Clearly defined risk tolerance should be the bedrock for all business decisions. Achieving growth by having a clear and robust risk tolerance framework is a topic WTW Risk Analytics experts examined in a previous insight and in an Autumn 2023 Outsmarting Uncertainty webinar, kicking off a series of sessions offering a ‘curriculum’ connecting the fundamentals of risk finance.
This insight, which delves into the actionable insight from the webinar considers:
Many risk managers are grasping the potential of redefined risk tolerance to boost growth, in part driven by the aftermath of the pandemic. Before COVID-19, many companies had set notions of what they believed would have constituted a catastrophic scenario that would lead to bankruptcy. But the pandemic changed that. The ability of companies to not only survive, but go on to thrive demonstrated deeper resilience and hinted at a future where they might safely take on more risk.
But the issue remains that without evidence-driven, rational definitions of what constitutes moves that would undermine your financial standing, the business could still end up taking undue risk.
The goal of risk tolerance is to help define and communicate success for business risk decisions. This clarity around risk tolerance enables you to say, for example, This decision helps protect our profit targets, only exposing it 1% of the time; the kind of statement senior decision-makers can easily understand and make decisions around.
Risk tolerance should be about using metrics aligned to what matters to your organizations, using its financial performance markers to help define and communicate success for risk decisions in a transparent way. It is also making risk management less about spending money and more about adding value by confidently taking risk.
Risk tolerance is ultimately an enterprise exercise. Every organization has risk, and some of that risk can be reduced through insurance or loss control. Sizing each risk (whether insurable or not) and then determining how to act upon that risk once you understand the financial impact is the next step in applying your framework.
At its heart, the process to establish risk tolerance centres on your ability to take on risk and your willingness for risk, creating the evidence your organization needs to confidently take risks that help it grow and avoid moves that compromise financial priorities.
More specifically, to establish a robust risk tolerance approach, you need to be able to:
This goes back to why your risk tolerance process should use metrics aligned to what matters to the financial performance the business.
As to who should be involved in your risk tolerance process, webinar delegates felt it should be a combination of cross-functional colleagues, from risk, insurance, finance and treasury, something WTW would agree with. The participation of diverse business functions, in particular finance and treasury, indicates both organizational value being attached to risk tolerance and the ability of risk managers to ‘speak the language’ of finance and align with strategic priorities for the business.
Recent WTW engagements give us some valuable cases of the positive outcomes possible for businesses that get a handle on risk tolerance. For example, we’re working with one of the world’s biggest retailers. Its insurance program had remained unchanged for some time and the risk manager had become convinced their captive could play a bigger role as they searched for a solution to significant premium increases in recent years.
Here, the risk manager had an almost instinctive idea of how to deliver better value, but, without the evidence and metrics the business would need to see, did not know how to convince their finance team to support this initiative. Getting cross-functional colleagues around the table they were able to have an informed risk retention and risk tolerance review conversation. This dialogue was objective and rational, discussing the financial ratios that really mattered to the finance, ultimately defining how much these ratios could differ from their current value before the business would face a critical financial situation.
The ultimate result was the organization being able to properly evaluate alternative risk transfer options and accessing alternative financing solutions that went beyond what traditional insurance markets could offer. Having a robust risk tolerance framework meant they could then view the captive as a strategic tool, rather than simply an insurance tool, just as the risk manager believed they could; the difference now being they had the analytical evidence to back-up their ‘hunch’.
The risk tolerance framework set limits and boundaries, defining a ‘no-go zone’ where risk would become too high to be considered bearable from a finance point of view and the overall process helped the business optimize its risk and the cost of its insurance program, incorporating the captive.
It’s also worth noting how this risk tolerance review raised the visibility of the risk manager. They were able to lead building a bridge between disconnected insurance and finance discussions in tailoring an aligned risk tolerance framework in transparent support of financial resilience and growth.
A risk tolerance framework can be highly impactful when you integrate it into enterprise risk management (ERM).
WTW recently worked to establish an ERM framework for a large global hotel franchising organization. Franchisees benefitted from the competitive advantage provided by the parent company’s brand, reputation, and customer loyalty, so ultimately shared similar exposures as the parent company. Risks to intangible assets, such as brand, are more challenging to navigate than those of tangible assets. Managing such risk requires a robust ERM framework and a culture of risk awareness throughout your organization.
In these sorts of scenarios, you can use a risk tolerance framework to establish impact scales; assessing your organization’s tolerance for risk, defining the consequences at significant thresholds and aligning with organization’s financial priorities. This can enable a clear delegation of responsibilities for enterprise risks. In the case of the hotelier, the business could determine those risks where the impact would be contained and handled locally by franchisees (albeit following a centrally managed standard operating procedure). The central risk function could then confidently focus on more unpredictable risks that could cause material damage at the enterprise level and therefore merited the attention of the board and executives.
Looping-in ERM with risk tolerance can empower better decisions. Your business can objectively and transparently evaluate both the cost and risk-reduction benefit of risk actions (whether preventative, mitigating, or transferring), paving the way for action by having both clear investment cases and business decision criteria.
Risk tolerance can, and should, be the foundation for making decisions. Once you have established the goalposts that define success, you can then apply these criteria at enterprise level and introduce it into risk finance more generally. This next step will be the focus of the next Outsmarting Uncertainty webinar: How to use analytics to make better decisions and enhance financial performance.
For support on establishing a risk tolerance framework fit to drive the growth of your organization, get in touch with WTW Risk Analytics team.