Actuarial Notes

Corporate-Level Strategy

Study guide: Exam CP-311

Corporate-Level Strategy specifies the actions a firm takes to gain a competitive advantage by selecting and managing a group of different businesses competing in different product markets. Its two questions are which businesses the firm should be in and how the corporate office should manage them, and its main tool is diversification, which creates value only when the businesses are worth more together than apart.

s_{\max} = \max_j \frac{R_j}{\sum_k R_k}

V_{AB} > V_A + V_B

\text{Value to acquirer} = \text{PV(synergies)} - \text{Integration cost} - \text{Premium paid}

  • Symbols: R_j is the revenue of business j, and s_{\max} is the share of the dominant business, which sets the level of diversification. V_A and V_B are the businesses' standalone values and V_{AB} their value under one owner. The inequality is the test every diversification must pass, and the last line applies it to an acquisition.
  • Levels of diversification: In Hitt, Ireland and Hoskisson's classification, a single-business firm earns 95% or more of its revenue from one business, and a dominant-business firm between 70% and 95%. Below 70%, a related constrained firm's businesses all share product, technology and distribution links, a related linked firm's businesses have only a few links, mixed between them, and an unrelated firm's businesses share none.
  • Operational relatedness: Businesses share activities in the value chain, such as a claims system, a call centre or a sales force, and gain economies of scope. A personal lines group that sells auto and home through the same agents is the standard insurance example.
  • Corporate relatedness: Businesses share core competencies, such as underwriting skill, pricing analytics or a brand, transferred from the corporate level rather than through shared operations. The transfer is hard for rivals to imitate, which is why it can create lasting value.
  • Financial economies: Unrelated diversification creates value through efficient internal capital allocation, moving cash to the businesses with the best prospects, and through restructuring businesses bought cheaply. For insurers there is a further source: combining uncorrelated risks lowers the capital the group needs, the diversification credit.
  • Value-neutral reasons: Some diversification responds to circumstances rather than creating value. Hitt lists antitrust regulation and tax law, low performance in the core business, uncertain future cash flows, the wish to reduce the firm's overall risk, and spare tangible or intangible resources.
  • Value-reducing reasons: Managers may diversify to reduce the risk to their own jobs or to raise their pay, since both tend to rise with firm size. Governance mechanisms, such as the board, incentive pay and the market for corporate control, exist partly to check these motives.
  • Means: Firms diversify by internal development, by merger and acquisition, or by cooperative strategies such as joint ventures. The syllabus pairs this reading with Hitt's material on acquisitions and cooperative strategy.

Classifying Three Groups by Level of Diversification Three insurance groups each have revenue of $5,000 million. Group A earns $3,600 million from individual life, $900 million from group benefits and $500 million from asset management. Group B earns $2,000 million from personal auto, $1,500 million from homeowners and $1,500 million from small commercial, all sold through the same agents on one policy system. Group C earns $2,250 million from insurance, $1,500 million from hotels and $1,250 million from timberland. Classify each group.

Answer

\begin{align*}
s_{\max}^{A} &= \frac{3{,}600}{5{,}000} \\
&= 72\% \\
s_{\max}^{B} &= \frac{2{,}000}{5{,}000} \\
&= 40\% \\
s_{\max}^{C} &= \frac{2{,}250}{5{,}000} \\
&= 45\%
\end{align*}

Group A is a dominant-business firm, since 72% is between 70% and 95%. Groups B and C both fall below 70%, so their links decide. Group B's businesses share distribution, systems and underwriting skills, which makes it related constrained. Group C's insurance, hotels and timber share nothing operational, which makes it unrelated, and its only route to value is financial economies.

Valuing Synergy in an Acquisition An insurer worth $800 million buys a regional insurer whose standalone value is $300 million, paying $360 million. Merging the two claims operations is expected to save $8 million a year after tax in perpetuity, discounted at 10%, and integration will cost $15 million. Find the value created for the acquirer's shareholders.

Answer

\begin{align*}
\text{PV(synergies)} &= \frac{8}{0.10} \\
&= 80 \\
\text{Premium paid} &= 360 - 300 \\
&= 60 \\
\text{Value to acquirer} &= 80 - 15 - 60 \\
&= \$5 \text{ million}
\end{align*}

The deal creates $65 million of net synergy, of which $60 million goes to the target's shareholders as the premium. Paying $6 million more would destroy value for the acquirer. The synergy is operational relatedness, a shared claims activity, and it has to be achieved through integration, which is where many acquisitions fall short.

How it appears on the exam

  • CP-311: Questions describe a group and its businesses and ask the candidate to identify its level of diversification, explain how it creates (or fails to create) value, and recommend a corporate-level strategy for a given situation. Strong answers name the type of relatedness and say how the corporate office captures it.
  • CP-311: The same material supports the questions on growth strategies, where the candidate compares internal development, acquisition and cooperative strategy as means of diversifying, and evaluates a deal's synergies against the premium paid.

Exam traps

  • Risk reduction is value-neutral for shareholders: Shareholders can diversify their own portfolios, so a firm lowering its earnings volatility does not by itself create value for them. For an insurer, the exception is when the diversification lowers required capital or the cost of financial distress, and the answer should say so.
  • The 70% line is not enough: Below 70%, the level depends on how the businesses are linked, not on the revenue shares alone. A group with three equal businesses can be related constrained or unrelated.
  • Business-level versus corporate-level: How a single unit competes is business-level strategy. Corporate-level strategy is about the portfolio of businesses and the role of the head office.
  • Synergy must exceed the premium: A deal with real synergies can still destroy value for the acquirer if it pays them all away. Compare the present value of the synergies, less integration cost, with the premium.