October 15, 2005

Risk Measurement and Disclosure

Risk disclosure decisions can have a direct impact on a firm's cost of capital. When is it in managers' best interests to voluntarily reveal information about firm-specific risk?

Two decades ago, the number of product-related lawsuits against U.S. corporations was skyrocketing, as juries awarded increasingly large payoffs to successful plaintiffs. As a result of these trends, the cost of product liability insurance quadrupled over a three-month period in 1985. By the following year, according to one study, 52 percent of firms that had previously purchased product liability insurance had discontinued their coverage, either because of higher premiums or because coverage was no longer available.

Recent research by Bjorn Jorgensen, Anne Beatty and Anne Gron shows a link between a firm’s response to the premium hike and its compensation structure prior to the liability insurance crisis. Firms that paid senior managers in stock were more likely to continue to buy insurance, while those that gave senior managers stock options were more likely to become self-insured. This correlation is consistent with the observation that executives who hold stock options care less about risk management instruments like insurance because, while they benefit when the stock price goes up, they bear no risk when it goes down.

“What we saw is that you can learn something about a firm’s risks and reaction to those risks by looking at the compensation of the senior management,” says Jorgensen, the Gary Winnick and Martin Granoff Associate Professor of Business at the School. “In broader terms, the corporate governance takeaway is that the way we pay management affects the operating decisions they choose to make.”

For the past five years, Jorgensen has studied managers’ decisions about measuring and disclosing risk and the impact of those decisions on a firm’s cost of capital. Investors can become nervous when firms provide either too much or too little information about firm-specific risks, so disclosure decisions often have a direct effect on a firm’s stock price and its ability to borrow money.

“The million-dollar question here really is, What can managers do to affect their cost of capital in the future?” says Jorgensen. “It has been addressed before in other settings, but not in terms of risk disclosure.” He notes that how a firm measures and discloses risk ultimately reflects back on the firm’s operating decisions and that risk disclosure is an important way of communicating the firm’s strategy to investors.

The accounting profession, with its emphasis on historical transactions, has traditionally paid little attention to the subject of risk — a shortcoming that Jorgensen and his colleagues hope to remedy. “When you drive a car, you can’t just look in the rearview mirror,” he says. “Sometimes you have to look ahead. And accounting is not well suited for that. This is why my research is about risk, because it’s one of the things that blindsides us as financial statement users when we look at what happened in the past. Regulations are changing to reflect this perceived need.”

Since 1998, the U.S. Securities and Exchange Commission (SEC) has required large public firms to reveal certain types of risk-related information, although managers outside the financial sector have considerable leeway regarding the confidence level, time horizon and method of estimating risk. By next summer, when the 2002 Sarbanes-Oxley Act is fully implemented, smaller public firms will be subject to similar risk disclosure requirements.

The question facing managers, then, is how much additional risk information to disclose. Jorgensen and Michael Kirschenheiter developed a theoretical framework for analyzing how investors should diversify their portfolios based on the voluntary risk disclosures of all firms in the economy. Their model demonstrates that managers maximize firm value by disclosing additional risk information only if the information is sufficiently favorable.

The critical factor in this framework is investors’ uncertainty about whether managers possess additional information about firm-specific risks. Managers elect to voluntarily disclose when their risk information is not particularly damaging, which makes investors more willing to buy the firm’s shares at a lower price.

In addition to examining total firm risk as measured by variances, Jorgensen and Kirschenheiter also studied systemic risk. They found that a firm’s disclosure strategy affects its beta — a measure of the correlation between firm-specific risk and market risk — as well as the beta of other firms. Thus, if most of the other firms in an industry have voluntarily disclosed information about their risks, a firm that chooses not to disclose must pay investors a higher risk premium to compensate for the uncertainty.

A robust risk measurement strategy may require a substantial investment in information technology, a cost that firms must take into account as they consider the potential benefits of disclosure. Still, the advantages of voluntary risk disclosure often outweigh the costs.

“Our research shows that when firms provide adequate risk disclosures, it allows investors to make better portfolio decisions,” Jorgensen says. “Once investors become better at diversifying their risks across different shares, they’re more willing to invest effectively. And that in turn means that firms become more willing to invest the funds that it takes to have good risk controls in place within the organization.”

Read More

Beatty, Anne, Anne Gron and Bjorn Jorgensen. “Corporate Risk Management: Evidence from Product Liability.” Journal of Financial Intermediation 14 (2005): 152–78.

Jorgensen, Bjorn, and Michael Kirschenheiter. “Discretionary Risk Disclosures.” The Accounting Review 78 (2003): 449–69.

“Voluntary versus Mandatory Risk Disclosures with Asymmetric Information and Costly Investment in Information Technology.” Working paper, 2003.

Bjorn Jorgensen is the Gary Winnick and Martin Granoff Associate Professor of Business. His working paper with Michael Kirschenheiter won the KPMG UIUC Competitive Manuscript Award on Risk Measurement and Disclosure in 2003. During the 2005–06 academic year, Jorgensen is a visiting academic fellow at the U.S. Securities and Exchange Commission.

Read more about faculty research on risk management at www.gsb.columbia.edu/ideas.

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