This is the first paper of a series of five on the topic of risk appetite. Understanding of risk appetite is very much a work in progress in many organizations. The author believes that enterprise risk management (ERM) will remain locked in organizational silos until boards are mobilized and comprehend the links between risk and strategy. This is achieved either through painful and expensive crises, or through the less expensive development of a risk appetite framework (RAF).
Paper 1 makes a number of general observations based on experience in working with a wide variety of companies. Paper 2 describes the risk landscape, measurable and unmeasurable uncertainties and the evolution of risk management. Paper 3 answers questions relating to the need for risk appetite frameworks and describes in some detail the relationship between them and strategy. Paper 4 answers further questions on risk appetite and goes into some detail on the questions of risk culture and maturity. Paper 5 describes the characteristics of a risk appetite statement and provides a detailed summary of how to operationalize the links between risk and strategy.
Paper 1: Introduction
Since the global financial crisis (GFC), regulators, investors and boards have become determined to avoid a repetition of such a cataclysmic event and have increased demand for more effective risk management. As financial risk reporting failed to predict the GFC, there is growing recognition of the need to build organizational resilience through effective mapping of risks and to demonstrate the capability to manage low-probability, high-impact events. Concern is also growing over the increase in cybercrime and over digital risk.
1. Directors and senior managers need a globally accepted guide on the attributes of an effective risk appetite framework.
2. Emphasis is shifting globally from risk management to building resilience. Risk optimization is achieved when risk and strategy are aligned with corporate objectives. Achieving this requires that both the board and executives master strategic, emerging and external/global risks through robust (risk) horizon scanning, proofing and testing.
3. “Strategic risks” are those that are most consequential to the organization’s ability to execute its strategies and achieve its business objectives. These are the risk exposures that can ultimately affect shareholder value or the viability of the organization. “Strategic risk management” is “the process of identifying, assessing and managing the risk in the organization’s business strategy—including taking swift action [when problems arise]. Strategic risk management is focused on those most consequential and significant risks to shareholder value, an area that requires the time and attention of executive management and the board of directors’’1
RMI thus defines board risk assurance as assurance that strategy, objectives and execution are aligned.
4. That alignment is achieved through operationalizing the links between risk and strategy. This involves:
- Strengthening the strategic planning process through organizational integration of the risk and strategy functions/processes, with authority derived directly from the board and CEO’s office,
- Establishing an effective risk appetite framework,
- Understanding, and improving, the organizational level of risk maturity,
- Building organizational resilience,
- Proofing and testing management’s ability to offer credible solutions when both exploiting and defending operations, the business model and reputation.
5. The risk appetite framework (RAF)2 is to the board what risk management3 is to the rest of the organization. As such, there is a direct correlation between the efficacy of the RAF and the efficacy of the risk management framework4. The audit committee of the board and the risk subcommittee must have charters that provide a risk governance framework that mandates:
- Direct CEO oversight of an integrated risk and strategy capability,
- Board risk subcommittee oversight of:
- The risk appetite framework,
- Advancing and maintaining risk maturity, which can deliver value through:
- Access to capital at lower cost than that achieved by less mature competitors,
- More favorable credit ratings than those achieved by less mature competitors,
- Optimization of risk transfer through both traditional and modern self-insurance methods.
- Risk data governance maintained to standards of rigor and consistency like those that apply for accounting data,
- Perpetual proofing and testing of management’s readiness to offer credible solutions when both opportunity strikes and abnormal and adverse events occur.
We agree with Peter Bernstein, author of Against the Gods: The Remarkable Story of Risk, when he says, “In the absence of certainty. . . [we must] focus on excellent execution and demonstrable resilience at the same time whilst taking as much acceptable risk as is reasonably possible.” We likewise agree with Robert S. Kaplan, author of Risk Management and the Strategy Execution System, who says: “Risk management. . . is about identifying, avoiding and overcoming the hurdles that the strategy may encounter along the way. Avoiding risk does not advance the strategy; but risk management can reduce obstacles and barriers that would otherwise prevent the organization from progressing to its strategic destination.”
1Source: Harvard Law School Forum on Corporate Governance and Financial Regulation: Strategic Risk Management: A Primer for Directors Aug 2012
2The RAF is the ‘’overall approach including the policies, controls and systems, through which risk appetite is established, communicated and monitored.’’
3Risk management: coordinated activities to direct and control an organization with regard to risk Source: ISO Guide 73 Risk Management – Vocabulary
4Risk management framework: set of components that provide the foundations and organizational arrangements for designing, implementing, monitoring, reviewing and continually improving risk management throughout the organization
- NOTE 1 The foundations include the policy, objectives, mandate and commitment to manage risk.
- NOTE 2 The organizational arrangements include plans, relationships, accountabilities, resources, processes and activities.
- NOTE 3 The risk management framework is embedded within the organization’s overall strategic and operational policies and practices.
(Source: ISO Guide 73 risk management vocabulary)