ABSTRACT
Corporations expend considerable resources in establishing strategic risk management programs, establishing risk tolerance levels, developing risk cultures, and transferring risk. Practitioners view these as value enhancing, eliminating the impact of stochastic shocks. Notwithstanding, a widespread, naïve interpretation of modern portfolio theory considers such investments as costly attempts to reduce idiosyncratic risk, costlessly eliminated via shareholder diversification. This chapter notes some limitations inherent in Modern Portfolio Theory (MPT) analysis with respect to insurance and risk management expenditures and reviews efficiencies associated with risk management and risk transfer for midrange losses. Finally, the chapter focuses on the impact of significant losses (localized black swan events) on a corporation’s cost of capital, noting increased information asymmetries, increased leverage and the weighted average cost of capital, and the associated increase in the cost of financial distress. Risk transfer/insurance is viewed as an option to reduce information asymmetries while providing immediate financial resources preventing major distortions in capital structure.
Key words: Corporate demand for insurance; localized black swan events; risk transfer; optimal capital structure; risk management culture; enterprise risk management.
This chapter explores the generation of firm value through strategic risk management. As the majority of the chapters in this book focus on financial risk management, the focus in this chapter is on what is commonly referred to as enterprise risk management, 2 the strategic plans that are established to manage risks associated with stochastic, unexpected events, especially those that have a negative impact on the value of assets, at times significantly. Stochastic risks are those that are largely beyond a firm’s control. They include elements such as property and bodily injury risks (related to fire, windstorms, earth movement, flooding, etc.), business income, transportation risks including commercial auto, aviation, etc. Finally, they include losses from operational errors and liability risks (product liability, worker’s compensation, employment practices liability, pollution, director’s and officer’s coverage, etc.). In recent years, transferring risks associated with terrorism, reputational, and cyber risks have figured more prominently in firm’s risk management 439programs. Stochastic risks do not include normal business risk (managing operations, marketing, pricing, overall management, etc.). In the insurance literature, these are often referred to as pure risks as they have only downside potential. 3 They are the known unknowns, and at times, the unknowable unknowns discussed by Nassim Nicholas Taleb in The Black Swan (2007).
Pure risks can range from small events (minor glass breakage, business interruption of a few hours or a few days due to a small fire, or a minor worker’s compensation claim) to large localized black swan events (major product liability claim, major cyber risks, or catastrophic disasters). In this chapter the latter will be referred to as “localized black swan events.” These are not the black swan events that impact the nation or the world, but events that significantly impact a specific firm, potentially leading to severe financial distress or bankruptcy.
In a response to the potential for a localized black swan event, firms have relieved on risk management and risk transfer programs to deal with unforeseen risks as well as those risks that are within their experience. Insurers, with a greater knowledge of and expertise in managing risks have likewise responded in providing new forms of coverage while setting up reinsurance and capital markets instruments (e.g., cat bonds) to deal with some of the known unknowns. Governments have played an important role in reinsuring terrorism risk following 9/11 as the risk profile was in complete flux, stabilizing markets as unknowable unknowns created an insurance crisis. 4 As such, investment of resources in enterprise risk management (including the purchase of insurance where appropriate) is undertaken to create value for the firm. Value can be created directly, where the value is observed on a year-in year-out basis, or indirectly via reducing the cost of debt and/or equity for the firm changing the weighted average cost of capital. There is general agreement that enterprise risk management can serve to reduce or eliminate negative cash flows and/or to modify the frequency and severity distributions of stochastic risks. Sometimes the impact is minor. An investment in safety training programs can reduce injuries or death, thereby reducing related worker’s compensation premiums. Others can have major impact on cash flows, such as reducing lawsuits against the firm, cyber attacks, environmental liability, etc.
