Just when Standard & Poor's had convinced me of certain aspects of this concept, I had the pleasure to audit the Risk and Insurance Management Society Inc.'s course on enterprise risk management implementation, this one taught by Dr. James Kallman, a friend and great thinker about risk and risk concepts. Yes, he's an academic, but he's hung around people like me enough that he can easily slip out of his professorial box to think more pragmatically.
Within this course is a more comprehensive view of the risk appetite referred to as "risk position." I believe this is moving in the right direction as it posits that this term be adopted to be more in line with financial terminology, a key necessity for more effective communications with management about risk. If you don't speak the normal language of the business, you'll make your influencing job all the more difficult.
Kallman assures me that "risk position" is a more complete approach to understanding how much risk an entity can take in the interest of both prudent risk taking that controls downside and leverages upside. It is the result of his relatively recent research and represents a more refined and definitive way in which to help management better understand the parameters of its risk-taking spectrum. While it may still ultimately be appropriate to define risk appetite in terms of corporate metrics such as a percentage of net income, net worth, or other measures that define what is most important to management the risk position concept and attendant formula is a better reflection of true risk-taking philosophy. It accounts more for the upside of risk and the potential gain it entails, whereas the more traditional downside focus on loss events is where risk managers more naturally lean.
There are two components to how risk position is measured. First, risk appetite can be measured by quantifying the total spending on marketing and advertising and adding to it the cost of research and development, or the total cost of projects and initiatives, and dividing the sum of these by total revenues in the same fiscal period. This produces a percentage that can be interpreted as the portion of revenues that management is willing to pay to take risks that will accomplish its goals.
The second half of the risk position is risk tolerance. Risk tolerance is the specific maximum amount of risk the entity can bear before its mission and objectives are threatened, or even its very survival. The formula for tolerance is the total cost of risk (TCOR) divided by total revenues.
However, don't be too quick to assume this TCOR is just insurance related, though it is a significant portion of the total. It must account for all significant risk retentions as well. This is where the challenge arises since so many "informal" retentions are not typically measured, least of all by reliable methods.
In effect, the cost of many "retentions" are best measured as the cost of controls, an element of operations that is seldom quantified. Nevertheless, this formula produces a percentage that is that portion of revenues that management would spend to prevent mission failure.
I like this concept. It represents a new way to both think about and measure risk appetite and tolerance. It also repackages risk in a form which management can better relate when making decisions about risk acceptance.
CHRIS MANDEL is the enterprise risk manager for a leading financial institution and a former president of the Risk and Insurance Management Society.
December 1, 2010
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