate OutlookBrian Duperreault: Geoff just told us that he thought the recession would probably end sometime near the end of this year, with a slow recovery thereafter. Nikolaus, as the chairman of Munich Re, what are you seeing in the general economy?

Nikolaus von Bomhard: As a big insurer and reinsurer, we tend to be a bit more conservative than others, and we think that the effects of the crisis are going to be with us for a while. We don’t expect much of a recovery in the general econ-omy until 2010, and maybe not until the second half of 2010. Although we’re seeing more liquidity in financial mar-kets, the deleveraging process is clearly holding down activity—and, again, I think this process has a good way to go before we return to more normal levels of activity.

So, we’re not expecting a recovery for a while; and when it happens, we think it will not be a “V”-shaped recovery, but one that looks more like an “L.”

Duperreault: Prem, is Fairfax taking the same view of things as Munich Re?

Prem Watsa: Let me respond to your question not with a forecast, but rather by giving you a brief account of our thought process. We think of the crisis as a 1-in-50 year, or even a 1-in-100-year, event. Something like this happened in the 1930s, as Geoff just told us, and a second, somewhat milder version has been going in Japan since the start of the 1990s. What worries me is that, if you look back to 1929, the U.S. unemploy-ment rate was 2.3%; and by 1930, after the market had crashed and the unem-

ployment rate had jumped to 9%, most people back then were pointing to “green shoots” and predicting a recovery in ’31. But, as things turned out, the unemploy-ment rate in ’31 was 16 or 17%; and in ’32, the rate went to 25% and remained at that level all the way through 1941, when the war put people to work.

So, with U.S. unemployment now at 9.5%, my question is this: Can the U.S. government, which now accounts for about 20% of the U.S. economy, use its stimulative power and might to offset the deleveraging that’s taking place in the other 80% of the economy, among businesses as well as individuals? I think that’s a difficult question. As Geoff says, no one really knows the answer today. But that’s what we have to worry about, to think about and plan for the possibility that the bailouts and stimulus packages will fail to restore the economy.

Now, it’s true that we are seeing signs of recovery in our stock markets, which of course are forward-looking discounting mechanisms. The markets are forecasting a recovery—and, in one sense, I think that’s a good thing. To the extent that corporate executives have faith in market prices, the higher stock prices will lead to more corporate invest-ment and, eventually, an expansion of general activity and job growth. But at the same time, credit spreads continue to be wide; and with stock markets still down about 50% from their peak levels, these effects are by no means assured. So, although the market signals look prom-ising, we’re still very concerned about the strength of the recovery of the global economy. When will it happen, and will it be strong enough to get people back to work?

Brian Duperreault: Bijan, since you were working for Fuji at the time of the crisis, you had a unique perspective on Japan’s problems. What do you think about both what they’ve been through and what we’ve been through? And what’s going to happen next?

Bijan Khosrowshahi: I agree with almost everything that Geoff and Prem have just said. But I want to come at this question from a somewhat different angle.

If you take a global perspective on the recession, I think it becomes clear that some parts of the world are going to recover more quickly than others—and that’s different from what we have experienced in the past. Economies like China and India have continued to grow throughout the financial crisis, albeit at a somewhat slower rate than before. And the same has been true of a number of smaller Asian economies, and some of the faster-growing developing nations generally. For this reason, finance and insurance companies in this part of the world have continued to find strong domestic demand for their products and services. So, while I agree with Geoff and Prem that the recoveries of large econo-mies like the U.S. and Japan are likely to be “L-shaped,” I think we’re going to be surprised by the strength of the recoveries in the developing countries.

As for Japan, I would argue that the difficulties faced by Japanese compa-nies when the country’s stock and real estate bubbles burst some 20 years ago are remarkably similar to what many companies are facing today. Most impor-tant, the Japanese banks, along with many Japanese manufacturing firms as well, had balance sheets with lots of real


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its “Lost Decade.” They lost ten years of growth.

As the CEO until last week of a Japanese insurance company, I will tell you that the Japanese economy is not growing and has not grown in the past several years. There has been demand for some of our products and services, in fact some have experienced double-digit growth in recent years. So, there are opportunities for insurers in Japan, and the best companies will find ways to identify and profit from those opportunities. But such companies should not expect much help from the Japanese economy any time soon.

So, again, my outlook is a decidedly mixed one. Large economies like the U.S., Japan, and the European Union will experience slow recoveries. At the same time, some of the more dynamic developing nations—particularly those that do not rely on exports into the large markets—should recover more quickly, provided they maintain and push domes-tic consumption.

estate assets that had lost much of their values—and the companies had to find a way to restore their balance sheets. And for the most part, the Japanese companies have succeeded in doing this. But accord-ing to Richard Koo, the chief economist of Nomura Securities, the economy-wide process of rebuilding balance sheets—or what we are calling “deleveraging”—has resulted in a very long “balance-sheet recession.” During all those years when Japanese companies were focused on restoring their balance sheets, their cor-porate investment and risk-taking fell off significantly—and that’s been reflected in the low growth numbers.

And I believe that this lack of investment and risk-taking is now a real danger to Western economies, especially given the current regulatory environment. My concern is that we may now be facing a balance-sheet recession of our own, with corporate risk-aversion leading to a long-term reduction in corporate investment and job growth. That, in my view, is what happened in Japan during

Lessons from the CrisisBrian Duperreault: I’m heartened by the optimism in some of the comments we’ve just heard from our corporate representa-tives. And I have to give high marks to each of you for bringing your companies through the crisis the way you have. But I also suspect that not everything went according to plan in your companies; not everything was perfect. One of the aims of this discussion is to identify the kinds of mistakes that companies made, and the lessons we have learned while managing through this crisis.

Prem, would you start us off by telling us about any corporate missteps or major problems you encountered, and what actions you might have taken—or have since taken—to correct them?

Prem Watsa: As I was just saying, Brian, we view the crisis as a 1-in-100-year event. And although there is clearly no way of predicting when such low-probability events will happen, thanks in part to our many years of experience in the insur-

If you are running a financial institution with a significant fixed income portfolio, you cannot delegate evaluations of credit risk entirely to the rating agencies. As part of a comprehensive risk management program, you need to do your own analysis and consider the possibility that the agencies are getting it wrong.

Prem Watsa


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ance business, we have long recognized the importance of planning for what we refer to in our business as “catastrophic” outcomes. One way you plan for such events is through conservatism and finan-cial strength, by having a large capital base. There is no substitute for financial strength and capital in coping with not just uncertainty, but the completely unex-pected. For example, if you were an auto maker or an auto parts company in the U.S. in the first quarter of this year, you saw your revenues drop 50%. No amount of planning would have prepared you for that drop in revenue.

