When I was in oil and gas, I learned that there’s a reserving calculation that’s done. You estimate the amount of reserves that you have that haven’t been produced yet. And that involves a fairly sophisticated engineering algorithm. Those are big numbers, and they can sway your external financial reporting. That’s because the company could take the costs of drilling the well and charge them out based on the life of the reserves. Someone can control earnings that way if you’re not watching carefully.
Compare your relationships with the audit committee and the CFO.
Having a solid line to the chair of the audit committee gives me a sufficient amount of independence and authority. That really allows and encourages me to critically assess what’s going on in the organization. And the reports that I do in the executive sessions of the audit committee provide me with enough of a communication mechanism to feel that I have a voice. I’m invited to just talk to the audit committee and report to them if I see something that makes me feel uncomfortable.
On the other hand, I absolutely need and work on my relationship with the CFO, as well as all the leadership. Administratively, [the CFO] oversees my staff and my resources. My information gets fed to me through the CFO. If I didn’t understand [the company's] risk appetite and don’t understand the strategic direction and the choices that [leadership is] making, it would be hard to take a look at what the appropriate controls are.
Why is it so important for you to understand your company’s risk appetite?
I’ll give you an example. We have a $90 billion dollar investment portfolio here at Allstate, and we have traders who trade in different financial products. They trade bonds, they trade equities. They’re given boundaries within which they can trade. But they have discretion and the freedom to move as long as they stay within the boundaries. Management sets those boundaries, and they’re very clear in what those boundaries are. And that is the risk appetite.
Let’s take another example, from our claims process. Let’s say you have a $100,000 claim with the company and your policy is written to $90,000. The claims adjusters have some level of discretion as to whether or not they can settle that claim a little bit above or a little bit below that policy limit. There’s a risk appetite there. There’s cost. If you have every claims adjuster adding another $10,000 to every claim, you’re going to go out of business quickly.
How can CFOs determine and communicate how much discretion to allow?
You’ve got to be clear about where you’re OK with applying discretion and where you’re not. In our space, for example, we don’t have a lot of fixed assets, so there’s a little less prescription in how we account for some of the assets of the organization — like our computer software, for example. You can charge that to your credit card or you can book it a different way. Back in my BP Amoco days we didn’t have that. It was such a fixed-asset business, and there was a different risk appetite. Risk appetite translates into how you’re going to calibrate your policies and procedures. Are you going to give some space or are you going to make it very clear and precise exactly what’s expected? For most companies, particularly big companies, they have to leave it less precise but be clear on what their appetite for risk is.