Fundamentals of Risk Management

Importance of risk appetite 
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The curved lines in Figure 25.1 represent the overall risk exposure of the 
organization and this is the optimal position, where the overall exposure cuts
through the lighter section. The risk capacity of the organization is shown as higher 
than both the risk appetite and the risk exposure and is embedded well within the 
darker area. This represents an optimal state of affairs. This ensures that the organ-
ization is taking risks that are within the appetite of the board and not exceeding
its ultimate risk capacity.
Total cost of risk calculations were commonplace in the 1980s and the intention 
was to calculate the total risk exposure. These calculations were usually undertaken 
by organizations or their insurance brokers. They enabled an organization to determine 
the total cost of hazard risks to the organization. The calculation had three main 
components: insurance premium, money spent on loss-control actions and cost of 
claims not covered by insurance.
Tables were published on the total cost of risk in various organizations and it was 
possible to benchmark the performance of an organization against other companies 
in the same sector. This sort of total cost of risk calculation was useful and was often 
used as a justification for setting up an in-house or captive insurance company,
as discussed in Chapter 17.
The difficulty with this type of calculation was that it depended substantially on 
historical information. Historical loss data is not necessarily a good guide to future 
loss performance. This approach was intended to encourage organizations to seek 
the lowest overall cost for the management of hazard risks. Unfortunately, this lowest- 
cost approach often proved to be a mistake when a major incident occurred.
Organizations should be aware that the total cost of risk calculation could represent 
the lowest cost for the management of hazard risks, but that might be achieved at a 
high overall risk position. It is worth noting that the purchase of too much insurance 
could represent a position for the organization that is the lowest risk position but 
achieved at a high overall cost.
The type of total cost of risk calculation undertaken by organizations is now 
somewhat different. Organizations often use the concept of risk appetite to under-
take calculations that identify the level of risk that the organization is willing to
accept. The risk appetite of the board can then be compared with the actual risk 
exposure that the organization faces. The actual risk exposure in this calculation is 
an updated version of the total cost of risk calculation, but should include all types 
of risks – not just those that can be insured.
Generally speaking, as the marketplace becomes more volatile, the organization 
will be forced to increase its risk exposure. This requires a discussion in the board-
room leading to an agreement to increase the total value that the organization is 
willing to put at risk and/or to find mechanisms to reduce the total risk exposure.
As a consequence, risk management becomes more important in times of rapid 
change and increased marketplace volatility.
Risk exposure will also increase when an organization decides whether to embark 
on a merger or acquisition. Organizations need to undertake an opportunity analysis 
of all acquisition opportunities and this analysis should include consideration of
at least the following features of the acquisition opportunity:

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