As early as 2003 or 2004, we were thinking about the possibility of these 1-in-100-year scenarios—and we gave them a major part in our strategic plan-ning exercises. But we certainly weren’t smart enough to know exactly when the crisis would occur—and I don’t think many companies or investors did. That’s why financial conservatism has always been, and will continue to be, a big part of our risk management plan. And that conservatism has clearly helped us in get-ting through the crisis.

Duperreault: Nikolaus, do you want to respond to Prem’s comments?

Nikolaus von Bomhard: Well, first of all, I want to attest to Prem’s foresight on this. When I last saw him in Toronto several years ago, he expressed concern about developing problems in the U.S. real estate market. I remember that vividly—and thanks in part to Prem’s comments, we looked into the issue too.

But, to answer your question, Brian, we haven’t had to change much during the current crisis. Of course, we have erred in

some instances. But the big mistakes were made earlier in the decade, and we were forced to learn some hard lessons during the capital market meltdown in 2003, which was a consequence of both the World Trade Center attack and the burst-ing of the dotcom bubble. The lessons we learned in 2003 have served us very well during the current crisis.

Let me just mention three of those lessons. One is the tendency to reach for returns as high as possible—by inves-tors as well as companies. “Greed” may sometimes be the right word for this, but whatever we agree to call it, this tendency affects the way risk is perceived. Reaching for higher returns is often made possible by underestimating or just ignoring risk. For example, I have had endless discussions with our investors about the rationality of pricing in the insurance and reinsurance businesses. And I often find myself talking investors out of investing in reinsurance in particular. I will say to them: “If I go into a high-severity, low-frequency risk business like reinsurance with too low a price, the current accounting rules and thus the bal-ance sheet will not show the risk. And if I’m lucky and nothing horrible happens during, say, the five-year period that I am bearing the risk, I will have avoided the 1-in-50 or 1-in-100-year calamities every-body keeps talking about. But is this really an economic gain?”

These same investors were also then pointing to the banks and saying, “They’re getting over 20% after-tax returns on equity for bearing even less risk. And you’re reaching just to get 12%?” Well, one thing we have clearly learned from the crisis is that the banks’ 20% returns were not sustainable. But, of course, it’s not easy to persuade people who see high

returns and few visible signs of risk.My second point concerns the contro-

versy about mark-to-market accounting. When I hear CEOs and managers com-plaining about the accounting rules, my first thought is that they should have thought about this when they took on their risky positions. If marking your posi-tions to market causes you problems, then you have done a poor job of risk manage-ment and planning. As CEOs, we should manage our companies while recognizing the rules of the game—and not complain about them when things go wrong. No one changed the accounting rules during the crisis; we all knew what they were.

Now, that doesn’t mean that our accounting system can’t be improved. For example, if liquidity in a market dries up completely, we need clear rules on what to use in place of mark-to-market account-ing. But to come to grips with volatility, we have to start by managing those things that we can control.

My third lesson learned has to do with some aspects of the life insurance business that I think life companies from all parts of the world have gotten wrong, and are con-tinuing to get wrong. I’m thinking mainly here of all the options and guarantees—for example, interest rate floors—that the companies have given away to their poli-cyholders. When I discuss these products with CEOs in the life insurance industry, they often seem not too concerned about what are in reality very large liabilities. The main reason for such indifference is the accounting. The value of such liabilities doesn’t show up on the balance sheet of the insurer. And if you’re guaranteeing your policyholders a 4% return on the cash value of their policies, you will be tempted to push your asset portfolios


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comment on the Japanese experience in this regard?

Bijan Khosrowshahi: Many Japanese insur-ers sold “maturity refund products”—that is, insurance combined with an investment product that guarantees a rate of return of, say, 4% or, in some cases, 5%. When the rates dropped, as Nikolaus said, the companies had a negative spread between what they promised and what they could earn without increasing their risk profiles. These products have very long expected lives, and they have put a huge burden on many Japanese insurance companies.

But let me make two other points here. The current crisis has brought out the real economic importance of risk management—and, more specifically, of performing “stress tests” that capture a wide range of possible outcomes. When the Nikkei average is at 14,000, few com-

farther out on the risk-return spectrum to create a positive spread, or at least the illusion of a positive spread. In economic terms, if you increase your asset returns only by taking more risk, you are likely to be reducing the economic value of your company, despite what is being reported on your balance sheet.

So I think our entire industry has a big job if it wants to get life insurance right. The accounting is clearly misleading, and the companies and analysts need to come up with an economic value approach that makes risk an important part of the valu-ation process. If we did this, I’m afraid many people would be shocked by the extent of the industry’s exposure to today’s low interest rates.

Brian Duperreault: That’s right. And Japa-nese insurers have been forced to learn this lesson the hard way. Bijan, can you

panies do stress tests with the Nikkei at 6,000. And when the yen-to-dollar ratio is at 115, we don’t do stress tests at 85. One important lesson from the current crisis is the need to work these improbable-seem-ing outcomes into our analysis.

Now, this last point concerns mainly the asset management side of the insur-ance business. My second main point starts by recognizing that the insurance industry—and this is especially true of the property and casualty companies—consists of two main activities: the underwriting or liability side of the busi-ness, and the investment or asset side. One major challenge raised by the cur-rent crisis—and it may be the biggest one—is the need for insurance companies to create more value on the underwrit-ing side. Companies with better products and services, and more satisfied and loyal customers, are more likely to survive hard

The current financial crisis has revealed a vulnerable spot in the risk management programs of many insurance companies—namely, the asset management function and its tendency to be run as a profit center independently of the core insurance business. To serve as part of an effective risk management program, the asset management side of the business should be designed in part to cushion risks that arise from the operating, or liability, side of the business.

Bijan Khosrowshahi


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times and stay competitive. To the extent that companies can execute more effec-tively on the insurance side, they can rely less on, and take less risk in, the asset side of the business. A major part of the value proposition for insurance companies with their customers is stability, the assurance that the companies will be able to service claims. And in my view, most insurance companies place too little emphasis on improving their products and services, and too much on increasing their asset returns. The companies face a lot of pres-sure, internally as well as externally, to take more risk on the asset side. But for most insurance companies, asset man-agement should not be viewed as an independent source of profit and value. Its main function should be to complement and support the basic insurance activities by ensuring that the company can meet its liabilities.

