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Exploring the concepts of Risk Appetite, Risk Tolerance, and Risk Bearing Capacity

Posted By Bronwyn Blyth, 07 June 2013
Updated: 06 June 2013

In May, the Institute of Risk Management South Africa (IRMSA) hosted breakfast presentations in Durban, Cape Town and Johannesburg. Volker von Widdern was the speaker and he shared insights on Risk Bearing Capacity (RBC), Risk Appetite and Risk Tolerance concepts focusing on their application on today’s risk activities.
Von Widdern began his talk with a bold statement: "If we understood RBC, risk appetite and tolerance better, the concepts would be applied more successfully and add measurable value”. He followed this up by exploring a number of probing issues including: how we can use RBC as a better capitalisation tool; dynamics of RBC; appetite and tolerance; alignment of RBC to ERM and historical as well as potential future use of RBC in Risk Management.
A key aspect of the presentation was to define the three key concepts starting with Risk Bearing Capacity: "RBC is the ability to absorb additional risk based volatility in its results without detrimental effects to key plans, strategies, operational and financial resources of the company,” explains Von Widdern. This is especially so when viewed over a longer time horizon of over 2 to 5 year time period and the condition if the financial loss can be endured in the medium term without changing strategic plans or financing requirements – this reflects a realistic RBC.
Risk appetite is the amount and type risk that management is prepared to take in the normal running of the entity to reach their objectives. Risk Appetite is measured using qualitative and quantitative factors that are based on specific key performance indicators.
Risk tolerance, on the other hand, indicates levels of risk that stakeholders would want to know about or have referred to them for decision prior to accepting the risk. The Risk tolerance is determined with reference to the qualitative aspects such as the operating processes and reporting requirements, mandates given to the executive by the stakeholders and governance expectation.
Von Widdern indicates that one of the obstacles in correctly applying RBC is that, in line with the financial cycles, Risk Bearing Capacity is usually measured on an annual basis.  This approach is one dimensional in that it excludes information on sustainability and resilience of financial (risk) capacity. 
Applied correctly, RBC introduces dynamism in the process in that it is inclusive of strategic plans, budgets and various financial scenarios – one of the key purposes of RBC is that it assesses both the optimistic and stressed risk capacities. Part of this process is to include adequate assurance measures and financial impact allocations thereof.
Whilst this process is more involving and intense, the outcome is that there are realistic RBC and risk appetite measurements.  One of the main challenges of the traditional appetite and tolerance approach is that the focus is short term and narrow context and the recommended RBC approach attempts to be more holistic in seeking to understand upside and downside scenarios.

Another contributing factor for the underutilisation of RBC is that, management bonuses are usually based on each year’s financial results. This is in contrast to capitalisation models applied to projects, seeking to optimise NPV over time, vs  the aspects of risk or volatility being superficially aggregated into annual operating results.  The annual financial statements tend not focus on medium term upside but have a short-term focus.   It therefore follows that executive management and other stakeholders often differ on RBC, risk appetite (tolerance) whilst the default position is performance in a financial year.
One of the recommendations made is that  RBC should be considered for the ‘business as usual’ scenarios separately from  key initiatives over medium to long-term. Further, Enterprise Risk Management should set the framework and policies to ensure alignment of RBC, tolerance and appetite scenario’s.  All top risks should be evaluated against dynamic  RBC, appetite and tolerance assessments. In this way, an organisation can ensure there a comprehensive and qualitative risk assessment process is in place.

Von Widdern then recommended an approach to risk assessment which combines the impact assessments with RBC / appetite, described as a ‘portfolio risk model”. This model considers the range of risk appetites, from incidental to financial ruin, the hazard / financial / operating / strategic risk volatilities, as well as to timing effects of deployed cash flows on both a modeled and scenario basis. RBC and capital allocation assessments can then be done with a view of the range of feasible or probable risk scenario’s. 
 Furthermore, it is important to assess the inter company (supply chain) dependencies and ensure that these transactions are catered for, to cover the impact of internal and external dependencies. All these risk factors must then be modelled for likelihood and impact, and an aggregated risk exposure (expected loss) curve is developed over a 3 to 5 year time horizon at entity level.
In conclusion, the RBC model is designed to show whether the "aggregated” portfolio of risk exposures on business as usual and key initiatives remain within the surplus financial capacity of the organisation in the medium term.   

Tags:  Risk Appetite  Risk Bearing Capacity  Risk Tolerance 

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