Risk tolerance is the degree of uncertainty or potential loss that you are willing to accept in your decision making. It is a key factor in risk management, as it influences how you identify, analyze, and respond to risks. Assessing your risk tolerance can help you align your goals, strategies, and actions with your risk appetite and capacity. Here are some steps to help you assess your risk tolerance.
Before you can measure your risk tolerance, you need to have a clear idea of what you want to achieve and why. Your objectives should be SMART: specific, measurable, achievable, relevant, and time-bound. They should also reflect your values, priorities, and preferences. For example, if you are planning a project, you might have objectives related to scope, quality, cost, time, and stakeholder satisfaction.
Your first step is to clarify how your company defines risk tolerance vs. risk appetite. Those terms should not be used interchangeably. In simple terms, risk appetite is the level of risk that a company is willing to take in pursuit of its goals. Risk tolerance is the level of risk that the company is able to withstand without compromising its operational existence and financial solvency.
Setting SMART objectives is crucial for measuring risk tolerance. In addition to specific, measurable, achievable, relevant, and time-bound goals, consider including risk-related objectives, flexibility, research and education, and regular review. These elements enhance the process, allowing you to manage risk effectively and align goals with changing circumstances.
When defining objectives, it is best to start with quantifiable and easily obtainable goals. Once accomplished, continue to add to your program. It will soon be second nature!
From the outset, as well as business risks you should also consider ESG risks, these might not always be financial but could have impact on the environment and/or society. Key to include the major stakeholders, share the development & ownership
Yes, well said. Risk cannot be parameterized, as it is unknown. At best we can only ring-fence our expectations. To my knowledge, that's what we are doing and ignoring some part of risk, which always remains unknown.
Once you have defined your objectives, you need to identify the potential risks that could affect them. Risks are uncertain events or conditions that could have a positive or negative impact on your objectives. You can use various methods to identify risks, such as brainstorming, interviewing, surveying, SWOT analysis, or checklists. You should consider both internal and external risks, as well as their sources, causes, and consequences.
One risk definition is the probability of an event (unwanted events) and the severity of the consequences of that event occurring. Use the qualitative tools (as mentioned in post) to find all the potential critical and catastrophic events that may result from the identified risks. Categorize the identified risks most important to the purpose of the risk evaluation such safety, cost, schedule, etc., into a pareto chart. Identify the best candidates for further risk evaluations. Also, consider a new MIT risk identification tool by Dr. Nancy Leveson - STAMP/STPA developed based on systems control theory that considers safety (or unwanted event) a system control issue rather than a component (or subsystem/ or system factor) failure issue.
Use both qualitative (expert judgment, research input, etc.) and quantitative methods (threshold metrics, probability distributions) to define and assess risk. When assessing a risk event, make sure to look for a potential positive outcome, aka. - opportunities.
To measure risk tolerance, follow these steps: 1) Identify risks using brainstorming, interviews, surveys, SWOT analysis. 2) Assess internal/external risks and their sources, causes, and consequences. 3) Perform business impact analysis by evaluating risks' effect on revenue, customers, and strategies. 4) Consider industry-specific challenges, location factors, and business model vulnerabilities. 5) Evaluate risks tied to capital funding and their impact on financial stability. 6) Assess leadership-related risks like succession planning and governance issues. By incorporating these steps, you can effectively gauge risk tolerance
Also use your network, what have your peers suffered? What can you learn from them, this might save you a lot of time and/or pain in the longer run. Make use of forums, professional bodies and your insurance partners; they will likely have seen some of these risks before
After you have identified your risks, you need to analyze them to determine their likelihood and impact. Likelihood is the probability of a risk occurring, and impact is the magnitude of the effect on your objectives. You can use qualitative or quantitative methods to analyze risks, such as rating scales, matrices, scenarios, or simulations. You should also consider the interrelationships, dependencies, and correlations among risks.
Look behind a plane two-dimensional risk scale (likelihood and severity). For a quality, multi-faceted assessment introduce additional dimensions, such as velocity, persistence and trajectory.
Risk has cross-sectional depedencies across time and space. I have even gone into metaphysics to see if I can get that unknown parameter. I am still trying.
The next step is to evaluate your risks to prioritize them and compare them with your risk tolerance. Risk evaluation is the process of comparing the results of risk analysis with risk criteria to decide whether a risk is acceptable or not. Risk criteria are the standards or thresholds that you use to judge the significance of a risk. They can be based on factors such as legal requirements, organizational policies, stakeholder expectations, or best practices.
Take Credit Risk (CECL framework) as an example for risk evaluation and quantification: Probability of Default (PD) and Loss Given Default (LGD) are integral to credit risk modeling. PD estimates the likelihood of a loan default within a year, while LGD represents the predicted loss if a default occurs. These parameters, used with Exposure At Default (EAD), form the Expected Loss (EL) calculation: EL = PD * LGD * EAD. This aids financial institutions in assessing credit risk and making informed decisions about loan provisions and interest rates.
Once you evaluated your risk, confirm if it remains within your established risk tolerance level. A risk scored as "low" might not look all that positive if an established tolerance level for this group of risk is "0".
Keep in mind the biggest financial impacts; in conjunction with Finance determine the balance sheet tolerance, how much $ does the company want to retain and/or transfer? What's the susceptibility of loss exceedance and what can you do to reduce that further?
Finally, you need to treat your risks according to your risk tolerance and evaluation. Risk treatment is the process of selecting and implementing actions to modify or control risks. You can choose from four main options: avoid, reduce, transfer, or accept. Avoiding a risk means eliminating it or its source. Reducing a risk means mitigating its likelihood or impact. Transferring a risk means shifting it or its consequences to another party. Accepting a risk means acknowledging it and its implications.
Risk treatment is a critical aspect of effective risk management. It involves identifying, evaluating, and implementing measures to mitigate or address potential risks. Organizations can minimize their impact and likelihood of occurrence by taking proactive steps to treat risks. Risk treatment strategies may include risk avoidance, reduction, sharing, or acceptance. These strategies allow organizations to make informed decisions on how to allocate resources best and implement controls to protect their assets, reputation, and overall business objectives. Ultimately, risk treatment enables organizations to navigate uncertainties more confidently and enhance their resilience in an ever-changing environment.
Yes, risk can be avoided/reduced/transferred. If one cannot, one has to accept the consequences. As I said, risk has various dimensions and certain dimesions are still unknown. In our investment strategy, we apply various methods to smooth returns for a certain amount of risk, which we are able to measure with its quantitative and qualitative dimensions.
Ideally your KRIs should be designed the way to alert you of the impending tolerance level breach. Monitor your KRIs carefully and assess their downward or upward trends.
Sometimes, the conversation about risk tolerance is much more productive when you start by talking through the risk that would be taken if the organization was exactly on plan. I would call that the Risk Target. Once you get the idea that risk management is about eliminating risk off the table by acknowledging that you are expecting to take some risk, the conversation about how much is too much becomes easier.
Once you have determined your risks and quantified them, for those that you transfer into the insurance market, stress test the policy to ensure it responds as expected. All major insurers will happily run these for you to ensure cover is fit for purpose.