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Issue 07 / October 2015

Why a firm knowledge of risk tolerance can be the risk manager’s compass

At a glance
  • Companies should clearly define risk capacity, risk tolerance and risk appetite
  • A clearer view of risk tolerance will help manage volatility in financial performance via insurance and other hedges
  • Discussions about risk tolerance need be based on financial metrics in order to engage the C-suite
Risk tolerance helps an organisation determine where they are going and the best path to take, and to understand when they get there, says Ben Fidlow and John Merkovsky

The concept of strategic risk management begins with the alignment of a risk manager’s activities with the organisation’s strategic goals. And, for risk professionals, there is no more important consideration than understanding the amount of risk an organisation is:

a) able to take

b) willing to take and

c) desires to take. 

The often-unsettled environment surrounding risk tolerance presents a terrific opportunity for a strategic risk manager to lead.

These factors are often referred to respectively as an organisation's risk capacity, risk tolerance and risk appetite.

Without a proper understanding of the organisation’s view of this arena, a risk manager cannot confidently make the fundamental decisions they are faced with as a function of their role within the organisation.

For instance:

  • How will a risk manager know if they are bringing the desired level of financial protection to the organisation?
  • Is the risk transfer programme supportive and aligned with other financial and strategic goals of the organisation?
  • How can the trade-off between risk transfer and mitigation activities versus the associated costs be effectively measured and communicated?
  • How can risk be properly reflected across the business functions and processes of your organisation?
ART goes mainstream

Becoming more widespread as companies retain more risk and traditional insurance struggles to cover emerging risks

http://www.resilience.willis.com/articles/2015/09/29/why-alternative-risk-transfer-entering-mainstream/

Yet, for something so fundamental to the risk management function, risk tolerance is rarely engrained in risk management processes and structures. This is because the concept of risk tolerance is challenging, and the nomenclature is not used consistently across the industry.

Moreover, financial executives within the same organisation often have varying views on the level of risk the organisation should be willing to take. This unsettled environment presents a terrific opportunity for a truly strategic risk manager to lead.

But first, a risk manager needs to be able to demonstrate the value accretion that a well-defined view of risk tolerance can add to decision making.

Components of risk tolerance

It is advisable to clearly define the aforementioned three terms and properly differentiate between them. There are no official, agreed-upon definitions but here are some definitions to consider:

  • Risk capacity: The maximum amount of risk a firm is able to assume given its capital base, liquidity, borrowing capacity and regulatory constraints.
  • Risk tolerance: The boundaries of risk taking outside of which the organisation is not prepared to venture in the pursuit of its long-term objectives.
  • Risk appetite: The amount and type of risk an organisation is willing to seek or accept in pursuit of its business objectives.

The concept of risk capacity is more tangible and thus more commonly used and agreed upon. It is typically thought of as a specific numerical threshold that, when breached, would put the company in question at great financial peril. This is why we consider risk capacity a good starting place for a discussion around limit purchasing.

Having a concise way to quantify risk tolerance will typically ‘bridge the gap’ between different perceptions on how to apply a risk tolerance.

The other two components, risk tolerance and risk appetite, are often used interchangeably. To help differentiate between the two, we like to think of risk appetite as an organisation’s overall view or philosophy on risk: meaning an organisation chooses to be conservative (risk averse) or aggressive (a risk taker) based on how much risk they want to take on.

Risk tolerance, however, can be thought of as the continuum between varying levels of risk and what it means to your organisation. We consider risk tolerance a more structured view of risk relating risk appetite to the financial performance and objectives of an organisation.

More sophisticated firms aim to create a risk tolerance statement, like a mission statement, allowing a clearly defined view of risk to be imbedded into risk management and used in proactive business decision making.

Application for insurance

One of the most practical ways to implement risk tolerance is in its application for insurance. Risk transfer creates value by transferring potential loss to a third party.

However, an organisation has a limited capacity for financial variability of results so decisions need to be made around which risks to transfer and which to retain. 

How risk capacity, risk tolerance and risk appetite relate

More

From a simplistic and static budgetary perspective the trade-off between premium and expected loss is used as the indicator of whether the pricing is reasonable. However this ignores the value of volatility reduction. A certain stream of stable cash flow is more valuable than a cash flow of equivalent expected value, but which is less certain.