So, again, I think the industry as a whole needs to shift its focus to better underwriting, and more effective product differentiation and market segmentation. At the same time, we need to do a better job of stress-testing our asset portfolios to ensure that they are designed to protect the policyholders and provide the rev-enues when the companies are most in need of them.

Regulatory Change and the Insurance IndustryBrian Duperreault: Geoff, let’s come back to this topic of regulation, and how it can be expected to affect our industry. You mentioned that bankers are going to be reined in and will no longer be the masters of the universe. Do you think insurance executives should be the new masters of the universe? We seem to have

done a whole lot better than the banks in weathering this crisis.

Geoffrey Bell: I would agree, with one exception—AIG. One thing that I think is worth mentioning, especially in the context of a discussion of corporate risk management, is that economists as a group are terrible forecasters of the future. They function much better as archeologists look-ing at the past, and therefore I wouldn’t put too much weight on what economists, including the Federal Reserve, are saying about the recovery. And my point in say-ing this, by the way, is not to disparage economists. My point is rather to empha-size that there is always a lot of uncertainty, and that we economists—and I include myself when I say this—are much better at thinking about what went wrong than at predicting what will happen. And econo-mists’ lack of forecasting ability makes the case for effective risk management that much more compelling.

Brian Duperreault: Yes, but there was one thing that you were absolutely certain about, and it was that more regulation is coming for our industry. One point you made was that if you are a financial insti-tution that is considered “systemically important,” you will have higher capital requirements and more restrictions on what you can do. So, what companies will be considered systemically impor-tant, what will the regulations for such companies look like, and how can the companies adjust in order to maintain adequate levels of profitability and returns on capital?

Geoffrey Bell: Good question, and the answer to the first part is pretty clear. Your

company will be regarded as systemically important if it is viewed by regulators as either “too big to fail” or “too complex to fail.” What this means is that if the com-pany gets into serious difficulties, it will not be allowed to fail. The management and directors may not be secure—indeed, they’re likely to be removed if seen as a major part of the problems—but the institution itself will not fail. And that recognition is, I think, terribly important both for management and for people in regulation and supervision.

Now, the quid pro quo for this pro-tection is higher capital requirements and restrictions on the kinds of assets you can hold and deal in. And my friend Paul Vol-cker wants to go even farther and say, “If you’re too big and important to fail, we don’t want you to have any trading activi-ties or risky assets—in fact, no risk-taking apart from the conventional businesses of making loans to individuals and busi-nesses.” This means that if you want to run a hedge fund, it would have to be outside of any financial institution, and thus sup-ported by your own capital and without any kind of government guarantees. Even for hedge funds, there will also be limits on leverage; you will not be allowed to leverage your proprietary trading book 50 times.

Now, Mrs. Bair, the head of the FDIC, wants to change that so there is no longer any such thing as “too big to fail.” Her view is that if you’re too big to fail, then you’re too big, and so you need to sell assets. In accordance with this thinking, for example, Citi was pressured into sell-ing Smith Barney to Morgan Stanley. But, as a result of that transaction, Morgan Stanley is now a much bigger institution. So, it’s not clear how this policy gets car-


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I do think that interest rates are about to go up at the medium and longer end of the yield curve, short-term interest rates may stay pretty low for some time. So my guess is that some insurance companies are going to face problems—or at least pres-sure to chase riskier assets—particularly those companies that promised their poli-cyholders 4% and 5% interest guarantees. And these pressures could wind up pro-ducing speculative losses.

Brian Duperreault: So, more regulation is coming for the industry. But do industry executives think we need more? Nikolaus, what are your thoughts on this?

Nikolaus von Bomhard: I would start by challenging Geoff’s suggestion that insur-ance companies pose a major systemic risk. As long as we stick to our business, and run our companies prudently and within the current regulatory guidelines, I would argue that we should not be viewed as systemically important. Our business model is very different from that of invest-ment, commercial, and retail banks.

This issue of “too big to fail” is a major concern for the industry. When the G20 recently asked the question, “Who is sys-temically important?,” my understanding is that they started by identifying about 40 companies. No one knows exactly who. At first, I thought to myself, “With the size and the scope of our operations, Munich Re is likely to be among this group.” And the more I think about this, the more I worry about the consequences for our company of possibly being reg-ulated like a bank. We don’t face, for example, the run-on-the-bank scenario that needs to be managed by deposit-taking institutions.

ried out and what kinds of institutions you’re left with after the adjustments have been made.

But, to go back to my original point, if you’re considered too big or important to fail, the quid pro quo is that you will be restricted. And to answer your very last question about how to maintain profitability—and I’m going to exagger-ate to make a point here—my prediction is that systemically important institutions, particularly banks, will become more like public utilities—in other words, low-risk and low-return businesses. And, as I said earlier, instead of accounting for 40% of the profits of the S&P 500, they’re going to account for a good deal less.

Brian Duperreault: Will the insurance industry generally, or any component part of it—life, say, or property & casualty—be viewed as systemically important?

Geoffrey Bell: I think insurance and all its various sectors will be included. For example, I think all the big insurance firms represented at this meeting will be regarded by their countries as too big to fail. And so you are all going to be forced by regulators to do more to protect your policyholders.

The countries themselves and their supervisory bodies need to be very careful in how they change regulations, especially since, as we’ve already heard, the insurance industry seems to have held up quite well during the recent crisis. As both Nikolaus and Bijan have just suggested, regulation and internal oversight of the asset side of the business may be the biggest challenge. How do the companies both meet their liabilities and make money if interest rates are as low as they are today? And although

In fact, the biggest fear of insurers is the “overspill” of new regulations from banking into insurance. Take the Larosiere Report, which proposes the idea of a European systemic risk board that would be managed and chaired by the European Central Bank. This is a welcome institution, and it’s something we would have benefited from having earlier. What troubles me, however, is the composition of the board—specif-ically, the idea of bankers dominating this macro-supervisor. That part of the proposal has just prompted a handful of large European insurance companies to intervene—that is, to try to change the composition of this new board. Our strong preference is for a smaller steer-ing group—one that is not made up of the 27 central bankers and the chairs of the three major supervisors—securities, banking, and insurance—but instead a carefully selected group of some 10 to 12 people that includes the relevant representatives for banks, insurers, and securities firms. We think that group should draw on the advice of the exist-ing supervisory bodies in Europe.

So, we will have more regulation, and I think we ought to have better regulation. And without going into details, let me just say that if a Solvency II-like regulatory approach that Geoff mentioned earlier had been in place for all financial institu-tions, we may have avoided much of the current problems. We were already follow-ing the Solvency II principles at Munich Re when the crisis hit, and this served us very well.

