LTVS: what's required?
The Financial Reporting Council (FRC) requires a Longer Term Viability Statement (LTVS) from Premium-listed UK companies. The LTVS sets out the Board's assessment of the company's solvency and liquidity position, subject to a range of stresses and scenarios and over a time period set by the Board.
The LTVS is required for financial years starting on or after 1 October 2014. Covered in the UK Corporate Governance Code (C.2: Risk Management and Internal Control), further guidance is available in the FRC's Guidance-on-Risk-Management (Appendix B). This article covers the LTVS and more.
Naturally the LTVS can't do everything – its focus is liquidity solvency. Companies which are serious about risk-adjusted value need an ORVA.
As well as covering (e.g.) "how to do a LTVS" I link to related areas:
- ORSA : an insurer's Own Risk and Solvency Assessment tests its solvency and liquidity over (e.g.) 3-5 years. ORSA lets us see a corresponding concept to LTVS for insurers – who will nonetheless need to file a LTVS. ORSA is required by the UK PRA and Solvency II.
- ORVA : 4ARM's Own Risk and Value Assessment extends LTVS/ORSA. ORVA is one way of moving from solvency and liquidity to long term risk-adjusted value management and maximisation. ORSA helps you compete "under the radar".
Defining ORSA, LTVS and ORVA
The FRC's Guidance on Risk Management implies that the LTVS is an assessment of solvency and liquidity over a period chosen by the Board:
Taking account of the company’s current position and principal risks, the directors should explain in the annual report how they have assessed the prospects of the company, over what period they have done so and why they consider that period to be appropriate. The directors should state whether they have a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due over the period of their assessment, drawing attention to any qualifications or assumptions as necessary. Section C.2.2. of The UK Corporate Governance Code (September 2014)
The UK Corporate Governance Code (September 2014) has general requirements regarding business model and performance which go beyond the LTVS:
The directors should confirm in the annual report that they have carried out a robust assessment of the principal risks facing the company, including those that would threaten its business model, future performance, solvency or liquidity.
The directors should describe those risks and explain how they are being managed or mitigated. Section C.2.1. of The UK Corporate Governance Code (September 2014)
Arguably the nearest equivalent to the LTVS for the financial sector, an insurer's Own Risk and Solvency Assessment tests its solvency and liquidity over (e.g.) 3-5 years. The ORSA is required by the UK PRA and Solvency II. The "Comparing ORSA, LTVS and ORVA" table below makes the LTVS:ORSA comparison.
Insurers must perform an ORSA as part of Solvency II. The ORSA's forward looking assessment of solvency goes beyond formulae, incorporating stress and scenario testing. Interpreted appropriately, it emphasises the role of management actions. The LTVS is a comparable requirement to ORSA for non-financial firms.
ORSA is helpful, but it's still about solvency. Insurers – and non-financial firms – should go beyond ORSA/LTVS, not least in the interests of their shareholders.
I suggest the discipline of an Own Risk and Value Assessment (ORVA) corresponding to the ORSA, but with a different target: risk-adjusted shareholder value.
OVRA is, most importantly, a way of working, although it can be an internal process and document. ORVA enables the adopter to formalise and optimise its approach to risk-adjusted value generation. For example the uncertainty regarding the drivers of future business and profit growth are acknowledged and managed.
A tailored a version of ORVA (e.g. an ORVA document, or disclosure of a formal approach) could be shared with regulators, rating agencies, analysts and shareholders, setting out at an appropriate level the techniques that the insurer is using to gain competitive advantage. This is turn may be viewed favourably, with potential for early adopter advantage. Read the "ORVA take up" section for why I expect non-financial firms to be big ORVA beneficiaries.
The ORSA, LTVS, ORVA progression
There is a sense is which the above represents a progression of Enterprise Risk Management (ERM):
- ORSA = ERM 1.0. ERM is a 21st century phenomenon, arising from bank and (subsequently) insurer regulation from the 1980s onwards.
- LTVS = ERM 1.5. A development (and staging post) in which the insights of ERM 1.0 flow to non-financial companies, increasing the level of "risk maturity". (*)
- ORVA = ERM 2.0. ORVA reaches the parts outside the ORSA / LTVS domain: James Lam's vision of uncertainty management and performance optimisation.
(*) This is not a pejorative statement, but rather concerns the more robust risk management tools and greater degree of formality employed in the LTVS versus previous incarnations of risk management in non-financial companies. The table below suggests that the ORVA generates more value than the LTVS.
