Managing the Invisible: Identifying Value-Maximizing Combinations of Risk and Capital

This article demonstrates the linkage—often asserted but seldom described—between Enterprise Risk Management (ERM) and maximizing a firm's value. I show that knowing a firm's aggregate risk exposure (via ERM), when combined with a valuation model like the one presented here, can enable the firm's managers to identify and choose value-maximizing combinations of risk and capital. Using value maximization as the criterion for choosing a firm's capital structure is quite distinct from rules of thumb that CFOs often use for such decisions. The valuation model shows that increasing an insurer's surplus from an initially low level typically increases the present value of future cash flows that take into account the probability of impairment from extreme losses. In contrast to traditional literature on the risk of ruin, impairment here is taken to mean a loss of creditworthiness such that the firm's business model is no longer sustainable, whether or not the firm is solvent. However, beyond a certain optimal level relative to a firm's risk, further increases in surplus actually reduce a firm's value added measured in this fashion. Sensitivity analyses presented here show how these conclusions are affected by changes in the values of crucial variables. In particular, the article shows how managers can use this model to identify specific actions that their firm can take to increase its value added, and it emphasizes the practical importance of making a firm's value both visible and manageable.