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6 Examples of Risk Capacity

 , November 26, 2018 updated on September 10, 2022
Risk capacity is the amount of risk an organization or individual requires to meet their goals. This can be described as the total risk exposure that is consistent with strategy and objectives. Risk capacity is commonly compared to risk tolerance, or the willingness to take on risk. The following are illustrative examples of a risk capacity.

Investing

An investor is completely risk adverse but wants to make 7% per year to meet their goals for retirement. This may require the investor to increase their risk capacity beyond their risk tolerance. The exact level of risk required depends on market conditions, particularly interest rates. If interest rates are near 7%, the investor may achieve their goals with little risk. Alternatively, if interest rates are near 0% significant risk may be required to have any chance of returns exceeding 7%.

Risk Management

An investment manager is expected to outperform the market which typically requires taking on more risk than the market average. However, the investment manager is also constrained to a risk exposure level set by a risk management team. This risk exposure level can be described as the manager's risk capacity.

Professional

A professional wants a promotion within a year to pay for changes to their lifestyle. This typically requires taking on additional responsibilities and increased visibility. If the individual is risk adverse, they may need to take on risk exposure that exceeds their risk tolerance to have a realistic chance of a timely promotion.

Projects

An IT project has zero risk tolerance, needs to be completed in a month, has a $1 million budget and a long list of requirements that are all high priority. A risk analysis shows that there is an 95% chance of project failure with a total risk exposure of $5 million meaning that the budget and schedule have a high probability of significant overruns. The business unit has a choice to accept this risk and proceed as planned with a $5 million risk capacity. Alternatively, dropping requirements, extending budget and increasing timelines will reduce risk capacity towards their risk tolerance level.

Dread Risk

A dread risk is a risk that people fear such that they are willing to pay to minimize risk exposure. When the goal is to minimize risk, risk capacity is near zero and risk exposure is driven as low as is feasible given constraints such as budget and technical limitations. For example, the public expect aircraft to be extremely safe and it is not considered acceptable to take risks with flight safety.

Unmanaged Risk

An unmanaged risk is a risk that isn't managed despite its ability to disrupt your goals. In this case, risk capacity may be low as you aren't expecting an unmanaged risk to disrupt your plans but actual risk exposure may be very high as nothing is done to treat risk. For example, a society that leaves known environmental risks unmanaged despite the likelihood these risks will disrupt quality of life, health and economic goals.
Overview: Risk Capacity
Type
Definition
Total risk exposure that is consistent with a set of goals.
Related Concepts
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