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DEFINING THE RISK APPETITE/RISK TOLERANCE OF THE ORGANISATION■ Provide a framework that will ensure that an action-based approach isundertaken in order to create a real effect on the organisation’s businessstrategy and approach.MANAGING EXTREMES USING KPIS AND FINANCIAL INDICATORSThere are various ways of expressing risk appetite, but in considering the pointsabove, the simplest and probably the most widely used approach is to considerindicators that provide a basis for setting limits, targets and thresholds. Keyperformance indicators (KPIs) are one such type of indicator, which helpcompanies track their financial performance and operational efficiency andenable management to focus efforts on areas that require the most attention.The use of KPIs in a risk appetite statement provides a basis to test thesensitivity against different levels of unplanned loss. Many companies areuncomfortable if their KPIs deviate by more than 3-5%, and it is thereforeimportant to identify the size of potential losses that will test these limits.Specifying risk appetite involves more than defining a monetary amountbecause there will always be extreme scenarios where this figure is breached. It isnecessary to add a probability dimension, so a typical VAR (value at risk) riskappetite statement might read: “The maximum acceptable annual aggregateretained loss is £65m with 95% confidence”. This means that the strategy is toavoid annual aggregate losses of more than £65m, more frequently than 5% ofthe time, or once in 20 years. The statement could be more refined than this, forexample: “The maximumSetting risk tolerancesacceptable annual aggregaterequires a company to retained loss is £65m with 95%consider in quantitative confidence and £100m with 99%terms exactly how much confidence”.of its capital it is willingAn acceptable risk managementto put at riskstrategy must meet the conditionsof the risk appetite statement. Therewill normally be more than one strategy that passes this test, so the challenge isto identify the best strategies from this set – those that strike an optimal balancebetween risk retention and risk transfer, subject to cost.44