Executive scandals in corporate America continue to disgust shareholders and to incite vocal opposition, but to what effect? Maybe one player is whispering softly and carrying a big stick over errant companies. This move might be a more effective persuasion to clean up corporate accounting and malpractice.
The insurance industry now emerges as a key enforcer in refusing to cover corporate executives, or to cancel current policies if executives do not open their company books to deeper scrutiny. Insurance providers of directors and officers (D&O) liability coverage have been less willing to pamper company clients. The risks were formerly passed on to the insurance companies who wrote the D&O policies. Incompetence or malfeasance would have to be paid for by the insurance companies and the shareholders – executives go scot-free. This no longer seems an acceptable business model for risk management.
Furthermore, the burden of proof is being passed back to the executives under examination. The previous assumption was that a company was clean unless there was overwhelming evidence to prove fraud. The “innocent until proven guilty” principle worked well in law courts for individuals, but when you are talking about potential damage to thousands of investors, this get-out clause seems inadequate. CEOs and executives have such remunerative incentives to cover up company bad news that an auditor is battling uphill. Shifting the burden of proof upon the client executives becomes an effective way of concentrating the mind upon finding all evidence. This is the well-known scientific technique of “null hypothesis” where it is easier to disprove a theory by finding exceptional data, rather than proving a hypothesis.
Countermeasures against errant executives are already in place. There has been a flurry of shareholder-initiated lawsuits, possibly empowered as US senior company officers are forced to swear to the accuracy of their financial statements. Punishment terms up to 10 years’ jail are on the scoreboards just to keep CEOs on the righteous path.
Marsh, AON, Chubb and AIG in the USA control most of the US underwriting business, including D&O coverage. Insurance companies are shoring up the ramparts by hiring more forensic accounting staff. More exacting financial data are requested from clients, followed by questioning top executives on their corporate performance and knowledge of the reports stated. A proper due diligence examining current management practices, accounting standards and board skills means that this procedure is no longer a rubber-stamp for the client.
The big stick waved by the insurer comprises demanding higher D&O premiums or refusing coverage. Former risk game rules permitted corporations to pay a few hundred thousand dollars for annual D&O coverage against litigation. The same policy will cost more than $1 million. There are additional deductibles running into millions of dollars that force companies to shoulder a large part of the cost of any litigant’s claim. Companies are given incentives to reduce the element of doubt in the insurer’s eyes by furnishing detailed proof of innocence.
Insurers are not suckers who are going to soak up the risks of “moral hazard” originating from immoral CEOs. Some insurers are rejecting coverage for clients that are judged to have questionable accounting and management practices because of the considerable downside risks. The insurers are faced with:
huge potential pay-outs for the D&O policies; the regulator imposing strict penalties; threat of shareholder lawsuits; the reputation risk from underwriting fraudulent accounts.
The investor public wants to know that corporate cleanliness is next to godliness. Only sound corporate management practices, instigated by a determined and ethical board, can provide it. Where the board feel that the operational loss events can have such high impact as to endanger the continuing business of the bank, then they may seek to insure against the severe loss. This brings in the role of “captives” within the financial markets. Banks may feel confident enough to take on, or self-insure (SIR) themselves for a part of the operational risk damage estimated. The captive can take or reinsure the rest in excess of the SIR. Captives may offer more cover than is readily available in the open market, they will go to the international market to reinsure their portfolio. The reinsurers will also want to avoid the “moral hazard” risk posed by inept or corrupt CEOs of the client bank.
Nevertheless, the insurance sector can provide a very useful foundation for enterprises trying to negotiate the modern risk conditions and a new raft of regulations. One is the use of risk financing using contingent capital. This offers some mitigation against severe operational risk events. Clients can sign up by paying a stream of premiums known as “commitment fees” that have some analogous points to options or warrants. It enables the substitution of on-balance sheet economic capital for contingent capital provided by the insurer. The purposes are limited only for operational loss events affecting the bank.
The contingent capital can only be unlocked or exercised when a major operational risk event triggers or breaks the agreed limit. Thus, the insurer can agree to provide cover for major risk impacts by providing contingent capital when the operational risk event is $50 million damage. This triggers the release of capital for covering damage. There is no cover for P&L damage or for protecting directors against the moral hazard of their own mistakes.
INSURANCE: THE BUCK USED TO STOP HERE
November 2nd, 2009RISK FIREPOWER
October 26th, 2009We use the Kalashknikov as a metaphor to demonstrate the power of corporate risk management. We need to question how more effective our risk firepower would be if we could deploy the right firepower upon the company’s leaders.
Executives and CEOs have been fortunate, up to now, that shareholders have been patient. AGMs have been peaceful, but it is only a question of time before avaricious CEOs suffer the full force of fate. Although HLS was an unpleasant case to observe, it does demonstrate that investors have not even come close to the full extent of venting their spleen.
