Matching returns and expectations: aggressive disclosure may help insurers bring investor expectations in line with competitive realities.

"I have this huge problem, confided my client. "It's my board--they're killing us. They've mandated a 15% target return on surplus, with executive bonuses that don't even start until we exceed that level. But the market has softened. If we price our products to achieve that return, we'll lose business--and key people--to our competitors. What should I do?"

This client and I both knew a 15% target return on surplus is rarely achieved in the property-casualty industry, except in years immediately following major disasters such as hurricanes Katrina, Rita and Wilma. When the industry does achieve high returns, insurance capacity or "supply" as indicated by industry surplus grows faster than does the demand for insurance, which typically grows in proportion to GNP So, prices and returns inevitably fall until another crisis intervenes.

The result is a persistent gap between the return on surplus actually achieved in our industry and the rate of return shareholders are perceived as demanding.

There is no easy solution to the client's problem. In one company I know, the chief executive officer mandated that all commercial insurance contracts had to be supported by spreadsheets demonstrating an expected 15% return on surplus. What happened, though, was that the pricing staff simply tinkered with assumptions about losses and interest rates until the results met the target return.

"Won't this come back to haunt you?" I asked one staffer, who I knew would be frank. "No," he explained, "Because no one ever compares our analysis to the results actually achieved, which we won't know for years. In reality we are rewarded for meeting revenue targets, not returns." Unlike his CEO, this staffer recognized that the gap between target returns and achievable returns was too large to be eliminated by executive mandate. Nor could the problem be dismissed by blaming competitors for lacking pricing discipline.

Perhaps a better solution lies in asking why investors demand such a high return on surplus from publicly traded property-casualty insurers. One possibility is that investors find property casualty insurers opaque rather than transparent. They have only a vague notion of the risks such firms are taking, and consequently estimate a firm's risk as higher than its actual level. If so, then a potential solution is aggressive disclosure. Firms can lower the returns that shareholders expect by demonstrating their risks are well managed and lower than what shareholders might pessimistically have estimated.

For this to happen, though, firms must themselves identify appropriate concepts and measures of their risks, assemble the data and systems to measure those risks, and demonstrate how they use that information in their strategic decision making. Another term for such a process is Enterprise Risk Management. Firms that do this, and then aggressively disclose the magnitude of their risk exposures and how they are managed, may well find that their shareholders respond by expecting a rate of return more appropriate to industry realities.

Informed shareholders may have more reasonable return expectations. But how can shareholders know what your firm doesn't know or disclose?

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