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 rose dramatically, as juries made bigger and bigger awards to successful plaintiffs. The cost of product liability insurance went through the roof: in just three months of 1985, the price quadrupled. By the end of 1986, 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 of Columbia, Anne Beatty of Ohio State and Anne Gron of Northwestern 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 options were less likely to continue their coverage than those that paid in stock. In other words, you care less about risk management instruments like insurance if you benefit when the stock price goes up but 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. “In broader terms, the corporate governance takeaway is that the way we pay management affects the operating decisions they choose to make.”
Jorgensen’s research studies 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 risk. “When you drive a car,” Jorgensen says, “you can’t just look in the rearview mirror. Sometimes you have to look ahead. And accounting is not well suited for that.” Jorgensen’s research helps fill that gap. New regulations help, too, by forcing companies to include in their financial statements items that accountants can use to assess risk. Since 1998, the U.S. Securities and Exchange Commission (SEC) has required large public firms, especially those in the financial sector, to reveal much more risk-related information. In other industries, managers still have greater leeway about the confidence level, time horizon and method of estimating risk. The 2002 Sarbanes-Oxley Act extends similar rules of risk disclosure to smaller public firms.
Yet managers still decide how much risk information to disclose beyond the legal requirements. Using an economic model of voluntary risk disclosure, Jorgensen and Michael Kirschenheiter of Purdue showed that firms maximize value by disclosing additional risk information only if it is sufficiently favorable. The key factor is investor uncertainty about whether managers possess additional information about firm-specific risk. Managers disclose when their risk information is not particularly damaging, so investors are more willing to buy the firm’s shares at a lower price.
The researchers found that a firm’s risk disclosure also affects its beta — the relation between firm-specific risk and market risk — as well as the beta of other firms. If other firms in a sector voluntarily disclose information about risk, a firm that fails to disclose must pay investors a higher risk premium to compensate for the uncertainty.
Effective risk measurement requires a big investment in information technology. Still, the benefits of voluntary risk disclosure often outweigh the costs. In the end, better information is better for firms, investors and the economy as a whole. “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.”
Bjorn Jorgensen is the Gary Winnick and Martin Granoff Associate Professor of Business at Columbia Business School. His 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 Exchange Commission.