Risk Appetite Meaning
Risk appetite denotes the amount, rate or percentage of risk an individual, or organization (foreseen by the Board of Directors or management) is willing to accept in return of its plan, objectives and innovation.
As per the ISO 31000, a risk management standard defines risk appetite as “Amount and type of risk that an organization is prepared to pursue, retain or take.” Every business or an individual has some aspirations, and to fulfill that strategic plans or objectives are foreseen. To apply these plans, and due to the uncertainties involved, multiple risks are associated too. To avail of the stated purpose, one has to do the cost-benefit analysisCost-benefit AnalysisCost-benefit analysis is the technique used by the companies to arrive at a critical decision after working out the potential returns of a particular action and considering its overall costs. Some of these models include Net Present Value, Benefit-Cost Ratio etc. and come to a point where the risk assumed is worth taking.
Let’s assume an organization is expecting to expand in a different country. The present net worth of the organization is close to $800 million. The entity could bear the risks until the bar of $400 million, but as decided by the management, the degree of risk accepted by the company should not exceed beyond $240 million. Thus the entity has set to the level of 30% of the net worth, and no business heads are allowed to decide a story that impacts the business more than its stated level.
Types of Risk Appetite
It could vary in different scenarios or entities. Broadly, the risk accepting abilities are the following:
- Some organization are risk-averse or always plays in a safe zone in certain areas of business. For instance, big MNCs mostly doesn’t show any level of risk appetite for reputational loss.
- Another option would be acceptance of risk but in a range of minimal to exemplary, where the management decides a point giving the best risk-reward ratioRisk-reward RatioThe risk-reward ratio is the measure used by the investors during the trading for knowing their potential loss to the potential profit. Hence it is used by the traders for effectively managing their risk and capital during the trading process..
- In this option, the management tries all the options which could offer the most successful results and fall in the criteria of value to the organization.
- It is quite rare but could be seen in the business environment, where irrespective of the degree of risk, the management assents to a project or an objective promising a healthy return.
How to Determine Risk Appetite?
Sometimes people confuse it with risk management. Risk appetite is a borderline below which the management is ready to pursue or continue its stated goals. But, even deciding the appetite of the organization towards the risks involved, a fair and robust risk management activities need to be in place. After a thorough understanding of the expected risks from all the corners, a line could be drawn to support the acceptable level. So, risk acceptance comes later to risk management routine.
Though the Board of Directors is responsible for shaping the decisions of the company, forming and preparing the risk appetite documents is the primary responsibility of the management. Managers of the various domain in the entity does an exercise to understand the risk levels and then pen it down and present to the Board for consideration. Then, the Board decides upon the given proposal that whether it reflects the real picture of the risks or not, and to take stand on it.
For evaluating the risks, the management needs to consider and ponder upon few questions such as what could be the significant risks faced by the organization, the risk-taking abilities of the entity, providing ranks to the dangers based on rewards offered, and doing qualitative analysis to arrive at the numbers, if any.
After the exercise mentioned above, the details are sent for approval to the top management who, after doing an elaborate discussion and pondering, approves it and allows it to become the written policy of the entity as its risk appetite.
Risk Appetite vs. Risk Tolerance
- In general parlance Risk Appetite and Risk ToleranceRisk ToleranceRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition. is used interchangeably, but these terms have a different meaning. Risk Appetite denotes the amount, rate, or percentage of risk an individual or an organization requires to bear to move ahead with its plans or objectives. The threats come as part and parcel with the entity’s aspirations and need to be accepted by the management to proceed forward.
- On the other hand, risk tolerance is when the investor or the organization would remain comfortable despite taking losses or bearing uncertainties. The endurance of risk depends upon many factors such as financial expectation, strength, age, earning capacity, etc. One of the popular methods to assess the risk tolerance level of an organization or individual is to design a questionnaire and get it filled by them.
- It is the fundamental step in arriving at the overall risk or risk management for the organization. After understanding the risk acceptance level, or doing the analysis of the uncertainties the project, expansion, or objective, an organization is in better shape to draw its risk tolerance and risk management policies.
- If an organization is not aware of its risk accepting capabilities, then It would not be able to either maximize the return or curtail the excessive losses. So, to remain efficient in the risk-reward relationship, Risk appetite needs to be calculated beforehand.
- After defining the appetite for risk or risk acceptance, an organization could create a balance between its innovation and cautionary policies. If the stated risk is in the range of entities accepted levels, then there is no need to spend further in risk reduction methodologies. If the present trouble is considerably lower than the stated or assumed risk, an organization could increase its thrust on additional innovation or extend its objectives until the risk accepted limit is reached.
- Apart from the benefits or advantages mentioned above, the exact expression of risk acceptance level of an entity provides other benefits too, such as allowing the Board or the management to pursue more decision to enhance its rewards, feasible fund allocation to a particular project for additional benefits, enhancement of transparency in the eyes of customers, investors, rating agencies, and such other parties.
Eventually, a broad exercise in risk management could entail managing the risks involved in a particular project, objective, or an action. Now it becomes the responsibility of the Board of Directors, or Strategic Committee, or any such authority capable of making a decision, whether or not to accept such proposition considering the risk and returns offered, and if yes, then to what extent.
This has been a guide to risk appetite and its meaning. Here we discuss examples, types, and how to determine the risk appetite along with its importance. You may learn more about financing from the following articles –