Comparing ORSA, LTVS and ORVA
All UK companies (including banks and insurers) with a premium listing will need to provide a LTVS e.g. in the strategic report. Insurers will also have to produce an ORSA, which is arguably very similar to the LTVS. The following table compares the ORSA (c.f. LTVS) and 4ARM's suggestion of an ORVA.
High level non-technical comparison
The following tables use high (H), medium (M) and low (L) to show the intended emphasis of the risk assessment. All assessments should incorporate action.
|Internal / External||Int||Ext||Int||ORSA: insurer's Board and its regulator. LTVS: publicly available in report and accounts. ORVA: internal (only).|
|Documentation||H||M||L||Solvency II has onerous documentation standards. The FRC is likely to be more proportionate.|
|Business model||–||?||H||C.2.1. says business model aspects are covered "in the annual report" – see below. ORVA goes further.|
|Future performance||–||?||H||This is the major contributor to ORVA, especially for non-financial firms.|
|Solvency||H||H||M||Value must incorporate allowance for likelihood of future insolvency. But solvency is a low hurdle for shareholders.|
|Liquidity||H||H||M||Companies can fail (or simply not be able to seize opportunities) due to not having cash at the right time.|
|Value metric||–||–||H||ORVA combines uncertainty over future growth (especially) and the contribution of solvency to value.|
What about those question marks?
The areas of LTVS tension
The directors should confirm in the annual report that they have carried out a robust assessment of the principal risks facing the company, including those that would threaten its business model, future performance, solvency or liquidity. FRC UK Corporate Governance Code Code provision C.2.1.
The statement should be based on a robust assessment of those risks that would threaten the business model, future performance, solvency or liquidity of the company, including its resilience to the threats to its viability posed by those risks in severe but plausible scenarios. FRC Guidance on Risk Management, Internal Control and Related Financial and Business Reporting : Appendix B on LTVS
What does this really mean?
Firms interpret the UK Corporate Governance Code in different ways. There are already risk management requirements. So what's new? We can take from the LTVS Appendix that the LTVS is supposed to assess risks related to the firm's:
- business model: high level coverage is arguably in the existing Strategic Report.
- future performance: again one might argue that this is implicit in the current Strategic Report.
- solvency: this is new in the LTVS
- liquidity: this is new in the LTVS
The new material seems to be the insistence of the guidance on a quantitative approach:
Such an assessment should include sufficient qualitative and quantitative analysis, and be as thorough as is judged necessary to make a soundly based statement. Stress and sensitivity analysis will often assist the directors in making their statement.
My conclusion: The main areas of tension will be in respect of how much work needs to be done, especially on quantifying business model and performance risks.
Risk management techniques comparison
The ORVA governance and documentation "hurdle" is low – whatever makes sense in terms of shareholder value. The ORVA is under your own control. Its development and deployment should be proportionate; introduced on a step-by-step basis and only progressed if it adds value. That's good risk management too.
Here's the point: ORVA reaches the parts ORSA and LTVS don't reach. The table below compares LTVS to ORVA.
|Governance and framework||L-M||L||The LTVS documentation might be relatively "light" compared to requirements of Solvency II on insurers.|
|Solvency||H||M||Central focus of LTVS. Insolvency enters ORVA as a particular way in which the future cashflows have zero value.|
|Assessment||H||H||The LTVS focus is solvency- and liquidity-related risks. ORVA considers risk and uncertainty in a much broader way.|
|Management actions||H||H||Supposed to play a central role in LTVS. ORVA builds these into the strategy from outset, valuing them explicitly.|
|Scenario testing||H||H||Used by LTVS to test solvency and liquidity over a period determined by the Board. Used by ORVA to test strategy.|
|Stress testing||H||H||LTVS used individual and combined stresses. ORVA uses stresses as a "reasonableness test" and in optimisation.|
|Optimisation||N/A||H||LTVS protects solvency; any "optimisation" is very loose. ORVA optimises value, conceptually and operationally.|
|Variability||L||H||LTVS considers only extreme variability. ORVA incorporates value and management of less extreme variability.|
|Risk appetite||M-H||H||Surprisingly implicit in the LTVS, but explicit in the FRC's Guidance on risk management. Covered in ORVA.|
|Simulation||M||H||Implicit in the LTVS, but mentioned once in the FRC's Guidance on risk management. Central to ORVA's optimisation.|
How to do a LTVS
One key to success is not to create something new unless necessary. Did your strategy work include SWOT or PEST/PESTLE analyses? Can these be re-used? That said, some of the main tools that will most likely be used in performing the LTVS are:
- People. Central should be (a) sponsor-like individuals, such as the CFO and any Chief Risk Officer and (b) front line risk assessors who know the business.
