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The enterprise risk manager or CRO must understand the risks inherent in both sides of the balance sheet of the firm’s financial statements. A balance sheetDocument that provides a snapshot of a firm’s assets and liabilities. provides a snapshot of a firm’s assets and liabilities. We show a balance sheet for a nonfinancial firm in Table 5.3 "Hypothetical Retail and Wholesaler Fashion Apparel Balance Sheet—(Risks and ERM)". Table 5.5 "A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM" then shows a balance sheet for an insurance company. Firms must produce annual financial reports including their balance sheets and income statements. Together, we call income statements and balance sheets financial statementsIncome statements and balance sheets.. While we focused in the section above on a simplified hypothetical income statement, now we focus on the assets and liabilities as they appear at a certain point. With this ammunition at hand, we will be able to explain why financial institutions created so many problems during the 2008–2009 credit crisis. You will be able to explain AIG’s major problems and why the government ended up bailing it out, along with many other financial institutions. The question that you will be able to answer is, “What side of the balance sheet did AIG fail to manage appropriately?”
First, we will work with a hypothetical, small, nonfinancial institution, such as a furniture manufacturer or high-tech hardware and software company. Table 5.3 "Hypothetical Retail and Wholesaler Fashion Apparel Balance Sheet—(Risks and ERM)" shows the hypothetical assets, liabilities, and equity of this business.
Table 5.3 Hypothetical Retail and Wholesaler Fashion Apparel Balance Sheet—(Risks and ERM)
|Assets||Liabilities and Owners’ Equity|
|Cash (loss of use risks)||$8,000||Liabilities|
|Accounts Receivable (customers quality, foreign exchange and interest rate risks)||$28,000||Notes Payable (cash flow, foreign exchange and interest rate risks)||$50,000|
|Accounts Payable and the mortgage on the building (real estate crisis, cash flow, and interest rate risks)||$90,000|
|Buildings (asset risk)||$100,000||Total liabilities||$140,000|
|Tools, furniture, inventory, and equipment (asset risk and opportunity asset risk in store design)||$27,000||Owners’ equity|
|Total owners’ equity||$23,000|
Based on Table 5.3 "Hypothetical Retail and Wholesaler Fashion Apparel Balance Sheet—(Risks and ERM)", we can list some areas for which enterprise risk managers (ERMs) need to involve themselves for risk mitigation. Note, these loss risks do not. As part of the executive team, enterprise risk managers regard all activities, including any involvement in opportunity risks that carry the potential of gains as discussed in Chapter 1 "The Nature of Risk: Losses and Opportunities".
Examples of ERM activities generated from the assets and the liabilities on the balance sheet are as follows:
Capital structure decisions as well as the nature of debt and its covenantsThe details of the contracts and promises between the debt contract parties. (the details of the contracts and promises between the debt contract parties), accounts receivables, and notes have been under the domain of the finance or treasury department of companies with a new breed of financial risk managersManagers responsible for managing the risk of the investments and assets of a firm.. These risk managers are responsible for managing the risk of the investments and assets of the firms using tools such as Value at Risk (VaR; discussed in Chapter 2 "Risk Measurement and Metrics") and capital markets instruments such as derivatives as explained in Chapter 2 "Risk Measurement and Metrics" and will be detailed in the next section of this chapter. Currently, the trend is to move financial risk management into the firm-wide enterprise risk management.
Next, we move to the risk management function with regard to the balance sheet of financial institutions. We delve into an example of a hypothetical life insurance company. As you will see in the coming chapters, insurance companies are in two businesses: the insurance and investment businesses. The insurance side is the underwriting and reserving liabilities. UnderwritingThe process of evaluating risks, selecting which risks to accept, and identifying potential adverse selection. is the process of evaluating risks, selecting which risks to accept, and identifying potential adverse selection. Reserving liabilitiesCalculating the amount that the insurer needs to set aside to pay future claims. involves the calculation of the amount that the insurer needs to set aside to pay future claims. It’s equivalent to the debt of a nonfinancial firm. The investment side includes decisions about asset allocationThe mix of assets held by an insurer. to achieve the best rate of return on the assets entrusted to the insurer by the policyholders seeking the security. Asset allocation is the mix of assets held by an insurer; also, the allocation of assets is necessary to meet the timing of the claims obligations. This activity is called asset-liabilities matchingAllocation of an insurer’s assets to meet claims obligations as they become due.. The matching is, in essence, to ensure liquidityDegree to which assets can be used to meet a firm’s obligations (the more liquid an asset, the easier it can be used to meet obligations). so that when claims come due the firm has available cash to pay for losses.