Brian Duperreault: Prem, what do you think about the prospects for regulation of the insurance industry?


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Prem Watsa: Well, I agree that we’re going to get more regulation, and that high capital requirements are a critical part of the solution. A couple of years ago, there were fewer than ten companies in the U.S. whose debt was rated AAA. At the same time, there were thousands of structured debt issues that were rated AAA. And from a period stretching from 2005 to 2007, 47% of all the issues backed by residential mortgages were downgraded below investment grade. In fact, 13%, or more than one in eight, of the issues were downgraded from AAA to CCC in a single day!

So, in a world where a security can change from AAA to CCC literally over-night, there is clearly a tremendous amount of uncertainty about levels of risk, and about the levels of capital needed to support such risks. If you managed an investment portfolio solely on the basis of ratings, which many—if not indeed most—fixed income managers at financial institutions continue to do, your whole world would have been turned upside down in one day. The same of course applies to many regula-tors, since regulation of portfolios has relied extensively on ratings in determining what kinds of securities can be held by different institutions. And I think this regulatory reliance on ratings is one of the things that should be changed. But, again, on one day, the regulators were telling the managers that their portfolios looked terrific—and the next day half of the portfolio had been downgraded.

So, given this kind of uncertainty, getting the right amount and kinds of regulation will be a very difficult and chal-lenging process. And I think Nikolaus hit the issue right on the head with his last comment about Solvency II. If you are

running a financial institution with a sig-nificant fixed income portfolio, you cannot delegate evaluations of credit risk entirely to the rating agencies. As part of a com-prehensive risk management program, you need to do your own analysis and consider the possibility that the agencies are getting it wrong. We were doing that work our-selves before the crisis and, like Munich Re, our own independent analysis allowed us to avoid an excessive reliance on ratings, and the havoc that caused throughout the system.

So, although we look at credit ratings, we don’t delegate the rating process com-pletely to the rating agencies. We think it’s too important for that; the consequences of their getting it wrong for us are just too great.

Another clear lesson from the crisis is the challenge that bubbles pose for regulators as well as investors and com-panies. Neither the regulators nor people in industry clearly identified the bubble and took actions to expose or end it. The same was true of the more recent housing bubble. Very few people were able to see it. And I don’t think that you can expect regulators to identify bubbles in a reliable way, particularly when they’re parts of large bureaucracies as opposed to people on the line with working knowledge of the markets.

So, I’m skeptical of the idea that we can or should rely on regulators to prevent bubbles. At the same time, I’m convinced that, in your own risk management pro-grams, you cannot rely on rating agencies or regulators. You have to do your own analysis, part of which has to do with the consequences of mistakes by the rat-ing agencies or the regulators. You need to ensure that you have enough capital

to survive if, say, a large fraction of AAA securities turn out to be CCCs. You have to look after your own company.

Brian Duperreault: Bijan, do you want to add to that?

Bijan Khosrowshahi: I agree with the com-ments made so far, but just want to add that much of the regulation in our indus-try is not on the asset or ratings side of our business, but on the product side. One of my biggest concerns is that regulations on the product side could have a negative effect on our ability to get approval for new products and approaches, and thus on our ability to expand the business.

In Japan, for example, after the stock market and real estate bubbles burst in the early ’90s, the regulators became very reluctant to approve any new products. In some cases, they insisted that we pro-vide actuarial data before they approved a new product. But since there’s no way of providing actuarial data for a brand-new product, we were completely blocked. When we tried to get around their objec-tion by offering data from comparable products in other countries or markets, we were told that because of differences between the countries and their markets, our data couldn’t be admitted and our requests were denied.

So, again, I’m very concerned that increased regulation of solvency margins and capital markets could spill over into the area of product innovation. That could really hurt our industry.

The Question of Capital RequirementsBrian Duperreault: Geoff, let’s go back to this question of capital requirements.


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something goes wrong, I’d rather err on the side of banks having too much capital than too little.” What I can tell you from my discussions with regulators and super-visors around the world is that, although nobody has a particular level in mind, they all believe it needs to be higher. The approach is likely to be, “Let’s try a bit more, see what happens, and then maybe we’ll go even higher if that seems to be workable—if the banks can live with it and still make adequate returns.”

As one example, the Swiss government decided about three months ago that they would use a very old-fashioned, and highly conservative or restrictive, leverage ratio in supervising their two largest banks. The regulators were saying in effect, “Even though we have forced you to operate with more capital, we’re still very nervous because your two banks alone account for about five times the GDP in Swit-

You mentioned the need for more capital. How much more capital are we talking about here? I thought most insurance companies were overcapitalized, at least that’s what some of the analysts have been saying.

Geoffrey Bell: This is a very difficult ques-tion, as I was suggesting earlier. And when I heard some of your skepticism about regulation, by the way, I couldn’t help but think of the observation by a very famous economist that, “If the government took over the Sahara, there would be a shortage of sand in the next five years.” So, there is clearly a risk of getting too much, or the wrong kinds of, regulation.

In terms of higher capital require-ments, I don’t think regulators and supervisors have any particular number in mind. I think they are falling back on conservatism and saying to themselves, “If

zerland. And our use of this old leverage ratio is simply a way of preventing you from getting too big.” At the same time, I suspect that if we have a period of rela-tive quiet—no more market crises for a bit—then Swiss regulators, and regulators everywhere, will be more inclined to go easier on capital levels.

One final point. As Nikolaus can tell you, several years ago I worked on a study with the Group of 30 on reinsur-ance companies. It was alleged by the Financial Stability Forum that clever bankers, the masters of the universe, were dumping their toxic waste on insurance companies—a group that was generally thought to be more conservative than most other kinds of financial institutions. So, I thought to myself, “This would be a great idea for a study”—that is, to deter-mine whether insurance companies were loading up on credit default swaps as well

Even in the strongest and best-run companies, the financial crisis has forced managements to reevaluate industry benchmarks and tried-and-tested methodologies. By using this as an opportunity to learn from past mistakes and improve or redefine our standards, we can come out of this with companies that are both more efficient and have the risk management knowledge and methods to ensure stability and continuity.

Brian Duperreault


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as CDO2s and CDO3s.What we found is that the motivating

premise of the study was clearly wrong. With the exception of AIG, very few insurance companies had positions in structured products, and what positions we found were pretty small. Moreover this finding is wholly consistent with what we now know about the stronger performance of insurance companies relative to banks during the crisis. Structured products have has not been a problem in your industry. That’s not to say that all insurance com-panies have avoided problems. But very, very few have failed.