- Business model, plan and strategy. These documents – if they exist – will help identify material risks and uncertainties. Don't just brainstorm.
- Corporate cashflow projection model. This will be needed to assess the impact(s) of changes / risks. No model = no reliable assessment.
- Risk register, or something similar. A resource for record keeping and structured thinking. But beware of using a risk register for risk assessment.
It is unlikely that everything will be covered in the year-1 version of the LTVS. What would shareholders and analysts find helpful?
- Agree objectives. A cost- and time-saving discussion with the CFO and the company's most senior risk professional. What do you want from your LTVS? Just to keep the FRC happy? Could a risk-based view add something to your business? Which of the resources above are readily available? Is anything else useful?
- Model and stresses: reality test. Senior people in the business know the most important drivers of profit or loss. Does the any corporate model incorporate these? The aim is to have a model in which parameters can be changed – "stressed" – away from their best estimates. test: do stress results make sense?
The importance of a good model
A model is an important contributor to a risk management process. While there will always be "black swans" and other forms of model risk, if developed and used with care, models are invaluable in enabling the rapid consideration of a wider range of variables and scenarios than the human mind alone is capable of.
- A good "internal model" quantifies the expected impact of management actions on company value. It works for supermarkets as well as insurers.
- The main value of a corporate model is not in any LTVS work – see "The ORVA: reaching the parts that the LTVS can't reach" below.
- Work on building a model – or validating and improving the existing model – can run in parallel with other LTVS items.
- Define appropriate stresses and scenarios. The Board agree the individual or combined changes that could make a material impact. What's the "story"? Scenarios may comprise stresses on individual model parameters or, more likely, a combination of consistent and less severe stresses.
- Model the impact. What is the scenario's impact on the balance sheet, cash, revenue and profit over the board-defined period? There is little point in considering lots of non-challenging scenarios. The FRC risk management guidance suggest reverse stress testing could be helpful, leading us to:
- Consider the probability. One approach is to develop a range of mutually exclusive scenarios – including the base or expected scenario – whose probabilities (seemingly) sum to 1. Then make some allowance for "black swan" events. These are challenging areas.
- Risk appetite. Surprisingly implicit in the LTVS, but explicit in the FRC's Guidance on risk management. This is where a company gets to make explicit its risk and reward trade offs. For example: "we target an annual return on capital of 17% and an insolvency risk of 1-in-25." Could cover earning and cash generation.
Reality check: historical failure results
I subsequently discovered that, averaged over 30 years, companies in the FTSE 100:
- Went bankrupt with a probability of 1-in-1000 each year and 1-in-200 over a business planning period of 5 years
- Failed to remain independently successful FTSE 100 members with a probability of 3.8% p.a. and 17.7% over 5 years
See "Presenting the results: beyond a good news story" below for more on this and how it might affect the presentation of LTVS results.
- Risk control and mitigation. Depending on the nature of the risk it may be possible to manage down the probability or impact of risks. There should be an important role for management contingency plans and actions, especially where the risk can crystallise and grow in impact rapidly – so-called "risk velocity".
- Model combinations beyond scenarios. Here's an approach used by insurance companies. Each model parameter has a "stress", generating its capital requirement at the 1-in-NN level (NN chosen by you). Combined "economic" capital is then calculated, using a range of techniques familiar to (e.g.) actuaries
This work is likely to be iterative and interactive, emphasising again the importance of an appropriate model.
Clearly there will be a formal statement, probably to go in the company's report and accounts, perhaps in the strategic report. This can be a useful tool in demonstrating to shareholders and other stakeholders – probably more clearly than previously – how the company manages risk and uncertainty.
Before then the LTVS will generate Board reporting and a range of challenging discussions: does the LTVS cover only itself extreme solvency and liquidity risks? if so how does the board discharge its other responsibilities to shareholders? If not covered in the LTVS broader uncertainty should be covered elsewhere:
When determining the principal risks, the board should focus on those risks that, given the company’s current position, could threaten the company’s business model, future performance, solvency or liquidity, irrespective of how they are classified or from where they arise. The board should treat such risks as principal risks and establish clearly the extent to which they are to be managed or mitigated. FRC's Guidance-on-Risk-Management and numerous references in the UK corporate governance code
Presenting the results: beyond a good news story
How does the research below – an annual "failure rate" of a little under 4% – compare to other sources?
