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How to Understand Your Risk Appetite

This is Paper 3 of a series of five on risk appetite and associated questions. The author believes that enterprise risk management (ERM) will remain locked in organizational silos until boards comprehend the links between risk and strategy. This is achieved either through painful crises or through the less expensive development of a risk appetite framework (RAF). Understanding of risk appetite is very much a work in progress for many organizations, but RAF development and approval can lead boards to demand action from executives.

Paper 1, the shortest paper, makes a number of general observations based on experience with a wide variety of companies. Paper 2 describes the risk landscape, measurable and unmeasurable uncertainties and the evolution of risk management. This paper, Paper 3, answers questions relating to the need for risk appetite frameworks and describes in some detail the relationship between risk appetite frameworks and strategy. Paper 4 answers further questions on risk appetite and goes into some detail on the questions of risk culture and risk 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 3: Should all organizations have a risk appetite framework?

The relationship between risk and strategy is a function or neither risk management nor strategic management. Rather, it is simply good management in an uncertain world, where business models are:

  1. Increasingly driven to be available on a 24/7 global footprint,
  2. Online using telecom networks,
  3. Becoming more dependent on third-party service providers,
  4. Becoming more connected within larger financial, supply chain and energy supply chains.

It is our view that the term “risk management” will, within the 2010 decade, become supplanted by the term “resilience management” and that the latter term will become an integral part of risk culture in organizations that are trading internationally or vulnerable to international supply chains.

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Maintaining a risk appetite framework will thus, before the end of this decade, be a matter of necessity, and not a matter of choice. The driver in this regard will be the pace of change. Look at the pictures above, both at a papal blessing, and you see what a difference less than a decade years can make.

What is leading organizations to put formal risk appetite frameworks in place?

Greater investor and regulatory focus, combined with a recognition that risk practices are becoming increasingly professional, has caused organizations to change attitude toward risk from a broadly negative stance to a more positive and engaged approach.

We note a global scarcity of skilled chief risk officers and unwillingness by organizations to commit resources in the current economic climate. Nevertheless, enlightened organizations are gaining appreciation of the links between risk and strategy and in turn toward putting in place the necessary resources and supports to provide greater risk professionalism.

How are risk appetite and strategy related?

The diagram below describes the relationship.

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Figure 2: RMI’s 7 elements approach to aligning strategy and risk

Earlier in these papers, we described board risk assurance as assurance that strategy, objectives and execution are aligned.

We further explained that alignment is achieved by operationalizing the links between risk and strategy. This is done by integrating each of the seven numbered elements described in the diagram above as follows:

1.     Reaching a determination as to long-term purpose and formulating those strategic initiatives and objectives that are required to achieve it[1],

2.     Understanding obstacles to the achievement of objectives: This needs to be understood practically in terms of a motor journey from say Dublin to Cork or Berlin to Paris.

Before the journey, people need to understand, and manage, what can stop them, slow them down or distract them on the journey. Once people understand risk management in these simple and practical terms, they understand that risk management is more about achieving objectives (getting from point A to point B) than compliance with regulations. It is about improving performance on the journey.

What people? In the simplest of terms, they are the owners of the car (shareholders represented by the board), the driver (CEO and executives) and passengers (primary stakeholders, i.e. customers, employees, investors, suppliers and secondary stakeholders and others with a legitimate interest in the business).

3. Setting objectives and getting balance and alignment (Note: strategy maps, e.g. Balanced Scorecard):

This is done in risk management terms by:

a. Strengthening the strategic planning process; for example:

i.     Increasing rigor, formality and consistency in the strategic planning office (SPO), which derives its authority from the board and  the CEO’s office,

ii.     Aligning strategy, risk and audit board subcommittees (through cross-representation) in a manner that largely mirrors the conventional three lines of defense model[2] and reflects the requirement to strengthen board risk oversight, reporting and monitoring[3],

iii.     Embedding risk management competence within the SPO[4],

iv.     Explicitly articulating corporate and organizational objectives,

v.     Testing the alignment of group, corporate and organizational objectives through development and review of risk appetite statements.

b. Establishing an effective risk appetite framework, which includes:

i.     Statement of purpose and values of the organization,

ii.    Explicitly stated board risk assurance requirements; factors to consider would include:

  1. Mapping objectives to a risk appetite continuum,
  2. Qualitatively expressed risk appetite statements,
  3. Quantitatively expressed risk criteria related to both risk tolerance and risk limits.