Now, as impressive and reassuring as it sounds, let me give you the bad news: this finding will not prevent the regulators from saying, “It’s great to have a fine belt, but we think you should have a good pair of braces as well.”

Brian Duperreault: Nikolaus, do you want to respond to Geoff’s comments?

Nikolaus von Bomhard: First of all, with regard to that Group of 30 study that Geoff just mentioned—as I recall, it came out in November ’06. The report said that there were $879 billion of dollars of credit derivatives on the books of insur-ers and financial guarantors. Some $485 billion of the $879 billion were found on the balance sheet of one company, AIG. Another $365 billion were on the books of the monoline insurance companies. But the most meaningful number in this study was $29 billion, which represented the entire net exposure of the global insur-ance industry, excluding the positions of AIG and the monoliners.

So, this was really a small number, a modest exposure. What’s more, people did

not react at all to the $485 billion number for AIG at the time. Apparently, it was viewed as quite manageable.

But turning to the question of regu-lation and capital requirements, I get nervous when I hear the terms “leverage ratios” and “dynamic provisioning.” Why? Because it represents a step backward into the world of Solvency I, a world in which capital requirements were not linked in any way to an economic assessment of risk. In this old world, you just take reported accounts and say something like, “Given your balance sheet, 25 is a reasonable leverage ratio. But if you are at 40 times, even if all your assets are in Treasuries with no interest rate mismatch, you have to downsize your balance sheet to be at 25 times.” What can such lever-age ratios tell you? Not much, because they rely on accounts, which do not paint a clear picture of the real risk exposure. Solvency II is an advance over Solvency I precisely because it tries to come as close as possible to the true risk exposure.

What we’re now hearing from regu-lators is that, “Since it would have been better not to have had that leverage, and risk models supported higher levels of leverage by distinguishing between low- and high-risk assets, we should throw away the risk models and stop trying to make distinctions among risk classes. We should go back to Solvency I.” But this has noth-ing to offer. In fact, it represents a complete turning away from the need for all finan-cial institutions to examine precisely the risk profiles of all their assets and liabilities, and to base their capital structure decisions on these assessments of risk.

So, there seems to be a tendency to reject all quantitative models and to revert back to an approach similar to Solvency I.

I think this is a big mistake. In assessing our risks and capital needs, all companies need to do the quantitative work first. Of course, we must make our models better—and this work will never end. We also need to recognize that some models, especially the credit models typically employed by banks, have a “pro-cyclical” nature. We who run companies must understand these effects, and we must make allowances for them. Finally, we need to use our common sense in interpreting the numbers. The numbers are based on historic experiences, so one has to stress-test them and to take care of the so-called tails, the highly unlikely events. That’s what most insurance companies have done in the past, and I’m confident they will continue to do so in the future.

But here’s where I also see a lot of positive room for regulators to go through the same thought process, to say to themselves, “Well, now that we have these numbers on our table, what do we do with them?” My vision, or at least my hope, is that regulators will be able to use their judgment to offset the pro-cyclicality problem as provided for under Pillar 2 of Solvency II. My point is that you should make sure you have the right amount of capital in place during the good days—an amount that already reflects the possibility of a crisis. In fact, I would call that “prudent capital manage-ment.” This way, you will be prepared for the crisis when it hits. And to the extent that companies behave this way, regula-tors should be able to say, “Because we know we’re in a crisis, we’re not asking you to double your capital even though you’re a little below your normal solvency ratio.” This way, nobody gets nervous, and the companies and regulators can move forward together.


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very important, and they will continue to be very important. In fact, I would argue that they are essential to keeping econo-mies going. But models are not economic reality, of course, and you have to be very careful in how you use them; you have to recognize their limitations. And you have to make sure that all your models are consistent with each other.

Having said this, I think we went far too far with the idea that a model can tell you how much capital you need, with lit-tle or no need for judgment. As has now become clear, we didn’t really understand the risks we were trying to model. Too often the data covered periods that were too short, failing to represent periods of real crises. So, although I think models are very useful, you should guard against falling in love with them.

To illustrate my point, think about what happened in 1998 when Long Term Capital Management failed. In that case, the risk management function was being performed by two Nobel prize winners who had invented several of the tech-

It’s also worth noting that, under this system, the rating agencies would lose ground to the regulators, who would be empowered by this flexibility in dealing with problems. Under the current system, regulators tend to shy away from exercis-ing their judgment and the responsibility that comes with it. But I think this is the very job of a regulator. I love my regulator. I want him to be strong and outspoken. And though his job is first and foremost to protect depositors and policyholders, I want him to be thinking hard about protecting them in ways that also keep companies productive and growing.

Brian Duperreault: Geoff, both you and Nikolaus have said that risk models are under serious challenge. The regulators were using models, and since they have clearly failed to restrain risk-taking, let’s throw them all out. Should we throw the models out?

Geoffrey Bell: I want to be careful in responding to this one. Models have been

niques used in financial risk modeling. But because of a combination of excessive con-fidence in those models and a number of unforeseen events, LTCM ended up with a leverage-to-capital ratio over 100—and it couldn’t attract the funding and regula-tory support to allow it to survive without a change of ownership.

But, as we moved past that event into the new millennium, we began to forget all about the dangers of high leverage. Companies regained their belief that they could add value by using more lever-age. And my guess is that the regulators responded by saying to themselves, “Well, some companies may be overdoing it, and they may be forced to make adjustments if they get in trouble. But we can deal with that problem if and when it arises.”

But now that we have been through a crisis, and the problems have materialized again, the regulatory attitude is completely different. We’re going to worry about over-leveraging by all companies, we’re going for the lowest common denominator. And I think that’s going to be very much

A company’s ERM program must be personally backed by the CEO. As the CEO, you have to make sure that you and your top management team have a good understanding of what the academics in your “backroom” are doing and why. That does not mean you have to understand each and every detail, but it should never be a black box.

Nikolaus von Bomhard


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the case for the next few years; and when people gradually come to realize that the crisis is over, the regulators will gradually feel a little bit more relaxed. But at the moment, people are really scared—and so are the regulators. And given the cur-rent pessimism about the expected length of the recession and the weakness of the recovery, it’s very difficult to criticize the regulators for wanting to err on the side of excessive caution.

The Future of Enterprise Risk ManagementBrian Duperreault: Bijan, what can you tell us about the state of enterprise risk management in the corporate or insur-ance worlds? Does it have a future, perhaps without the use of models, or has it proved to be an impossible under-taking?

