The Impact of Enterprise Risk Management on the Marginal Cost of Reducing Risk: Evidence from the Insurance Industry

In this paper, we test the hypothesis that practicing Enterprise Risk Management (ERM) reduces firms’ cost of reducing firm risk. Adoption of ERM represents a radical paradigm shift from the traditional method of managing risks individually to managing risks collectively, in a portfolio. This formation and management of a portfolio of risks allows ERM-adopting firms to better recognize natural hedges, prioritize hedging activities towards the risks that contribute most to the total risk of the firm, and optimize the evaluation and selection of available hedging instruments. We hypothesize that these advantages allow ERM-adopting firms to produce greater risk reduction per dollar spent. The resulting lower marginal cost of risk reduction provides economic incentive for profit-maximizing firms to reduce risk until the marginal cost of risk reduction equals the marginal benefits. Therefore, our hypothesis predicts that, after implementing ERM, firms experience profit maximizing incentives to lower risk. Consistent with this hypothesis, we find that firms adopting ERM experience a reduction in stock return volatility. Due to the costs and complexity of ERM implementation, we also find that the reduction in return volatility for ERM-adopting firms becomes stronger over time. Further, we find that operating profits per unit of risk (ROA/return volatility) increase post ERM adoption.