EDHEC Risk: How to calibrate risk appetite, tolerance and limits - The issues at stake for capital allocation, ERM and business performance

25 January 2016

Risk appetite allows to determine the level of risk that a company considers acceptable, the risks that will be kept, and those that will be reduced or avoided. As such, it is thus one of the main indicators of risk for the strategic management of insurance companies.

The Solvency II prudential framework which comes into to effect in January 2016, is likely to trigger profound changes in the insurance sector, notably i) by requiring a holistic vision of risk management, ii) coherent with risk appetite as defined in accordance with governing bodies, and iii) in line with a clearly identified governance structure. Although the Directive leaves insurance companies free to choose how they structure the risk management system and function, it does, however, require that this system be fully integrated into the organisation and the decisionmaking process. This requires a real overhaul of the organisation of most companies and a significant cultural (r)evolution, notably in the formalisation of risk appetite.

The explicit formulation of risk appetite is the first step in the implementation of the ORSA (Own Risk and Solvency Assessment), which itself operationally fits into a more global Enterprise Risk Management (ERM ) process. As risk appetite is integrated into all decision-making processes, management and the Board of Directors are responsible for formulating its definition, its calibration and its application when determining a strategy in line with this appetite.

The regulator offers great flexibility with regard to the definition and calibration of the appetite, so that it can be fully coherent with the company’s culture and its strategic objectives. However, on ground, many players in the insurance industry question the definition, the choice of indicators, the calibration of risk appetite and the coherence it has with its own risk tolerances and risk limits. The objective of this study is to analyse the relevance of the concepts of risk appetite, risk tolerance and risk limits that are adopted by players in the insurance sector, and to show how they will impact the management of insurance companies, mutual insurance companies and provident institutions.

In order for risk management to be fully integrated into the day-to-day management of a company and for it to be fully present within all corporate processes, regardless of the hierarchical level in question, risk appetite must be deployed to a tactical level (risk tolerance) and/or to an operational level (risk limits). In practice, we note that conducting a breakdown by business unit is not trivial, as on one hand it highlights problems linked to the treatment of correlations and diversification benefits, and on the other hand, it shows the willingness to adopt a pragmatic approach so as not to affect the business development and the work of operatives. Some significant disparities are again clearly evident.

Lastly, it has shown what exactly this new lifeblood of the company (the now-explicitly stated risk appetite) is made up of: each strategic decision that is made will thus be subjected to the company’s risk appetite. This requires a profound culture change for many players, the setting up of a sophisticated governance structure, and more generally a rethink of every element of the value chain (product design, distribution, contract management, handling of claims and the management of investments and capital). The generalisation and the widespread implementation of the holistic vision of risk management should lead to the optimal allocation of available capital, which lies at the heart of the competition among players in the insurance sector. We are thus witnessing a profound cultural change among all players in the insurance industry, which should mark the beginning of a new era in the art of managing a company.

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