Consumer fund management lessons
By Mike Boot
Society of Actuaries
In the past year, corporations have learned much about reputational risk. With several banks and insurance companies having received funds from the Troubled Assets Relief Program (TARP) to increase their capital, every company must clearly state its financial strength and reputation. The Joint Risk Management Section of the Society of Actuaries (SOA), Casualty Actuarial Society, and Canadian Institute of Actuaries released a new Enterprise Risk Management (ERM) study that not only applies to corporations, but also has important lessons that will be valuable to financial advisors who work with individuals who've lost significant funds in the past year. This study shows the actions that are important to take -- and that a holistic approach from a financial advisor will be imperative.
The study, entitled "Corporate Reputational Risk and Enterprise Risk Management: An Analysis from the Perspective of Various Stakeholders," is available here. It was prepared by Donald Pagach, Ph. D. and Richard Warr, Ph. D. from the Jenkins Graduate School of Management of North Carolina State University. In this study, the authors state, "From our examination of reputational proxies, we find evidence that implementation of an ERM program may enhance corporate reputation, although not in the short term. In addition, we find evidence that ERM adoption tends to occur during a period in which the various reputation measures tend to be decreasing. This suggests that firms may be implementing ERM as a response to a decline in corporate finances. However, our results suggest that by following ERM adoption, this decline in reputational measures is somewhat reduced and in some cases reversed."
The researchers used hiring announcements of senior risk officers as a signal of a firm adopting an ERM program. There is strong evidence that hiring a chief risk officer (CRO) coincides with the senior leadership decision to follow an ERM program. The researchers followed 158 CRO announcements at major corporations from 1990-2005 and tracked the results by looking at specific financial, customer and employee measures. Some of the financial measures include profitability, return on assets, probability of bankruptcy, restatement of financials, probability of earnings manipulation, and cash flow volatility.
At first blush, these measures decline after the announcement of a CRO hiring. So does this prove that ERM really failed? Not at all. The researchers carefully detailed how ERM is frequently adopted in the midst of a firm's declining reputation. The big question is whether ERM adoption is able to improve the reputational situation of a firm. To answer that question, they examine the trends of the key variables. For example, in looking at debt rating, there is a steady decline in the debt rating for the five years before a CRO appointment. Then, the data shows that the decline appears to be stopped and the level is stabilized once an ERM program is in place. For example, looking at the frequency of financial statements shows significant improvement after the CRO announcement. This is consistent with greater financial controls being implemented. This research paper is the first of its kind looking at this analysis, and it indicates ERM does appear to be working in the longer-term. This longer-term result may be appropriate when examining reputational risk, as reputation is difficult and costly to repair.
So what does this mean to you as a financial producer?
Once corporations saw their financial measures erode and their reputations go downhill, they decided to implement ERM. In the same manner, many individuals tried to manage their own funds without professional help, and they are seeing huge losses from over-exposure to the downturn in the stock market. Individuals need to understand that this is the ideal time for them to consider professional management of their funds.
A recent MetLife survey found that more than a quarter of U.S. workers born after 1964 have put "meet with a financial advisor" on their personal to-do lists. Many individuals know that they suffered their own "reputational risk" by failing as an investment manager when they see their fund statements. They are looking for someone who can bring a holistic perspective to help them. The timing is now and there is no immediate short-term fix.
It is important to have a long-term view, as it will be necessary to make up losses steadily throughout many years. Short of winning the lottery, there is no immediate way to make up all of the losses of the past year. Too often, customers think of the highest balance that they ever had in their account and compare their current balance against that level. If customers had $500,000 in their account balance a year ago, but saw it fall down to $250,000 after the financial crisis, then that should define the new level to which they need to compare. If customers' accounts are diversified and moved up to $300,000, you must emphasize the 20 percent return over the lowest level, and counter the thinking that the customer lost 40 percent from its highest level.
Just as companies had to make tough decisions to start ERM program spending, they determined the gains with a management process that enables the firm to holistically manage all risks. If individuals do not have a holistic long-term perspective, they will quickly fall into the trap of moving all of their equity exposure to money market funds. Or, they may go to the other extreme of investing their remaining balance in a high-risk portfolio to try to make up the losses.
This ERM study illustrated that the financial measures of the companies that implemented ERM programs had stabilized results, but they were often not as high as prior to the time when ERM was implemented. This does prove, however, that fund management and ERM truly need a long-term horizon to see all of the results.
There is an opportunity to position you as the professional who will help the customer avoid either of those two extremes. If corporations with sophisticated management processes are moving to ERM programs after a downturn, individuals can benefit with this same style of thinking from you as their personal risk officer.
To visit the study discussed in this article, please visit this link: http://www.producersweb.com/r/SOA/d/contentFocus/?adcID=4caf6f016727eb42f6a980ca39a35992