c. Understanding and improving the organizational level of risk maturity

Risk maturity is outside the scope of this paper; however, discussion on the topic would be welcomed by RMI. RMI has developed a five-level RMI Risk Maturity Index, which provides a road map to risk optimization. The index scores risk maturity capability requirements, etc. In summary, it describes:

  • Level 5: “Value-Driven” — Optimizing value through aligning risk and strategy with corporate objectives,
  • Level 4: “Managed” — Gaining value through aligning risk and strategy in pursuit of corporate objectives,
  • Level 3: “Insight” — Gaining insights into how to better align risk and strategy in pursuit of corporate objectives,
  • Level 2: “Awareness” — Developing awareness  into how to align risk and strategy in pursuit of corporate objectives,
  • Level 1: “Basic” — Seeking awareness of the links of risk and strategy in pursuit of corporate objectives.

d.   Building resilience:

i.     Ensuring that the SPO engages in systematic risk horizon scanning as well as:

1. Understanding near misses and escalation reports in the organization and externally,
2. Monitoring performance of risk treatments[5],
3. Proofs and tests of the quality of decision making, and decision making processes, through simulated threat and opportunity crisis[6] scenario(s) exercises,

ii.     Anticipating Emerging Risks[7].

4.     Evaluating the amount of risk the organization is prepared to accept in pursuit of the long-term statement of purpose; and then deciding how to treat risks:

Just as implementation is critical to performance[8], risk treatment is at the cutting edge of risk management and managing risks!

Disappointingly, however, very many organizations commit disproportionate resources to risk assessment with inadequate attention paid to what really matters; that is, treating risks. In essence, very many organizations concentrate on the P in the PDCA (plan, do, check, act) cycle, with not enough attention paid to doing, checking and acting on continuous improvement requirements.

This is pretty much in evidence in a review of many of the risk registers we have examined on behalf of clients. The majority of the surface area/content of the report (sadly, and sometimes tragically, an Excel, Word or Power Point document, as distinct from a credible database solution[9]) is given to risk assessment.

In our experience, often, precious little detail is given to:

  1. Who, specifically is responsible for individual risk treatments,
  2. Change management and resource requirements supporting risk treatments,
  3. The project/risk treatment key performance indicators (KPIs), milestones and gateways,
  4. The expected residual effect of risk treatments on likelihood and impact,
  5. The role of management in reviewing performance against KPIs, milestones and gateways. 

Risk treatment reports, which are presented to the level of detail described above and which are evaluated by the SPO in a manner that provides a feedback loop to the performance of objectives, become leading indicators of the future state of health of objectives.

5.       Weighing the odds consistently throughout the organization: This is the function of the chief risk officer (CRO), a most important role within the organization, and risk committee.

The ability of the CRO and risk committee to efficiently and effectively perform this function is directly proportional to the efficacy of the assurances delivered as described above.

Typical weaknesses and challenges that can occur include:

1. Frequency of changes required to risk criteria (tolerances and limits) in early stage (risk) maturity organizations as a consequence of:

  • Pace of change internally and externally in the organization,

Identification of emerging and external risks hitherto not understood.

2. Inability to undertake real time dynamic tests of risk aggregations:

  • Around discrete objectives,
  • Across risk categories.

The weaknesses and challenges described above often result in:

1. Meetings where questions asked can only be answered in terms of:

i.     This is the historic “point in time” information we have prepared.

ii.     We will need to revert with answers to your query in X days.

2. Risk aggregation tests not being run and emerging/known unknown risks not being identified until there is an occurrence.

6.     Compliance with laws and regulations: Organizations are established to achieve superior returns, with limited liability to risk takers. However, they are expected to do so having full regard for all legal requirements.

Clearly, it is axiomatic to assume the lawful intent of a company’s original promoters, and thereafter its directors and the executive. To this extent, compliance is an operational imperative and a sunken cost.

Compliance alone does not drive value, but without it value cannot be created.

It would seem inappropriate to place compliance at the center of board agenda, just as it would be a mistake to place compliance at the center of the diagram above, which describes the relationship between risk and strategy.

However, compliance is a mission-critical element within the risk/strategy governance framework.

7.    Tough governance, setting policy and monitoring performance: In the context of the relationship between risk and strategy, tough governance means risk culture.

“Risk culture” is a term describing the values, belief, knowledge and understanding about risk shared by a group of people with a common purpose, in particular the employees of an organization or of teams or groups within an organization. This applies whether the organizations are private companies, public bodies or not-for profits, wherever they are in the world.[10].