Bijan Khosrowshahi: I think that if you look at enterprise risk management correctly—that is, as a comprehensive corporate-wide system for identifying and managing corporate risks—then you have to view it as having a number of important components. Done prop-erly, and to be effective, enterprise risk management for insurance companies must take account of operational risk and underwriting risk, as well as the asset management and financial risks that we tend to focus on. And when assessing whether corporate risk management sys-tems have failed, I think it’s important to examine each of these components to see where problems may have arisen. If you can do a reasonably good job of identify-ing the major risks associated with each of these components—and the nature and extent of any linkages among these differ-

ent risks—you will have a very effective tool for helping senior management to understand and manage risk.

But having said that, I also think that the current financial crisis has revealed a vulnerable spot in the risk management programs of many insurance compa-nies that several people have already commented on—namely, the asset man-agement function and its tendency to be run as a profit center independently of the main insurance business. As I stated earlier, to serve as part of an effective risk man-agement program, the asset management side of the business should be designed in part to cushion risks that arise from the operating, or liability, side of the business. In other words, the asset side should be designed to produce higher income when expected losses are highest and insurance operating income is lowest.

The other point I wanted to make is that in thinking about capital adequacy, we have to keep in mind the financial accounting regulations and rules. They differ from country to country. When you are trying to determine if you have adequate capital in a place like Japan, your reserves are accounted for as if you have already paid out the capital—and so they don’t count as part of your equity capital. In other countries, the reserve accounting might be much more relaxed, so it may look like you have multiples of the required solvency margin. But, at some point, you will probably want to determine whether or not your reserve accounting in all countries is consistent with Internationally Accepted Account-ing Standards. This is a very big challenge for regulators, especially when they look at insurance companies that are operating in different countries. And these accounting

differences, because of their substantial effects on capital adequacy and solvency margins, will affect how companies look at enterprise risk management.

Brian Duperreault: Nikolaus?

Nikolaus von Bomhard: I would like to add on a couple of comments on enter-prise risk management. First, let me suggest that the use of international accounting rules may provide a way to bypass or solve Bijan’s problem with cross-country differences in accounting rules. In other words, in addition to pro-viding statements that adhere to the local accounting rules, companies may want to also provide figures that conform to the standards of an international accounting authority like the IASB. I think it’s prom-ising that these international accounting rules are largely consistent with those of Solvency II. Let me also repeat my earlier point that it is the use of local accounting rules that allows life insurance companies to persist in the illusion that they don’t have major interest rate exposures from issuing policies with 4% and 5% interest guarantees. In this way, local accounting allows companies to avoid acknowledging problems they don’t want to see, much less deal with.

But to come back to the question of the proper use of models and enterprise risk management, let’s start with the obvi-ous: A model is just that—a model. And like all models, its reliability and effec-tiveness depend, first of all, on what you put in, and second, what you do with the result. There is one thing about models that we should have learned for sure from the past year or so: In making decisions with models, you have to look at not just


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with what was done at the front end of the company. So if you cannot or do not want to ensure that what is being done in the backroom has any influence on what is done at the front end of the company—and that is the CEO’s job—then forget about ERM. In that case, all you’re doing is compiling reports that get delivered to the regulator, while the company is run in accordance with a completely different set of management rules or numbers.

Let me also respond to Bijan’s point about the need to rein in asset managers. If you’re serious about having an effective asset-liability management program, you will not be the friend of your asset man-agers anymore. If you try to introduce asset-liability management in the true sense, the asset managers will fight you, at least initially, because you will be limiting their scope and reducing their expected returns. And if you have lower expected returns on the asset side of your busi-ness, then you will lower returns overall. Insurers should not think of themselves as competing with hedge funds or private equity. Besides being a prescription for disaster, trying to earn the highest possi-ble asset returns is completely inconsistent with their economic function as providers of insurance. As Bijan said earlier, the job of an insurer is to earn adequate returns for its shareholders while protecting its policyholders—and effective asset-liability management is a critical part of that.

The asset side should be designed to cover the liabilities when they become due. And this means that to come close to replicating your liabilities, the asset side of an insurance company’s balance sheet generally will end up being less risky. Once you have delivered this bad news to and then appeased the asset managers,

the average, or expected, outcome, but the entire distribution of expected outcomes. Bankers like to focus on the middle, on the fat part of the distribution. By contrast, insurers, and even more so reinsurers, love to play with “the tails” of the distribution. For this reason, the black swan that Nas-sim Taleb wrote his book about may still be unsettling when it appears, but it’s a much more manageable and less trou-bling creature than the one the banks were forced to deal with. The banks were great in lobbying their regulators to ensure that capital adequacy measures could be based on, say, just the last ten years of data, with little if any sensitivity analysis required. As a consequence, the capital they had to have grew smaller and smaller, and their returns on equity went through the ceil-ing—which ended up making us insurers look like fools. But that has changed.

Now, on the subject of enterprise risk management programs, or ERM, prob-ably the most important comment I want to make is that the program must be backed personally by the CEO. There is what I call the “backroom work,” where academics crunch numbers and come up with potentially useful insights. And as the CEO, you have to make sure that you and your top management team have a very good understanding of what they are doing there and why. That does not mean that you have to understand each and every detail, but it should never be a black box.

But for ERM to be really effective, it must be lived throughout the company. If you read the UBS report on risk man-agement that the company was forced by some of its shareholders to publish, you would learn that what was done in the backroom had almost nothing to do

you have to examine the other side of the balance sheet—the liabilities. Then your underwriters will also start to dislike you when you start asking questions they have never been asked. They will say, “Why are you asking that question? We’ve been doing that business for 20 years. Look at our results, they’re great.” Then you have to explain to them that their results don’t capture all the risks they have imposed on the firm. You have to show them that it’s not only their level of returns that matters, but the volatility of those returns, and how their risks are correlated with the rest of the firm’s activities.

So, the objective of ERM is to make it an instrument that integrates the view on the asset and liability sides of the bal-ance sheet. In this respect, I think we have done a much better job than the banks. We do not look at risk categories as single columns and say, “Here we have the credit risk, and here we have the market risk.” We try to look at the entire array of risks and how they interact with each other. After we have aggregated them into one single number, we come up with a solid estimate of the capital that we need. Once we have that number, we scrutinize it and simulate outcomes for an enormous range of possible scenarios—the stress tests. I think that’s what all financial institutions should do.

