Do Board Risk Committees Matter to Ratings Agencies and for Performance?
The 2008 financial crisis was the greatest financial crisis since the Great Depression and The Financial Crisis Inquiry Commission conclude that " dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis" (National Commission, 2011).
Although the board of directors bears primary responsibility for risk management (Tonello, 2012), many insurers have delegated this obligation to stand-alone risk committees (board risk committees). In fact, board risk committees have become more common since the 2008 financial crisis, partly due to Dodd Frank Act 2010. This paper uses the insurance industry to investigate whether a board risk committee adds value from the standpoint of rating agencies and impacts firm performance.
The study finds that firms with a board risk committee report higher A.M. Best's Financial Strength Ratings after controlling for corporate governance characteristics and other relevant factors. However, this result only holds during the post-financial crisis period. The authors suggest that external evaluators may have responded stronger after the financial crisis began, when regulators monitored insurer board-level governance mechanisms more closely.
In addition, firms adopting a board risk committee experience an immediate increase in financial strength ratings and the presence of a board risk committee appears to be related to long-term firm performance (it takes at least five years for ROE to improve). However, financial strength ratings does not appear to be related to board risk committee age or short-run performance.
Overall, the study provides evidence consistent with board risk committees being effective and beneficial from the standpoint of rating agencies and long-term financial performance.
A.M. Best, 2012. Best's financial strength rating. www.ambest.com/ratings/guide.asp.
A.M. Best, 2013. A.M. Best Methodology: Risk Management and the Rating Process for Insurance Companies. http://www3.ambest.com/ambv/ratingmethodology/openpdf.aspx?rc=197707
A.M. Best, 2017. Best's Credit Rating Methodology: Global Life and Non-Life Insurance Edition. http://www3.ambest.com/ambv/ratingmethodology/OpenPDF.aspx?rc=250950.
Akhigbe, A., McNulty, J., 2005. Profit efficiency sources and differences among small and large U.S. commercial banks. Journal of Economics and Finance 29 (3), 289-299.
Ames, D., Hines, C.S., Sankara, J., 2014. Are earnings quality attributes reflected in financial strength ratings? American Journal of Business 29 (3/4), 293-311.
Ayers, B.C., Laplante, S.K., McGuire, S.T., 2010. Credit ratings and taxes: The effect of book–tax differences on ratings changes. Contemporary Accounting Research 27 (2), 359-402.
Bates, E., Leclerc, R., 2009. Boards of directors and risk committees. The Corporate Governance Advisor 17 (6), 15-17.
Baxter, R., Bedard, J.C., Hoitash, R., Yezegel, A., 2013. Enterprise risk management program quality: Determinants, value relevance, and the financial crisis. Contemporary Accounting Research 30 (4), 1264-1295.
Beasley, M.S., Clune, R., Hermanson, D.R., 2005. Enterprise risk management: An empirical analysis of factors associated with the extent of implementation. Journal of Accounting and Public Policy 24 (6), 521-531.
Beasley, M.S., Frigo, M.L., 2007. Strategic risk management: Creating and protecting value. Strategic Finance 88 (11), 24-33.
Beaver, W.H., Shakespeare, C., Soliman, M.T., 2006. Differential properties in the ratings of certified versus non-certified bond-rating agencies. Journal of Accounting & Economics 42 (3), 303-334.
Berger, A.N., Di Patti, E.B., 2006. Capital structure and firm performance: A new approach to testing agency theory and an application to the banking industry. Journal of Banking & Finance 30 (4), 1065-1102.
Bhagat, S., Bolton, B., 2008. Corporate governance and firm performance. Journal of Corporate Finance 14 (3), 257-273.
Bostrom, R., 2002. Corporate governance, risk management, and compliance: Best practices after Sarbanes-Oxley. International Financial Law Review (Supplement), 165-172.
Cohen, J.R., Krishnamoorth, G., Wright, A.M., 2008. Form versus substance: The implications for auditing practice and research of alternative perspectives on corporate governance. Auditing: A Journal of Practice and Theory 27 (2), 181-198.
Committee of Sponsoring Organizations of the Treadway Commission (COSO), 2009. Board Risk Oversight – A Progress Report. COSO, New York.
Core, J.E., Guay, W.R., Rusticus, T.O., 2006. Does weak governance cause weak stock returns? An examination of firm operating performance and investors' expectations. Journal of Finance 61 (2), 655-687.
Dechow, P., Dichev, I., 2002. The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review 77, 35–59.
Deloitte, 2011. Global risk management survey, seventh edition: Navigating in a changed world 7e, Deloitte Global Services Limited. http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/us_fsi_grms_031711.pdf
Dichev, I., Piotroski, J.D., 2001. The long-run stock returns following bond ratings changes. Journal of Finance 56, 173-204.
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), 2010. Dodd-Frank Wall Street Reform and Consumer Protection Act. [Section 165].