Risk culture, as an aspect of culture, can be practically described thus:

Culture: The way we do things around here!

Risk culture: The freedom we have to challenge around here!

Risk culture is capable of being demonstrably and credibly evidenced by:

1. Board and executive messaging[11] on threats and risks to operations and jobs when people fail to act/report when they:

i.     Identify a smarter way of completing a task, achieving an objective,
ii.     See a threat or risk to the organization.

2. Escalation reports and their treatment by the executive and management,

3. Near misses reported and averted.

References

 


[1] Strategy formulation is not part of the development of risk appetite frameworks; however, each is intrinsic to, and informs, the other.

[2] IIA Position Paper: The Three Lines of Defense in Effective Risk Management and Internal Control, January 2013

[3] Board Risk Oversight, A Progress Report: Where Boards of Directors Currently Stand in Executing Their Risk Oversight Responsibilities (Protiviti Report commissioned by COSO (Committee of Sponsoring Organizations of the Threadway Commission))

[4] NOTE: Risk Management and the Strategy Execution System by Robert S. Kaplan, which advances a method for aligning enterprise risk management with strategy through the Balanced Scorecard

[5] Effective reporting and monitoring of risk treatments delivers the twin benefits of 1) monitoring risk performance, and 2) establishing leading indicators on the future state of health of objectives

[6] Crisis is defined as: An inherently abnormal, unstable and complex situation that represents a threat to the strategic objectives, reputation or existence of an organization: PAS 200:2011 Crisis Management – Guidance and Good Practice, UK Cabinet Office in partnership with the British Standards Institute

[7] Reference Kaplan, Mikes Level 1 Global Enterprise Risks,

[8] McKinsey, August 2014, Why Implementation Matters: Good implementers—defined as companies where respondents reported top-quartile scores for their implementation capabilities—are 4.7 times more likely than bottom-quartile companies to say they ran successful change efforts over the past five years. Respondents at the good implementers also score their companies around 30% higher on a series of financial performance indexes. Perhaps most important, the good-implementer respondents say their companies sustained twice the value from their prioritized opportunities two years after the change efforts ended, compared with those at poor implementers

[9] Functionally designed and specified to meet the ISO 31000 series

[10] Institute of Risk Management (IRM) , Risk Culture, Under the Microscope: Guidance for Boards

[11] Speak up/Stand up/Ethics Line/Whistleblower Lines etc.

How to Understand Your Risk Landscape

This is part two of a series of five on the topic of risk appetite and its associated FAQs.

The author believes that enterprise risk management (ERM) will remain locked in organizational silos until boards are mobilized in terms of their comprehension of 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). Understanding risk appetite is very much a work in progress for many organizations. The first article made a number of observations of a general nature based on experience in working with a wide variety of companies. This article describes the risk landscape, measurable and unmeasurable uncertainties and the evolution of risk management.

The Risk Landscape

Lessons learned following the great financial crisis (GFC) include the importance of establishing an effective risk governance framework at the board level. In essence, two key questions must now be addressed by boards.

First, do boards express clearly and comprehensively the extent of their willingness to take risk to meet their strategic and business objectives?  Second, do they explicitly articulate risks that have the potential to threaten their operations, business model and reputation?

To be in a position to provide credible answers to these fundamental questions, we must first seek to understand the relationship between risk and strategy.

It is RMI’s experience that risk and strategy are intertwined. One does not exist without the other, and they must be considered together. Such consideration needs to take place throughout the execution of strategy. Consequently, it is vital that due regard is given to risk appetite when strategy is being formulated

Crucially, risk is now defined as “the effect of uncertainty on objectives.”

It is clear, therefore, that effective corporate governance is strategy- and objective-setting on the one hand, and superior execution with due regard for risks on the other. This particular landscape is what we in RMI refer to as the interpolation of risk and strategy. For this reason, RMI describes board risk assurance as assurance that strategy, objectives and execution are aligned. Alignment is achieved through operationalization of the links between risk and strategy, which will be described in the final article in this series.

Before further discussion, however, we would like to draw attention to observations based on our practical experience that give cause for concern, namely:

1.  Risk appetite: While we now have a globally accepted risk management standard3 and sharper regulatory definition of effective risk management for regulated organizations, there is as yet much confusion, and neither a consensus nor an internationally accepted guidance, as to the attributes of an effective risk appetite framework.

