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CHAPTER 1
Introduction to Enterprise
Risk Management and Insurance
I. SUGGESTED CLASSROOM TIME: 60–75 MINUTES
II. CHAPTER OVERVIEW
This chapter lays the groundwork for all that follows in the book, introducing the modern
concept of enterprise risk management (ERM). ERM differs in several important ways
from traditional risk management and has been hailed as a giant step forward in business
III. LECTURE OUTLINE
A. Introduction: Enterprise Risk Management, with its entity-wide focus, differs from
traditional Corporate Risk Management, which had a focus on pure risk.
B. Why Interest in Risk Management Is Growing
1. Catastrophe loss events, such as Hurricane Katrina and the September 11 event
C. Methods of Classifying Risk
1. Pure risk, where only loss is possible, versus speculative risk, where both gain and
loss are possible
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E. Protection from Risk: Insurance, Employee Benefits, and Risk Management
1. The default strategy is retention, to retain the possible loss. This is called passive
2. A better alternative is personal insurance protection. (A later chapter looks at the
2. Employee benefit plans offset particular risks, such as health care costs and
retirement.
F. The Risk Management Process (Note: The term process implies an ongoing activity.)
1. Establish risk management goals
2. Identify potential loss exposures (the KEY step)
a. Property, e.g., buildings, contents
3. Measure potential losses
4. Choose risk-handling techniques
a. Avoidance, i.e., frequency and severity are both zero
5. Implement techniques and monitor effectiveness
G. Enterprise Risk Management
1. Characteristics
a. Top-down focus
2. Types of exposures
a. Pure risk
Chapter 1/Introduction to Enterprise Risk Management and Insurance 3
IV. ANSWERS TO REVIEW QUESTIONS
1. Describe how the scope of risks encompassed in enterprise risk
management differs from those of traditional corporate risk management.
Traditional corporate risk management had a focus on pure risks only, mainly those
2. Explain why interest in risk management has increased dramatically in the
United States in recent years. There are several factors, including catastrophic
3. How did the corporate scandal at Enron prompt the accounting profession
to take a leading role in the call for improvements in corporate risk
management? One of the key factors in the failure of Enron was the use of
4. Describe the difference between pure and speculative risks. Provide an
example of each. Pure risks involve only the possibility of loss. Examples are loss of
5. Describe the process of risk diversification, noting the two conditions that
must exist for diversification to be effective. Risk diversification involves
6. Explain why auto and life insurance are two types of risk that are well
suited to diversification by insurers through the use of risk pooling. In both
7. Explain why damage from floods and wars are two types of risk that are
not well suited to diversification by insurers through the use of risk
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8. Financial advisors encourage investors to hold a well-diversified portfolio
of investments. Explain whether this level of diversification can protect an
investor if:
a. one of her stock holdings is a firm with an unsuccessful new product
launch, or
b. the global economy falls into a recession.
9. Describe the concept of risk aversion. Is it an equally appropriate strategy
for dealing with pure and speculative risks? Risk aversion, generally the
10. Describe the alternatives available to people and firms across the globe to
protect themselves from adverse loss exposures. Generally there are four
management, appropriate to a firm with significant loss exposures.
11. How does social insurance differ from private insurance? In your answer,
explain why some loss exposures are insured better through social
insurance than through private insurance. Social insurance is generally
mandatory and involves programs sponsored by the government but not for
12. Explain why it may be advantageous for people to get insurance protection
from employee benefit plans instead of buying individual insurance
policies. Because employee benefit plans have tax advantages for both the employee
13. List and briefly describe the five steps in the risk management process.
1) Formulate risk management objectives. What do you want to achieve through risk–
management efforts?
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14. Describe four different types of risk that need to be addressed by the risk
manager in a typical corporation. Discuss whether each of these four types
of risk are equally important across different industries.
1) Pure risks—those where only loss is possible
this is unlikely to be a problem.
15. Describe the difference between loss frequency and loss severity. Loss
16. Describe the three broad categories of risk-handling techniques used by
risk managers. In your answer, provide at least two specific examples of
each technique.
1) Avoidance or loss control—trying to affect the frequency or severity of losses.
17. Explain why it is necessary to monitor the effectiveness of the chosen risk-
handling techniques of the risk management process on a continuous
basis. Periodically, two questions are asked about any risk-handling technique: 1) Is it
effective in reducing or financing losses? and 2) Is it cost effective? If these cannot be
18. While no single, universally accepted definition of ERM exists, describe
four characteristics that commonly are attributed to a well-designed ERM
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19. List and describe the four areas of risk encompassed in an enterprise risk-
management program. For each risk area, provide an example of a recent
risk event that has been described in the popular business media.
1) Pure risk, for example the explosion that damaged the BP oil well that spilled oil in
V. ANSWERS TO OBJECTIVE QUESTIONS
1. Which of the following have led to a growing interest in risk management?
2. Auto collision claims are an example of which of the following?
3. Which of the following is not a speculative risk?
4. Risk aversion
I. is the tendency of a person to prefer less risk instead of more risk when faced with
risky decisions.
II. is a more appropriate strategy for pure risks than for speculative risks.
Chapter 1/Introduction to Enterprise Risk Management and Insurance 7
5. Which of the following statements about insurance is correct?
6. Which of the following statements about employee benefits are correct?
I. Workers are granted favorable tax treatment on the employee benefits that they
receive from their employers.
II. Employee benefits account for over half of the compensation paid by employers in
7. Which of the following is a step in the risk-management process?
8. A building’s owner inserts a provision in the lease that makes the tenant legally
responsible for clearing snow and ice from the building’s sidewalks. This provision is
an example of which of the following?
9. ACA is a leading global automaker. ACA has to stop production of a popular vehicle
when a labor strike shuts down the factories of BBB Company, the sole supplier of auto
transmissions to ACA. The lost production resulting from this supply chain disruption
is an example of a(n) __________ that is borne by ACA.
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10. Which of the following is not a characteristic of an ERM program?
VI. IDEAS FOR INSTRUCTORS AND TEACHING METHODS
1. Have the class look at Review Question 19 and research a recent incident in Business
Insurance, The National Underwriter, or The Wall Street Journal. Are they able to
identify the strategic and operational risks? Is it sometimes difficult to tell these two
types apart? (Hint: Strategy involves the questions of what will be done and in what
2. Discuss whether a Chief Risk Officer is a necessity for an ERM program or whether a
traditional risk manager can be retrained. Is this a function that should be outsourced,
perhaps to an insurance broker or a consultant?
3. Risk aversion leads persons to pay more for insurance than their expected value of loss.