Risk appetite - the Central Bank’s discussion paper

By John Lyons
INSURANCE companies have been required by the Corporate Governance Code to have Risk Appetite Statements in place since 30th June 2011. In December 2011 the Central Bank sent companies the results of a review of a sample of risk appetite statements it had received and it was clear that it was not impressed. Eight areas were identified for improvement and the Central Bank also stated that a risk appetite statement ‘written solely in the context of current solvency requirements is not acceptable’.

Three years on and it is does not seem that the Central Bank is much happier. In June this year it issued a discussion paper “to generate discussion and debate with Central Bank stakeholders on risk appetite, its linkage with organisational strategy and its importance for financial institutions”. The paper covers all institutions regulated by the Central Bank, not just insurance companies, and it states that reviews of risk appetite statements it has conducted have found that the ‘statements were of mixed quality and raised questions over the adequacy of skills, experience and knowledge of members of Risk Committees collectively’.

In Central Bank parlance the discussion paper aims to gather views on the best approach to possible changes to the Regulatory framework and may result in a subsequent consultation paper. Consultation papers are produced when enhancements to the Regulatory framework are being proposed. So this could be the first stage of more specific regulation around risk appetite statements.

One thing the Bank does not seem to favour is a generic checklist setting out the expected content of the statement against which the Supervisor would be able to tick off whether these requirements have been met. The paper states that ‘the risk appetite of an organisation must express the strategy of that organisation through desirable and undesirable risk exposures’ and argues that a generic list is unlikely to achieve this.

In drawing up the discussion paper the authors have been influenced by international developments, especially documents produced by the Financial Stability Board in mid to late 2013, as well as definitions used in other jurisdictions and listed in the appendices.

A hierarchy of risk taxonomy is described showing the relationship between risk capacity, risk appetite, risk tolerance and risk limits. The concept of a risk appetite framework is also discussed as is the risk culture of an organisation. It can all get quite confusing trying to remember precisely what all these terms mean, even before you overlay the requirements of Solvency II with its ORSA and FLAOR.

The closing date for comments on the paper was 1st September. Some experts have already shared their submissions with Finance Dublin.
Colm Fagan, the well known actuary and an independent non-executive director of several companies, says that a serious omission from the paper is any reference to the special considerations that apply when the institution is a subsidiary, pointing out that well over 90% of financial institutions regulated by the CBI are subsidiaries. He challenges a key theme of the paper that ‘risk appetite and strategic policy occur and evolve in parallel’.

While true at the parent company level, he argues that for subsidiaries ‘the board and management have little to gain by spending time on questions such as what risks the organisation wishes to take or avoid....They are told by their shareholder/parent which risks to take. The board then decides how much capital it needs and how the risks should be managed’.

Brian Woods, another prominent actuary and also an INED, thinks that the approach of the paper over-engineers the risk appetite statement and that the elaborate taxonomy is highly contrived in a retail life assurance context. For example, he believes the setting of minimum targets for risk exposure, as suggested in the discussion paper, would be inappropriate. Woods also questions the need for a risk culture imbuing the whole organisation, also suggested by the paper, noting that a more robust ethics culture would have been more effective in preventing the miss-selling problems that were the main disasters that impacted UK life insurance companies in the past. It looks as though the Central Bank may have got the debate it asked for.