For firms of all sorts, understanding risk appetite has proved to be one of the more intractable problems on the risk agenda. And yet, with no means of calibrating the risks the firm is taking against a target level, firms are effectively ‘flying blind’ on risk. Usually, executives’ intuition suffices, but not always.
In order to move to a higher level of performance – higher return for the risks the firm is running or less risk for the same level of return – the board and executive need to understand the risk represented by the firm’s mix of assets, cash flows, contingent liabilities and hazards and major operating contingencies. And they need to know whether that represents too much, about the right amount or too little risk.
The risk of the enterprise is almost inevitably less than the sum of the risk in its constituent parts. This comes from diversification effects of different products, markets and geographies. But to know how much risk is the right level for the firm is partly an analytical exercise, partly a strategic one. The real benefit of understanding risk appetite of the firm – and the related idea of risk tolerance of the firm – is to raise executive understanding of risk and what it means at the corporate level.
Below the corporate level, the firm needs to determine the right level of disaggregation – the right level of the business at which to calculate business risk, to which to allocate capital and costs of risk transfer through insurance and hedging. This important journey takes the firm’s executives to a higher level of understanding of what risk means strategically and helps to frame and focus the strategic debate within the firm and how t balance strategic decisions in the firm. We can help you on the journey (but we cannot take it for you).