risk appetite: establishing boundaries

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Presentation on the concept of risk appetite/ Présentation sur le concept de l'appétance au risque

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Page 1: RISK APPETITE: ESTABLISHING BOUNDARIES
Page 2: RISK APPETITE: ESTABLISHING BOUNDARIES

ESTABLISHING RISK BOUNDARIES

Michel Rochette, MBA, FSACaribbean Actuarial Association Annual MeetingTrinidad & TobagoDecember 4th 2008

Enterprise Risk Advisory

Page 3: RISK APPETITE: ESTABLISHING BOUNDARIES

TOPICS Context from 2006 to 2008 Risk appetite and ERM Definition and its evolution Value of articulating risk appetite Stakeholders’ influence on risk appetite statement Components of risk appetite and responsibilities Ex. of a risk appetite statement: ING Summary of methods to determine risk appetite Success factors

Page 4: RISK APPETITE: ESTABLISHING BOUNDARIES

Risk Appetite: 2006 UK FSA Most firms have documented their approach for risk

management through risk policies/procedures/risk appetite.

However, « risk appetite » is not well understood throughout many firms to a level of clarity that provides a reference point for all material decision making.

A big step exists between defining and applying risk appetite.

UK FSA Insurance Sector Briefing, Risk Management in Insurance, 2006

Page 5: RISK APPETITE: ESTABLISHING BOUNDARIES

Risk Appetite: 2008 UK FSA For insurers demonstrating a strong integration of

risk and capital management: Clearly articulated and quantified risk appetite,

tolerances, and trigger points for each risk. Processes are set to assess on a continuous basis the

level of risk appetite. Coherent and well articulated processes to actively

manage risk exposures that exceed risk appetite: risk monitoring.

UK FSA Insurance Sector Briefing, 2008

Michel Rochette

Page 6: RISK APPETITE: ESTABLISHING BOUNDARIES

Risk Appetite and ERM

Page 7: RISK APPETITE: ESTABLISHING BOUNDARIES

Strategy Objectives: markets, products and services,

distribution channels, stakeholders Financial goals:

Capital goals in relation to solvency issues. ROA and ROE without considering risk taking. RAROC if integrating risk taking into the strategic

framework. Value creation goals if objective is to maximize

shareholder’s: Embedded Value. Non Financial goals: customer satisfication, corporate

social responsibility objectives.

Page 8: RISK APPETITE: ESTABLISHING BOUNDARIES

ERM Framework Enterprise risk Policy:

All existing key risks: financial/operational/business/strategic

Emerging risks: « known and unknown risks » Champion of Risk: CRO who can initiate a discussion of

risk appetite at the Board/top management level, supported by a centralized risk unit.

Risk technology: control of risk taking through risk limits, risk reporting through a dashboard.

Businesses: risk management at the unit level. Audit/Compliance: independent oversight of the risk

framework.

Page 9: RISK APPETITE: ESTABLISHING BOUNDARIES

Risk Appetite: Evolution Turnbull Report: Risk appetite reflected indirectly by

« those risks which are acceptable » UK 1999. COSO I: Focused on internal controls only. 1992 COSO II ERM: Give management reasonable assurance

that strategic objectives will be met within risk appetite. 2004

CAS ERM Definition: Process to manage risks to create value. Risk appetite not explicit but indirect.

Solvency II: Risk tolerance limits and business strategy must be defined.

UK FSA Prudential Regulations: Risk appetite defined. ISO 31000: Risk appetite is defined indirectly in relation to

value creation and risk acceptability.

Page 10: RISK APPETITE: ESTABLISHING BOUNDARIES

Risk Appetite: Definitions COSO II ERM: Amount of risk that an entity is willing

to accept in pursuit of value. Would add: « in line with the firm’s strategic

objectives taking into the capability of its ERM framework.

Similar to a mission statement but focused on risk: Impact that risk can have on the capacity of the firm to

attain its strategic objectives. Defines boundaries of what is « too much » or « too

little » and what is « acceptable » or « non accpetable » in relation to the firm’s strategic objectives.

