Press Releases

Hong Kong, November 24, 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, ge as its top three based on their impact and the risk together with the degree of uncertainty in assessing the risk. The bottom three are the end of fiat money, a major global conflict and a killer pandemic.the firm ranks depression, hyperinflation and excessive levera

Peter Ryan-Kane, Head of Portfolio Advisory, Asia Pacific, 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.  

Peter Ryan-Kane said; “By accounting for 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 & other. 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. It suggests the primary triggers for financial risks are falling asset prices and falling incomes or they can be generated by a recession in the real economy and transmitted to the financial sector through a default on loans. 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 crisis, sovereign default and the end of fiat money. 

The third category of extreme risks derive from politics but include climate change and killer pandemics, as a consequence they 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. 

Peter Ryan-Kane 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. It cites the example of the outcome of a killer pandemic being highly uncertain and therefore its impact on assets and liabilities unknowable. But suggests that it will be useful to be in a position to decide how effective the hedge is required to be based on how much loss is acceptable. It concludes that the more loss that is acceptable the easier it is to hedge smaller proportions of the portfolio. 

Peter Ryan-Kane said: “More complete hedging increases complexity and is almost certain to require the use of derivatives, so thought needs to be given to whether the counterparty would be willing and able to pay out should that extreme event happen. In addition, the carrying cost of such a hedge is likely to be higher the more complex it is. On the positive side, derivatives provide much greater flexibility and the more precise targeting of risks. They also don’t require much capital therefore leaving the bulk of the portfolio untouched.” 

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

 

Ranking of extreme risks

 *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 further information please contact:

Romy Serfaty                                                        
Head of Marketing and Communications              
Tel: (852) 2820 8228                                              
romy.serfaty@watsonwyatt.com                           

Kelvin Ko
Investment Marketing & Systems Consultant
Tel: (852) 2820 9947
kelvin.ko@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 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.