Managing the Invisible: Measuring Risk, Managing Capital, Maximizing Value

Enterprise Risk Management (ERM) is a body of knowledge – concepts, methods, and techniques – that enables a firm to understand, measure, and manage its overall risk so as to maximize the firm’s value to shareholders and policyholders. The purpose of this paper is to demonstrate this often-asserted but seldom-described linkage between ERM on the one hand, and maximizing a firm’s value on the other. In Part 1 I argue that ERM, by measuring the firm’s aggregate risk exposure, enables the firm’s managers to identify and choose value-maximizing combinations of risk and capital. In Part 2 I describe and critique the rules of thumb that CFO’s typically rely on to make critical decisions concerning the firm’s capital structure, and propose value maximization as an alternative. Part 3 describes alternative approaches to valuing a firm, and Part 4 presents a valuation model for a property-casualty firm. Part 5 shows how this valuation model can assist managers in making value-maximizing strategic decisions, and Part 6 emphasizes the substantial importance to insurance executives of value-focused ERM, which makes the value of the firm both visible and manageable.

Keywords: Enterprise Risk Management, ERM, franchise value, valuation, capital structure, optimization, property-casualty.