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Reader Profile

Henry Essert
Executive Advisor, Financial Services Office
Ernst & Young LLP

Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase.

Risk appetite is often described as a company’s propensity to take on risk, but it’s really so much more than that. How would you describe risk appetite?

Yes, it’s much more. If properly done, it’s the link that connects risk management to the company’s strategy and to its day to day business decisions. “Properly done” means that the appetite statement is connected to operating risk tolerances and limits. A board-level statement might be “maintain our current debt rating with 95% certainty.” For a financial institution, for example, this can be configured as “maintain our solvency ratio at its current level with 95% certainty.” That statement then would establish risk taking tolerances by type of risk and business unit (for example, “no more than $X of our capital at risk from credit losses.”) Each of those in turn would establish limits at the operating level that, taken together, keep risks within the defined appetite. Without this top to bottom connectivity, the appetite statement is aspirational at best. In fact, some would argue that an unsubstantiated statement is actually hazardous because it creates a false sense of security.

Lessons from the financial crisis and resulting regulatory imperatives have put development and adoption of risk appetite front and center. Do you think that boards of financial institutions see the critical role that risk appetite plays in effective governance today?

Yes, I think many do and the rest are on their way. But what boards need to understand better is the need for completeness in coverage. One important lesson from the crisis is that risk can’t be understood by looking at a single number, whether that’s the rating assigned by an agency to a structured credit or a bank’s own value at risk calculation. We believe a good risk appetite framework should cover at least four dimensions. The first dimension is capital; the appetite statement should focus on safeguarding the company’s ongoing capacity to deliver on customer obligations and repay debt. The second is earnings volatility; ensuring that value growth and dividend capacity are not compromised by acute incidences. The third dimension is liquidity; what needs to be emphasized is pre-planning to safeguard access to cash in a crisis. Stress testing is a great tool for this dimension. And finally, risk appetite should address maintaining the confidence of key stakeholders. Some call this brand or reputational risk, either way the essential feature is the development of measureable indicators that warn us of pending problems with enough time to act.

While public companies probably recognize the need for a robust risk appetite framework and can even define what it should look like, putting it into practice remains a key challenge. What do you see as the biggest challenge to developing and implementing a risk appetite framework?

The biggest challenge is building the linkages between the board-level statement and operating limits, and doing this over a number of dimensions. We have found that tackling all risks, all business lines and all risk appetite dimensions all at once is not the best way to proceed. Instead, it is better to start with one risk or line of business and maybe just a couple of dimensions, say capital and liquidity. Get this proto-type working; that is, connect the board-level statement to this risk or line of business’ particular operating tolerances and limits. Then proceed to add the remaining risks, business and appetite dimensions. It is also best to select the prototype with an eye to solving a current business problem. For example, “How much can we continue to grow this line of business and still be comfortable about its impact on our company?” The managers of this line of business are looking for a solution and it is the type of question that having a risk appetite can resolve.

What should be a company’s first step? Should the board lead this effort?

Most companies start by defining a board-level statement. Either the company or the board can initiate this. But if the company doesn’t take this step, I think it is the board’s obligation to do so. Regardless of where the development of this statement starts, it’s important to recognize that the first version of the board-level statement is provisional. Building the top to bottom connection can show that the statement as first constructed does not reflect the company’s current risk position, which is a very meaningful outcome in its own right. Sometimes building the connection shows that current limits and tolerances more readily support a differently articulated, but equally acceptable, board-level statement. Most often though companies find that they need to build out operating level tolerances and limits to monitor risks in line with the appetite.

If done properly, what is the biggest benefit to a risk appetite framework?

You might expect the answer to be something like “better understanding and management of risks.” This definitely happens and is definitely a benefit. But the biggest benefit is better business decisions. Once a risk appetite is in place and seen to be accorded board-level attention, business managers adopt it as their own measure of what’s important. Added to an earnings objective, it completes the connection between risk management, business management and strategic planning. Managers can now see their strategic and operational decisions in the context of both the return and the risks that those decisions generate. It is the link that has been missing.

Henry Essert is an executive advisor in the Financial Services Office of Ernst & Young LLP. Prior to joining Ernst & Young, Henry was the Chief Risk Officer of MetLife, a market leader in the U.S. insurance industry. His risk and insurance experience also includes roles as managing director of a major global financial strategy and risk management consultancy, president and CEO of the Enterprise Risk Consulting division of a leading insurance brokerage and consulting services provider and managing partner of a global insurance actuarial consultancy.

Henry holds a Master’s degree in mathematics from McMaster University. He has attained Fellowship in the Society of Actuaries and the Canadian Institute of Actuaries. He is a Member of the American Academy of Actuaries. He has published a number of articles on risk and insurance, including “Risk and Enterprise Value” in the Geneva Papers and “Actuarial Appraisals – Theory and Practice” winner of the best paper of the Canadian Institute of Actuaries Proceedings (1995).

Henry is based in New York and can be reached at 212-773-5944 or henry.essert@ey.com.

The views expressed herein are those of the interviewee and do not necessarily reflect the views of Ernst & Young LLP.