Page 11: RISK APPETITE: ESTABLISHING BOUNDARIES

Risk Appetite: Another View

Page 12: RISK APPETITE: ESTABLISHING BOUNDARIES

Value of Articulating Risk Appetite Allow a FI to:

Clarify desired risks: retained and non retained . Set the tone from the Top. Preferable to a bottom-up

approach which tends to overemphasize exisiting risks. Estimate/Assess their impact, both financial and non

financial – ex. social responsibility – Evaluation of risks, not a valuation of risks! Establish clearly the risk preferences of the company:

Are we risk averse, risk takers in light of potential returns?

Page 13: RISK APPETITE: ESTABLISHING BOUNDARIES

Value of Articulating Risk Appetite Set a consistent communication - transparency -

from management to : Business units/product lines External parties:

Shareholders: can diversify away if they don’t like it! Regulators: Part of Pillar II and III of SolvencyII/Basel II. Other stakeholders: Employees may not want to be part of

your organization. Ex. Army! Customers as well. Recent example: AIG only mentions the word risk

appetite without ever elaborating about it in their official published documents.

Page 14: RISK APPETITE: ESTABLISHING BOUNDARIES

Value of Articulating Risk Appetite Top –down approch is preferable because:

Stakeholders’ requirements are discussed explicitely among board members. Allows a more balanced view of risks instead of just focusing on one

group: credit agencies, financial analysts, employees, shareholders, regulators, customers, society at large!

More forward looking: Introduces forward thinking in terms of desired risk profile, not just

existing risk profile! Can link risk appetite with strategic goals and required capital to

support growth and risks. Board members/management are on the same page on risk

appetite. Management can then react/take action if the risk profile

exceeds/is below its desired/target risk appetite.

Page 15: RISK APPETITE: ESTABLISHING BOUNDARIES

Stakeholders’ Influence: Board Risk preferences of individual board members/management:

Risk averse vs risk takers. Risk Averse Type Board:

Focuses on « value preservation ». Reduces earnings volatility. Low impact of extreme events! « Keep us out of trouble » We don’t want surprises! Concerns about legal fines, external scrutinity if they take too

much risk. Wants to keep their desired ratings.  Usually found in mutuals. Wants to preserve capital. Less concerned about capital efficiency. Incurring losses is perceived to be negative. Don’t consider the

gains realized before losses occured.

Page 16: RISK APPETITE: ESTABLISHING BOUNDARIES

Stakeholders’ Influence: Board Risk Taker Type Board:

Focused on « Value Enhancement ». Considers risk vs opportunity relationship. Focuses on higher returns and risks. Anticipates « newer » risks, capitalizes on them, optimizes

the risk/return relationship. Concept of efficient frontier! Optimizes use of capital. Capital management and risk

management are done proactively. Usually found in public companies.   When risks materialize, board shouldn’t panic if within

target risk appetite! Risk and losses are not viewed as negative!

Page 17: RISK APPETITE: ESTABLISHING BOUNDARIES

Stakeholders’ Influence: Regulators Risk preferences of the local/global regulators:

Asian: stricter, more rules based. European: more principle based. US: more rules based…Stricter on Admitted assets, … Single regulator - OSFI/UK FSA – vs a diversified

group of regulators – US SEC, NAIC, OCC, OTS, FED, FDIC –

My prediction: US will tend towards a « single regulator model » common view, not one organization!

Internationally: Moving towards « college »

Page 18: RISK APPETITE: ESTABLISHING BOUNDARIES

Stakeholders’ Influence: Rating Ag. Risk preferences of rating agencies:

Impact on agencies’ rating: Financial Strength or Claims Paying ability. If risk appetite is expressed solely as « desired AA rating »,

constraints immediately risk appetite to a certain overal probability of default/ruin.

SP’s ERM evaluation method: Risk Appetite is part of their Governance evaluation: «  Clearly articulated risk tolerance is a key factor. »

Page 19: RISK APPETITE: ESTABLISHING BOUNDARIES

Stakeholders’ Influence: Others Risk preferences of :

Employees/customers/clients/policyholders: Risk of loosing key employees if taking too much risk! Will customers buy our products if the firm may not longer

be there to service them in the future? Ex. GM/Ford… In a pension plan, ratio of projected active/retired employees

would certainly affect your desired risk appetite. Shareh0lders:

If long-term/passive investors, may be willing to tolerate more risks.