... risk of failure averages between 2% for the largest and most secure firms and 5% for all other firms Riskviews: Why isn’t strategic risk included in ERM?
Will an LTVS be helpful to shareholders beyond "your Board is confident that we will remain both solvent and commercially successful over the next 5 years"?
We probably should not expect companies to be as candid as the famous annual reports and, being fair the words "insolvent" and "liquidity crisis" are panic-inducing. Clearly the LTVS applies way beyond the FTSE 100, but keeping with it for now:
- we know that very few FTSE 100 companies go insolvent – only 3 in 30 years. A LTVS which stops there may therefore not be helpful.
- we also know that many of the original (1984) constituents are no longer FTSE 100 companies – see the research below.
The FTSE100's constituent history shows that of the initial FTSE 100 members, 30 years later:
31 relatively successful
- 31 had survived
61 relatively unsuccessful
- 51 had been acquired
- 10 had been relegated to a lower index
Those companies acquired may include successful results for shareholders, but inspection indicates this is "a few".
8 absolutely unsuccessful
- 05 had been disbanded
- 03 had gone bankrupt
Sobering: over 30 years only 31% survived as independent businesses. Equivalently, on average, about:
- 03.8% of FTSE companies lost their "independently successful" status each year i.e. (1-3.8%)30 = 31%
- 17.7% lost this status every 5 years i.e. (1-17.7%)30/6 = 31% (there are 6 non-overlapping 5-year periods)
So here's one way of presenting the results, honestly:
- LTVS focus: 3 companies went bankrupt (see note 1). Examine their circumstances. Say how you'll prevent this happening to you.
- Publish the above summary statistics to give context. In particular cover how that, on average, for FTSE 100 companies:
- 82% (roughly 5-in-6) remained independently successful FTSE 100 companies over the full 5-year business planning period (see note 2)
- 1.4% were disbanded or went insolvent over 5-year business planning period (see note 2)
- Shareholder value focus: On average roughly 4% of companies either lose their independent status or significantly underperform each year (see note 3). Very helpful material for shareholders would include the contribution risk management makes to performance management and enhancement.
- British & Commonwealth Shipping, Ferranti and MFI furniture.
- This changes to 8 in 9 and 0.8% respectively, over a 3 year period.
- The situation is somewhat worse than this; the statistics look better, due to excluding:
- FTSE100 companies taken over, unless they were there at the outset
- relegations from the FTSE 100 for companies not initially present
- the "bumpy rides" of relegation to the FTSE 250 and re-entry are never included
This approach gives credibility for what should be a low solvency risk. It gives context for companies that want to be more candid about any value-focused risk management they are doing. That's where the own risk and value assessment – ORVA – comes in.
Other useful links
The ORVA: reaching the parts that the LTVS can't reach
The following notes were originally written for and applied to an insurer's ORSA. But they apply to the LTVS too.
Lam's vision for enterprise risk management
There are three major business applications of risk management: loss reduction, uncertainty management and performance optimisation. The combination of all three is enterprise risk management.James Lam – the world’s first Chief Risk Officer
The contribution of LTVS to the Lam vision
The LTVS makes an excellent contribution to (a). Beyond that I'd argue the effect is limited:
- LTVS and strategy: LTVS's scenario testing provides a check on the adequacy of the current capital to support the intended strategy. It's a short stretch to management actions and risk appetite – good.
- LTVS and decision making: LTVS's limitation is that it is simply a (reasonable!) hurdle for a business strategy (capital, risk appetite etc). But there's not much of an overlap with Lam's (b) and (c).
LTVS and risk management maturity
The diagram on the right comes from Professor Panjer's presentation Enterprise risk management: an introduction and the controlling / trading / steering terminology (*) is from the IAA's Comprehensive Actuarial Risk Evaluation – Ingram et al.
There are three areas LTVS doesn't touch:
- Strategy formulation. Beyond a solvency- and liquidity-focused approach, Scenario testing can help set strategy.
- Capital allocation as part of return optimization.
- Risk trading e.g. RAROC at the transaction level.
Of course you don't need an ORVA. There are many ways for you to maximise risk-adjusted value. You might work with management tools such as an internal cashflow projection model and the Balanced Scorecard. But, like data, risk and uncertainty management is going to be a 21st century theme.
Models: beyond the LTVS
Like actuary Mark Graham I believe that there is greater potential to add value towards the centre of distributions rather than at the "tails".
