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Risk appetite reflects the amount of risk taking that is acceptable to an organisation. As a result, risk appetite refers to the organisation’s attitude towards risk taking and whether it is willing and able to tolerate either a high or a low level of exposure to specific risks or risk groups.

As the diagram below illustrates, risk appetite, first and foremost, is a function of the organisation’s capacity to bear risk and of its attitude towards managed risk taking. Risk appetite can also be viewed as assigned or allocated risk capacity.

Risk capacity Risk appetite Qualitative statements Risk limits Risk thresholds Risk indicators

Represents the ability to bear risk

(need to consider what capital is available, ability to raise capital, strength of operational processes and strength of operating culture) Reflects the willingness to take on risk

Serve as essential elements in risk control

Why is it important?

Among other things, risk appetite plays an important part in supporting risk assessment, monitoring and control activities. It does this by helping staff to understand the relative significance of the risks faced by the organisation and thereby betterprioritises risk monitoring and control activities.

Risk appetite plays a key role in maximising return on capital invested as it acts as a driver for allocation of capital to identified risks. The better the understanding of risk appetite, the more efficient the allocation of capital across the organisation. Risk appetite should be a function of the capacity to bear riskand should not exceed it. Constraints on risk appetite include the capital which needs to be maintained to support a target rating agency’s rating and regulatory capital requirements. It is important to note that businesses trading at Lloyd’s are subject to a number of guidelines in respect of risk appetite, through the operation of the Franchise guidelines.

What are the benefits of articulating risk appetite?

Organisations that effectively articulate their risk appetite and adequately fund their managed risk taking are better insulated against shock to future earnings, better placed to allocate scarce resources when and where needed, and better prepared to take advantage of changes in insurance cycles as they arise.

Specifically, risk appetite playstwo roles in supporting the business objectives and risk management activities of an organisation:

firstly, it establishes a benchmark from which transaction specific limits or thresholds can be set and monitored for an organisation’s exposure to particular risks:

Section 3 Risk appetite

a limit reflects the absolute maximum level of exposure that is acceptable for a particular risk (i.e. it represents a level of exposure that should not normally be exceeded);

in contrast a threshold represents a level of exposure which, with appropriate approvals, can be exceeded, but which, when exceeded, will trigger some form of response (e.g. additional capital or expenditure on risk control, reporting the situation to senior management, etc.);

secondly, as a resource allocation tool, risk appetite helps determine the degree of control that needs to be applied to a particular risk. For example:

if current exposure to a particular risk is considered to be acceptable there is usually little value, other than for efficiency reasons, in changing the extent of control (either in terms of using tighter controls or by increasing capital or the amount invested in risk control); in contrast, where current exposure to a particular risk is considered unacceptable, an agent may decide that it needs to invest more capital and introduce more rigorous controls. There are a number of additional benefits of articulating risk appetite:

risk appetite is an essential element of risk governance and provides a framework for the business to operate within, as it provides clear boundaries regarding what is and is not acceptable to the organisation;

articulating risk appetite leaves room for creativity within acceptable limits and reduces the possibility of exposure to unpleasant incidents due to a lack of awareness;

provides a framework for considering and approving risk taking levels and activities that are outside the current appetite for risk; and

assists in the identification and prioritisation of areas where additional resources or controls may be necessary to bring the risk into line with the stated risk appetite.

What practical steps are necessary for implementation?

The following guidance is intended to help you understand what is involved from a practical standpoint to implement this risk appetite section:

Staff resource and skills

senior management buy-in is vital in order to establish and articulate an organisation’s risk appetite

Board and senior management assessment of risk bearing capacity and risk appetite, as an integral part of business planning, with facilitation and proposals from the risk committee and risk management function

business unit and functional area management workshops to consider, interpret and cascade risk appetite for their function(s)

IT programming resource to develop and implement system limits, monitoring and exception reports, thresholds and KRIs as appropriate

internal audit review to give assurance that reliable monitoring systems against appetite are in place

Section 3 Risk appetite

Enabling technology

underwriting system implementation of limits, thresholds, KRIs and/or other expressions of appetite

Time

Board – extending the business planning process to articulate clearly the risk appetite business unit managers – cascade and interpret board appetite for each business unit and functional area, e.g. via workshops, as part of business plan roll out

overall implementation time – an integral part of business planning cycle and performance monitoring process

Direct / indirect costs

Board and senior management time – integral part of business planning and performance monitoring process

IT staff time – for programming limits, thresholds etc.

risk management time – proposals for risk appetite, facilitation of appetite setting, documentation, review and monitoring

internal audit / external consultants – review, technical support, assistance and assurance over appetite setting and resetting

Notwithstanding the wide range in size and sophistication of organisations, it is anticipated that setting risk appetite should be an integral partof the business planning process, including roll out and monitoring against plans, for all organisations.

Relevant toolkit contents

With regard to operational risk, there are a number of ways of expressing risk appetite. The toolkit provides explanations of each approach with advantages and disadvantages and worked examples covering:

Tool 3.1 – Key questions to consider when setting appetite: highlights key questions organisations should consider when setting and expressing risk appetite;

Tool 3.2 – Example appetite articulation via qualitative statements: provides examples of and advantages and disadvantages of risk appetite articulation using qualitative statements;

Tool 3.3 – Example appetite articulation via quantitative methods: provides quantitative examples of and advantages and disadvantages of risk appetite articulation through limits and thresholds;

Tool 3.4 – Example appetite articulation via key risk indicators: provides quantitative examples of and advantages and disadvantages of risk appetite articulation through key risk indicators;

Tool 3.5 – Examples of high level articulation of risk appetite: an example high-level (Board level) articulation of risk appetite in terms of various operational risk classes; and

Tool 3.6 – Examples of low level articulation of risk appetite: an example low-level

TOOL 3.1