And let me finish by telling you that this exercise—the experience of getting the data and the IT in place, and devel-oping the management culture capable of using it—has taken us at least five years, and we were not starting anywhere near zero. So don’t think this is a quick fix that can be done in a year’s time; it can take up to a decade. But once you have reached that point, you feel much more comfort-


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able, you have transparency and the basis to draw on to make the right strategic and operating decisions. Of course, you will still make mistakes, but they will not endanger the company the way they could have before.

More on RegulationDuperreault: Let me ask a couple of other questions on regulation. What advice would you give regulators in emerging markets at this time of increased regula-tion? How should they adapt? And the second one is, since there’s going to be so much pressure on the regulators, how do we upgrade the quality of regulators?

Geoffrey Bell: As we saw in the case of Basel I, trends seem to start in the devel-oped economies and then move to the developing world. Today, there is no country in the world that doesn’t use Basel I for the regulation of banks. And the same thing will happen with Basel II. Once the regulators finally decided how Basel II is going to look, it will be adopted around the world.

As we discussed earlier, developing economies have been performing better than the developed ones. And the Middle East is doing well, especially Jordan. And because the industrial world is doing much worse than many parts of the emerging world, there’s less to fix in China or India, or even in Latin America. Countries like Mexico and Brazil have held up remark-ably well during the downturn. Emerging economies have in general made less use of leverage, and many of them have now got a lot of international reserves. So I am fairly optimistic that the emerging mar-kets will come out of this recession quicker than industrial countries.

But, as your second question suggests, emerging economies will need more sophisticated regulators—and so, of course, will industrial economies. But how do you get more sophisticated regulators? That is a very, very interesting question.

In the U.S., for example, I suspect the only major regulatory change will be the disappearance of the Office of Thrift Supervision. Everything else is going to stay the same. Now, the Federal Reserve has a large number of mathematicians and actuaries—as do most large insurance companies. And I think the larger banks are beginning to employ more of these people as well; they will get there bit by bit.

But, in the case of insurance, for exam-ple, the Volcker Report has proposed that there be one national regulator instead of having lots of state regulators—one national regulator with a large staff and highly sophisticated supervisors. Although that proposal going to meet with a lot of resistance, I think it has a chance of get-ting enacted for reinsurers—and then things might move forward from there. The general view among the regulators and executives I talk to is that we need to move toward the goal of having one big supervisor with the resources to hire more and better qualified people. And as I men-tioned earlier, if you asked me to identify a promising area of future growth for your sons and daughters, I would point to regu-lation and supervision.

Brian Duperreault: Do you think they will attract the best and the brightest?

Geoffrey Bell: Some of them, at any rate. But I will tell you that not nearly as many will now be going into hedge funds as before. In 2007, if you added up all the

hedge funds around the world, they had a bit over $2 trillion under management. Today there’s now less than $800 billion. So there’s been quite a fallout. If you’ve been good, you’ve been very good; if you haven’t been very good, then you’re out of business.

Brian Duperreault: Any other thoughts on this?

Nikolaus von Bomhard: On the question of emerging markets and regulation, my hope is that Solvency II will become a kind of global paradigm that is followed by other markets. We know that in coun-tries like China, India, Brazil, and many other emerging markets, people are look-ing deeply into that approach. It would be very helpful if Solvency II caught on everywhere.

In the U.S. they have what the regu-lators call a “risk-based” approach, but it doesn’t go as far as Solvency II in adjusting capital requirements for risk. I know that U.S. regulators are looking at Solvency II very seriously, but I have little hope that it will be adopted in all its aspects. But even here, my expecta-tion is that we will see some convergence along the lines of Solvency II over the next three to five years. To the extent that happens, it will help a great deal in coordinating the supervision of truly global companies throughout the world. That will make all our lives easier, and I think we should all push for it. And I would hasten to add that getting a global standard is not about who is setting the scenery or the standard. It’s getting the right thing in place as soon as possible, and the momentum behind a model like Solvency II is now very strong.


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and his group are only going to expand. The Financial Stability Forum, together with the Bank for International Settle-ments, could be a very useful forum for the insurance world as well as the banks. I would also like to see the BIS, which now houses the IAIS, do more with insurance companies and regulators.

Brian Duperreault: Geoff mentioned the idea of a single federal insurance regulator as a possibility now under consideration. Prem, what’s your position on that? Should we have a federal regulator in the U.S. for insurance?

Prem Watsa: In the case of insurance, I think the idea of a single regulator is a good one. I tend to think of the “prudent man rule” that is used for pension regu-lation in the United States as a possible model, as opposed to all these old formu-las used by other regulators.

Brian Duperreault: Would you handicap the chances that we get a federal insur-ance regulator?

Prem Watsa: Your guess is as good as mine on that one.

Nikolaus von Bomhard: If you don’t get it now, you will never get it given the experience the U.S. economy has just gone through. And I think it will not be optional. It could be a federal charter for just the national entities, while U.S. regional companies keep their regional commissioners.

Brian Duperreault: Geoff told us earlier that the insurance industry will be viewed as systemically important. So that means

As for the work of regulators in gen-eral, we face a challenge in that regulators working for the government earn far less than people with comparable training and skills in the private sector. We need to find ways to make sure that the remuneration is such that the regulators don’t keep losing their best, or at least their most special-ized, people after only two years. On the other hand, the IAIS has been in contact with many local European and U.S. super-visors to find ways to support education and training with some help from the industry. The industry has expressed its willingness to assist through a variety of institutions, including the idea of build-ing networks with universities. I also think that some effort should be made to center this training in a handful of places instead of spreading it around the globe, which will lead to a costly duplication of facilities and efforts. If you have a small number of hubs, you could bring together these supervisors; and with the help of the industry and perhaps local governments as well, such training centers could raise the level of regulatory sophistication every-where. And in case I haven’t already made this clear, this increase in the quality of and resources devoted to supervision is needed everywhere, not just in emerging markets. We all need some pepping up.

Geoffrey Bell: On this point, let me just mention that the Financial Stability Forum, which is now the Financial Stabil-ity Board, has been playing a much more important role in the training of regu-lators in banking, insurance and other industries than it had ever done in the past. That was part of the initiative of the G20 in London in April. And I think the activities and influence of Mario Draghi

that some companies in the industry must be systemically important. And if that’s the case, doesn’t that cry out for a federal regulator?

Nikolaus von Bomhard: From my experi-ence, I would say that there used to be a general consensus that an optional federal charter was the way to go. But when I go back and talk to the same CEOs today, they’re not so sure anymore because you’re going to get 51 regulators under that system. You still have the states, and then you’ll have a federal regulator that will impose additional and, in some cases, contradictory requirements, particularly if you become systemically important. If you’re unfortunate enough to get that designation, then you could really find yourself with problems.