2.  Risk reporting: In relation to risk reporting, two significant matters arise:

Risk registers that are primarily generated on the basis of a compliance-centric requirement, as distinct from an objectives-centric4 approach, tend to contain lists of risks that are not explicitly associated with objectives. As such, they offer little value in terms of reporting on risk performance.

Note: RMI supports the adoption of a board-driven, objectives-centric approach5 to reporting and monitoring risks to operations, the business model and reputation.

Risk registers and other reporting tools detail known risks and what we know we know. They tend not to detail emerging or high-velocity risks that have the potential to threaten the business model. As such they tend to be of limited value in terms of reporting or monitoring either unknown knowns6, or unknown unknown7 risks. This is a matter that should give boards cause for concern given pace of change, hyper-connectivity and the disruptive nature of new technologies.

3.  Risk data governance: The quality, rigor and consistency in application of accounting data that is present in well-managed organizations does not equally exist in those same organizations in the risk domain.

The responsibility of directors to use reliable accounting information and apply controls over assets, etc. (internal controls) as part of their legally mandated role extends equally to information pertaining to risks that threaten financial performance. The latter is not, however, treated in an equivalent fashion to accounting data. Whereas the integrity of accounting data is assured through the use of proven and accepted accounting systems subject to audit, information pertaining to risks typically relies on the use of disparate Excel spreadsheets, word documents and Power Points with weak controls over the efficacy of copying and pasting of data from one level of report to another.

Weaknesses and failings in risk data governance can be addressed in much the same way as for other governance requirements.

For example:

a.    Comprehensive training for business line managers and supervisors on:

  •  (Risk) Management Processes,
  •  (Risk) Vocabulary,
  •  (Risk) Reporting,
  •  Board (Risk) Assurance Requirements

b.    Performance in executing (risk) management roles and responsibilities included in annual performance appraisals,  

c.   System8 put to process through the use of database/work flow solutions, providing an evidence basis of assurance that:

  • The quality, timing, accessibility and auditability of risk performance data is as rigorously and consistently applied as that for accounting data,
  • Dynamic management of risk data (including risk appetite/tolerance/criteria) can be tracked at the pace of change
  • Tests can be applied to the aggregation of risks to objectives at the pace of change and prompt interdictions applied when required,
  • Reports, or notification, of significant risks are escalated without delay, and without risk to the originator of information.

4.  Lack of understanding of the nature of the risks that need to be mastered in the boardroom:

Going back to our definition of risk as the effect of uncertainty on objectives: There are many types of objectives — for example, economic, financial, political, regulatory, operational, customer service, product innovation, market share, health safety, etc. — and there are multiple categories of risk. But what is uncertainty?

Uncertainty9 is the state, even partial, of deficiency of information related to understanding or knowledge of an event, its consequence or its likelihood.

There are essentially two kinds of uncertainty:

1.   Measurable uncertainties: These are inherently insurable because they occur independently (for example, traffic accidents, house fires, etc.) and with sufficient frequency as to be reckonable using traditional statistical methods.

Measurable uncertainties are treated individually through traditional (risk) management supervision, and residually through insurance.

Measurable uncertainties are funded out of operating profits.

2.   Unmeasurable uncertainties:  These are inherently un-insurable using traditional methods because of the paucity of reliable data. For example, whereas we can observe multiple supply chain and service interruptions, data breaches, etc. they are not sufficiently similar or comparable to be soundly put to a probability distribution and statistically analyzed.

Un-measurable uncertainties are treated on a broad basis through organizational resilience. For the top 5-15 corporate risks10 that are typically inestimable in terms of likelihood of occurrence, the organization seeks to maintain an ability to absorb and respond to shocks and surprises and to deliver credible solutions before reputation is damaged and stakeholders lose confidence.

Un-measurable uncertainties are funded out of the balance sheet.

The hyper-connected and multispeed world in which we live today has driven the effect of un-measurable uncertainties on company objectives to unprecedented, heights, and so amplified the risk potential enormously.

5.  Urgent need to recognize the mission-critical importance of building  and preparing management to always be prepared to offer credible solutions in the face of unexpected shocks and surprises  Figure 1 below describes the evolution of risk management as depicted within the red dotted line11 and the next stage of the evolution (resilience) as envisioned by RMI.

RMIFINAL

Figure 1: Evolution of risk and the emergence of “resilience” as the current era in the evolution of 21st century understanding of risk  

Resilience was the theme that ran through the World Economic Forum: Global Risks 2013, Eight Edition Report.  Resilience was described as capability to

  1. Adapt to changing contexts,
  2. Withstand sudden shocks, and
  3. Recover to a desired equilibrium, either the previous one or a new one, while preserving the continuity of operations.

