All Set to Go?
You are convinced that good Enterprise Risk Management is a valuable strategic and tactical tool. That’s great. Now, where to start? In this blogpost I try to share a practical view on risk appetite definitions. The focus is on ERM in Hong Kong, where the regulator has issued relevant guidelines for industry consultation.
A myriad of cogwheels needs to fall in place to make ERM work and add value to your company. COSO publishes a comprehensive framework, vendors offer special software and rating agencies place increased emphasis on ERM. And finally, ‘your’ board of directors has its own ideas as well. And most certainly, you have some well-established risk management practices already established in your company.
How to put this all together in an efficient and effective manner?
The Hong Kong Journey
I use the Hong Kong ERM/RBC journey in this blogpost to illustrate the steps, write about some challenges and, of course, how Megrow can support your ERM-journey. After all, ERM is a strategic tool to support your business and not to paralyze it. I choose Hong Kong, firstly because it is a good example of a measured, gradual implementation of ERM. And secondly, Megrow has been fortunate to do quite a bit of ERM-related consulting work for companies in Hong Kong. And finally, the Insurance authority in Hong Kong (“IA”) launched the RBC/ERM process over the course of 2017/2018.
step 1 – the tone from the top
IA mandated insurers to establish a board risk committee and assign a risk officer function to a suitably qualified staff. Starting at the top was the right thing to do. Insurers have completed this step over the course of 2017 and early 2018 already. Time to move on.
step 2 – risk appetite
Now with the risk officer and the risk committee in place, what is the next step? Risk committee and risk officer…. correct …. risk “appetite” is next on the agenda. That is exactly what the ERM guidelines that IA proposes to do as the next step of the ERM in Hong Kong journey.
What is risk appetite?
I like to use the famous half-full glass analogy to describe my preferred definition of risk appetite.
The capacity of the glass represents the total maximum net risk – across all business activities – your company can bear with the current capital, reinsurance and other hedging mechanisms in place. Simply, it cannot hold more water than its volume. (let’s omit surface tension and other considerations here, it’s not a science class….).
This capacity is largely given by the available capital and regulatory constraints, such as minimum solvency levels. This “capacity” is relatively stable.
How much water you actually decide to pour into the glass is almost entirely the company’s decision. If you overfill, the company will have challenges. If you leave it (almost) empty, then you are not making use of the capital that shareholders gave you. In other words, how full you want the glass to be is your specific risk appetite setting. The great thing is that the water level can vary over time, i.e. companies have quite some entrepreneurial freedom to accept more or less risk (as long as it doesn’t overflow).
how to set risk appetite?
The challenge for management, the risk committee and the board is to find out how full is the glass with the current business and how full (or empty…) will it be going forward? In other words, is the glass big enough to support the company’s expansion strategy? The forward-looking angle is very important: that is the linkage of good ERM with strategy!!!!
How to go about determining the “level of water” in the glass? All companies have risk appetite statements readily available. However, these statements might sometimes be insular. For instance, the investment department might use a different language to describe risk compared to the underwriting department. The true value of risk appetite definitions emerges, once the statements are quantified, comparable and linking risk taking to capital.
Ultimately, the best way of going about it to use a capital model, which allocates capital in a mathematical way to the main business activities of the company. However, a few years will pass before RBC is mature enough in Hong Kong. So, what is an interim solution for Hong Kong based insurers?
Several options are available:
- if your company has a credit rating, the respective agency’s capital model is worth looking at.
- and/or you develop your own capital model.
- and/or you find an interim, discrete solution and implement HK-RBC capital model along the way.
Every company is unique; hence it is difficult to make general recommendations. A practical view on risk appetite definitions: if a credit rating is available, using the agency’s capital model is certainly a way to go. If not, then taking the route via an interim solution would be my preference.
Megrow is well-positioned to support you through the decision making process and the subsequent development and implementation of the chosen path. A practical view on risk appetite definitions is what drives our work.
step 3 & Step 4
Stay tuned for forthcoming blogposts about ERM in Hong Kong here @megrow.asia !