A Practical Approach to the Vexing Issue of 'Risk Appetite'

Abstract

This white paper is about a very important (but too seldom discussed) enterprise risk management issue that I have encountered as the CEO and CFO of non-financial companies: Just how can a director or executive practically apply the concept of organizational “risk appetite” that figures so prominently in many well known ERM frameworks? I will begin by addressing some basic linguistic and intellectual confusion that underlies this issue, the most important of which is the distinction between risk and uncertainty noted by Knight, Keynes and other writers. After discussing the different sources of uncertainty (variability, lack of knowledge, and the nature of complex adaptive systems), I review the ways we deal with it, as individuals and in groups. Broadly speaking, the net result of these processes is that a corporate director is quite likely to face situations in which the actual degree of uncertainty has been significantly underestimated. Finally, I review what a director can do to accurately assess the extent of uncertainty that is inherent in a strategy, to evaluate the actions taken by an organization to manage it, and to determine if this degree of uncertainty is acceptable to a board, investors, and other stakeholders, given the circumstances facing a company.