In spite of being implemented broadly by both banks and insurers, using RAPMs is challenging for two reasons. The first is practical: while often used to take pricing decisions, RAPMs rarely influence corporate strategy. This is because the link between management actions, RAPMs and the share price is not easily understood by management and external stakeholders. As a consequence, RAPMs are frequently supplanted by simpler measures such as earnings, earnings growth and the P/E multiple when setting corporate strategy. Unfortunately, these simpler metrics fail to capture the important role of risk and capital for creating value in risk-based, capital-intensive businesses.
The second challenge is technical. How to ensure that the RAPM gives the “right” valuation signals for banking and insurance businesses? More often than not, RAPMs confuse risk-based capital constraints with the shareholder capital invested in the business and fail to charge an appropriate cost of capital. The net effect is that many firms destroy value by over-investing in high-risk businesses and taking too much financial market risk in their asset/liability mismatch portfolio.
This chapter discusses in detail both the practical and technical challenges in using RAPMs.
Most banks and insurers have developed complex RAPMs, building consensus amongst business managers and technical “gurus” and implementing them at great expense in their management ...