Actuaries, because of insurance regulation, need to consider events at least as remote as 1-in-200. In The great 99.5th percentile swindle Graham boldly answers the question "What should companies do?" with such extreme assessments as follows:
- As little as possible at the extremes of the distribution as is necessary to get internal model approval
- Not believe the results from the extremes of the distribution
- Concentrate on design, parameterisation and use between the [5th] to [95th] percentile, where:
- Data is more complete
- History may be a guide
- Expertise is more relevant
It is in the central part of the distribution that models can provide valuable insights and, used correctly, add material commercial value. The great 99.5th percentile swindle
Uncertainty around estimation and "the central part of the distribution" is an explicit purpose of ORVA
LTVS: a role for actuaries
Reasons to think an actuary can help:
- Part super-hero. Part fortune-teller. Part trusted advisor. See the set of skills an actuary has.
- In 1775 an actuary quantified mortality risks. 200+ years later, we're still doing risk and probability.
- Beyond liabilities actuaries now manage assets, solvency and the uncertainty around company value.
- Pricing risk. Whether it's life, health, cars, homes or businesses, insurers rely on actuaries to get prices right.
- Mitigation experience. e.g. using techniques such as contract design, (re)insurance, hedging, diversification.
- Making sense of total risk. We can combine operational, insurance and financial risks into a common currency.
LTVS – ORSA overlap. Solvency II insurance regulation requires actuarial and risk functions to delivering the ORSA. Actuaries are able to extend this experience to your industry and your LTVS. Actuaries can make sense out of risk.
Three particularly relevant areas of expertise
The first is modelling. Actuaries have been building and using practical models which help their clients and employers run their businesses for decades. These obviously include models to set prices (for life and health insurance, car and home insurance and many more esoteric risks) but also to ensure that companies don't run out of money under extreme circumstances. Actuaries use predictive modelling and examine the drivers of performance e.g. "what makes a bad salesman?"
The limits of models
Actuaries may be good at modelling, but thinking actuaries understand their limits. Recent actuarial resources on model risk include:
The second is probability. It will become increasingly untenable to claim good risk management without having an understanding of probability. Indeed in his book The Flaw of Averages, Stanford Professor Sam Savage urges companies to appoint a "Chief Probability Officer" (CPO) – the LessWrong coverage. Many actuaries have a maths degree and actuarial exams covers probability. Actuaries combine data and expert opinion, using Bayesian probability and other techniques.
The third is LTVS-like investigations and reporting. Actuaries have always assessed insurer solvency, under old regimes ("Solvency I"), the FCA's ICAS in 2005 and the more recent Solvency II – including internal models and the so-called ORSA, which is akin to a "LTVS for insurers". This work includes the full spectrum of risks to viability. Actuaries can also assess uncertainty at less extreme levels of risk using models which quantify firm value, including franchise value.
And reasons to take care:
- Communication: it is claimed that, with their technical expertise, actuaries are not natural communicators.
- Criticism from other professionals: Economist John Kay isn't a fan but then Taleb dislikes economists.
- Domain expertise: An actuary may not have a deep understanding of you industry. But actuaries can reach out:
An actuary who is only an actuary is not an actuary Frank Redington, voted the greatest British actuary ever
Grill an actuary
As with any important process, due diligence is important. Your actuary should be able to give confidence:
- Communication: Can he convey how risks may differ between insurance and your industry?
- Practical skills: Will he be able to combine (your) experts' views, data and models in a risk assessment?
- Action focus: Will his report lead to actions which could protect and produce value?
- Technical prowess: Do heavy tails mean anything to him? Are they relevant to you? Are the answers credible?
- Your specific concerns: Your may have particular issues you want to cover. Your actuary should naturally engage.
ERM 1.0 critique
- Enterprise Risk Management: Review, Critique, and Research Directions
- Risk culture in financial organisations
ERM 1.5 and the LTVS
- EY on LTVS: Finding opportunities in the new regulatory challenge
- EY on risk and value How leading companies use risk management to fuel better performance
ERM 2.0 for non-financial firms
- Enterprise risk management for non-financial companies : clear consultancy paper on the value of ERM for non-financial firms.
ERM: the contribution to securing and building value
- Corporate Value of Enterprise Risk Management : book by US risk management expert Sim Segal.
- Implementing the value-based approach : a review of one US insurer's experience, by Michael J. Moody.
- Managing the Invisible : prize winning paper by US risk management expert Bill Panning.
- Making money safely : a personal view of risk management for banks, insurers and non-financial corporates – Philip Scott, ex-IFoA president.