Political groups/media/advocacy groups.

Page 20: RISK APPETITE: ESTABLISHING BOUNDARIES

« Risk Appetite »: Components Risk Capacity:

Maximum amount of risk that an enterprise is able to accept in line with its mission/values/strategic goals.

Risk appetite per se: Overall statement about the amount and type of risk that an

enterprise is willing to accept in line with its strategic goals. Risk Target: Optimal level of risk desired. Risk Tolerance: Max/Min amount of risk for each

class/subclass of risk. Risk Limits/Budgets: Thresholds not to exceed/min to

accept. Not all firms have all these components!

Page 21: RISK APPETITE: ESTABLISHING BOUNDARIES

Components: Risk Capacity Influenced by the quality of its risk management framework and processes:

Overall ERM effectiveness: Sources could be an external view as assessed by a rating agency, external governance score.

Management of past losses, especially unexpected and risk transfer options. Influenced by the amount and quality of its capital structure or Value of the business:

Amount: measured by RBC, rating agencies’ required capital, economic view. Quality: Tier 1 versus Tiers 2 & 3 capital. Liquidity of capital: sources and availability particularly in times of stress. Access to central banks’ liquidity facilities: US recent history with AIG for ex. Systemic view by governments/markets:

Too big too fail! Too big to rescue! Think of how Iceland was affected by the combined effect of risk appetite of its

banks on the country itself. Value: Value of the business model to generate economic value.

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Components: Risk Appetite Lower than Risk Capacity and if focused on downside risk: Defined as acceptable/non acceptable volatility of capital -

quantitative component/metric – over a certain horizon for certain risks deemed to be acceptable/non acceptable. – qualitative component

Quatitative metric: prob of ruin/ certain target rating/ minimum regulatory capital ratio

Golden rule on acceptable/non acceptable risks: Would our stakeholders be surprised if we annonced losses due to this

risk? Think of AIG with credit derivatives! Focused on existing balance sheet risks/preservation of capital. Capital centric statement. Ex. « Level of risk that results in no more than a 0,1% chance of failure

over a one-year horizon, where failure is defined as loosing 100% of capital, measure by US GAAP. »

Page 23: RISK APPETITE: ESTABLISHING BOUNDARIES

Components: Risk Appetite If focused on downside/upside risk: Defined as an acceptable/non acceptable volatility of

value - quantitative component/metric – over a certain horizon for certain risks deemed to be acceptable/non acceptable. – qualitative component –

Value metric: could be economic value/embedded value based on discounted earnings/cash flows at WACC.

Focused not only on existing balance sheet risks but also takes into account emerging risks in line with strategy.

Value centric statement, but not necessarily optimizing risk/return relationship as it expresses risk preferences.

Tends towards a portfolio view of risks.

Page 24: RISK APPETITE: ESTABLISHING BOUNDARIES

Components: Risk Target Specifies the optimal level of risk that an organization

desires taking into account its risk capacity, risk appetite and desired returns.

Efficient frontier concept: for a given level of capital – capital centric approach – or returns – value centric approach - where do I want to be in terms of risk given my strategic goals? Target risk profile vs actual risk profile?

Set risk objectives so that if risk is outside target – monitoring of risk profile – then actions are taken to reduce/enhance/increase risk taking.

Could be done overall and by type of major risk class. Not all firms have risk targets.

Page 25: RISK APPETITE: ESTABLISHING BOUNDARIES

Components: Risk Tolerance Sinceestimating risk capacity/appetite/target is not a perfect

exercise, tolerance sets bands around which company is tolerating fluctuations of its risk appetite/target.

