Enterprise Risk Management and the Cost of Capital

• DOI: http://doi.org/10.1111/jori.12152
• Published date: 01 March 2018
• Date: 01 March 2018

© 2016 The Journal of Risk and Insurance. Vol. 85, No. 1, 159–201 (2018).

DOI: 10.1111/jori.12152

159

ENTERPRISE RISK MANAGEMENT AND THE COST OF

CAPITAL

Thomas R. Berry-St€

olzle

Jianren Xu

ABSTRACT

Enterprise risk management (ERM) is a process that manages all risks in an

integrated, holistic fashion by controlling and coordinating any offsetting

risks across the enterprise. This research investigates whether the adoption

of the ERM approach affects firms’ cost of equity capital. We restrict our

analysis to the U.S. insurance industry to control for unobservable

differences in business models and risk exposures across industries. We

simultaneously model firms’ adoption of ERM and the effect of ERM on the

cost of capital. We find that ERM adoption significantly reduces firm’s cost of

capital. Our results suggest that cost of capital benefits are one answer to the

question how ERM can create value.

INTRODUCTION

Enterprise risk management (ERM) is a holistic approach to risk management.

Traditionally, corporations managed risks arising from their business units

separately in each unit. ERM improves on this traditional “silo”-based approach

by coordinating and controlling any offsetting risks across the enterprise. A number

of surveys document how firms implement ERM programs to achieve such synergies

between different risk management activities (see, e.g., Colquitt, Hoyt, and Lee, 1999;

Kleffner, Lee, and McGannon, 2003; Beasley, Clune, and Hermanson, 2005; Altuntas,

Berry-St€

olzle, and Hoyt, 2011), a number of studies on firms’ decision to start an ERM

program provide evidence that firms adopt ERM for direct economic benefits (see,

e.g., Liebenberg and Hoyt, 2003; Pagach and Warr, 2011; Altuntas, Berry-St€

olzle, and

Hoyt, 2012), and a limited number of studies provide evidence that ERM is associated

Thomas R. Berry-St€

olzle is at the Henry B. Tippie College, University of Iowa, 108 John

Pappajohn Business Bldg, Iowa City, IA 52242–1994. He can be contacted via e-mail: thomas-

berry@uiowa.edu. Jianren Xu is at the Mihaylo College of Business and Economics, California

State University, Fullerton, 800 N. State College Blvd., Fullerton, CA 92831. He can be contacted

via e-mail: jrxu@fullerton.edu.

160 THE JOURNAL OF RISK AND INSURANCE

with improvements in firm performance and increases in firm value (see, e.g., Hoyt

and Liebenberg, 2011; Eckles, Hoyt, and Miller, 2014; Farrell and Gallagher, 2015;

Grace et al., 2015). While this prior literature argues that ERM can create value by

creating synergies between different risk management activities, increasing capital

efficiency, avoiding the underinvestment problem in financially constrained firms,

and by reducing the cost of external financing, there is a lack of empirical evidence

supporting these claims.

The goal of our research is to shed some light on the fundamental question of how

ERM can create value. We specifically focus on the relationship between ERM

adoption and firms’ cost of external financing, and investigate whether ERM adoption

is negatively associated with the cost of equity capital. Such a research design allows

us to evaluate whether cost of capital benefits are one mechanism for value creation by

the ERM approach.

There are multiple conceptual arguments why ERM adoption should reduce a firm’s

cost of capital. First, an ERM program improves the information available about a

firm’s risk profile, and this information can be shared with investors, reducing

information asymmetries and leading to a lower cost of capital (see, e.g., Easley and

O’Hara, 2004; Lambert, Leuz, and Verrecchia, 2007). Second, ERM decreases firms’

cost of capital through reducing firms’ systematic risk. Hann, Ogneva, and Ozbas

(2013) originally used this argument to explain why diversified firms benefit from a

lower cost of capital than their focused counterparts. When firms experience low cash

flows, they incur certain deadweight losses, for example, the loss of valuable

personnel. Such deadweight losses are more pronounced during economic down-

turns. In other words, these deadweight losses are at least partially countercyclical

and increase systematic risk. Hann, Ogneva, and Ozbas document that diversified

firms with less correlated segment cash flows have a lower cost of capital, supporting

the view that coinsurance reduces systematic risk. ERM improves on the traditional

risk management approach by its focus on understanding and managing correla-

tions and interaction of risk or, in other words, by its focus on managing the

coinsurance effect, thereby reducing systematic risk. Third, ERM adoption reduces

the probability that a firm needs expensive external financing (Froot, Scharfstein,

and Stein, 1993). In addition, ERM adoption can improve firms’ ratings, which are

used by outside investors as a signal of financial strength; Standard & Poor’s aswell as

other rating agencies explicitly evaluate firms’ ERM program as part of the rating

process.

