The Risk/Earnings RatioNew Perspectives for Achieving Bottom-Line Stability
“The study presents persuasive Eye-Opening Findings Such cutbacks may instigate potential evidence of a clear correlation earnings volatility to the detriment of Compelling research into FORTUNE between earnings and physical shareholders. Maintaining or increas- 1000-size companies pinpoints a cor- risk management. This should ing these resources, the study con- relation between the earnings stability assist finance departments with tends, will guide bottom line improve- of large multinational corporations making more informed decisions ments, potentially increasing earnings and their ability to manage physical about resource allocations.” stability and shareholder value. plant and other property-related risks. Michael Vitacco, By adopting strong risk management global fire protection The study of physical risk manage- practices to prevent fire, natural haz- manager, Goodyear Tire ment and the potential impact on ards and other causes of property loss and Rubber Company earnings stability was commissioned and business disruption, the findings by commercial and industrial property suggest that a company will reduce insurer FM Global and conducted by the frequency and severity of these Oxford Metrica, an independent strate- loss exposures (if not prevent them), gic adviser to FORTUNE 500 com- and may reduce its earnings volatility panies that provides research-based too—a striking outcome. intelligence on all aspects of financial performance. Oxford Metrica perhaps The results of this study arrive at a is best known for its quantitative as- time when many organizations con- sessments of critical reputation issues, tinue to reduce budgeted capital and measuring the impact of crises on a other resources across diverse func- company’s reputation and shareholder tional areas and operations, including value performance, and identifying the physical risk management. While key drivers of recovery. reductions in expenses are a critical necessity for many enterprises, the research suggests there are nega- tive consequences to cutting back on physical loss prevention resources.
This new study, according to Dr. out of your performance the greater The bottom line: Companies withDeborah Pretty, the Oxford Metrica the reliability of earnings, which trans- strong physical risk managementprincipal who headed the research lates into a more consistent valuation practices, on average, produced earn-effort and author of Risk Financing by Wall Street. Likewise, the more ings that fluctuated by 17.9 percent,Strategies: The Impact on Shareholder resources a company earmarks toward whereas companies with weak physicalValue, “indicates both empirically and reducing physical risk, the higher the risk management practices, on average,quantitatively that there is a strong opportunity for enhanced shareholder had earnings that fluctuated by 31.4correlation between physical risk value.” Ball Corporation is traded on percent. The stronger the physicalmanagement and earnings stability.” the New York Stock Exchange. risk management practices, the lower the earnings volatility; the weaker theSimply put, by pursuing strong physi- Culling the Data physical risk management practices,cal risk management processes and the higher the earnings volatility. “The In its research, Oxford Metricasystems to prevent the likelihood of results reveal a strong correlation be- compared the physical risk manage-losses caused by fire, natural hazards, tween earnings stability and property ment practices of 520 large (moreequipment failure, human error and loss prevention,” Dr. Pretty observes than US$1 billion in annual revenue)other perils, a company will poten- (See Chart 1). multinational companies with thesetially reap a measurable reduction organizations’ financial performancein earnings volatility—the degree to The study findings are further support- over two periods of several yearswhich earnings fluctuate over a given ed by FM Global’s internal quantita- each, to increase statistical accuracy.period of time. tive research. The company, which In assessing the companies’ manage- insures one of every three FORTUNEThe study finds that companies, with ment of their physical risks, the firm 1000-size companies in more than 130best practices in managing their prop- leveraged proprietary data provided countries, is privy to extensive under-erty risks, produced earnings on aver- by FM Global, the companies’ global writing and engineering informationage that were 40 percent less volatile property insurer. FM Global rates its on its clients’ businesses, their physi-than companies with less advanced commercial clients on a 1-to-100 scale cal risks, vulnerabilities, loss historyphysical risk management. “The study for property risk management practic- and risk quality (i.e., level of physicalindicates that resources allocated to es—a score of 100, for example, is an protection and facility risk manage-control property risks are well-spent, indicator of exceptional physical risk ment practices).given the demonstrable improvement management practices.in earnings stability, a key driver ofshareholder value,” Dr. Pretty says.The research findings present persua-sive evidence of a significant returnon investment in physical risk man- Chart 1agement. Scott Morrison, senior vice Correlation between Physical Risk Management Practicespresident and chief financial officer and Earnings Volatility (2005–07)of Ball Corporation, a large, publiclytraded supplier of metal and plasticconsumer packaging products, says 17.9%the correlation is useful data to keep inmind in terms of resource allocations. STRONG PRACTICES“The research findings make sense.Shutting down one of our 50 plantsworldwide because of a fire, for ex- 31.4%ample, would obviously affect perfor-mance. The more volatility you take WEAK PRACTICES 3
“As a public company, earnings stability is a major strategic goal. Now that there is a demonstrated correlation between physical risk management and earnings, our work takes on even greater meaning. ” Rick Moroney, environmental, health and safety manager, Raytheon“We’re in an opportune position to compared with less than US$725,000 A Judicious Investmentevaluate the frequency of property on average for companies with strong What do these findings mean in termslosses and their individual severity, physical risk management practices of corporate performance? Simplyand then compare this information to (See Chart 3). that preventing the potential of fireeach company’s physical risk manage- and natural disasters, which arement practices,” explains Jeff Burchill, With regard to property exposures major drivers of property loss andFM Global senior vice president and related to hurricanes, earthquakes related business disruptions, provideschief financial officer. and other natural hazards, overall the confirmable bottom-line benefits. average risk for companies with weak Similarly, investing in preventing twoFM Global has discovered that the