Toy Manufacturer Makes Risk/Reward Trade-Offs in Daily Management Consider a very successful and innovative toy manufacturing company. This example highlights two high-level organizational risk appetite statements that are then used for decision making, whether in general for the company or as applied in particular for each project. The company is willing to bear or retain risks that are assessed as medium or low after mitigation in pursuit of its objectives. In this way, risk appetite is tied to the traditional risk map and the variability around earning levels. It is adaptable in that—based on how risk is characterized within the organization’s earnings at any particular time—it can reflect either a higher risk appetite or a lower risk appetite. The actual risk appetite can be modified based on the company’s determination of "High Risk." If circumstances change and it prefers to adopt a lower risk appetite, it can designate "High Risk" to encompass lower impact levels as shown in. However, this does not change the risk appetite statement itself. Suppose the company wants to be 95% certain that earnings exceed $160 million. If budgeted earnings are set at $200 million, management determines that the acceptable lower range limit (or boundary) is 20% of budgeted earnings, that is, $40 million. Therefore, if actual earnings are above $160 million in 19 out of 20 quarters, they will have met their objective. To arrive at this situation, the company looks at the assumptions used in calculating the budgeted earnings as well as its risk portfolio and determines through simulations that the worst case scenario at the 95th percentile is an acceptable value of 20% below budget (that is, all but 5% of the scenarios result in budgeted earnings of at least $160 million). This means that all things being equal, only once in 20 quarters will the actual earnings be less than $160 million. In this process, management has determined that up to a 20% "miss" on earnings is acceptable, i.e., within its risk tolerance range. The major benefit of defining the risk appetite in this way is that the board and senior management understand the methodology and calculations enough to trust it. There are certain occasions when senior management or the board asks whether the company is taking enough risk and what would happen if they accept more risk? The solution would be to compare the utilized risk capacity with the available risk capacity. If the company is far from utilizing the full extent of it, solutions involving being more aggressive and taking more risks are considered. In any situation, the available risk capacity will not be exceeded and considering the risk appetite, will be better utilized. Using a driving analogy, the condition of your vehicle may determine that you can safely drive 50 mph (available capacity). If you are currently doing 35 mph (utilized capacity), you may decide to go faster, as long as you do not exceed 50 mph.
3.1 With reference to the case study, distinguish between the educational, statistical and enforcement approaches to risk control. (12)
3.2 Select the approach you think is most appropriate to the case study and motivate your choice. (6)
3.3 Describe the use of risk retention as a risk management tool. (7)