Every company responds to risk differently. Some companies are comfortable accepting large risks in their pursuit of progress. Others prefer to avoid it as much as possible. When evaluating where your company stands on its willingness to take risks, it’s best to know the difference between risk appetite and risk tolerance.
A company’s management team, including directors and senior executives, should thoroughly understand risk appetite and risk tolerance. Company leaders are responsible for identifying and managing business risks. They should also ensure that all employees understand the company’s risk-taking preferences.
Drawing a clear line between the two concepts can help align risk-taking behaviors across the organization. It can also help prevent your company from accepting unnecessary risks or using resources ineffectively.
What is Risk Appetite?
Risk appetite identifies the amount of risk your company is willing to accept. It also evaluates the level and type of risk that companies face during day-to-day operations.
Although company leaders can evaluate their risk appetite whenever, it’s best to do it as soon as possible — especially if you want it to help determine which actions are acceptable, and which are too risky in your business plans and goals.
Determining risk appetite isn’t a one-time task. Companies should reassess it regularly. For example, you might reevaluate after a change in your operations, or after a change in the market.
Levels of Risk Appetite
You can define risk appetite at many levels of your organization, from executive leadership to individual departments. Each department may also fall into a separate category — or level — of risk appetite.
Here are a few common levels:
- Corporate risk appetite: This level reflects senior management’s willingness to take risks that help them achieve strategic goals.
- Business unit risk appetite: A business unit’s preferred level of risk can depend on its business model, market position, leadership style, and level of authority.
- Department risk appetite: Departments like marketing and sales can sometimes have a larger risk appetite than legal or HR, where even small risks can threaten compliance.
- Individual risk appetite: This level of risk reflects an employee’s willingness to accept risks. It is influenced by factors like job responsibilities and incentives.
Companies should identify how much risk they prefer to handle within their organization. This helps align risk-taking preferences with company objectives.
Risk Appetite Statement Example
The best way to follow through with risk appetite is to create a statement that outlines the type of risks that the organization considers acceptable and the risks it should avoid.
These statements should be reviewed and revised as a company evolves. When operations change, markets change, or competitors change, a company’s willingness to take on risk may change with it. A statement can record this change, and it can be a cornerstone for companies to look back to in the future.
Here is an example:
“Our organization accepts a moderate level of risk. We will accept risks in new product development, geographic expansion, and technological innovation. However, we will not tolerate risks that threaten financial stability, company reputation, or legal compliance. Our risk management activities will prioritize these areas of risk and allocate resources accordingly. We commit to reviewing and updating this statement annually as operations evolve.”
What is Risk Tolerance?
Risk tolerance indicates a company’s ability to handle potential risks. It measures the level of risk a company can absorb without compromising operations. Some companies can tolerate high levels of risk without any impact on their success. For some businesses, even low-level risks can affect revenue, profitability, or market share.
Assessing your company’s risk tolerance starts with risk identification — identifying the risks that your company faces and determining the potential impact of each. Many companies use risk management analytics to accelerate this identification process.
In addition, several factors can influence the evaluation process:
- Financial strength: Companies with strong finances can typically allocate more resources toward risk management. More resources allow those organizations to tolerate higher levels of risk.
- Business model: Companies with established business models can often offset losses with gains in another area.
- Risk management capabilities: Companies with developed risk management strategies are better equipped to handle losses. This flexibility allows them more time to assess and respond to higher levels of risk.
- Regulatory environment: Companies operating in heavily regulated industries may have a lower threshold for risk. These organizations are often subject to scrutiny and additional penalties for non-compliance.
Businesses should regularly audit risk tolerance whenever the company undergoes significant changes. For example, changes to company operations, personnel, products, or markets could require a new assessment.
Risk Tolerance Types
Different organizations may have varying levels of risk tolerance, which depend on your objectives, resources, and market.
Here are some common types of risk tolerance:
- Aggressive risk tolerance: Companies capable of accepting risks with a potentially high impact, despite a significant chance for failure.
- Moderate risk tolerance: Companies that balance risk and reward, capable of taking calculated risks with a reasonable chance for success.
- Conservative risk tolerance: Companies that are risk-averse and only capable of accepting low levels of risk.
Company type can also affect tolerance levels. For example, aggressive risk tolerance is often found in start-up companies with high-growth potential. By contrast, conservative tolerance is often found in highly-regulated industries.
Risk Tolerance Statement Example
A risk tolerance statement explains your company’s capacity to handle different levels of risk. It should describe the level of risk that a company is willing and able to accept.
Begin your statement by identifying your company's objectives and the risks you face. Use clear, concise language to define how heavily each risk might impact your company’s success. Review your statement regularly to keep it continually aligned with your strategic objectives.
Here is an example:
“Our organization has a moderate risk tolerance. We can accept risks related to short-term finance, product changes, and new audience testing. We cannot accept risks that threaten compliance, employee retention, or stakeholder investment. We will review this statement annually to ensure it remains relevant to our current objectives.”
Differences Between Risk Appetite and Risk Tolerance
The difference between these two terms comes down to business growth and goals. Risk tolerance factors are the amount of risk a company can handle without compromising operations or growth. Risk appetite is the level of risk a company decides to take based on its goals.
As a business and its leaders grow, risk assessments for both concepts must be conducted to maintain risk management strategies over time. It can also lead to better operations, and help cultivate employees who understand which risks to take and which to avoid.
Similarities Between Risk Appetite and Risk Tolerance
Both risk appetite and risk tolerance are necessary for businesses that want to make informed decisions about their future. Both are important for companies seeking to keep pace with competitors.
Risk appetite and risk tolerance are also critical components of an effective risk management strategy. Many companies trust risk management software to manage all aspects of their risk framework. Risk management software can help companies save time and improve accuracy when identifying goals. They can also educate employees on a company’s risk tolerance and risk appetite levels.