risk management practices was 29 other major contributors to propertyaverage risk of a property loss is 20 times larger than those with strong losses—human error and equipmenttimes larger for companies with weak practices. The average natural disaster breakdown—also can enhance corpo-physical risk management practices loss per location for companies with rate performance. There are no guar-than for those with strong physical inferior risk management practices antees, of course. But, the findingsrisk management practices. A location exceeds US$3.4 million per loss, demonstrate a significant return onwith weak physical risk management compared with an average US$478,000 investment in physical loss prevention.practices is more than twice as likely for companies with more advancedto experience a property loss, not to processes. Also, companies with inferior The most important revelation is themention a consequent disruption in its practices were more than twice as likely apparent correlation between thebusiness operations. to experience a natural disaster-related management of property risks and property loss (See Chart 4). earnings stability. “The study presentsFactoring in the financial costs of persuasive evidence of a clear correla-these losses indicates that the average tion between earnings and physicalloss at a location deemed to have weak risk management,” says Michael Vit-physical risk management practices acco, global fire protection manager atexceeds US$3 million, comparedwith approximately US$620,000 for a Chart 2company that manages its physical All Property-Related Perils:risks well (See Chart 2). Physical Risk Management Practices vs. Average Loss Severity (2005–08)Further examination of the datareveals other alarming statistics. US$620,000The average risk of a property losscaused by fire, for example, is 55 STRONG PRACTICEStimes greater for a company withweak physical risk managementpractices than for those with strong US$3,000,000practices. The severity of the fire lossalso is much higher—exceeding an WEAK PRACTICESaverage US$3.2 million per loss,4
“Reliability in the performance of our physical assets is a component of our reputation. The way to improve this reliability is to invest in the physical safety and security of our plants. ” Scott Morrison, chief financial officer, Ball Corporation Goodyear Tire and Rubber Company. which of its facilities require immedi- At defense technology giant Raytheon, “This should assist finance depart- ate upgrades in fire protection equip- a company that self-insures a sig- ments with making more informed ment. “Companies only have so much nificant portion of its property losses, decisions about resource allocations.” money to spend on physical upgrades, superior risk management is a “vital requiring a systematic process for de- objective,” says Rick Moroney, Ray- Ball Corporation’s CFO points out an- termining which sites require enhance- theon environmental, health and safety other side benefit to superior physical ments first,” Vitacco explains. manager. “We’ve got a lot of our own risk management: “Reliability in the money on the line, so it is imperative performance of our physical assets is a He points to ongoing improvements at for us to understand the physical risks component of our reputation. The way a Goodyear tire manufacturing plant at our 150 major sites and the hun- to improve this reliability is to invest in in Taiwan as an example. Small by dreds of smaller facilities we operate. the physical safety and security of our comparison to other Goodyear plants We model these risks, compare them, plants. We want our employees to work that have insurable values five times and then make determinations where in a safe environment and don’t want to higher, the Taiwan plant was among our resources will be budgeted.” disappoint our customers by not being the least protected Goodyear facilities, able to supply their needs because of lacking even a basic sprinkler system. a business disruption. That’s why “We set into motion plans to put in a improving physical risk management water supply with pumps, tanks and is a key initiative,” says Morrison. yard mains to feed the hydrants and sprinklers, even before the plant ex- Leveraging internal research and loss perienced a small fire in the Banbury prevention engineering services also mixer that mixes the rubber com- can advance property risk manage- pounds,” Vitacco says. Upgrades at the ment at a companies’ facilities. plant are slated for completion within Goodyear, for instance, has prioritized approximately two years. Chart 3 Fire: Physical Risk Management Practices vs. Average Loss Severity (2005–08) US$724,000 STRONG PRACTICES US$3,200,000 WEAK PRACTICES 5
Chart 4 Natural Catastrophes: Physical Risk Management Practices vs. Average Loss Severity (2005–08) US$478,000 STRONG PRACTICES US$3,400,000 WEAK PRACTICESA Business Essential “The study indicates that resources allocated to control property risksThe risk managers say the correlation are well-spent, given the demonstrable improvement in earningsbetween physical risk management stability, a key driver of shareholder value. ”and earnings stability gives them the Dr. Deborah Pretty, principal, Oxford Metricaevidence they need to continue tomake improvements to their facilities.“Anything that supports our bottomline objectives—revealing costs thatheretofore may have been hidden—has value here,” says Moroney. “As apublic company, earnings stability isa major strategic goal. Now that thereis a demonstrated correlation betweenphysical risk management and earn-ings, our work takes on even greatermeaning.”6
About FM GlobalFor 175 years, many of the world’s largest organizations have worked with FM Global (www.fmglobal.com) todevelop cost-effective property insurance and engineering solutions to protect their business operations from fire,natural disasters and other types of property risk. The metrics used as the basis for the research and statistics referencedin this report were derived from RiskMark®, a fact-based analytics tool developed by FM Global that produces data tohelp users precisely understand the risk of major property loss at each facility, the potential business impact andthe best solutions to address related vulnerabilities. With clients in more than 130 countries, FM Global ranks amongFortune magazine’s largest companies in America and is rated A+ (Superior) by A.M. Best and AA (Very Strong)by Fitch Ratings. The company has been named “Best Property Insurer in the World” by Euromoney magazine and“Best Global Property Insurer” by Global Finance magazine.About Oxford MetricaOxford Metrica (www.oxfordmetrica.com) is an independent research and analytics firm specializing in corporatereputation and international investments. Oxford Metrica has been recognized as a leading adviser in managingreputation recovery from crisis, in evaluating the benefits of establishing an international shareholder base, and inthe provision of analytics on hedge fund performance and asset allocation strategy.