Risk appetite

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Risk appetite is the level of risk that an organization is prepared to accept in pursuit of its objectives, before action is deemed necessary to reduce the risk. It represents a balance between the potential benefits of innovation and the threats that change inevitably brings. The ISO 31000 risk management standard refers to risk appetite as the "Amount and type of risk that an organization is prepared to pursue, retain or take". This concept helps guide an organization's approach to risk and risk management.

ISO 31000 is a family of standards relating to risk management codified by the International Organization for Standardization. The purpose of ISO 31000:2018 is to provide principles and generic guidelines on risk management. ISO 31000 seeks to provide a universally recognised paradigm for practitioners and companies employing risk management processes to replace the myriad of existing standards, methodologies and paradigms that differed between industries, subject matters and regions.

Risk is the possibility of losing something of value. Values can be gained or lost when taking risk resulting from a given action or inaction, foreseen or unforeseen. Risk can also be defined as the intentional interaction with uncertainty. Uncertainty is a potential, unpredictable, and uncontrollable outcome; risk is an aspect of action taken in spite of uncertainty.

Risk management Set of measures for the systematic identification, analysis, assessment, monitoring and control of risks

Risk management is the identification, evaluation, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability or impact of unfortunate events or to maximize the realization of opportunities.

Contents

Levels

The Board of Directors are normally responsible for setting an organisation's risk appetite. In the UK the Financial Reporting Council says: "the Board determines the nature, and extent, of the significant risks the company is willing to embrace." [1] The appropriate level will depend on the nature of the work undertaken and the objectives pursued. For example, where public safety is critical (e.g. operating a nuclear power station) appetite will tend to be low, while for an innovative project (e.g. early development on an innovative computer program) it may be very high, with the acceptance of short term failure that could pave the way to longer term success.

Financial Reporting Council regulator responsible for promoting high quality corporate governance

The Financial Reporting Council (FRC) is an independent regulator in the UK and Ireland, responsible for regulating auditors, accountants and actuaries, and setting the UK's Corporate Governance and Stewardship Codes. The FRC seeks to promote transparency and integrity in business by aiming its work at investors and others who rely on company reports, audits and high-quality risk management.

Below are examples of broad approaches to setting risk appetite that a business may adopt to ensure a response to risk that is proportionate given their business objectives. [2]

The appropriate approach may vary across an organization, with different parts of the business adopting an appetite that reflects their specific role, with an overarching risk appetite framework to ensure consistency.

Measurement

Precise measurement is not always possible and risk appetite will sometimes be defined by a broad statement of approach. An organization may have an appetite for some types of risk and be averse to others, depending on the context and the potential losses or gains.

However, often measures can be developed for different categories of risk. For example, it may aid a project to know what level of delay or financial loss it is permitted to bear. Where an organization has standard measures to define the impact and likelihood of risks, this can be used to define the maximum level of risk tolerable before action should be taken to lower it. [3]

Purpose and benefits

By defining its risk appetite, an organization can arrive at an appropriate balance between uncontrolled innovation and excessive caution. It can guide people on the level of risk permitted and encourage consistency of approach across an organisation.

Defined acceptable levels of risk also means that resources are not spent on further reducing risks that are already at an acceptable level.

Main areas

In literature[ citation needed ] there are six main areas of risk appetite:

  1. financial
  2. health
  3. recreational
  4. ethical
  5. social
  6. information

There is often a confusion between risk management and risk appetite, with the rigor of the former now recovering some of its lost ground from the vagueness of the latter. Derived correctly the risk appetite is a consequence of a rigorous risk management analysis not a precursor. Simple risk management techniques deal with the impact of hazardous events, but this ignores the possibility of collateral effects of a bad outcome, such as for example becoming technically bankrupt. The quantity that can be put at risk depends on the cover available should there be a loss, and a proper analysis takes this into account. The "appetite" follows logically from this analysis. For example an organization should be "hungry for risk" if it has more than ample cover compared with its competitors and should therefore be able to gain greater returns in the market from high risk ventures.

See also

Related Research Articles

Security management is the identification of an organization's assets, followed by the development, documentation, and implementation of policies and procedures for protecting these assets.

Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events, differ from the expected losses". This definition, adopted by the European Solvency II Directive for insurers, is a variation from that adopted in the Basel II regulations for banks. In October 2014, the Basel Committee on Banking Supervision proposed a revision to its operational risk capital framework that sets out a new standardized approach to replace the basic indicator approach and the standardized approach for calculating operational risk capital.

A feasibility study is an assessment of the practicality of a proposed project or system.

