Modern Middle Manager
Primarily my musings on the practical application of technology and management principles at a financial services company.
Profits and Probability

Wednesday, May 07, 2003  

About 60% of our business is in the personal trust, ahem, I mean wealth management industry (I forgot that we're rebranding that department). As I've mentioned before, we take wealthy people's money and keep it from their kids (and the government if at all possible).

The trust business is unpredictable and tempermental. Most trusts are unique by nature; everybody has their own goals in the management of their assets while they are alive and after they're gone. Most wealthy people have a variety of assets: cash, stocks, bonds, real estate, annuities, businesses, limited partnerships and the like. In addition, trust documents are legally binding contracts. Add into the equation that the trustee (the company running the trust, aka my firm) is required by law to provide for the beneficiaries of the trust (i.e., those who get money from the trust right now) as well as take into consideration the "remaindermen" (those who get the assets divided up for them when the trust distributes). Like politicians and money, those factors create a volatile mix -- one that can easily end in litigation at some point along the way, either because of the nature of a particular asset (e.g., real estate) or because the beneficiaries and the remaindermen have conflicting agendas.

The ubiquity of litigation results in the need for risk management and the application of probability, put succinctly as, "What's our likelihood of getting sued if we take this piece of business?" Taking some risk is necessary if the company wants to make any money at all. Taking too much risk could put the company out of business with litigation damages. So how does the company determine what business to take? By applying certain controls and reviews, management attempts to weed out business that may result in litigation down the road. Most analyses are done by instinct, but let's use a more scientific approach. Let's say we take a piece of business expected to last 5 years resulting in $100,000 in fees. Although it seems like a slam-dunk trust, there is always some risk of litigation, say 5%, resulting in a maximum guesstimate (based on experience) of $200,000 in damages and legal fees. Would you take this business? The expected return on this trust would be $100K - (5% X $200K) or $90K. I would say yes. This is the application of probability to the analysis of new business. It's like the example of flipping a fair coin where heads results in you winning $200 and tails results in you winning $100. Would you take the bet? Statistically you should. The expected return is $200 X 50% minus $100 X 50% equalling $50. That's a winning bet.

Taking this thought further, risk management should be an integral part of the sales process with management review able to quantify, as best as possible, why new business should or should not be accepted. The sales force and senior management should be incentivized on the expected return, wouldn't you think? What if, instead, the sales force and senior management were given incentives based on revenue goals. Or even net income, unadjusted for risk. And what if, on top of that, a new position was created to try to clean up and manage the risky business brought in by that sales force after the contracts are signed. Would that bring in trust business that was more or less likely to be exposed to litigation? Would it create a sales force that attempted to bring in riskier types of business just to run up the company's revenues and their commission checks? No, my company couldn't possibly be that shortsighted.

posted by Henry Jenkins | 5/07/2003 12:26:00 PM

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