Fundamentals of Enterprise Risk Management
How Top Companies Assess Risk, Manage Exposure, and Seize Opportunity
Author: John J. Hampton
Pub Date: December 2014
Print Edition: $79.95
Print ISBN: 9780814449035
Page Count: 320
Edition: Second Edition
e-Book ISBN: 9780814449042
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Risk Quote: More than at any other time in history, mankind
faces a crossroads. One path leads to despair and utter hopelessness.
The other to total extinction. Let us pray that we have the
wisdom to choose correctly.
—Woody Allen, movie producer
Risk Quote: Better to remain silent and be thought a fool than to
speak out and remove all doubt.
—Abraham Lincoln, U.S. president
In 1992, Hurricane Andrew caused significant losses to Allstate,
State Farm, and other insurance companies because Florida insurance
law did not handle flood and wind damage properly. If wind
took off the roof before a storm surge destroyed a house, how
much would separate wind and water policies pay to reimburse
the damage? After cleaning up the mess, insurance companies
worked with the Florida State Insurance Department to apportion
loss from a combination of water and wind. In 2004 and 2005,
hurricanes Frances, Charley, Ivan, Katrina, and Rita damaged
property in Florida. As a result of the new laws, insurers saved
money, and homeowners received prompt and efficient claims
The change made after Hurricane Andrew is effective risk
management. Still, it had a flaw. The insurance companies operated
in isolated units that did not share risk information. They did
not seek changes in the laws in Georgia, Mississippi, Louisiana,
or Texas. The results were unnecessary complications resolving
losses in 2005, when hurricanes damaged property in those states.
A second Hurricane Andrew story reveals another flaw in sharing
data. It involves the role of an actuary, a mathematician who
determines the rate charged for insurance coverage. Actuaries
work with historical data to make estimates of the frequency and
severity of loss.
In 1992, the data for Florida hurricanes was taken from the
Okeechobee hurricane in 1928. It killed 2,500 people in South
Florida when a storm surge breached the dike surrounding Lake
Okeechobee. It also did serious wind damage to houses.
In the 1920s, houses had been built with masonry walls and
clay tile roofs. Both withstood wind damage very well. Still, 5 percent
of roofs were lifted from their connections to homes. This
was the damage level used in actuarial projections of property
damage in the 1980s.
The problem was that houses built in Florida in the 1980s had
shingled roofs connected to the walls with nails or staples. A person
visiting Miami in the months after the storm could drive on
an overpass and see subdivisions where all the homes were covered
with blue tarpaulins. Every single roof had been removed by the
storm. The actuarial data failed to provide sufficient funds to pay
the claims. It is not a surprise that 11 insurance companies were
forced into bankruptcy.
Definitions of Risk
When someone tells us to take a risk or not to take a risk, what is
the message? In most cases, ‘‘risk’’ has one of three meanings:
1. Possibility of Loss or Injury. This is the most common. We
have something to lose, and we might lose it through an accident
2. Potential for a Negative Impact. This is generic. Something
could go wrong. What could go wrong? We might face a decline
in the value of a brand, or competitors might penetrate our
markets. The negative impact may be vague and unknown.
3. Likelihood of an Undesirable Event. This moves us into the
world of quantitative analysis. We see a risk on the horizon.
What is the likelihood that it will materialize? What will be the
impact if it occurs? Can we quantify the damage? What will be
our best case if it occurs? Our worst case?
This includes exposures that cause loss without the possibility of
gain. A company may suffer physical damage to assets, as when
fire destroys a building. Physical injury may occur when accidents,
injuries, or disease strike employees or customers. Lawsuits can
be the outcome of contractual or liability claims.
Hazard risk can be broader than the direct damage it causes.
An explosion at a refinery requires repair and renovation directly.
Indirectly, the waiting period until the refinery is repaired causes
an immediate loss of sales and may cause future business and
An insurable risk is a form of hazard risk that meets specific criteria.
Definite Loss. We can identify the cause, time, place, and
extent of damage.
Monetary Decline. If an exposure has no financial impact, it is
not an insurable risk.
Contingent Loss. The exposure must be fortuitous, covering
only losses not certain to happen.
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