The Value of Investing in Enterprise Risk Management

• Date: 01 June 2015
• DOI: http://doi.org/10.1111/jori.12022
• Published date: 01 June 2015

THE VALUE OF INVESTING IN ENTERPRISE RISK

MANAGEMENT

Martin F. Grace

J. Tyler Leverty

Richard D. Phillips

Prakash Shimpi

ABSTRACT

Prior studies show that enterprise risk management improves firm

performance. This article investigates which aspects of enterprise risk

management add value. We find that the use of economic capital models and

dedicated risk managers improve operating performance. Requiring the

dedicated risk manager report to the board of directors or to the chief

executive officer (CEO) also increases value. The following combination of

enterprise risk management initiatives yields the greatest increase in firm

value: a simple economic capital model, a dedicated risk manager that is a

cross-functional committee, and requiring the risk manager report to the

board or CEO.

Modigliani and Miller (1958) establish that in perfect capital markets capital structure

does not affect the market value of the firm. Risk management also does not create value

in perfect capital markets. In imperfect capital markets, however, researchers

have posited that risk management may create value by reducing and/or exploiting

market imperfections—taxes (Modigliani and Miller, 1963; Graham and Smith, 1999),

bankruptcy costs (Kraus and Litzenberger, 1973; MacMinn, 1987), the cost of external

capital (Froot, Scharfstein, and Stein, 1993), and agency costs (Jensen and Meckling, 1976;

Myers, 1977; Mayers and Smith, 1982, 1987; MacMinn, 1987; Garven and MacMinn,

1993). The focus of these studies is largely on traditional risk management.

The traditional approach to risk management is a silo technique in which one risk is

managed at a time without acknowledging the interrelationship of risks. In contrast,

Martin F. Grace is the James S. Kemper Professor of Risk Management, Georgia State

University. J. Tyler Leverty is an Associate Professor of Finance at the University of Iowa.

Richard D. Phillips is the C.V. Starr Professor of Risk Management, Georgia State University.

Prakash Shimpi is President of Fraime LLC. J. Tyler Leverty can be contacted via e-mail: ty-

leverty@uiowa.edu. This project was supported by a generous grant from the Risk Foundation.

The opinions expressed here are those of the authors and not necessarily of the sponsoring

organization.

© 2014 The Journal of Risk and Insurance. 82, No. 2, 289–316 (2015).

DOI: 10.1111/jori.12022

289

enterprise risk management (ERM) is an enterprise-level assessment, quantification,

financing, and managing of risk. It is a holistic approach to risk management. ERM

emphasizes that the organizational benefits of risk management can also create value

for firms (Nocco and Stulz, 2006). With ERM a firm examines risks jointly, assessing

the interaction of each risk with the firm’s portfolio of other important risks (Froot and

Stein, 1998).

1

Beyond improving internal decision making (Nocco and Stulz, 2006),

ERM can also lead to more efficient capital allocation (Myers and Read, 2001), better

capital structure decisions (Graham and Rogers, 2002), and better risk management

decisions (Mayers and Smith, 1982; Cummins, Phillips, and Smith, 2001). ERM can

also advance risk awareness that improves operational and strategic decisions.

Even though researchers have pointed to the strategic and operational value of using

an enterprise risk approach (Doherty, 2000), the vast majority of empirical studies

investigate whether the behavior of firms that use financial derivatives is consistent

with extant theories about market imperfections (e.g., Allayannis and Weston, 2001;

Kim, Mathur, and Nam, 2006). A handful of studies examine the value of ERM by

investigating the appointment of a chief risk officer (CRO) (e.g., Hoyt and

Liebenberg, 2003, 2011; Beasley, Pagach, and Warr, 2008; Pagach and Warr, 2011;

Lin, Wen, and Yu, Forthcoming). Hoyt and Liebenberg (2011) find that ERM adds

significant value to publicly traded insurers. They conclude that future research

should identify the specific ways in which ERM contributes to firm value.

This study seeks to do just that. Specifically, it identifies the components of an ERM

program and investigates the impact of each on firm value. We do this by using a

unique survey conducted by Tillinghast Towers Perrin. The objective of the survey

was to evaluate the ERM practices of their worldwide insurance clients. We link this

survey information to insurer annual statutory financial data to examine the impact of

ERM initiatives on firm cost and revenue efficiency. We then calculate the annual

costs savings and revenue enhancement of adopting various ERM initiatives and the

associated impact on the average firm’s return on assets (ROA). In sum, linking the

survey information to insurer annual financial data allows us to investigate the cash

flow implications of adopting various ERM initiatives for both public and private

firms.

The insurance industry is particularly useful to study the value of ERM. The industry

is in the business of risk management and insurers are on the forefront of

implementing ERM.

2

There are also established measures of firm cost and revenue

efficiency using frontier efficiency techniques in the insurance literature (Cummins

and Weiss, Forthcoming)

3

and these measures are strongly linked to traditional and

market measures of firm performance (Cummins, Grace, and Phillips, 2008;

1

ERM is also commonly referred to as an integrated or portfolio approach to risk management.

2

Beasley, Branson, and Hancock (2012) report that the ERM programs of financial services’

organizations are significantly more mature than other organizations. In addition, Pagach and

Warr (2011) find a substantial portion of CRO appointments are located in the financial

industry.

3

Cummins and Weiss (Forthcoming) identify 74 studies spanning the period 1983–2011 that use

frontier efficiency to measure insurer performance.

290 THE JOURNAL OF RISK AND INSURANCE