This has clouded the corporate bottom line in many cases. So, we have to look through the fog. One thing we need to change is auditors’ attitude and professional execution of the job. They must pay more attention and exercise own professional judgement to prevent or detect fraud. All professions are waking up to the dangers of fraud. Sleeping through the investment crises, or passing the buck is not a risk option anymore.
Professional exams now check whether students have grasped the value of corporate ethics. The Association of Investment and Management Research (AIMR) formulate the Chartered Financial Analyst (CFA) exams. Whereas professional exams may have included little on ethics before, the CFA curriculum has changed with time. The Level I 2003 exam has a 15 % topic
weight for Ethics and Professional Standards, and a 30 % weight for Asset Valuation. There is real hope that these can safeguard against some of the flagrant corporate excesses committed recently.
Graduates and auditors are also more familiar with IT systems and technology. They understand the principles of IT operations, including off-site storage and backup facilities. This means that they are able to consult with others to rebuild an incriminating audit trail of evidence against directors who have committed serious corporate errors.16 One infamous example was the Enron–Andersen shredding of vital documents. Another case was New York attorney Eliot Spitzer successful action against Merrill Lynch and CSFB for their part in “ramping” worthless dot-com shares during the TMT craze. All these are possible with technology to reconstruct shredded statements or deleted emails.
The successful litigation against Merrill Lynch and CSFB shows that punitive action can be effectively taken despite attempts to obstruct it, or to destroy vital evidence. A business tradition was to take risk as an inevitable part of life, callously saying: “Leave losses to be recovered from insurance or law-suits.”
This does not add to corporate profits, but detracts from it, once the final bills have been calculated. The litigation against the culprits of the Barings and other banking and fund fiascos still continues, and there seems little net compensation for the losers, after accountants and lawyers have deducted their fees. Insurers are not mugs, and they are reluctant to pay for someone else’s errors, especially when they stem from a risk-seeking or risk-ignorant attitude.
RISK COUNTERMEASURES
October 19th, 2009Once detecting operational risk conditions is in existence, we can think about deploying risk countermeasures. Could any CEO shark engineer himself some huge pay-off based on undisclosed benchmarks?
Frankly, yes and no. Yes, they could get away with it easily in the old days. General Motors was a classic example where the head of a modern corporation could do what he liked in the era of Roger Smith. Pressure from the board, CalPers and H. Ross Perrot eventually forced him out. More recently, NYSE chairman Richard Grasso was pressured into resigning after the resultant furore that erupted when his $140m pay package was made public. Was this a case of Kalashnikov risk management used successfully? Some would say with justification that the aggrieved Western shareholders are amateurish when it comes to reining in the wayward behaviour of boards and CEOs. The professionals in the Japanese mafia do it so much better.Western shareholders could well adopt this tactic as a last resort. The UK GSK and the US GM meetings do not even compare in skill. This is one of the positive role models of the Yakuza systematically ignored in the Western world. They could teach shareholders how to level the corporate playing field by disrupting the AGM. If they get continually fobbed off, then they could always shoot the directors one supposes.
Badgering and damaging leaders’ reputation certainly can have effect. Corporate governance is coming along slowly. It would arrive faster if we could borrow some of the Yakuza’s tactics in Western companies. In the meantime, we have the regulatory cogs slowly grinding around the Combined Code, Higgs Report and Sarbanes–Oxley to protect us.
The covering up of negative financial reports and losses are examples of corporate misgovernance to head off risk of reputation damage. The eventual cost on ongoing business may be greater where the fundamental causes of the original loss have not been remedied, but merely swept under the carpet until recurring later.
This behavioural trend increases systemic risk where greater eventual damage is vested upon the wider industry. We have already seen this in Lloyds insurance, where a nepotistic code of doing business with “our sort of chaps” represents a sclerosis risk that nearly blew the UK insurance industry. The more we ignore it, the more it can blow up in our faces.
These hidden losses and weaknesses make it more difficult to value a company and its assets. The persistent ramping of a company’s value, and the love of M&A to increase company size instantly, creates additional problems for investors in Western firms. It is a problem rooted in the modern business culture, much influenced by the USA.
The weaknesses inherent in embedded value methods are repeated and added to in US GAAP reporting. These need to be anticipated, adjusted for and fully understood before reliance should be placed on the results.
How to discourage the executives from acting in an irresponsible fashion?
MORAL HAZARD
October 5th, 2009Investor risk is perceived as fear or underperformance, notably in losing the value of the original investment. Substantial benchmarking occurs, notably in the comparison of returns against inflation, stock-market and other industrial yardsticks. Similar executive peer-group pressure and benchmarking lead them to see who gained the highest award from the remuneration committee. Not all CEOs are intent on removing value from the company, a fine minority contribute by increasing investor wealth whether in share price or earnings per share.
