General Insurance Article - Risk Appetite: Linkage with Strategic Planning

 With recent advances in computational capability, progressive and complex models have been created to assist risk management. At the same time, regulators, rating agencies, and investment markets have put more attention on risk controls of financial institutes. Those factors, however, did not prevent financial institutions from going bankrupt or needing a government bailout in the past few years. Most of the defaulted financial firms stated they had good risk management policies and implementation and the resources spent on risk management were not trivial.

 
 The firms failed for different reasons but clearly their “good risk management” went wrong. Without a clear understanding of the risks of their business, decision makers adopted risky strategic plans. Advanced risk management models and stress testing may help with assessing the quantitative impact of risks, but understanding the company’s core competence and the risks before taking them is far more important.
 It is critical to have clear answers to the following questions before making decisions:

 
 • What is the company’s competence in the market?
 • Are the decision makers familiar with the risks involved including the tail risks and understand their potential impact?
 • Is the company capable of surviving extreme events?

 
 Risk appetite articulates the level of risk a company is prepared to accept to achieve its strategic objectives. Risk appetite frameworks help management understand a company’s risk profile, find an optimal balance between risk and return, and nurture a healthy risk culture in the organization. It explains the risk tolerance of the company both qualitatively and quantitatively. Qualitative measures specify major business strategies and business goals that set up the direction of the business and outline favorable risks. Quantitative measures provide concrete levels of risk tolerance and risk limits, critical in implementing effective risk management.
 Risk appetite represents the willingness and the ability to take risk. Due to the sophisticated nature of financial institutions, it requires a lot of effort to fully understand the constraints and the ability to assume risk. Therefore, it is a gradual cognitive process to be updated from time to time if you enter new markets, new business and have new understanding of risks assumed.

 
 With the help of several case studies, this paper tries to explain the role of a risk appetite framework in effective risk management and how it can be used to make more informed strategic decisions. The paper does not seek a golden rule for risk appetite framework and the integration of risk appetite and strategic decision making. Assumptions validation, parameter calibration and model risks are not the focus of this paper either.
 It is hoped this paper will formalize the thinking process of assessing the risks of strategic plans and reflecting them in the risk appetite framework. It is an integrated interactive process.

  

 If you have any questions or comments regarding the report, please contact Steve Siegel, Research Actuary at ssiegel@soa.org.

  

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