Integrated Risk Management: Techniques and Strategies for Reducing Risk.
Reviewer: Nicos A. Scordis, The College of Insurance, New York City
Neil Doherty's book Integrated Risk Management begins by answering the question of why risk management programs add value to firms. Cash-flow smoothing cannot justify corporate risk management programs. The rate of return shareholders require from a firm depends on the covariance of the firm's cash-flow with broad market movement, not its overall cash-flow volatility, or variance. In general, risk managers reduce cash-flow volatility by insuring and hedging perils shareholders can eliminate themselves at lower cost by holding diversified portfolios of assets. The cashflow volatility shareholders cannot diversify is the unavoidable trapping of a business venture promising its shareholders a rate of return above the "risk-free" rate of government bonds. When risk managers reduce volatility associated with this nondiversifiable or systematic part of cash flow, they change the covariance of the firm's cash flow to broad market movements. Any reduction in systematic risk, however, is accompanied by reductions in t he shareholder's return, according to traditional financial theory.
If shareholders value a risk management program, it is because it mitigates the frictional costs created by cash-flow volatility. One frictional cost is management's unwillingness or inability to make optimal capital investment decisions. Another frictional cost is that progressive tax codes, together with the tax treatment of business expenses, create higher tax bills for firms with volatile taxable cash flows. Thus a risk management program may realize value for shareholders by making possible a program of optimal capital investments and by reducing tax bills. But there are alternative ways to mitigate suboptimal investment and reduce taxes.
Doherty explores these alternatives and shows how they may have an effect on the value of a firm, as compared to a traditional risk management program. For example, managers can reduce the amount of interest-bearing debt in a firm's capital structure, and shareholders can alter the compensation structure of managers. Reductions in the leverage of the firm and changes in the incentives of managers have the same effect on the tendency for suboptimal investment as a risk management program. As for reducing taxes, managers can enter into operating leases, accelerate depreciation schedules, boost R&D spending, or increase the amount of interest-bearing debt in the firm's capital structure. Increases in these tax shields have the same effect as a risk management program on the firm's tax bill. Doherty explores these alternatives to illustrate the dual nature of integrated risk financing. To deal with the consequences of a loss, a manager may arrange for an infusion of cash or rearrange the firm's capital structure in a way that a loss creates few or no frictional costs. He uses a delightful analogy: Assume that you suffer from an allergy. You can either manage the allergy by removing the cause of the allergy or you can treat the symptoms of the allergy by taking antihistamine.
Doherty devotes the remainder of his book to helping any student of integrated risk financing decide when it is appropriate to manage the cause and when it is appropriate to manage the effect of cash-flow volatility. This is not an easy task, Doherty warns us. Even though the economic objective of each alternative technique is similar, some involve risk transfer, while others only finance risk. Some alternative techniques are bastions of insurance markets, while others are firmly established in capital markets. Furthermore, each technique has a unique profile of opportunity cost, liquidity risk, basis risk, and moral hazard. Doherty examines insurance and hedging techniques, but most important, he examines pre- and post-loss financing under different financing alternatives, contingent financing techniques, and risk-financing applications of the diversification principle.
Doherty's timely and comprehensive research, his case studies, his detailed examples as well as his step-by-step development of ideas clearly illustrate the interrelated nature of the opportunity cost, liquidity risk, basis risk and moral hazard of the most popular insurance and financing techniques today. For example, Doherty shows why basis risk is a crucial design element in structuring new risk financing techniques, and how increases in basis risk mitigate the technique's moral hazard.
After absorbing the book's material, the student of integrated risk financing will be able to combine today's best insurance and financial strategies into innovative, effective solutions for managing a firm's exposure to risk in a way that creates value for shareholders. For example, Doherty addresses whether a firm should undertake future investments and how it should pay for them. These are standard capital budgeting questions, but the difference here is that Doherty examines these questions at a time when the firm is subject to stress, just after some value-destroying shock. Thus the investment decisions of the firm become, in part, a recovery option.
Integrated Risk Management is a delight to read, especially if the reader has a corporate finance background. For those without, Doherty devotes the first six chapters to a thorough review of key corporate finance concepts. This is a book well worth the trees it took to make the paper for its 600-plus pages. I strongly recommend it.
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|Author:||Scordis, Nicos A.|
|Publication:||Journal of Risk and Insurance|
|Article Type:||Book Review|
|Date:||Dec 1, 2000|
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