Risk Capacity vs. Risk Appetite

Instructor: Olga Bugajenko

Olga is a registered PRINCE2 Practitioner and has a master's degree in project management.

While traveling, you probably bring extra cash with you for unforeseen situations but might not be willing to spend all of it. In this lesson, we review the differences between risk capacity and risk appetite.

What Are Risks?

Most travelers put some money aside for dealing with unforeseen situations, like having to take a cab to the airport instead of a cancelled train. While the maximum amount of unplanned expenditures will be limited by the total amount of money you bring with you--for example, $1,000--ideally, you would prefer not to spend the whole sum.

Inevitably, any project is exposed to different risks. Risks are events that may affect a project. In monetary terms, risk exposure of an organization is low, medium, or high. It quantifies potential loss, for example having to pay a $10,000 fine. To make sure that materializing risks don't affect an organization's ability to complete a project, it must have a sound risk management strategy. As part of managing risks, an organization has to define its risk capacity and risk appetite.

Risk Capacity

Risk capacity refers to the maximum amount of risk that an organization is able to tolerate. Risk capacity should be set in the beginning of the risk management process; it will be used during the risk analysis and drive the choice of appropriate risk responses.

For example, the risk capacity of a contractor currently undertaking a railway construction project might be $500,000. This means that the contractor company is able to bear risk exposure up to $500,000 and will avoid or transfer any risks that result in a larger risk exposure. If the contract with a customer requires the company to pay $750,000 compensation in case the project is delivered late, the contractor will try to renegotiate the contract or purchase insurance in the event of a delay.

Risk Appetite

Risk appetite refers to the amount of risk that an organization is willing to tolerate. Naturally, this will be lower than the maximum amount of risk it can take on. The difference between the risk capacity and the risk appetite is referred to as a safety margin.

For example, even if the financial resources of the construction company allow it to take on risks up to $500,000, it might be unwilling to expose itself to such large risk on a single project if it currently has two major projects running in parallel. Therefore, its risk appetite on the railway construction project will be only $250,000. The risk appetite of an organization should connect to its strategy and objectives. Different departments or projects may have different targets and risk appetites. On a project that allows the company to tap into a new market or test out a new technology, it might be ready to take on larger risks.

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