Fundamentals of Enterprise Risk Management

How Top Companies Assess Risk, Manage Exposure, and Seize Opportunity

 Fundamentals of Enterprise Risk Management

Author: John J. Hampton
Pub Date: December 2014
Print Edition: $79.95
Print ISBN: 9780814449035
Page Count: 320
Format: Hardback
Edition: Second Edition
e-Book ISBN: 9780814449042

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Excerpt

CHAPTER 1

HAZARD AND

ENTERPRISE RISK

MANAGEMENT

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

Hurricane Andrew

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

processing.

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

or misfortune.

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?

Hazard Risk

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

financial losses.

Insurable Risk

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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