First research to directly prove risk management impact on company financial performance
A new study from the Wisconsin School of Business at the University of Wisconsin-Madison finds that using enterprise risk management (ERM) techniques, such as the use of simple economic capital models (ECM) and having a dedicated risk manager (or risk management entity), can lead to millions of dollars in reduced costs and enhanced revenues.
Tyler Leverty, associate professor of risk and insurance at the University of Wisconsin-Madison’s Wisconsin School of Business, Martin F. Grace and Richard D. Phillips of Georgia State University, and Prakash Shimpi of Fraime, LLC evaluated survey results from insurance companies with ERM programs and evaluated their financial data to investigate the cash flow implications of adopting specific ERM practices.
The research found that:
- firms benefit from the use of simple ECMs to determine how much money to keep on hand to cover risks and that there was no added value from investing in advanced ECMs;
- having a dedicated risk manager or an entity responsible for firm-wide risk management led to a higher level of efficiency and return on assets; and
- requiring that individual or entity to report to a board of directors or C-Suite officials (CEO, CFO, general counsel, or chief auditor) also translated into increased efficiency and returns on assets.
“Firms use ERM to manage risk holistically across all divisions of the organization as a means of managing their exposure, creating efficiencies, and adding value,” says Leverty at the Wisconsin School of Business. “The challenge is putting the right set of programs in place to generate real value, and our research has identified best practices that are working for successful companies.”
The analysis found that firms adopting a simple ECM, having a dedicated risk manager or entity, and a reporting process that involved the board of directors or C-Suite executives resulted in $83.3 million in cost savings and $49.5 million in revenue enhancement for the average insurer. For U.S.-based companies, the savings and revenue increases were significantly higher. For a subsample of firms headquartered in the United States, the savings translated into $181.8 million in cost savings for the average insurer using those practices and $154.8 million in revenue enhancement.
“Our results suggest ERM practices result in economically and statistically significant increases in cost and revenue efficiency,” says Leverty. “It’s one thing to believe effective risk management efforts have an impact, but for the first time we have been able to directly document its impact on reducing firm costs and enhancing revenues.”
Leverty said that past research had stressed the importance of organizational structure in encouraging the success of information sharing across business segments and top management. For that reason, how the risk management function is organized within a firm is likely to be important in determining how effectively information on risk is being shared. The presence of a risk management team or a dedicated risk manager can avoid the problems that come from having a more siloed approach to risk management—where each division establishes and implements its own plans. Such efforts can be inefficient and lead to managing opposing risks that cancel each other out.
Reporting relationships are also important to the success of risk management. Firms with strong dialogue between their senior management team and business segments regarding organization-wide risks are going to have a better understanding of those risks. And a risk manager with access to the board of directors or C-Suite leadership is going to have more credibility than one who does not.
Access Leverty’s paper “The Value of Investing in Enterprise Risk Management” in The Journal of Risk and Insurance.