The hazard remains that many CEOs are executive recruitment failures. They create negative shareholder return and blacken the name of the company. Reputational risk emerges as one of the more obscure risks, while being costly too. An incompetent executive seems to be excusable in the markets, certainly if we believe the newspaper accounts; being crooked is not. Either way, CEO tenure is usually short term, so CEOs may adopt the attitude: “Better clean up the company assets before they boot me out.”
We have seen that the Board of Directors is not always an adequate counter to the ego of the CEO and the wish for more M&A and self-aggrandisement. Non-executive directors, who are enlisted in a cabal to add to the existing yes-men on the Board, can never serve to deter the company from embarking on an unacceptably risky course. We need an essential set of conditions for successful corporate guidance.1
An appropriate range of multidisciplinary skills Power to ensure effective implementation of decisions Ability to undertake effective assessments of the soundness of decisions associated with projects
Suitably qualified and dedicated support staff for the collection and analysis of data
Otherwise, we are condemned with the dire corporate leadership that has steered so many companies on the rocks.
An incompetent or crooked CEO underperforms colleagues and rivals. The bottom line is either the profit level or the share price. They fail on both scores. Failure should destroy their reputation in the industry. While the CEO can inflict great damage upon the company, reputational risk decrees that the executive can be punished with the embarrassment of being summarily ejected. By then it may be too late. There are two subrisks operating here – stemming from:
an inept executive; a crooked executive.
What to do? Risk management becomes an empirical business study in corporate control. We have seen how risk comprises:
hazard; catalyst; result.
The shark has a large dorsal fin that alerts us to its impending attack. We have already detailed an AEW warning system to alert us to the adverse CEO choice.
There are various risk management techniques to shed light upon a dark corporate operational area. These can include more effective interviewing to bring unsuitable executive candidates under the spotlight. Another is to undertake a management review of the control structure for recruiting key staff.3 Redesign the audit processes to block potential fraudulent financial statements passing the accounting process.4
Compare this risk management arsenal against the risk of a fraudulent CEO. Fraud needs conditions:
1. motivation; 2. opportunity; 3. rationalisation
We deploy risk countermeasures:
1. Anti-fraud motivation measures – better training of staff and recruitment, screening and interviewing of new applicants, monitor HR performance at work plus instigate an effective ethics programmes.
2. Anti-fraud opportunity measures – better staff monitoring, accounts screening, external audits, limit IT systems access and raise security physical access limits.
3. Anti-fraud rationalisation measures – raise chances of detection, raise punishment levels to act as deterrent, lower expectations of profit.
Risk management is really about a logical sequence of tasks to protect the business investment. The enterprise risk management strategy or life-cycle could be outlined as the series of tasks.
I. Risk detection. II. Risk countermeasures.
III. Risk monitoring.
The role of option markets
September 29th, 2009As we did with futures markets, we conclude the series of posts by looking at the important role options markets play in the financial system. We noted that derivative markets provide price discovery and risk management, make the markets for the underlying assets more efficient, and permit trading at low transaction costs. These features are also associated with options markets. Yet, options offer further advantages that some other derivatives do not offer.
For example, forward and futures contracts have bidirectional payoffs. They have the potential for a substantial gain in one direction and a substantial loss in the other direction. The advantage of taking such a position lies in the fact that one need pay no cash up front. In contrast, options offer the feature that, if one is willing to pay cash up front, one can limit the loss in a given direction. In other words, options have unidirectional payoffs. This feature can be attractive to the holder of an option. To the writer, options offer the opportunity to be paid cash up front for a willingness to assume the risk of the unidirectional payoff. An option writer can assume the risk of potentially a large loss unmatched by the potential for a large gain. In fact, the potential gain is small. But for this risk, the option writer receives money up front.
Options also offer excellent devices for managing the risk of various exposures. An obvious one is the protective put, which we saw earlier and which can protect a position against loss by paying off when the value of the underlying is down.
Recall that futures contracts offer price discovery, the revelation of the prices at which investors will contract today for transactions to take place later. Options, on the other hand, provide volatility discovery. Through the implied volatility, investors can determine the market’s assessment of how volatile it believes the underlying asset is. This valuable information can be difficult to obtain from any other source.
Futures offer advantages over forwards, in that futures are standardized, tend to be actively traded in a secondary market, and are protected by the exchange’s clearinghouse against credit risk. Although some options, such as interest rate options, are available only in over-the-counterforms, many options exist in both over-the-counter and exchange-listed forms. Hence, one can often customize an option if necessary or trade it on an exchange.