Business Risk

Study guides: Exam 9, Exam CFE-201

Business Risk is the uncertainty in a firm's operating results — and so in its value — that comes from the business it is in and the way it runs it: its markets and competitors, the pricing cycle, its strategy and its operations, before any effect of how it is financed. In ERM it is the overall risk the enterprise faces, the thing ERM exists to manage as a whole.

\text{ROE} = \text{ROA} \times \frac{A}{E}

\sigma_{\text{ROE}} = \frac{A}{E}\;\sigma_{\text{ROA}}

• ROA is the operating result — underwriting plus investment, before financing costs and tax — divided by assets A; E is equity. \sigma_{\text{ROA}} measures business risk; the multiplier A/E is financial (leverage) risk, which converts it into risk to shareholders. A P&C insurer's liabilities are mostly loss reserves and unearned premium, so it is highly levered — the reason premium-to-surplus and reserves-to-surplus ratios are watched (Insurance Leverage).
• Broad and narrow senses. Broadly, business risk is the total risk to the plan from every source in the taxonomy. Narrowly, it is the strategic category: competition, shifts in demand, the underwriting cycle, regulatory and political change, reputation, technology, and simply choosing the wrong plan. For a P&C insurer the underwriting cycle is the classic case — rates soften under competition until business written in the soft market proves inadequate.
• How ERM relates to it. Some risks are the business: underwriting risk is what the insurer is paid to take, and ERM's job is to take it efficiently and exploit it. Others are incidental — most operational risk — and should simply be reduced. ERM's contribution is to see them together, so strategy is chosen with its risk known.
• ERM tools change business risk, and therefore strategy. Reinsurance, hedging and diversification lower \sigma_{\text{ROA}}; more capital lowers A/E. Either creates room to grow, to hold price, or to take a risk the firm could not previously afford. Each has a cost and may create another risk — reinsurance swaps insurance risk for credit risk. See Risk Mitigation and Business Strategy.

Growth, Leverage and Reinsurance An insurer has assets of \$1{,}000 million and equity of \$300 million; the standard deviation of its operating return on assets is 3.0\%. A growth plan would take assets to \$1{,}200 million with equity unchanged. Find \sigma_{\text{ROE}} before and after, and the \sigma_{\text{ROA}} that would keep equity risk at today's level.

Answer

\begin{align*}
\sigma_{\text{ROE, today}} &= 3.0\% \times \frac{1{,}000}{300} \\
&= 10.0\% \\[4pt]
\sigma_{\text{ROE, growth}} &= 3.0\% \times \frac{1{,}200}{300} \\
&= 12.0\% \\[4pt]
\sigma_{\text{ROA, needed}} &= \frac{10.0\%}{4} \\
&= 2.5\%
\end{align*}

Unchanged, the plan raises shareholders' risk by a fifth. Two ERM tools restore it: a reinsurance programme that cuts operating volatility from 3.0\% to 2.5\% of assets, or new equity of \$1{,}200\text{M} \times 0.30 - \$300\text{M} = \$60 million to hold A/E at 3.33. The choice is between the net cost of the reinsurance and the cost of \$60 million of capital — a strategic decision made with risk numbers.

Soft Market: Hold Price or Hold Volume? Competitors have cut commercial property rates 10\% two years running, and the insurer's own analysis puts its current rates 5\% below the technical price. Matching the market keeps volume; holding price would lose about a quarter of the book. How should ERM inform the choice?

Answer This is business (strategic) risk, not hazard risk: the danger is writing a year of business at an expected loss, and the loss is invisible until the cycle turns and those accident years develop adversely.

• Model both paths over several years, including pricing risk and parameter risk — soft-market years are exactly where loss-cost estimates are most optimistic.
• Count the costs of shrinking: fixed expenses spread over less premium, broker relationships and renewal retention that are hard to rebuild.
• Use the tools to change the trade-off: keep a market presence on a smaller net line by ceding more, redeploy capital to lines that are adequately priced, or return idle capital to shareholders.

ERM does not make the call. It makes the risk of each path explicit, so the board chooses a strategy knowing what it is buying.