Regulation and Corporate GovernanceBrian Duperreault: But, to change the subject, let’s talk about AIG. What, if anything, does the nationalization of the world’s largest insurance company say about the future of the private mar-ket? And has AIG negatively affected the insurance industry because consumers confuse banks and insurance companies, putting us all in the same box?

Prem Watsa: It’s a bit frightening for companies like ours to look at what hap-pened to AIG in 2008. The company got its start in 1919, and it took 89 years to accumulate $96 billion of capital. Then, in one year, 2008, the company lost $100 billion. And for all of us in the insurance business, an experience and outcome like this for AIG would have been unthink-able just a few years ago.


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Brian Duperreault: Any thought of chang-ing corporate governance as a result of what happened at AIG?

Prem Watsa: I think the main lesson there is what Nikolaus said earlier—namely, that the CEO must personally oversee the risk management function. You can’t just delegate it to a Chief Risk Officer and forget about it. You have to have a reasonably good understanding of every major risk facing your compa-ny—and you have to know how you are managing them, and what assumptions you’re using both when estimating the risks and devising solutions.

Brian Duperreault: Do you have a risk committee on your board?

Prem Watsa: We do. We have a very small group of people at the top, and everyone is conscious of risk. That’s considered to be the number-one role of all the members of our risk committee—to look at all the possibilities. We still miss many. But we look very hard at the downside.

Geoffrey Bell: I sit on a number of boards, and one thing that I’ve learned about gov-ernance, which is not always followed in the United States, is the importance of separating the positions of chairman and chief executive. I know this is a British view, but I do believe that in large, com-plex institutions, it is absolutely right to have a chairman that worries about the board and about external relations, while someone else is responsible for running the company. There is a report coming out in the U.K. in the next couple of months that will make that recommendation.

My second point—and this is one

that has already been implemented in the United States and the U.K.—is that bank boards should have more directors who actually understand banking. And the same principle would apply to insurance companies and any kind of corporation—more specialized business and financial knowledge among the directors. Let me also say that I believe that governance is very important. The idea that you can become an imperial chief executive in the U.S. is one of my few major concerns about U.S. corporate governance. And I think that our experience in the U.K. in separating the two functions makes an unassailable case for insisting on that separation.

Brian Duperreault: Okay, and what about the question of executive pay. Financial incentives and excessive risk-taking have been recognized as a problem in the bank-ing business. And I think the banks have made some useful changes to respond to the problem. But what do you think about proposals to regulate executive pay in insurance companies?

Nikolaus von Bomhard: Well, I think the most important thing is to make sure that whatever incentive system you have is truly risk-based and not based on reported accounting numbers. In addition to capturing risk in your performance fig-ures, you need to make sure that you’re paying for several years of results, and not just the previous year’s. Many insurance lines, especially P&C, are long-term in nature and require farsighted and pru-dent management of the risks. And by rewarding people for long-term results, you also ensure that they stay with the company. At the same time, you have to

be sure that you don’t make the rewards too large. Don’t overdo it.

The Question of SustainabilityBrian Duperreault: One more question before we close. We’ve been talking about financial or economic crisis, but we obvi-ously have other, and in some ways even more pressing, matters to deal with—cli-mate change, food and water crises, and problems of overpopulation. So, in addi-tion to making a profit, creating value for shareholders, paying taxes, and putting people to work, are there other ways that insurance companies can contribute to general economic and social progress?

Nikolaus von Bomhard: This question could last us for two hours at least. But let me give you my short answer. I think the insurance world has one big advan-tage in that sustainability is and always has been an essential preoccupation of our business. You can’t underwrite insur-ance unless you’re planning to be around for a very long time. And that’s precisely the mindset we need in thinking about questions like climate change, food and water supply, and urbanization.

So, in addition to helping people and companies manage risk, we should always be thinking about how our methods and ways of thinking can be applied to broader social problems. We can make our voices heard and our know-how available. And in fact, we are likely to find ourselves addressing social problems while trying to come up with new insurance products. For example, our loss-control methods and approaches, which are a fundamental part of most insurance operations, may turn out to have applications in areas we have not thought of.


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customers, whether it be commercial or individual, and then work hard to come up with products that address those issues.

To go back to Prem’s example, if you’re talking about farmers in India, then weather insurance might be developed to address that. And if you’re talking about social issues like temporary unemploy-ment, there might be ways of allowing individuals to shift that risk to insurance companies or, ultimately, private inves-tors. In many of the emerging markets, for example, you can buy personal accident policies with very, very low premiums that cover narrowly specified accidental events. Such products can provide important protection for families with very modest means.

But that’s just a starting point for this way of thinking. To the extent we can find economic ways to provide peace of mind for families and customers, we may find ourselves developing new products and addressing all kinds of problems that insurance companies had never thought of before. And I think the prospects for this kind of innovation are especially promising for emerging countries, where relatively small amounts of capital can turn out to make a huge difference. That appears to be the lesson we’re learning from microfinance.

Brian Duperreault: Let’s a great point, and let’s end it with that. Thank you all for taking part in this provocative, and I hope instructive, discussion. And I hope I see you, panelists and audience members alike, at next year’s annual meeting of the International Insurance Society.

Prem Watsa: That’s right. Take the area of micro-finance. In countries like India, monsoons continue to wipe out farm-ers’ crops and ruin the farmers. If you could provide relatively low-cost weather insurance for the lesser-developed world and transfer that risk to investors in the developed world, you could protect the farmers.

More generally, some companies may find that, by showing an increased willing-ness to sacrifice some immediate profit to help meet the needs of employees and cus-tomers and communities, they may in fact be strengthening their long-run prospects for profitability. Most companies have recognized the value of being good cor-porate citizens, and the demand for such citizenship is only likely to grow. And my prediction is that, for a growing number of companies, making investments in a variety of non-investor stakeholders, including the environment, is going to be a long-run, positive NPV project. It’s just good business.

Bijan Khosrowshahi: As someone who has worked in Turkey and South Korea as well as Japan and the U.S., I agree with all those comments. But, on a practical side, how can we address social problems and make a difference for our commu-nities while continuing to satisfy our shareholders? Like Nikolaus, I too think that insurance companies are in a unique position to do all this.

But the key to our effectiveness will be in developing innovative products. And to develop innovative products, we need to get a better understanding of risk, and of the best ways of transferring risk. We need to improve our understanding of what peace of mind means for our different

journal of applied corporate finance - … 21 | number 4 | fall 2009 applied corporate finance...

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