Integrated Risk Management: Techniques and Strategies for Reducing Risk

Abstract

Integrated Risk Management: Techniques and Strategies for Reducing Risk, by Neil A. Doherty (New York: McGraw-Hill, 2000). 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 the 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. …