Before the start of the 21st century, silo-risk management was a more widespread practice that enabled individual departments to perform risk identification and mitigation.
However, this approach was ineffective as it lacked an integrated view of company-wide risk-management activities. This often led to missing key risks, resulting in the emergence of interrelated risks. This created a domino effect and would lead to successive failures in the banking and insurance industries, forcing supervisors to implement risk-based capital (RBC) regulations where capital was a function of risk and not a factor-based standalone capital.
There is a close relationship between RBC and Enterprise Risk Management (ERM), as the existence of ERM helps optimise the capital requirement. A better risk-managed company reduces the overall capital requirement and keeps regulators and shareholders equally interested.
RBC and ERM in the banking and insurance sectors have developed together as they complement each other and further accelerated growth after the 2008 Global Financial Crisis.
ERM is a holistic risk management framework implemented across the organisation. It often starts at the board level and affects every employee, with the Chief Risk Officer at the helm of the risk vertical. Over the past 20 years, ERM has developed at a practitioner level as well as at the academic level. At the practitioner level, risk management standards were brought by COSO, ISO 31000 and other standards, whereas in the academic world, they performed research on assessing the value of ERM on the firm performance, which was measured by improving return on capital and assets, improving expense and revenue efficiency and much more.
In this article, we will look at four academic pieces of literature to investigate and identify how ERM helped improve firm performance based on research from different authors. This article will also delve into the contribution of corporate governance in enhancing the ERM, bridging the gap between the academic and the practitioners’ world.
ERM augmentation to insurance value
The fundamental shift from silo risk management to enterprise risk management is changing the attitude of managing the downside risk in the former style to managing opportunities in the latter.
This shift changed the focus towards looking at both upside and downside risk with the development of ERM. Much of the academic research from 2000 focused on quantifying the value addition of ERM on firm performance. One of the challenges faced by CRO Teams worldwide was assessing the value contribution towards either mitigation of risks or value enhancement due to CRO intervention at the end of the financial year. Such contributions are often qualitatively assessed, with opinions given based on judgement.
Various academic researchers worldwide have used empirical models to quantify the impact of ERM on firm performance and provide quantification for value enhancement. A 10% value enhancement due to ERM on the insurance company’s value of USD 10 million is USD 1 million, which is a substantial amount given the budget of the Risk Team explores that some authors have identified value enhancement in the firm performance between 6.5% to 20%.
This allows ERM practitioners to demonstrate quantitatively their value addition. Such quantification also helps risk management professionals communicate ERM results to key stakeholders such as board, regulators, management and rating agencies. For example, from 2007 to 2015, capturing the development towards Solvency-II, Bohnert et al (2019) analysed ERM’s impact on European insurance companies’ shareholder value. They studied 41 insurance companies during this period and used Tobin Q to measure the market-based firm value on the implementation of ERM. They found that the implementation of ERM improved the firm value by 6.5%. They also discovered that large insurance companies have a significant positive impact on ERM implementation.
Another author, Hoyt and Liebenberg (2011) studied the impact of the implementation of ERM programs on firm value for 275 US insurers from 1995 to 2005 and found it enhanced the substantial firm value by 20%. This is a considerable enhancement in the firm value. Yet another author, Eckles et al. (2015), who studied companies that adopted ERM between the period of 1995 to 2008, found that ERM helped reduce risk by 14%.
A crucial element to ERM success
Corporate governance is a crucial element of the success of ERM and its firm performance. Without good corporate governance, an organisation cannot run successfully.
Hsu and Petchsakulwong (2010) studied the relationship between corporate governance and the efficiency performance of public non-life insurance companies in Thailand from 2000–2007.
They found that as the Board of Directors and shareholders play a vital role in determining the policy and strategy of a company, it is essential that companies review the performance of management to ensure the implementation of company policies and procedures to maximise their shareholders’ benefits. It was discovered that larger board size is more beneficial to the efficiency performance of a firm because more board members mean more knowledge and varied opinions, as well as stricter monitoring to ensure the reduction of financial fraud.
Additionally, as a board comprises independent directors, they are used as a proxy of board independence. They are an essential factor in measuring the effectiveness of board monitoring, similar to the way in which an audit committee works. The author concluded that board independence and the efficiency performance of insurers are positively related as results suggest that a board dominated by independent directors is associated with effective monitoring that enhances a firm’s efficiency.
Board meeting frequency is also positively correlated to its cost efficiency. The result indicates that board diligence can improve the efficiency performance of a firm as the Board has more opportunities to monitor management performance.
There is a clear benefit to adopting ERM through the value addition in the firm performance and as such, there should be enough incentive for shareholders to adopt ERM practices proactively rather than waiting for a regulator’s push. There also still remains a need to bridge the gap between the academic and practising world, as much of the research on the academic side can be used on the practitioner’s side.
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