I. SUGGESTED CLASSROOM TIME: 6075 MINUTES

Instructor Manual For Introduction to Risk Management and Insurance Tenth Edition Mark S. Dorfman David A. Cather 1 / 4

1 ©2013 Pearson Education, Inc. Publishing as Prentice Hall

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 management. The reasons for the growth of ERM are detailed here, along with several pertinent examples.The methods of classifying risk are detailed, along with a discussion of the risk-averse nature of most human beings. A discussion of several of the key methods by which firms and individuals protect themselves for risk then follows.The most significant issue covered in this chapter is the risk management process, the process by which economic entities identify, assess, and treat their exposures to loss.Finally, a description of ERM is presented, laying out both the exposures and the key differences from traditional risk management.

III. LECTURE OUTLINE

• Introduction: Enterprise Risk Management, with its entity-wide focus, differs from

traditional Corporate Risk Management, which had a focus on pure risk.

• Why Interest in Risk Management Is Growing
• Catastrophe loss events, such as Hurricane Katrina and the September 11 event
• Corporate financial failures, such as Enron and Washington Mutual
• Shrinking employee benefits, leading to a loss of confidence in the whole concept of

401(k) plans

• Methods of Classifying Risk
• Pure risk, where only loss is possible, versus speculative risk, where both gain and

loss are possible

• Diversifiable risks, risks that can be offset by diversification, versus non-

diversifiable risks

• Risk pooling may be used to capture advantages of diversification
• Some, including insurer, use the Law of Large Numbers to benefit from pooling
• Risk Aversion: Most human beings are risk-averse, i.e., risk avoiders, yet most

understand that there are risk/return trade-offs in many activities. Higher risk can bring higher returns. 2 / 4

• Chapter 1/Introduction to Enterprise Risk Management and Insurance

©2013 Pearson Education, Inc. Publishing as Prentice Hall

E. Protection from Risk: Insurance, Employee Benefits, and Risk Management

• The default strategy is retention, to retain the possible loss. This is called passive

retention when the subject has not identified the exposure or underestimates the potential severity of the exposure.

• A better alternative is personal insurance protection. (A later chapter looks at the

possible costs of this strategy.)

• Social insurance
• Private insurance
• Employee benefit plans offset particular risks, such as health care costs and

retirement.

• Corporate risk management looks at the exposures of a firm and seeks to treat

them in a logical manner.

• The Risk Management Process (Note: The term process implies an ongoing activity.)
• Establish risk management goals
• Pre-loss, e.g., prevent loss, be cost effective
• Post-loss, e.g., survive, minimize disruption
• Identify potential loss exposures (the KEY step)
• Property, e.g., buildings, contents
• Liability, e.g., products, professional
• Human resources, e.g., employee benefits, worker safety
• Indirect, e.g., building codes, business interruption
• Measure potential losses
• Frequency
• Severity
• Choose risk-handling techniques
• Avoidance, i.e., frequency and severity are both zero
• Loss control, i.e., prevention and reduction
• Transfer
• Financing
• Implement techniques and monitor effectiveness
• Enterprise Risk Management
• Characteristics
• Top-down focus
• Broad scope
• Portfolio perspective
• Systematic process of identification, assessment, treatment
• Types of exposures
• Pure risk
• Operational, e.g., supply chains, distribution chains 3 / 4

Chapter 1/Introduction to Enterprise Risk Management and Insurance 3 ©2013 Pearson Education, Inc. Publishing as Prentice Hall

• Financial, e.g., credit risk, currency risk
• Strategic, e.g., product development
• Chief risk officer, a new concept and a new occupant of the “C-Suite”

IV. ANSWERS TO REVIEW QUESTIONS

• 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 things that could be insured. Enterprise risk management has a broader scope, taking into consideration financial risks, operational risks, and strategic risks.

• Explain why interest in risk management has increased dramatically in the

United States in recent years. There are several factors, including catastrophic events such as the September 11, 2001, event in New York, corporate financial failures, and shrinking employee benefits. The latter has resulted in the shift of many pension plans to a government agency that oversees failed pension plans.

• 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 fraudulent financial statements to increase the market value of Enron stock. When the company failed, these odd numbers came to light, and there were calls for not only better accounting procedures but also better management oversight.

• Describe the difference between pure and specula tive risks. Provide an

example of each. Pure risks involve only the possibility of loss. Examples are loss of a building to fire or the premature death of a family head. Speculative risks involve the possibility of gain as well as loss. Examples are gambling, investing in the stock market, and starting a business.

• Describe the process of risk diversification, noting the two conditions that

must exist for diversification to be effective. Risk diversification involves spreading the losses in a group among all the members of the group. There must be a large number of members, and the potential that a loss will affect more than a few members of the group at one time must be small.

• Explain why auto and life insurance are two types of r isk that are well

suited to diversification by insurers through the use of risk pooling. In both cases there are a large number of exposure units and a very small probability that multiple members of the group will suffer loss at the same time.

• 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 pooling. These are not well-suited because there is a large probability that numerous members of the group will be subject to loss at the same time.

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