So, a much more meaningful evaluation of insurance should also include the impact of volatility reduction. This component is typically referred to as the reduction in the cost of volatility.

Given identical premium versus loss expectations, it would make financial sense to retain the risks that have less uncertainty around them. These are usually the risks that are within the core competencies of an organisation. The balance of risks, those which are less predictable, would then be transferred, where possible, ultimately reducing the cost of volatility – thereby creating value for the organisation.

With a clearer view of risk tolerance, valuations of volatility can be imbedded into the decision framework. This will allow strategic risk managers to add value to their organisations by helping manage volatility in financial performance via insurance and other hedges.

The risk tolerance discussion

Risk tolerance discussions within organisations are insightful, but challenging. The biggest obstacle is often the different frames of reference for the various internal stakeholders. The two main challenges are related to financial fluency and personal perceptions of risk. 

Premium allocations

How to ensure your premium allocations are efficient and commensurate with your spread of risks

http://www.resilience.willis.com/articles/2015/09/29/benefits-risk-based-premium-allocation/

Financial fluency is something that all risk managers need to develop, including knowledge of general accounting and financials as well as how their organisation presents them to the outside world. The latter is more nuanced but, through communication with corporate finance, the C-suite, and functions such as investor relations, a common ground can be found.

Having a concise way to analyse and quantify risk tolerance will typically ‘bridge the gap’ between different stakeholders’ perceptions on how to apply a risk tolerance. This then puts the firm on a course for adoption and engagement.

Effective engagement

To engage the C-suite and important stakeholders on the risk tolerance issue effectively, certain key elements are required. The discussion needs to include tangible elements and be based on financial metrics. Benchmarking and evaluation against peers are critical as most stakeholders are not just concerned about their own company-specific financial targets but how they stack up versus their peers. 

For large companies and those that are publicly traded, profitability and earnings are of the most common concern, as risk tolerance is determined by stakeholders' expectations of profitability more than a commonly perceived ‘rule of thumb’ figure.

Debt and liquidity levels are still important for smaller companies and those that may have issues servicing their debt, but in the current economic environment of low cost debt and investing for growth (organic or inorganic) operating cash flow metrics have dominated many current risk tolerance strategies.

For large profitable corporates, when the C-suite talks about risk tolerance it is most likely that their main concern is sustaining operating cash flow to fund investment in current operations and the future business growth strategy.

Elevating the risk manager 

Many organisations are looking to advance their thinking about their approach to risk tolerance yet they lack the consistent nomenclature, tools and focus to do so. Risk managers are well positioned to provide leadership here. Their experience in thinking across a broad range of risk topics and doing so in both financial and operational terms is unique in most organisations.

And, if leading an organisational initiative on risk tolerance is not for every risk manager, it is still a great opportunity to ensure that their own insurance and risk management activities are built with a clear alignment of organisational goals.

In this way it will be clear to senior management and other risk stakeholders that the risk management function is much more than a cost centre, and truly adds value to the organisation.

Find out more

Photo of Ben Fidlow
Ben Fidlow

ben.fidlow@willis.com

Ben leads Willis’s Core Analytics Practice globally. He is responsible for the strategic implementation and delivery of industry leading decision support risk analytics to Willis Group's brokerage clients. He previously founded analytics capabilities at two other major insurance brokers.

Photo of John  Merkovsky
John Merkovsky

John.Merkovsky@willis.com

John is paving the way for Willis to become the analytical broker. His current focus is around building and expanding capabilities in actuarial science, forensic accounting, risk technology, risk management, claims, risk engineering, and workers compensation risk. He began his career in 1984 working as a forensic accountant and fraud specialist serving the insurance and legal industry.

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Photo of Ben Fidlow
Ben Fidlow

ben.fidlow@willis.com

Ben leads Willis’s Core Analytics Practice globally. He is responsible for the strategic implementation and delivery of industry leading decision support risk analytics to Willis Group's brokerage clients. He previously founded analytics capabilities at two other major insurance brokers.

Photo of John  Merkovsky
John Merkovsky

John.Merkovsky@willis.com

John is paving the way for Willis to become the analytical broker. His current focus is around building and expanding capabilities in actuarial science, forensic accounting, risk technology, risk management, claims, risk engineering, and workers compensation risk. He began his career in 1984 working as a forensic accountant and fraud specialist serving the insurance and legal industry.

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