Managing the invisible: we shouldn't let accountants tell us what is valuable and what is not. (Loss/Risk Management Insight: Property/Casualty).

In many insurance and reinsurance companies, the single most important component of the firm's value remains unmanaged, principally because it is invisible or only dimly visible to the firm's senior officers. Making this value visible, measuring it and understanding how to manage it well will distinguish successful insurers and reinsurers from unsuccessful ones.

In most firms, what is visible is what has to be reported in the firm's statutory or GAAP--Generally Accepted Accounting Principles--financials. The incredible importance of financial reporting became especially evident to me more than two decades ago when, as a junior analyst at a large property/casualty insurer, I was asked to help build a financial planning model for a new division that would directly market auto insurance. The existing model, based on GAAP, showed that the division's prospective earnings would be unacceptably low. From a GAAP standpoint, every new policy that was written lost money and added to the deficit already created by start-up expenditures, which were considerable. But slowing the rate of growth only postponed the day when the operation would become profitable. At first glance, there appeared to be no way to salvage an initiative on which the chairman had staked his reputation with the board.

The solution, it turned out, lay in thinking about the problem in an entirely different way--by discarding GAAP accounting as a framework for understanding the business and instead adopting an economic value approach. From this perspective, the first year of a newly written policy was indeed a money-loser, since the cost of marketing a new policy was about twice the expected profit from that policy once written. So why bother with selling that policy? Because there was a very high probability that the policyholder would renew the policy year after year, without any additional marketing costs. After about two years then, each policy generated substantial profits. Consequently, the faster the business grew, the faster these future profits would offset startup expenses and generate positive economic earnings.

Whatever their strengths, GAAP and statutory accounting both recognize only the revenues, expenses and expected losses associated with business that is already on the books, the policies already written. From an accounting perspective, it made little sense to spend, say, $200 to market a policy with an expected profit of $100. Neither accounting framework recognizes the enormous potential value of policy renewals, no matter how likely. As a consequence, GAAP and statutory accounting both typically underestimate the real economic value of an insurance or reinsurance enterprise.

To confirm that this is so, one can compare the GAAP We shouldn't let accountants tell us what is valuable and what is not or statutory surplus of a publicly traded insurer or reinsurer with its market capitalization--the total value of its stock. For a profitable firm, market capitalization will be considerably larger than its surplus by a factor of two or three. The difference reflects the potential value of policy renewals, which are by no means exclusive to directly marketed auto business. These same considerations apply to mutual companies, despite the absence of a market-generated valuation of such firms.

What can we conclude from these considerations? That we shouldn't let accountants tell us what is valuable and what is not. One firm in our industry has assets of $13 billion, liabilities of $9 billion (predominantly short-term), and therefore surplus of $4 billion. But its market capitalization is $14 billion! More than three-quarters of this firm's value therefore consists of future business opportunities, as contrasted with its accounting surplus, which represents profits from its past business. Apart from claims management, this future business profit is really the only portion of the firm's value that can effectively be managed, and only if relevant information is provided to senior management.

Managing the value of future business is not just a matter of maximizing renewals. In fact, the value of future business is substantially affected by corporate underwriting and investment strategy. Corporate value will be increased to the extent that growth is increased when underwriting is profitable and decreased when it is not. Similarly, investment strategy can be designed to protect the investment value of both current and future policies. Determining these strategies, although complex, has enormous impact on the value of the firm in the marketplace.

Ultimately, though, managing the value of the firm is possible only for firms that make the value of future business visible by quantifying its magnitude, by estimating its sensitivity to factors such as changes in interest rates, and by estimating the impact of different corporate strategies on the overall value of the firm. Ultimately, managers manage only what they can see and quantify.

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