When reviewing the asset portfolioDetails the assets that are to be matched to liabilities in the asset-liabilities matching process., also referred to as the investment portfolioDetails the assets that are to be matched to liabilities in the asset-liabilities matching process.. or asset allocationThe mix of assets held by an insurer. of an insurer, we see the characteristics of the assets needed to support the payment of claims of the specific insurer. Asset allocation is the mix of assets held by an insurer. A property or health insurer needs a quick movement of funds and cannot invest in many long-term investments. On the other hand, insurers that sell mostly life insurance or liability coverage know that the funds will remain for longer-term investment, as claims may not arrive until years into the future.
The firm maintains liability accountsReserves held on balance sheets to cover future claims and other obligations, such as taxes and premium reserves. in the form of reserves on balance sheets to cover future claims and other obligations such as taxes and premium reserves. The firm must maintain assets to cover the reserves and still leave the insurer with an adequate net worth in the form of capital and surplusThe equivalent of equity on the balance sheet of any firm—the net worth of the firm, or assets minus liabilities.. Capital and surplus represent equity on the balance sheet of a nonfinancial firm. We calculate the firm’s net worth by taking the asset minus liabilities. For students who have taken a basic accounting course, the balance sheet of a firm will be very familiar. Table 5.4 "Balance Sheet Structure of an Insurer" provides the two sides of the balance sheet of an insurer in insurance terminology.
Table 5.4 Balance Sheet Structure of an Insurer
|Portfolio of invested assets||Liabilities including reserves|
|Premiums, reinsurance, and other assets||Capital and surplus|
The following is Table 5.5 "A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM", which shows the investment portfolio or the asset allocation of a hypothetical life insurer within its balance sheet. The asset mix reflects the industry’s asset distribution. Table 5.5 "A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM" also shows the liabilities side of that insurer.
Table 5.5 A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM
|Assets||Liabilities and Capital and Surplus|
|Bonds: risks of junk bonds and nonperforming, mortgage-backed securities.||$1,800||Loans and advances||$10|
|Stocks: risks of the market fluctuations||990||Life insurance and annuities reserves [risk of catastrophes and miscalculations by actuaries (longevity risk) and lack of underwriting||950|
|Mortgages: risk of nonperforming mortgages, no liquidity||260||Pension fund reserves: risk of inability to keep the promises of the guarantees||1,200|
|Real Estate: risks of real estate collapse and lack of liquidity||50||Taxes payable||25|
|Policy Loans: risk of inability of policyholders to pay||110||Miscellaneous liabilities||650|
|Capital and Surplus||$495|
The hypothetical life insurer in Table 5.5 "A Hypothetical Balance Sheet of a Hypothetical Life Insurance Firm with Its Asset Allocation Mix (in Millions of Dollars)—Risks and ERM" represents a typical insurer in the United States with a larger percentage of investment in bonds and mortgages and less investment in stocks. The ERM joins the executive team and regards all activities, including firm undertakings in opportunity and financial risks. Therefore, the risk manager works also as a financial risk manager on the side of the insurer’s asset allocation and capital structure questions. Examples of ERM activities generated from the assets and liabilities on the balance sheet are as follows:
As an insurer, the firm faces an outcome to the ERM function, since underwriting is a critical component for the insurer’s sustainability. Here, the balance sheet would show that the insurer invested in mortgage-backed securities (MBS), not doing its underwriting work itself. The insurers allowed the investment professionals to invest in financial instruments that did not underwrite the mortgage holders prudently. If the CRO was in charge completely, he would have known how to apply the expertise of the liabilities side into the expertise of the assets side and would have demanded clear due diligence into the nature of MBS. Warren Buffet, the owner of insurance companies, said he did not trust MBS and did not invest in such instruments in his successful and thriving businesses. Due diligenceThe process of examining every action and items in the financial statement of companies to ensure the data reflect true value. examines every action and items in the financial statement of companies to ensure the data reflect true value.
In this section you learned the following: