© 2007 Towers Perrin

Recognising Risk in

Financial Decision Making

Tim Gorst and Anton Kapel

© 2007 Towers Perrin 2

There are a number of steps that should be followed in

order to appropriately recognise risk in financial

decision making

Section 4.1 -

U nderstand

O rganisational

R isk Appetite

Section 3.3 -

N om inate C ash

F lows to R isk

Adjust

Value C ash

F lows at R isk

Free R ate

Section 2 -

C onduct R isk

Assessm ent

Section 3.1 -

M odel Best

Estim ate C ash

F lows

Section 3.4 -

M odel C apita l

R equirem ent

AN D / O R

Section 3.4 -

Value C apita l

R equirem ent at

Suitable R D R

Section 4.2 -

C om m unicate

R isk Adjusted

Value O utcom es

N om inate C ash

F lows N ot To

Be R isk

Adjusted

Section 3.5 -

Value C ash

F lows w ith a

Suitable R D R

© 2007 Towers Perrin 3

Understanding the organisation’s risk appetite and

attitudes is critical context to financial decision

making ...

T AB LE 2

Exam ple Risk Appetite Statem ent – Key Capital M etrics

Total

B usiness

B usiness

U nit A

B usiness

U nit B

B usiness

U nit C

C ash Earn ings $ $ $ $

End of Year B ook C apita l (“E”) $ $ $ $

End of Year R egulatory C ap ita l (“R C ”) $ $ $ $

End of Year R isk C apita l

- Econom ic C apita l (@ 99.95% *) $ $ $ $

- Severe D ow nturn (@ 95 % *) $ $ $ $

- M oderate D ow nturn (@ 80% *) $ $ $ $

R eturn on A verage C apita l

- R O E (Book C apita l) % % % %

- R O R C (R egula tory C ap ita l) % % % %

- R O EC (E conom ic C apita l) % % % %

* R isk cap ita l confidence in terva ls are genera lly a function o f the organisation ’s target debt ra ting .

© 2007 Towers Perrin 4

... where risk capital corresponds to agreed

points on the aggregate loss distribution

* Economic capital confidence interval is generally a function of the organisation’s target debt rating

Expected Loss

Amount of Loss

Probability

Economic Capital (99.95%

Percentile)

Severe Downturn (95% Percentile)

Moderate Downturn (80% Percentile)

© 2007 Towers Perrin 5

A risk assessment will assess the potential risks

associated with a decision across relevant risk

classes, and time horizon

T AB LE 1

Exam ple – A G eneric R isk Type Fram ew ork

R isk T ype As defined by the chance that, over the re levant tim e horizon, losses

result from :

M arket risk the business be ing exposed to adverse m arket m ovem ents

C red it risk a payee ’s (or borrow er ’s) fa ilu re to m eet the term of any contract

O perationa l risk inadequate or fa iled in terna l processes, people and system s or from externa l events

Insurance risk an unforeseen increase to insurance cla im s, that cannot be o ffset by a corresponding tim ely

increase in insurance prem ium s

L iqu id ity risk an inab ility to rea lise assets w ith in a requ ired tim e horizon

Funding risk an inab ility to ra ise requ ired bus iness cap ita l, on appropria te term s, w ith in a requ ired tim e horizon

S tra teg ic risk poor stra teg ic cho ices

R eputation R isk reputation / brand dam age

Business risk any o ther unexpected reduction in revenue that cannot be o ffset by a corresponding tim ely

decrease in expenses

© 2007 Towers Perrin 6

Base cash flows should reference the “mean”, not

mode, and be suitably adjusted for implementation risk

Y1 Y2 Y3 Y4 Y5

cash

flows

im plem entation costs

cash flows (adjusted for im plem entation risk )

effect of a 50% im plem entation risk on future cash flows

Expected Loss

Am ount of Loss

Probability

Econom ic Capital

Most Com m on Observation (Mode)

Expected Loss

Am ount of Loss

Probability

Econom ic Capital

Most Com m on Observation (Mode)

Recognising

implementation risk

© 2007 Towers Perrin 7

Cost of Capital should be recognised:

* primarily through a risk-based Economic Capital lens

* by forecasting an explicit annual “Capital Charge”

Some “secondary” capital lenses through which to

consider the financial decision might include:

regulatory

physical book

target

liquid

etc.

© 2007 Towers Perrin 8

Example: same cash flow but different risk adjusted value

A B

Cash Flow 1 pa 1 pa

Economic Capital 2.3 5.5

Discount Rate (RDR) LOWER HIGHER

Valuation HIGHER LOWER

Value is reduced through the impact

of the initiative risk, and risk attitudes

of decision makers, to increase both

the capital charge, and the risk

adjusted discount rate

© 2007 Towers Perrin 9

Where cash flows are adjusted for risk, then the

appropriate RDR for these cash flows would be the risk

free rate

Section 4.1 -

U nderstand

O rganisational

R isk Appetite

Section 3.3 -

N om inate C ash

F lows to R isk

Adjust

Value C ash

F lows at R isk

Free R ate

Section 2 -

C onduct R isk

Assessm ent

Section 3.1 -

M odel Best

Estim ate C ash

F lows

Section 3.4 -

M odel C apita l

R equirem ent

AN D / O R

Section 3.4 -

Value C apita l

R equirem ent at

Suitable R D R

Section 4.2 -

C om m unicate

R isk Adjusted

Value O utcom es

N om inate C ash

F lows N ot To

Be R isk

Adjusted

Section 3.5 -

Value C ash

F lows w ith a

Suitable R D R

© 2007 Towers Perrin 10

Where cash flows are adjusted for risk, then the

appropriate RDR for these cash flows would be the risk

free rate

However this requires:

decomposing revenue and cost cash flows into

components that are affected by each individual

underlying risk type

deriving or assuming a statistical distribution for

each risk type

understanding the correlations that might exist

between these various risk types

© 2007 Towers Perrin 11

Communicating results of the financial assessment of

initiative(s) should provide transparency around the

manner in which adjustments for risk have been made

T AB LE 4

Exam ple – “Base Case” NPV of a Pipeline of Alternative In itiatives

In itiative A In itiative B In itiative C

N PV of C ash F low s

- Im plem entation Investm ent R equired (if app licab le) $ $ $

- Best Estim ate (M ean) C ash F low s $ $ $

- Im plem entation R isk Ad justm ents to C ash F low s $ $ $

- In troduced R isk Adjustm ents to C ash F low s $ $ $

Less N PV of C ost o f Econom ic C apita l B y K ey Type

- M arket R isk $ $ $

- C red it R isk $ $ $

- O perationa l R isk $ $ $

- e tc …

Total N PV $ $ $

C hosen D iscount (H urd le) R ate % % %

IR R (if app licab le) % % %

© 2007 Towers Perrin 12

CONCLUSION - The 7 Deadly Sins

1. rigidly applying a fixed discount rate irrespective of risk to

decide on “yes/no” investment decisions

2. undisciplined ad hoc adjustments to get to the NPV that “feels

right”

3. over reliance on recent history to define future losses

4. over aggressive revenue forecasts

5. an “ad hoc” risk assessment process

6. ignoring implementation risk

7. inconsistent application of time horizon and terminal values

to financial assessment