Düllmann, K., Uhrig‐Homburg, M., Windfuhr, M., 2000. Risk structure of interest rates: An empirical analysis for Deutschemark‐denominated bonds. European Financial Management 6 (3), 367-388.
Ederington, L.H., Goh, J.C., 1998. Bond rating agencies and stock analysts: Who knows what when? Journal of Financial and Quantitative Analysis 33 (404), 569-585.
Goh, J.C., Ederington, L.H., 1999. Cross-sectional variation in the stock market reaction to bond rating changes. Quarterly Review of Economics & Finance 39 (1), 101-112.
Grace, M.F., Leverty, J.T., Phillips, R.D., Shimpi, P., 2014. The value of investing in enterprise risk management. The Journal of Risk and Insurance 82 (2), 289-316.
Hand, J. R., Holthausen, R. W., Leftwich, R. W., 1992. The effect of bond rating agency announcements on bond and stock prices. The Journal of Finance 47 (2), 733-752.
Heckman, J.J., 1979. Sample selection bias as a specification error. Econometrica 47 (1), 153-161.
Hines, C.S., Masli, A., Mauldin, E.G., Peters, G.F., 2015. Board risk committees and audit pricing. Auditing: A Journal of Practice and Theory 34 (4), 59-84.
Holder-Webb, L., Cohen, J., 2012. The cut and paste society: Isomorphism in codes of ethics. Journal of Business Ethics 107, 485-509.
Holthausen, R.W., Leftwich R.W., 1986. The effect of bond rating changes on common stock prices. Journal of Financial Economics 17 (1), 57-89.
Hoyt, R.E., Liebenberg, A.P., 2011. The value of enterprise risk management. The Journal of Risk and Insurance 78 (4), 795-822.
Jorion, P., Liu, Z., Shi, C., 2005. Informational effects of regulation FD: Evidence from rating agencies. Journal of Financial Economics 76 (2), 309-330.
Kisgen, D. J., Strahan, P. E., 2010. Do regulations based on credit ratings affect a firm's cost of capital? Review of Financial Studies 23 (12), 4324-4347.
Kuang, Y. F., Qin, B., 2013. Credit ratings and CEO risk-taking incentives. Contemporary Accounting Research 30 (4), 1524-1559.
Lundqvist, S.A., 2015. Why firms implement risk governance – Stepping beyond traditional risk management to enterprise risk management. Journal of Accounting and Public Policy 34 (5), 441-466.
Modigliani, F., Merton, H.M., 1958. The cost of capital, corporation finance and the theory of investment. The American Economic Review 48 (3), 261-297.
Molyneux, P., Thornton, J., 1992. Determinants of European bank profitability: A note. Journal of Banking & Finance 16 (6), 1173-1178.
Moody's Investor Service (Special Comment), 2006. Best practices for a board's role in risk oversight.
Moore, M., Brauneis, M., 2008. U.S. subprime crisis: Risk management's next steps. Bank Accounting and Finance 21 (3), 18-48.
Mora, N., 2006. Sovereign credit ratings: Guilty beyond reasonable doubt? Journal of Banking & Finance 30 (7), 2041-2062.
Murcia, F.C., Murcia, F., Borba, J.A., 2013. The informational content of credit ratings in Brazil: An event study/(Conteúdo informacional de ratings de crédito no Brasil: Um estudo de evento). Revista Brasileira de Finanças 11 (4), 503-526.
National Commission, 2011. The financial crisis inquiry report. Official Government Edition, FCIC Website, 17, pp.417-719.
Nayer, N., Rozeff, M.S., 2012. Ratings, commercial paper, and equity returns. The Journal of Finance 49 (4), 1431-1449.
Nixon Peabody, 2010. The role and construction of risk committees. Nixon Peabody – Corporate Responsibility Alert. August 11, 2010.
Petroni, K.R., 1992. Optimistic reporting in the property-casualty insurance industry. Journal of Accounting and Economics 15 (4), 485-508.
Protiviti, 2011. Should the board have a separate risk committee? Board Perspectives: Risk Oversight. Issue 24.
Schlich, B., Prybylski, H., 2009. Crisis changes view of risk management. Bank Accounting and Finance 22 (5), 48-51.
Sloan, R., 1996. Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289–315.
Tonello, M., 2012. Should your board have a separate risk committee? The Conference Board. February. http://blogs.law.harvard.edu/corpgov/2012/02/12/should-your-board-have-a-separate-risk-committee/
United Nations Conference on Trade and Development, 2010. Corporate governance in the wake of the financial crisis. United Nations Publication.
Whyntie, P., 2013. Pros and cons of a dedicated risk committee. Keeping Good Companies 65 (7), 400-402.
Zboron, M., 2006. Reputational risk in the context of A.M. Best's rating analysis. The Geneva Papers 31, 500-511.