Watson Wyatt identifies major extreme risks and how to manage them

Sydney, 25 November 2009- Watson Wyatt has identified and ranked fifteen extreme risks that would have a high impact on global economic growth and asset returns if they occurred. In a new paper, entitled Extreme Risks, the firm ranks depression, hyperinflation and excessive leverage as its top three risks, based on their potential impact and likelihood of occurring, together with the degree of uncertainty in assessing the risk. The bottom three are the end of fiat money (money declared by a government to be legal tender), a major global conflict and a killer pandemic. 

Tim Unger, investment consultant and Head of Strategy Research in Australia, said: “The events of the last two years have demonstrated that risk management cannot afford to stop at the 95^th percentile and that we need to find ways of factoring in very unlikely, but high impact events. Being aware of risk in the extremes before they happen can protect value if built into a plan of action that can be implemented as soon as the need arises.” 

In the paper, the firm recommends that a robust defence against extreme risks can be built by combining a qualitative understanding, quantitative modelling and a cost-benefit analysis of possible strategies. According to Watson Wyatt, a qualitative understanding can be developed by institutional investors asking themselves what could cause certain events, whether they are plausible and what the consequences could be. Then it advises them to consider the investment risks and the impact on asset returns and, in some cases, liabilities.  

Tim Unger said: “By considering the possible impact of these risks in advance, rescue plans can be formulated so that they are ready to implement as soon as necessary to prevent value destruction. However, this approach does not come naturally as it goes against the status quo of reacting to events as they occur.”  

The firm groups these risks into one of three areas: financial, economic and political. Financial extreme risks revolve around solvency and whether a financial institution is able to pay its debts with available cash. The paper describes the interconnected nature of the modern financial system and that high levels of leverage mean insolvency for one institution can quickly become a systemic problem. The extreme risks included in this category are: excessive leverage, banking crises and insurance crises. 

Economic extreme risks are less homogenous than the financial risks and range from a deflationary depression to hyperinflation and a return to a gold standard. The deflationary depression risk implies that government actions will prove incapable of returning the economy to sustainable growth, while the other economic risks essentially assume that government actions are successful, but at a price. The other economic extreme risks are currency crises, sovereign default and the end of fiat money.


The third category of extreme risks derives from politics, but also includes climate change and killer pandemics. These risks are much harder to monitor and predict and in most cases will be hard to hedge, according to the paper. Other extreme risks included in this category are the end of capitalism, political crisis, disunity in Europe, major war and protectionism. 

Tim Unger said: “Having identified which risk category, the next challenge is to determine the likelihood and impact. The problem here is that these are ‘tail events’. If they have occurred before, they have done so only infrequently and therefore there are very few historical observations. Consequently, quantitatively-derived probabilities would give the appearance of accuracy but be prone to large errors. We have therefore used historical data to inform a subjective allocation of each risk to one of three probability categories. In addition, the risks are placed in an impact category and we also use a subjective scoring system to derive a ranking. This ranking serves as a priority list for considering the various risks and whether any portfolio hedging activity could or should be undertaken. ” 

The firm observes that not all of these extreme risks are hedgable and that any hedge used is likely to be very imprecise.  

The paper concludes that of all of the things to be considered, public policy issues should be a priority, as they will influence the risks. They will also be shaped by the shifting likelihood of the different risks through time.

Ranking of extreme risks

 

Risk ranking* as at 30 June 2009
Rank	Risk	Description	Possible hedge
**1	Depression	Debt-deflation trap; falling growth and incomes	Globally-diversified long-dates Sovereign nominal bonds
2	Hyperinflation	Extremely high inflation	Real assets, for example gold, globally-diversified inflation-linked bonds
**3	Excessive leverage	Debt burden cannot be services from income	Gold, reserve-status currency
**4	Currency crisis	Extreme movement between floating rates	Gold, foreign assets
**5	Banking crisis	Balance sheet cannot absorb another shock	Nominal sovereign bonds (medium duration)
6	Sovereign default	Default by a developed country on its debt	Country insurance (for example CDS)
7	Climate change	Diversion of capital to mitigation uses	No general hedge
8	Political crisis	Rise in power of extremist group	No obvious hedge
**9	Insurance crisis	Insolvency within insurance sector	Nominal sovereign bonds (medium duration: short insurance equity
10	Protectionism	Reversal of movement towards free trade	No general hedge
11	Disunity in Europe	Break-up of the euro	Long Germany (hedged)
12	End of capitalism	Move to socialism and closing of markets	Gold
13	End of fiat money	Return to a gold standard	Gold
14	War	A major global conflict	Long neutral countries
15	Killer pandemic	Contagious disease with very high mortality	Long pharmaceutical equities, short airline equities

*Our subjective measure based on the impact, the risk and the degree of uncertainty in assessing the risk level

** Watson Wyatt is more confident in being able to attach a probability to these events

 For the full report

For more information on Australia contact

Sonja Lee
National Marketing Manager
Watson Wyatt Australia
Tel: +61 2 9253 3176
sonja.lee@watsonwyatt.com.au 

Ex-Australia
Paul Deane-Williams
Head of Public Relations - Investment and Insurance & Financial Services
Watson Wyatt Limited
Tel: +44 (0)1737 274397
paul.deane-williams@watsonwyatt.com

About Watson Wyatt Investment Consulting

Watson Wyatt Investment Consulting, a division of Watson Wyatt, is focused on creating financial value for institutional investors through independent, best-in-class investment advice. We are specialist investment professionals who provide co-ordinated investment strategy advice based on expertise in risk assessment, strategic asset allocation, and investment manager selection. Watson Wyatt Investment Consulting provides investment advice to some of the world’s largest pension funds and institutional investors, and has over 550 associates in Europe, the Americas and Asia. 

In Australia, Watson Wyatt is the leading investment consultant to institutional investors, and advises clients with assets of over $200 billion. It has offices in Sydney and Melbourne. 

In the US investment advisory and investment consulting services are provided by Watson Wyatt Investment Consulting, Inc., which is a subsidiary of Watson Wyatt Worldwide Inc. Watson Wyatt Investment Consulting, Inc., is a registered investment adviser with the Securities and Exchange Commission.

 

Watson Wyatt (NYSE, NASDAQ: WW) is the trusted business partner to the world’s leading organisations on people and financial issues. The firm’s global services include: managing the cost and effectiveness of employee benefit programs; developing attraction, retention and reward strategies; advising pension plan sponsors and other institutions on optimal investment strategies; providing strategic and financial advice to insurance and financial services companies; and delivering related technology, outsourcing and data services. Watson Wyatt has 7,500 associates in 33 countries and is located on the Web at www.watsonwyatt.com.