Focusing on value: there is an optimal level of risk that maximizes a firm's shareholder value.

British wit Samuel Johnson once was asked whether there were any benefits of being sentenced to hang. Perhaps one, he replied: "It wonderfully focuses the mind." Financial reporting has much the same effect--by focusing attention on the next year-end report, it tends to distract attention from virtually everything else, including a key determinant of shareholder value.

Shareholder value ultimately has two components: a firm's current net worth and its expected future profits. Investors may well adjust the first component to eliminate peculiarities of accounting conventions. For example, an insurer's statutory or GAAP surplus (net worth) may need to be revised up or down to take into account such factors as perceived adequacy of loss reserves, the fact that losses may be paid out over long periods, credit worthiness of receivables and recoverables, differences between market value and book value of invested assets, and expected profit embedded in unearned premium reserve.

For many publicly traded firms, the value that shareholders place on the second component--expected future profits--matches or exceeds the firm's adjusted current net worth. This is seen by comparing a firm's market capitalization--its number of shares times its share price--with its current surplus or book value. The extent to which a firm's price-to-book ratio exceeds 1.0 indicates the relative value that its shareholders place on the firm's expected future earnings, as compared to its current net worth.

But these expected future earnings are not recognized by current accounting conventions and play no role in the firm's financial reports. From an accounting viewpoint, every firm appears to be in liquidation. Ironically, if a firm is purchased, the excess of its purchase price over its net worth--an amount that does reflect future earnings--will suddenly appear on the balance sheet of the acquirer as goodwill. But as a corrective to this lapse into rationality, firms are required to write off goodwill over time.

An accounting-induced focus on short-term changes in net worth (earnings) may conceal longer-term effects on shareholder value. Think of the man who jumped off a tall building and, as he passed an open window on the 16th floor, shouted, "So far so good!" A firm can, in fact, achieve potential future profits only if it has an appropriate amount of capital or is adequately protected against risk. If a firm is too thinly capitalized, or lacks sufficient insurance or reinsurance protection, its survival is not assured, and shareholders will discount its potential future profits to reflect the risk that they will not be achieved. In this case, adding capital or purchasing protection against risk can increase shareholder value, even after the costs of capital or protection are taken into account. This is because potential future profits, although lowered by the cost of capital or protection, have a higher probability of being achieved, so that expected future profits are higher than before.

Although adding capital or protection against risk can increase shareholder value, adding too much of either reverses that effect, since costs will exceed benefits. In principle, then, there is an optimal amount of capital or protection against risk--and a corresponding optimum level of retained risk exposure--that maximizes a firm's shareholder value. Quantitatively identifying this optimum may be difficult. Nonetheless, choosing a firm's net risk exposure shouldn't be thought of as simply a matter of taste or risk appetite.

Executives who choose among alternative levels of" protection against risk often try to reduce the problem to a single question: "How much can we afford to lose?" Viewed in the context of near-term financial reporting, a loss may be seen as a one-time hit to earnings and capital. But viewed from the standpoint of shareholder value, a loss has a leveraged effect on the achievement of future profits, particularly for firms that are growing. A loss may impair the ability of the firm to capture potential profits by reducing its probability of survival, by preventing it from making investments required to create future profits, or by reducing its ability to meet regulatory or rating requirements for maintaining or growing its business. Consequently, a dollar of short-term losses may translate into a two- or three-dollar loss in shareholder value.

For firms that care about their shareholders, the accounting focus on short-term earnings must be counterbalanced by considering the leveraged effect on shareholder value of near-term decisions concerning capital and protection from risk.

William H. Panning, a Best's Review columnist, is executive vice president of Willis Re Inc. He can be reached at [e-mail].