The Combined Effect of Enterprise Risk Management and Diversification on Property and Casualty Insurer Performance

• Published date: 01 June 2018
• Date: 01 June 2018
• Author: Tianyang Wang,Vickie Bajtelsmit,Jing Ai
• DOI: http://doi.org/10.1111/jori.12166

©2016 The Journal of Risk and Insurance. Vol.85, No. 2, 513–543 (2018).

DOI: 10.1111/jori.12166

The Combined Effect of Enterprise Risk Management

and Diversification on Property and Casualty

Insurer Performance

Jing Ai

Vickie Bajtelsmit

Tianyang Wang

Abstract

In a well-designed enterprise risk management (ERM) program, the firm

integrates risk management into the strategic planning process, addressing

strategic, financial, operational, and hazard risks under a single overarching

process. This is particularly important to large financial firms, such as prop-

erty and casualty (P&C) insurers, which face a diverse set of risks. Using a

sample of P&C insurers with S&P ERM quality ratings from 2006 to 2013,

we find that the quality of a firm’s ERM is a significant determinant of P&C

insurer performance and that, for firms with high-quality ERM programs,

product line diversification has a significant positive effect on performance.

Introduction

As compared to traditional silo approaches to risk management, a holistic approach

is believed to be more effective for firms with complex and interrelated risks, such

as property and casualty (P&C) insurers (Hoyt and Liebenberg, 2011; Ai et al., 2012).

In a well-designed enterprise risk management (ERM) program, the firm integrates

risk management into the strategic planning process, addressing strategic, financial,

operational, and hazard risks under a single overarchingprocess. A portfolio approach

to risk management theoretically allows a firm to reduce inefficiencies and exploit

natural hedges across the organization, thereby enhancing returns and value. In the

last decade, in part due to regulatory requirements and rating agency criteria, nearly

all insurers have adopted ERM-based approaches for dealing with the wide variety of

risks they face (Beasley, Branson, and Hancock, 2012). However, the extent to which

they have done so and the quality of their ERM programs differ from firm to firm

(Grace et al., 2015). The academic literature has found ERM adoption to have positive

Jing Ai is at the Department of Finance, University of Hawaii. Ai can be contacted via e-mail:

Jing.Ai@hawaii.edu. Vickie Bajtelsmit is at the Department of Finance and Real Estate, Col-

orado State University.Bajtelsmit can be contacted via e-mail: Vickie.Bajtelsmit@colostate.edu.

Tianyang Wang is at the Department of Finance and Real Estate, Colorado State University.

Wang can be contacted via e-mail: Tianyang.Wang@colostate.edu.

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effects on firm value and performance.1However,these conclusions have been based

on short time series and have used ERM-implementation proxies(e.g., announcements

and management surveys) that do not distinguish ERM programs based on quality of

implementation. This study adds to this growing literature by evaluating the effect of

ERM quality on P&C insurer performance, while controlling for firm diversification

strategy.

In theory, ERM should be most beneficial for large complex organizations. There-

fore, consideration of the effects of ERM must necessarily take size and complexity

into account. However, previous research has also shown that more diversified firms

tend to suffer value and performance discounts relative to more focused competi-

tors. Although large diverse organizations arguably benefit from scope economies

and greater access to internal capital, they also may be less efficient due to complexity

of coordination across units and potentially duplicative management and processes

(Laeven and Levine, 2007). The most common explanation for the destruction of value

for diversified firms is unwieldy operational costs (see, e.g., Elango, Ma, and Pope,

2008). These may include costs of coordinating across diverse units, incentive degra-

dation (employees act in their own self-interest, undermining broader firm efforts

in value creation, despite incentive systems), and bureaucratic distortions (Nayyar,

1992). Additionally,it may be difficult and expensive for senior management of highly

diversified firms to properly manage an increasingly dissimilar set of business oper-

ations (Jones and Hill, 1988). The empirical evidence in the insurance literature sug-

gests that the costs of being diversified often outweigh the benefits, with many studies

concluding that product line and/or geographic diversification result in reduced per-

formance and/or value relative to more focused peers (Berger, Cummins, and Weiss,

2000; Elango, Ma, and Pope, 2008; Liebenberg and Sommer,2008; Berry-Stölzle, Hoyt,

and Wende, 2013).

It is our hypothesis that one way in which high-quality ERM programs can add value

to large complex organizations is through the establishment of metrics and decision

processes that result in improved analysis of the benefits and costs associated with the

corporate diversification strategy.There are obvious synergies from using a consistent

risk management framework and process across the organization rather than in silos.

Firms may benefit from improved operational efficiency, establishment of more effec-

tive incentive structures, and more appropriate allocation of capital, all of which are

notable challenges for a diversified organization (Berry-St¨

olzle and Xu, 2013; Grace

et al., 2015). Shareholder value is arguably enhanced by optimizing the risk–return

trade-off in a portfolio context (Farrell and Gallagher, 2014).

Previous insurance research has identified positive value effects for ERM adoption

and negative value effects for product line and geographic diversification. Our study

contributes to this literature by identifying the combined performance and value ef-

fects of ERM and diversification for large P&C insurers for the period 2006–2013,

using a third-party ERM quality assessment from Standard & Poor’s (S&P). We find

1For two recent reviews of the empirical literature on the determinants and value impact of

ERM in the insurance industry,see Kraus and Lehner (2012) and Gatzert and Martin (2013).