Today’s economic climate is proving challenging to successfully manage risk and volatility while also striving for sustainable and predictable earnings for the organisations and its shareholders. In fact, articulating risk appetite and building a robust enterprise risk management framework still remains challenging for most firms especially in the financial services sector.
This financial crisis has led bankers, insurers, and other financial services firms to challenge the components of their previous risk appetite as well as the prior measurements of their tolerance to such risks.
In addition to a more prominent focus on the traditional risk management categories, financial services firms are also elevating the importance of systematic risks arising from counterparty exposures, be they corporate or even countries. But even with the heightened awareness of risk appetite, are the risks truly being understood? And if so, how are these organisations moving forward to better manage them?
Is Risk Appetite Truly Being Understood?
It is estimated that roughly one-third of all insurers believe that their investors do not understand the risk appetite of the firms they are investing in – and across the board, there are a number of deficiencies in terms of how effectively risk appetite is being transmitted throughout these firms, primarily with regard to their capabilities as well as the applications that are being used.
One such deficiency among companies seems to the lack of leadership in the area of risk appetite. This was especially true prior to the recent financial crisis. Thus, if these firms were truly moving forward there would be more of a full engagement of management at all levels of the organisation. This would help to translate risk appetite into more of a pragmatic direction for the company as a whole, especially as it would be supported by the firm’s infrastructure and overall practices. In fact, there is litre investment in analytics and data management to make risk appetite and its associated processes across the organisation more effective and useable in for business decision making.
Even though risk appetite statements tend to exist at a number of financial institutions, many still fail to actually execute it according to the approved and established risk management framework.
According to one industry source, “Risk appetite appears to remain an underdeveloped aspect of many insurers’ response not only to the external demands of rating agencies and regulators, but also in relation to achieving a h3 foundation for strategic decision making. A clearly articulated risk appetite has become essential for businesses to achieve a higher rating and attract investors, which makes it a potential source of real competitive advantage.”
Once Understood, Can Risk Appetite Be Easily Used?
This lack of understanding has led many financial organisations to assert that there is a real need for a much h3er focus on the breadth of the risks that are being faced. In highlighting these risks, the firms also feel that better transparency would very likely enhance their overall standing in the industry.
In fact, a recent survey showed that a majority of insurance companies – approximately 85 percent – are responding to Solvency II with plans to make use of their own internally generated models for regulatory purposes. Of these insurers, nearly half of them felt that the key benefits of having an internal model would be for their own business purposes such as in achieving wider decision making as well as for Solvency II and IFRS.
Some of the primary challenges that are still being faced, however, in implementing such models are data issues as well as available resources. Other obstacles could include the firms’ inability to manage down their concentrated risk exposures, along with a straying outside of acceptable product or geographic boundaries. In addition, it is felt by many in the financial field that there also must be a cultural reinforcement of the risk appetite in order for all involved to better understand it.
With this in mind, a better understanding of risk appetite should encompass a deeper knowledge of what is acceptable as a risk and what is acceptable as a business practice. Likewise, the decisions that are approved at the executive or senior level should then be carried out throughout the entire organisation.
Using a Top Down Strategy
If risk appetite is to truly be understood and successfully implemented, then the approach must be undertaken from the top of these organisations. In so doing, those at the executive level should initiate a specific identification of the risks that they are either required or willing to accept in their businesses.
In addition, key risk relationships must also be incorporated into the determination of the firm’s risk appetite. In so doing, there must be a re-evaluation of the benchmarks that are being used for a company’s risk management. Likewise, all of the compliance applications within the company should also be identified, along with the risks that are associated with non-compliance.
Once completed, these executives should also work towards the development of a reliable method of the measurement of risk appetite in order to better understand when the firm’s risk tolerance level is being exceeded.
Benefits to the Business When Undertaking Acceptable Risks
There are numerous benefits when firms begin to successfully undertake acceptable risks. When properly understood and articulated, risk appetite can be a very powerful tool in both managing risk as well as in enhancing the overall performance of the business.
In many ways, the successful implementation of risk appetite can help a company in providing a cornerstone for the firm’s complete framework of risk management and it can also oftentimes incorporate a good mix of both qualitative and quantitative measures.
Proper understanding, incorporation, and efficient allocation of risk appetite can also help an organisation to increase its overall capacity for taking on risks, making the firm much more resilient to changes in the financial services environment as well as in the economy as a whole.
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