To avoid possible spurious correlations cause d by unobservable diffe rences in

business models and risk exposures across industr ies, we restrict our analy sis to a

single industry, an ind ustry that is almost tai lor-made for an empiric al analysis

of ERM programs and their cost of capital implica tions: the U.S. insuran ce

industry. The insuranc e industry embraced the ERM approach, and a substantia l

fraction of insurers adop ted an ERM program, provid ing the necessary variat ion

for an empirical analysi s. In addition, the U.S . insurance industry is t he only

insurance industry wo rldwide with a substant ial number of publicly t raded stock

companies, providing t he necessary stock pric e data for cost of equity ca pital

calculations. Since insu rance companies hardly ever iss ue bonds, we can simply

ERM AND THE COST OF CAPITAL 161

focus on their cost of equity ca pital to approximate their weighted average or tot al

cost of capital.

1

Our cost of equity capital measure is based on the implied cost of capital approach

(see, e.g., Gebhardt, Lee, and Swaminathan, 2001), which equates the firm’s market

value of equity with its discounted future cash flow estimates, and solves for the

required internal rate of return. We use an implied cost of capital measure because

such measures better explain variations in expected stock returns than realized stock

returns (see, e.g., Gebhardt, Lee, and Swaminathan, 2001; P

astor, Sinha, and

Swaminathan, 2008; Li, Ng, and Swaminathan, 2013). The main differences between

implied cost of capital measures are the valuation model used to describe future cash

flows and the growth assumptions in perpetuity. To ensure that our results are robust

to method choice, we calculate four different implied cost of capital measures and

take the average across those four measures. This average is the main cost of capital

measure used in our analysis.

2

Following the procedure suggested by Beasley, Pagach, and Warr (2008), Hoyt and

Liebenberg (2011), and Pagach and Warr (2011), we systematically search newswires

and other media, as well as financial reports, for evidence of ERM program adoption

by our sample insurance companies. We then use two procedures to test whether

ERM adoption is actually accompanied by a decrease in firms’ cost of capital. First,

we use an event study methodology and test for an abnormal reduction in the cost

of capital around the year of ERM adoption. Second, we explicitly model the

determinants of ERM adoption and estimate a two-equation treatment effects model

to assess the effect of ERM use on firms’ cost of capital. For ERM adopters, the ERM

indicator variable in this model is coded equal to 1 in the year of ERM adoption and all

following years; the variable is equal to 0 in the years prior to ERM adoption. For firms

that do not adopt ERM during our sample period, the ERM indicator is equal to 0 for

1

Insurance companies receive premium payments up front, invest the premium money in the

capital markets, and pay claims once they occur. If premiums are calculated properly and

investments are well managed, there is no need for additional liquidity. Capital has the

important function to serve as a buffer that can absorb higher than expected losses.

The insurance industry is a regulated industry and regulators monitor how much capital

insurance companies have on their balance sheet relative to the liabilities to policyholders.

There are regulatory capital requirements, and bonds do not count as capital. While the

average industrial firm issues capital as well as bonds and focuses on its weighted cost of

capital including the cost of debt to make investment decisions, for insurance companies, the

weighted cost of capital is basically equivalent to the cost of equity capital. All articles

measuring insurance companies’ cost of capital we are aware of only focus on the cost of equity

capital (see, e.g., Cummins and Phillips, 2005; Wen et al., 2008; Pottier and Xu, 2014). Cummins

and Phillips (2005) even break down the overall cost of capital of a firm to the individual

business lines, providing a methodology to use the cost of equity capital for financial decision

making within insurance companies.

2

The four implied cost of capital measures used in our analysis are Gebhardt, Lee, and

Swaminathan’s (2001) industry ROE method, Gordon and Gordon’s (1997) finite horizon

method, Gode and Mohanram’s (2003) economy-wide growth method, and Easton’s (2004)

price-earnings-growth ratio.