Some finance departments are beginning to incorporate methods such as scenario modeling, sensitivity analysis, and contingency planning to help CFOs think through a wide-ranging set of potential situations, thus avoiding a monocular view of what’s ahead. They are refreshing forecasts more frequently, homing in on a handful of measures that have a financial effect on the company (so-called driver-based forecasting), and doing more to provide synchronous information flow between finance and operations.
Taking the Long View
Most companies may feel that adapting any of these techniques, or attempting to refine their current approaches to forecasting, is not exactly top-of-mind at the moment. In an environment like this one, “the urgent drives out the important and they operate in panic mode, instead of developing a longer-term, more-rational understanding,” says Nick Turner, co-president of Global Business Network, a scenario-planning consultancy and a member of the Monitor Group.
An exception is The Principal Financial Group, a life and health insurer as well as a large administrator of employer-sponsored retirement plans. The Principal has some exposure to mortgage insurers as well as a commercial real estate portfolio, but it has weathered the credit storm by cutting its dividend and suspending stock buybacks. It also employs a comprehensive forecasting process that includes short- and long-term components and incorporates what CFO Terry Lillis calls “stochastic” modeling — generating a host of scenarios that follow a random distribution.
The Principal develops five-quarter, 5-year, and 10-year forecasts that have a set of conservative baseline assumptions, such as the equity market growing 2 percent a quarter. Then it introduces variances to that baseline to understand the magnitude of the effect on operating earnings, sales, and assets under management — the key drivers. The forecasts are now revisited every two weeks. “You get into problems by trying to model too much minutiae,” notes Lillis. “Your best models are those that identify four or five key drivers and focus on the interplay between them.”
The stochastic element, which emphasizes randomness, enables The Principal to spot potential blowups. The modeling generates a wide distribution of scenarios, which Lillis uses to determine how much capital the company needs to hold in 99 percent of all possible outcomes, from the best to the worst cases of economic performance. Says Lillis, “It helps us deal with tail risk” — those potential futures that are several standard deviations from the mean. The model also projects items such as cash flow from investments versus the surrender of liabilities, critical for a company that uses asset-liability management.
While 10-year (and even 5-year) forecasts may appear anachronistic at a time when so many companies say they are “in the dark,” some industries demand them. At Bonny Doon Vineyard near Santa Cruz, California, it can take 5 years to go from vine planting to bottling. CFO Lisa Kohrs employs a 10-year forecast of revenues and liabilities, factoring in items such as vineyard labor costs, cellar costs, and eventual selling prices in four different channels. To complicate matters, the business is managed as three different companies affected in different ways by environmental, regulatory, and economic forces. Current projects are as diverse as developing a new 300-acre estate vineyard and building a new tasting room.