The three elements in this definition encompass both recoverability (the capacity for speedy recovery after a crisis) and adaptability (timely adaptation in response to a changing environment).

The Global Risks 2013 Report emphasized that global risks do not fit neatly into existing conceptual frameworks but that this is changing insofar as the Harvard Business Review (Kaplan and Mikes12) recently published a concise and practical taxonomy that may also be used to consider global risks13.

The report advises that building resilience against external risks is of paramount importance and alerts directors to the importance of scanning a wider risk horizon than that normally scoped in risk frameworks.

When considering external risks, directors need to be cognizant of the growing awareness and understanding of the importance of emerging risks.

Emerging risks can be internal as well as external, particularly given growing trends in outsourcing core functions and processes.

table3

It is also interesting to observe the diversity in understanding of emerging risk definitions. For example:

  • Lloyds: An issue that is perceived to be potentially significant but that may not be fully understood or allowed for in insurance terms and conditions, pricing, reserving or capital setting,
  • PWC: Those large-scale events or circumstances beyond one’s direct capacity to control, that have impact in ways difficult to imagine today,
  • S&P: Risks that do not currently exist,

The 2014 annual Emerging Risks Survey (a poll of more than 200 risk managers predominantly based at North American re/insurance companies) reported the top five emerging risks as follows:

  1. Financial volatility (24% of respondents)
  2. Cyber security/interconnectedness of infrastructure (14%)
  3. Liability regimes/regulatory framework (10%)
  4. Blowup in asset prices (8%)
  5. Chinese economic hard landing (6%)

Maintaining business defense systems capable of defending the business model has become an additional fiduciary requirement for the board, alongside succession planning and setting strategic direction15.

References:

Influenced by COSO (Committee of Sponsoring Organizations of the Threadway Commission, Enterprise Risk Management (ERM)  Understanding and Communicating Risk Appetite, by Dr. Larry Rittenberg and Frank Martens

2 Source: ISO 31000 (Risk Management 2009). ISO 31000 is now the globally accepted risk management standard.

3 The new globally accepted risk management standard (ISO 31000) is not intended for the purposes of certification. Rather, it contains guidance as to risk-management principles, a framework and risk management process that can be applied to any organization, part of an organization or project, etc. As such, it provides an overarching context for the application of domain-specific risk standards and regulations — for example, Solvency II, environmental risk, supply chain risks, etc.

4 Risk Communication Aligning the Board and C-Suite: Exhibit 1 Top Challenges of Board and Management Risk Communication by Association for Financial Professionals (AFP), the National Association of Corporate Directors (NACD) and Oliver Wyman

5  The Conference Board Governance Centre, Risk Oversight: Evolving Expectations of Board, by Parveen P. Gupta and Tim J Leech

6 An unknown known risk is one that is known, and understood, at one level (e.g. typically top, middle, lower level management) in an organization but not known at the leadership and governance levels (i.e. executive and board levels)

7An unknown unknown risk is a so called black-swan (The Black Swan: The Impact of the Highly Improbable, Nassim Nicholas Taleb)

8 Specified to the ISO 31000 series

9 Source: ISO 31000 (Risk Management 2009). ISO 31000 is now the globally accepted risk management standard

10 More than 80% of volatility in earnings and financial results comes from the top 10 to 15 high-impact risks facing a company: Risk Communication Aligning the Board and C-Suite, by the Association for Financial Professionals (AFP), the National Association of Corporate Directors (NACD), and Oliver Wyman

11 Source: Institute of Management Accountants, Statements on Management Accounting, Enterprise Risk Management : Frameworks, Elements and Integration

12 Managing Risks: A New Framework

13 Kaplan and Mikes’ third category of risk is termed “external” risks, but the Global Risk 2013 report refers to them as “global risks.” They are complex and go beyond a company’s scope to manage and mitigate (i.e. they are exogenous in nature).

14 Audit and Risk, 21 July 2014, Matt Taylor, Protiviti UK,

15 The Financial Reporting Council has determined that it will integrate its current guidance on going concern and risk management and internal control and make some associated revisions to the UK Corporate Governance Code (expected in 2014). It is expected that emphasis will be placed on the board’s making a robust assessment of the principal risks to the company’s business model and ability to deliver its strategy, including solvency and liquidity risks. In making that assessment, the board will be expected to consider the likelihood and impact of these risks materializing in the short and longer term;