Similar to the statistical concept of estimating a mean from a sample: Real mean = sample mean +/- Variability/Noize

Set so that the aggregation of total risk is within the overall organization’s risk appetite/target. Certain risks like SOX/Fraud/Legal Compliance: Zero Tolerance Financial risks: Tolerance expressed as a +/- yearly IRR duration

mismatch, % of ALM, Greeks, GAP, Unexpected losses, yearly expected losses above a certain threshold, % economic capital depleted, volatility of embedded value

Non financial risks: min customer satisfaction rates, employee retention rates, % of clients’ funds retained …

Page 26: RISK APPETITE: ESTABLISHING BOUNDARIES

Components: Risk Limits/Budgets Max not to exceed/min to accept. Practical/day-to-day constraints on business activities with some risk

tolerances. Limits/risk budgets can be set up for:

Business units, product lines, country, types of risks, concentration, market limit of securities held, existing, future – derivatives -.

Ex. ABCP recent problems in Canada. CDP Capital held 1/3 of market…too much..didn’t have a market limit…

Devising an overall limit system should be done so that it akes into account all acceptable/non acceptable risks, correlation, aggregation of risks, & risk tolerances in order to tend towards the firm’s desired risk target/risk appetite.

Risk limits should also be explained/negotitated with business units and embedded into compensation schemes.

Limits should be established in the same units: Capital/Value As much an art as science here!

Page 27: RISK APPETITE: ESTABLISHING BOUNDARIES

Risk Appetite: Responsibilities Board:

Approves, discusses & challenges the Risk Appetite Statement. Reviews it annually & authorizes exception. Communicates it to stakeholders.

Management: Reviews/discusses the risk capacity exercise. Proposes the risk appetite to the Board along with its components:

target/tolerances/risk limits. Negotiates/explains the limits with the business units. Reports risk appetite to the Board. Frequency: quaterly.

ERM Group: Performs the risk capacity/appetite/target/tolerance/limits

exercise. Monitors the overall risk appetite/limit system. Updates analysis with changes in external environment, strategy…

Page 28: RISK APPETITE: ESTABLISHING BOUNDARIES

Examples of Risk Appetite: ING Risk appetite measured along 3 dimensions:

Earnings at Risk, Capital At Risk, Economic Capital Earnings at Risk (EaR) is a measure of the potential reduction in IFRS earnings

from expectations, assuming no mitigating management actions, during a moderate (i.e. ‘1 in 10’) stressscenario.

Capital at Risk (CaR) is the potential reduction of the current net asset value (based on fair values) of the balance sheet over the next year relative to the expected value during a moderate (i.e. ‘1 in 10’) stress scenario, and assuming no mitigating management action.

Economic Capital (EC) is the amount of capital required to absorb unexpected losses in times of severe stress given ING’s AA target rating, 99,95%, (i.e. ‘1 in 2000’ ).

Integrates shareholder’s point of view: EaR & CaR Integrates rating agencies/debtholders point of view: EC Integrates their banking and insurance operations/all risks Risk appetite appears 34 times in their 2007 Financial Statements compared to

1 time in AIG’s 2007 Statements!

Page 29: RISK APPETITE: ESTABLISHING BOUNDARIES

Risk Appetite: Methods Simple like KPI/KRIs combined in a scorecard indicator.

Easy to set up and monitor. Concept of the Green/Amber/Red zones.

Heat Map Approach: Evaluate Likelihood and Impact. Risk Appetite is the boundary line.

Efficient frontier Approach: Investment Perspective. « Sophisticated Approach » : EC/Enterprise/Embedded

Value Modelling. Recommend: Combination of methods if sophisticated

modelling fails!

Page 30: RISK APPETITE: ESTABLISHING BOUNDARIES

Risk Appetite: Success Factors Integrate both internal and external stakeholders’ different risk

tolerances into the process from value protection to value creation.

Integrate process within the overall strategy, culture and risk capabilities.

Consider past historical decision making, reactions to events to assess risk appetite/tolerance. If CRO is fired all the time, maybe risk appetite is lower than said! ING CRO is leaving?

Integrate non financial and financial risks: portfolio view of risks.

Create a few measures that are practical and that represent the most critical aspects of the business.

Communicate it through the firm! From top-down to bottom-up feedback.

Page 31: RISK APPETITE: ESTABLISHING BOUNDARIES

CONTACT

Michel RochetteEnterprise Risk Advisory, LLC

[email protected]