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New ways to think about risk

It’s time for asset owners to modernise their risk management practices, argues Towers Watson. The possibility of mission impairment gives rise to the need for buffers.

New ways to think about risk
Naomi Denning, managing director of investment services, Asia-Pacific

Risk means different things to different people. Our context here is investment and, in particular, decision-making by asset owners.

Those decisions relate to the mission of a fund, which is generally expressed as a desire to meet liabilities or other future commitments whilst balancing the needs of different stakeholders.

Risk in this mission context is a multi-faceted concept with a focus on the possibility of shortfall (of liabilities or future commitments not being fully met). The table below shows the four facets of risk: size, likelihood, impact and significance.

As well as being multi-faceted, risk comes from many sources: economic conditions, financial markets, capital structures, leverage, counterparties, operations and threats to reputation. Immediately, the complexity of the subject is apparent, highlighting that risk is far more than a volatility or tracking-error measure.

We should note, however, that not all risk is “bad”. Indeed, for wealth creation to occur (and hence fund missions to succeed) some risk-taking is absolutely necessary. That is why we focus on risk understanding and management, and not simply minimisation.

To create value we need to open up to the possibility of loss events. This is the deliberate taking of risk – where risk can be seen as “good” – in areas where it is economically justifiable.

Identifying these justifiable risk factors is one of the most important decisions that investors make. At Towers Watson, our model portfolios focus on five primary secular risk factors: equity risk, credit, insurance, illiquidity and skill.

We seek to realign the risk focus from measurement to management and from impact to significance. This is because, ultimately, risk is concerned with the possibility that a fund’s goals will not be fully met.

This mission impairment could either be because insufficient wealth is created or because the journey to wealth creation is too hazardous given the circumstances of the fund, its stakeholders or the regulatory environment.

For many funds today, the route to intended mission success is codified by way of a journey plan which sets the time-frame, investment policies and risk decisions. It includes a current risk budget and a view of how risk will change over time, contingent on investment results.

The risk event (or more likely, series of inter-connected events) that we should be most concerned about is the one that leads to permanent impairment of the fund’s mission.

Taking investment risk is necessary for wealth creation, but introduces the possibility of mission impairment – that assets are insufficient to cover actual or projected liabilities or wealth targets.

In a journey-plan construct there are both within-horizon risks (where poor outcomes lead to a requirement to adapt) and end-of-horizon risks (where shortfall means mission failure).

The possibility of mission impairment gives rise to a need for what we term adaptive buffers, which can see a fund and its mission through an adverse period. These can be both financial and non-financial, which means their measurement needs to be quantitative and qualitative.

Most of the buffers can be termed “capital”. Financial capital is the most obvious adaptive buffer. Use of these buffers is contingent on there being a risk event.

Examples of non-financial adaptive buffers are governance capital, human capital and political capital. The buffers might come from the investors themselves, but many will be sourced from other organisations or stakeholders. This is particularly important in defined benefit pensions.

Like all capital, it is important to note that adaptive buffers are scarce, need to be bargained for and have a cost of use. Risk management aligned to mission goals means taking an amount of risk that recognises the availability of various adaptive buffers.

Assessing this is a complex process that involves testing the buffers necessary in a number of potential future scenarios and looking to take risk that facilitates wealth creation but allows for the scarcity of adaptive buffers and makes realistic expectations about their drawdown.

The way forward for funds seeking to modernise their approach to risk management is to pull together these ideas on risk in the context of mission, adaptive buffers, appropriate risk measures and a longer-term focus into a risk framework. The key to this framework is clear thinking on risk that starts with understanding.

¬ Haymarket Media Limited. All rights reserved.


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