Risk tolerance

Category: Risk management frameworks · Reviewed by Taylor Watts, Broker · New Business · Last reviewed

Risk tolerance

Risk tolerance is the acceptable level of variation around a risk appetite target — the boundary an organisation will not knowingly cross. Where risk appetite expresses what the firm wants, risk tolerance expresses the operating range within which deviations are accepted without escalation.

Worked example

A general insurer may set:

• Appetite: target loss ratio of 60%.
• Tolerance: loss ratio within 55%–67%; outside this range triggers a board reporting requirement.
• Capacity: the firm could absorb a loss ratio up to 85% in a single year without breaching its solvency coverage floor.

Tolerance metrics

Tolerance is typically expressed in one of three forms:

1. Hard limits — single counterparty exposure, single-risk PML, gross concentration in a peril zone. Breach requires board action.
2. Soft / amber thresholds — early-warning levels that trigger management review (e.g. SCR coverage ratio falling below 150% before reaching the hard appetite floor).
3. Qualitative tolerances — statements about behaviour (e.g. zero tolerance for unlicensed business, zero tolerance for sanctions breaches).

Calibration

Tolerance levels should be calibrated against the firm’s capital position (SCR/MCR coverage), liquidity profile, reinsurance programme and stress-testing results. The ORSA process is the natural home for tolerance calibration in Solvency II firms.

References

• ISO Guide 73:2009 — Risk management — Vocabulary.
• FSB (2013). Principles for an Effective Risk Appetite Framework.
• IFoA (2016). Risk Appetite for a General Insurance Undertaking.

Cross-references

• Risk appetite
• Risk capacity
• Risk monitoring

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