The chief risk officer (CRO) or chief risk management officer (CRMO) of a firm or corporation is the executive accountable for enabling the efficient and effective governance of significant risks, and related opportunities, to a business and its various segments. Risks are commonly categorized as strategic, reputational, operational, financial, or compliance-related. CROs are accountable to the Executive Committee and The Board for enabling the business to balance risk and reward. In more complex organizations, they are generally responsible for coordinating the organization's Enterprise Risk Management (ERM) approach. The CRO is responsible for assessing and mitigating significant competitive, regulatory, and technological threats to a firm's capital and earnings. The CRO roles and responsibilities vary depending on the size of the organization and industry. The CRO works to ensure that the firm is compliant with government regulations, such as Sarbanes-Oxley, and reviews factors that could negatively affect investments. Typically, the CRO is responsible for the firm's risk management operations, including managing, identifying, evaluating, reporting and overseeing the firm's risks externally and internally to the organization and works diligently with senior management such as Chief Executive officer and Chief Financial Officer.

Business analysis is a research discipline of identifying business needs and determining solutions to business problems. Solutions often include a software-systems development component, but may also consist of process improvement, organizational change or strategic planning and policy development. The person who carries out this task is called a business analyst or BA.

Supplier relationship management (SRM) is the discipline of strategically planning for, and managing, all interactions with third party organizations that supply goods and/or services to an organization in order to maximize the value of those interactions. In practice, SRM entails creating closer, more collaborative relationships with key suppliers in order to uncover and realize new value and reduce risk of failure.

Intellectual property assets such as patents are the core of many organizations and transactions related to technology. Licenses and assignments of intellectual property rights are common operations in the technology markets, as well as the use of these types of assets as loan security. These uses give rise to the growing importance of financial valuation of intellectual property, since knowing the economic value of patents is a critical factor in order to define their trading conditions.

Internal audit An audit of accounting for audiences within a firm

Internal auditing is an independent, objective assurance and consulting activity designed to add value to and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control and governance processes. Internal auditing achieves this by providing insight and recommendations based on analyses and assessments of data and business processes. With commitment to integrity and accountability, internal auditing provides value to governing bodies and senior management as an objective source of independent advice. Professionals called internal auditors are employed by organizations to perform the internal auditing activity.

IT portfolio management is the application of systematic management to the investments, projects and activities of enterprise Information Technology (IT) departments. Examples of IT portfolios would be planned initiatives, projects, and ongoing IT services. The promise of IT portfolio management is the quantification of previously informal IT efforts, enabling measurement and objective evaluation of investment scenarios.

Governance, risk management and compliance (GRC) is the term covering an organization's approach across these three practices: Governance, risk management, and compliance. The first scholarly research on GRC was published in 2007 where GRC was formally defined as "the integrated collection of capabilities that enable an organization to reliably achieve objectives, address uncertainty and act with integrity." The research referred to common "keep the company on track" activities conducted in departments such as internal audit, compliance, risk, legal, finance, IT, HR as well as the lines of business, executive suite and the board itself.

Internal control, as defined by accounting and auditing, is a process for assuring of an organization's objectives in operational effectiveness and efficiency, reliable financial reporting, and compliance with laws, regulations and policies. A broad concept, internal control involves everything that controls risks to an organization.

Asset and liability management is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.

Entity-level controls

Entity-level controls are internal controls that help to ensure that management directives pertaining to the entire entity are carried out. They are the second level of a top-down approach to understanding the risks of an organization. Generally, entity refers to the entire company.

Risk IT provides an end-to-end, comprehensive view of all risks related to the use of information technology (IT) and a similarly thorough treatment of risk management, from the tone and culture at the top, to operational issues.

IT risk management

IT risk management is the application of risk management methods to information technology in order to manage IT risk, i.e.:

Project risk management

Project risk management is an important aspect of project management. According to the Project Management Institute's PMBOK, Risk management is one of the ten knowledge areas in which a project manager must be competent. Project risk is defined by PMI as, "an uncertain event or condition that, if it occurs, has a positive or negative effect on a project’s objectives."

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

Risk based Internal Audit (RBIA) is an internal methodology which is primarily focused on the inherent risk involved in the activities or system and provide assurance that risk is being managed by the management within the defined risk appetite level. It is the risk management framework of the management and seeks at every stage to reinforce the responsibility of management and BOD for managing risk.

References

  1. "Guidance on Board Effectiveness" (PDF). FEC. Retrieved 2 July 2019.
  2. Thinking about Risk - Managing your risk appetite: A practitioner's guide November 2006 HM Treasury, page 12.
  3. Hassani, B.K. (2015). "Risk Appetite in Practice: Vulgaris Mathematica". The IUP Journal of Financial Risk Management. 12 (1): 7–22. SSRN   2672757 .