Value and Capital Management: A Handbook for the Finance and Risk Functions of Financial Institutions

Part TwoBetter Information – Measuring Value

In contrast to other industries, both banking and insurance are risk-based, capital-intensive businesses. Any attempt to manage the value of banks and insurers therefore needs to explicitly recognize both the risks taken as well as the capital deployed. Not surprisingly, RAPMs are now ubiquitous across both industries.

In spite of their prevalence, RAPMs are challenging to use 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 RAPMs and share price is not easily understood by management and external stakeholders.

As a consequence, RAPMs are frequently supplanted by simpler measures when setting corporate strategy. It is easier to “connect the dots” between sales or cost-cutting initiatives, earnings growth, the P/E¹ multiple and the growth in share price than it is between RAPMs and share value. Unfortunately, ease of use is not of much use if applied to risk-based, capital-intensive businesses where improvements in underwriting effectiveness and capital efficiency may have a much stronger influence on value but only an indirect influence on realized earnings and earnings growth.

The second challenge is technical: how to ensure that the RAPM gives the “right” valuation signals for complex financial businesses? More often than not, RAPMs confuse risk-based capital constraints with the shareholder capital invested in the business ...