Risk Appetite – What the CEO and Board should be doing

Ian LaughlinAPRA Member

NETWORKING

25 July 2011

Today

• Recent History • What is it?• Whose is it? • Articulation, Translation, Co-ordination

etc• Consistency with Plans• APRA’s Requirements • Assessment of RA Statements• How Actuaries Can Help

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Bad luck? Appetite Unclear?

Appetite > Capacity? Risk > Appetite?

• Westpoint, ACR, MFS, City Pacific …• Opes Prime• Tricom• Centro• Allco • Babcock and Brown• NAB (CDOs), ANZ (Opes), RAMS, • AMI (NZ)

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• Bear Stearns, Lehman Bros … • Credit Agricole• Northern Rock, RBS, …• Irish Banks• Icelandic Banks• AIG • MBIA • UBS• Fannie Mae, Freddie Mac

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Useful references

• Risk appetite - The strategic balancing act – Ernst & Young 2010• Risk appetite – How hungry are you? – PWC• What’s your risk appetite – Oliver Wyman 2008• Understanding and articulating risk appetite – KPMG 2008• Risk Appetite - Society of Actuaries Webinar 2011 – Kent Griffin• Risk Appetite - Bennet and Cusick 2007• Implementing Robust Risk Appetite Frameworks to Strengthen

Financial Institutions – Institute of International Finance June 2011• Strengthening the board-management dialogue on risk and

strategy – Tapestry Networks 2010

Source: Risk appetite. The strategic balancing act. Ernst & Young 2010 5

Risk capacity: the amount and type of risk an organization is able to support in pursuit of its business objectives.

Risk appetite: the amount and type of risk an organization is willing to accept in pursuit of its business objectives.

Risk tolerance: the specific maximum risk that an organization is willing to take regarding each relevant risk.

Risk target: the optimal level of risk that an organization wants to take in pursuit of a specific business goal.

What is it?

Whose appetite is it anyway?

• Shareholders focus is usually here

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Whose appetite is it anyway?

• Shareholders focus is usually here• Customers but needed here too

e.g. – Lifeco Par Policy-holders– Debenture-holders– Depositors

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Articulation: Risk Appetite

Qualitative

Quantitative

“conservative”; “aggressively pursue opportunities ..”“low appetite for risk except if directly related to core skills”“we have no appetite for systematicoperational risk”“not tolerate damage to reputation”

“less than a 10% chance of a loss each year”“less than x% chance of a breach of PCR in next 2 years”“maintain S&P rating of AA”“no more than X% decline in embedded value with 95% prob.”“a negative return once in about every 7 years”

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“considerable appetite for new ventures”“we have a war chest for …”“guaranteed”“backed by first mortgages”“low risk”“speculative”“aggressive”

Articulation: Risk Tolerance

“return on economic capital of no less than x% over 3 years”“system downtime no more than …”“no more than xx complaints each year”;“expenses not to exceed budget by more than xx%”“fraud less than yy% of total claims”“counterparty credit rating no less than B”“we will not tolerate fraud or illegal activity by staff”“we have no tolerance for discrimination”“unit pricing rectification no more than $Y”“individual claim exposure of no more than $X”“credit losses of no more than $Z”“VAR of no more than …”

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Translation

CompanyAppetite(Quant/Qual)

Tolerance(quant)

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Bus. UnitRisk by Type

Coordination

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Appetite(Quant/Qual)

Tolerance(quant)

Company

Bus. UnitRisk by Type

Monitoring & Corrective Action

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Company

Bus. UnitRisk by Type

Tolerance(quant)

Appetite(Quant/Qual)

All this is difficult to do well

• Articulation• Translation and quantification• Co-ordination• Monitoring & Corrective Action

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APRA’s Requirements (LPS/GPS 220)

• Risk Management Framework

• Risk Management Strategy• Risk Appetite

Board Responsibility

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RA and Capital Management

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Assessment of Risk Appetite Statements

Draft Guidelines for APRA Supervisors

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RA GUIDE FOR SUPERVISORS - GOVERNANCE

• Board engaged in the development of the RA

• RA considers the interests & expectations of all relevant stakeholders.

• RA is periodically reviewed in the context of the economic conditions and competitive environment.

• There is a feedback loop to Board

• Board satisfied that risk tolerances & limits are understood & applied as intended.

• The RA seems reasonable, makes sense.

• Within group structures a) a group RAS; and b) a RAS for each entity which is consistent with the group RAS.

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RA GUIDE FOR SUPERVISORS - RISK MANAGEMENT

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• The RA considers the material types of risks.

• The RA statement is core to the risk management framework and sets clear boundaries and expectations.

• The RA is supported by tolerances and limits, which are embedded in the business.

• The RA is considered when assessing the adequacy of controls in mitigating risks.

RA GUIDE FOR SUPERVISORS - IMPLEMENTATION

• The entity’s strategic objectives and business plans are consistent with the RA.

• The entity’s capital management plan is consistent with the RA; and capital levels and targets are monitored and reported against the RA.

• The risks necessary to produce required returns on capital are within the RA.

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RA GUIDE FOR SUPERVISORS - COMMUNICATION

• The board regularly receives reporting on the entity’s level of risk relative to its RA.

• Scenario analysis and stress testing are performed against the RA and reported to the board.

• Communication of the entity’s RA and/or its derived tolerances and limits to each part of the entity’s operations.

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Discussion

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Actuaries can help CEOs and Boards

• Articulation• Translation/quant• Co-ordination• Monitoring & Corrective

Action

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Actuaries can help CEOs and Boards

• Articulation• Translation/quant• Co-ordination• Monitoring & Corrective

Action

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• Remuneration and RA• ICAAP and RA• Stress testing and RA

Summary

• Risk Appetite is foundation of sound risk management

• It is difficult, but critical, to:– Clearly articulate RA– Translate RA into risk tolerances – Co-ordinate risk positions by type and BU– Monitor risk and take corrective action

• APRA is increasing its intensity of RA supervision

• Actuaries can help CEOs and Boards

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Discussion

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