Download (direct link):
Centralized Risk Management
Although current mismatch profits or losses may be illusory, the fact that they fluctuate with unexpected changes in the term structure of interest rates means that mismatch creates risk for shareholders. Financial futures positions can be used to offset this mismatch risk. A bank that lends long term and borrows short term can hedge against the risk of an increase in interest rates by taking an offsetting short position in financial futures. This form of risk management is best implemented by the treasury unit, which has a centralized point of view.
The Cost of Equity
The recommended transfer-pricing mechanism collects interest-rate risks in the treasury unit. If the treasury does nothing to hedge these risks, then the cost of equity will generally be higher for the treasury than for the bank as a whole. To the extent that risks are hedged, the cost of equity will be lower.
The Shared-Cost Problem
Most banks try to use cost accounting systems to push all overhead costs down to the business-unit level. It is better to allocate only those costs that the business units would incur were they standing alone. Unallocated headquarters costs should be kept at headquarters as a cost center. Business units should be encouraged to compare costs of providing services through outsourcing with internal costs. This provides a means of checking that internally provided services are cost-efficient.
The shared-cost problem arises from the fact that multiple business units may use the same resource. For example, a teller may provide services for non-interest-bearing checking, money market accounts, coupon clipping, and mortgage loan payments. If all these activities are within the same business unit—for example, retail banking—no problem results for valuation at the business-unit level. If the costs are shared between business units—for example, retail banking and the trust department—then an effort should be made to allocate the costs on the basis of services used.
Valuing banks is difficult. From an outsider's point of view, banks are particularly opaque businesses because of blind pool risk in loan portfolios and inadequate information concerning hedging practices. From an insider's perspective, a variety of transfer-pricing schemes are possible. We have discussed an approach that match-funds each business unit for interest rate and credit risk, thereby collecting these risks in a centralized treasury operation where they can be explicitly managed. One of the
by-products of this approach is that each match-funded unit, as well as the treasury, has no good market comparables that can be used to estimate the cost of equity. Some guesswork is involved and the answers are soft, requiring the use of ranges rather than point estimates. Nevertheless, the most relevant differences among banking business units are reflected in their expected free cash flow to shareholders, and this is adequately captured in the value process.
22— Valuing Insurance Companies
In insurance companies, operations and financing are intertwined, as they are in banks. As a result, the equity, rather than enterprise, discounted cash flow approach must be employed to value insurance companies. In addition, insurance companies have unique operating characteristics that warrant further discussion.
Insurance Company Accounting and Economics
There are three classes of insurance companies: Life insurance companies offer long-term contracts that pay off in retirement annuities, or as lump sums upon the insured's death, property and casualty companies insure against hazards like worker injuries, automobile accidents, and flood and fire damage, and reinsurance companies take risks from other insurance firms that may be too large for the original underwriters to bear. All three types are heavily regulated and have three accounting systems: statutory accounting for regulatory authorities, generally accepted accounting principles (GAAP) for reports to the public, and a set of accounts for tax authorities. Insurance companies also have two types of ownership. They are either publicly held in the traditional corporate form or held by their policyholders as mutual companies.
Exhibits 22.1 and 22.2 show the balance sheet and income statement for the TransAmerica insurance company prepared under GAAP. We will use the TransAmerica example to talk about the economics and valuation of insurance companies.1 Any such discussion starts with the fact that insurers
1 We valued TransAmerica as of June 1999, shortly before it was taken over by Aegon.
Exhibit 22.1 TransAmerica—Historical Balance Sheet
$ million 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Assets Insurance investments 16,444 18,548 20,181 18,294 20,972 22,496 28,027 29,385 32,356 33,656
Cash and short-term investments 74 40 43 22 93 64 68 472 133 159
Excess marketable securities 0 0 0 0 0 0 0 0 0 a
Accounts receivable 1,444 1,535 1,621 885 2,015 2,610 3,130 2,383 2,166 2,254