Every company exists to provide value for its stakeholders, where value will vary depending of company’s structure and purpose. As an example, the core business of financial firms is to translate risk taking activities into value to stakeholders. Insurance companies in particular specialize in the pricing, underwriting, pooling and taking of complex risks. Portfolios of risk are managed with the objective of making a profit commensurate with the risk being taken. Risk is a traded commodity with companies seeking risks that maximize risk adjusted return and stakeholder value. Any companies that manage risk well will be able to maximize value for a given level of risk. This realization of an optimal risk / return profile leads us to the critical question: what is the desired level of risk for which we want to maximize value?
This question is inextricably linked with the desired level of value maximization. Before a company can answer what level risk it desires, something must be known about the company's long-term vision, strategic and financial objectives. The willingness to take on more or less risk is fundamentally tied to the company’s risk philosophy and how high or how low it sets the bar in respect of its financial objectives.
Risk appetite is one half of the question. The answer to this question will provide strategic and day-to-day direction for all of the business's activities including hedging, new business development, growth into new markets, acquisitions, and investment strategy.
The Canadian regulator, the Office of the Superintendent of Financial Institutions, has issued in 2013 a Corporate Governance Guideline that identified risk governance has one of the fundamental components of sound corporate governance that supports their Supervisory Framework and Assessment Criteria. Full compliance of the Corporate Governance Guideline, including risk governance components are expected by January 2014. In 2006, Standard & Poor's formally started incorporating ERM in its ratings process. The European Solvency II Framework Directive establishes ERM as the second pillar of the framework.
ERM has evolved from a risk control tool to a risk optimization tool to run the business and achieve overall company’s strategic and financial objectives. Establishing the risk appetite is an important element required to implement ERM as a strategic decision making framework. However, it can only properly be determined in the context of the overall conceptual framework for ERM.
For companies that choose to make decisions in the "Real World", risk appetite is one key element of an overall ERM conceptual framework that can be used run the company.
For companies that choose to make decisions in the "Risk-Neutral World" on a market consistent basis, risk appetite is a subjective measure that does not add shareholder value. Investing in a risky asset for example does not add value on a market consistent basis.
From a shareholder's perspective, a higher risk appetite may be more consistent with investment objectives - higher risk / higher return. Companies may have superior risk-taking abilities in certain areas and be well compensated for assuming particular risks.
Nexus Risk Management provides a wide variety of assistance to financial and non-financial companies that enable them to implement ERM as a strategic decision making framework to run the business and seizing business opportunities while making effective risk-based decisions so companies can get where they want to go and avoid pitfalls and surprises.
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