Prior studies show that enterprise risk management improves firm performance. This article investigates which aspects of enterprise risk management add value. We find that the use of economic capital models and dedicated risk managers improve operating performance. Requiring the dedicated risk manager report to the board of directors or to the chief executive officer (CEO) also increases value. The following combination of enterprise risk management initiatives yields the greatest increase in firm value: a simple economic capital model, a dedicated risk manager that is a cross‐functional committee, and requiring the risk manager report to the board or CEO.

We use two reserve error definitions found in the literature to investigate the joint impact of previously studied incentives on the magnitude of reserve error. We find many prior conclusions are dependent upon the restricted setting in which the hypotheses are tested and on the definition of the reserve error. We find strong evidence that financially weak insurers underreserve to a greater extent than other insurers. However, our evidence casts doubt on the conclusion that insurers manipulate reserves to avoid solvency monitoring. We also find insurers increase reserves for tax purposes and to reduce the impact of regulatory rate suppression.

This paper analyzes the accuracy of the principal models used by U.S. insurance regulators to predict insolvencies in the property-liability insurance industry and compares these models with a relatively new solvency testing approach-cash flow simulation. Specifically, we compare the risk-based capital (RBC) system introduced by the National Associati~m of Insurance Commissioners (NAIC) in 1994, the "FAST" audit ratio) system used by the NAIC, and a cash flow simulation model developed by the authors. Both the RBC and FAST systems are static, ratio based approaches to solvency testing, whereas the cash flow simulation lnodel implements dynamic financial analysis, kx~gistic regression analysis is used to test the models for a large sample of solvent and insolvent property-liability insurers, using data from the years 1990-1992 to predict insolvencies over three-year prediction horizons. We find that the FAST system dominates RBC as a static method for predicting insurer insolvencies. Further, we find the cash flow simulation variables add significant explanatory power to the regressions and lead t¢~ more accurate solvency prediction than the ratio-based m¢xtels taken alone.

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