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Risk appetite is the same as risk strategy
Although most insurers operate with a good risk appetite, in
most cases it is not articulated in a way that managers can
connect to ERM terminology.
The United States' National Association of Insurance
Commissioners (NAIC) has provided some helpful definitions
of risk appetite and tolerance that we can use to bridge the
gap between company practice and ERM terminology.
In its ORSA Guidance Manual, NAIC defines risk appetite in
'Document the overall principles that a company follows
with respect to risk taking, given its business strategy,
financial soundness objectives and capital resources.'
In other words, risk appetite is the risk-taking strategy
Here are four suggestions for risk-taking strategy statements:
• grow risk -- increase risks faster than capital
• manage -- balance risk growth and surplus growth
• grow capacity -- increase capital faster than risk
• diversify -- any growth will come from new types of risk.
Many insurers can identify with one of those four strategies.
If not, it is likely that their reasoning would itself constitute a
statement of their strategy.
Risk tolerance is risk budget
The NAIC definition for risk tolerance is also helpful. They
define risk tolerance as:
'The company's qualitative and quantitative boundaries
around risk taking, consistent with its risk appetite.'
In other words, it is a risk budget -- a statement of what
risks the company will and will not take, along with an
expression of how much risk the company will take.
The NAIC says that risk tolerance should be consistent with
risk appetite. To me, this means that if your strategy is to
grow risk, then your risk tolerance should be significantly
higher than your current situation. If your strategy is to grow
capacity, then your risk tolerance should be pretty restrictive.
Different ways to develop the first risk tolerance
The first part of risk tolerance should already be a part
of your company strategy document -- it is the list of the
insurance businesses in which you will participate.
For the second part, we have four different suggestions
for how to proceed to develop that first written risk
1. Based upon what peers are doing
When a primary consideration is the appearance of
security to customers and distributors, an insurer's risk
appetite needs to be set with consideration of the levels
of security of peer competitors. This requires some
careful analysis of the risk levels of those firms. Usually,
an insurer will perform their risk analysis using non-public
information. To perform the necessary peer analysis
with public information requires judgment informed by
experience working with many insurers. That then needs
to be coupled with a target for standing within the peer
group to get to a risk tolerance statement.
2. Based upon the rating target
Many insurers have a clear target for capital in relation to
risk, which is based upon a rating agency capital standard
(such as the A.M. Best Capital Adequacy Ratio (BCAR)).
The risk tolerance statement can then be communicated
in terms of a target BCAR score, along with a minimum
acceptable BCAR score. Since BCAR is actually a risk-
adjusted view of required capital, this target and minimum
acceptable BCAR scores are actually a clear risk tolerance
statement. It is widely known that rating agencies do not
favour the use of their calculation as a risk tolerance. But
an insurer will get to better understand the concept of
risk tolerance if they can actually use their de facto risk
tolerance with a plan to modify it as their view of their risk
matures. What this means is that, eventually, an insurer will
notice that BCAR is not the most accurate representation
of their risk, and will want to develop their own modified risk
capital adequacy ratio as their risk tolerance.
3. Based upon reinsurance purchasing
The decisions that an insurer makes about reinsurance
retention are an expression of risk tolerance. Based upon
our analysis of your reinsurance purchase, we can tell you
the likely loss that you have retained at any return period.
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