Focus on the extreme risks ‘that can kill you’ Towers Watson warns institutional investors

Extreme Risks – 2013

October 29, 2013 | Tim Hodgson

• Extreme risks are potential events that are very unlikely to occur but could have a significant impact on economic growth and asset returns, should they happen.
• Three of the risks are health related.
• The starting point to building a robust investment portfolio and reducing tail risks is to introduce greater diversity.

This paper has focussed on the top 15 risks, but we acknowledge that it is not possible to anticipate all risks – by definition, there are ‘unknown unknowns’ out there that cannot be included even with the best analysis. The range of potential consequences of the identified risks is very wide. Local-endurable risks would be uncomfortable for institutions caught in the wrong locale, or with the wrong exposures, and would likely be enough to cause the weaker ones to become incapable of completing their mission. At the other end of the spectrum, global-crushing risks represent a systemic and potentially terminal outcome for investors. The value of this exercise, however, lies outside prediction. To navigate through this complex world, we suggest investors need to be open-minded, avoid concentrated risks, be sensitive to early warning signs, constantly adapt and always prepare for the worst.

Focus on the extreme risks ‘that can kill you’ Towers Watson warns institutional investors

Euro break-up and Killer pandemic out; Nuclear contamination and Extreme longevity inOctober 29, 2013

LONDON – Tuesday 29 October, 2013 –Towers Watson’s extreme risks ranking has a new top three: Food/water/energy crisis, Stagnationand Global temperature change – while Sovereign default and Insurance crisis have both fallen five places and Depression loses the top spot for the first time since the research began in 2009.  While Food/water/energy crisis (previously Resource scarcity) rose ten places to take the top slot, other extreme risks that have also risen up the ranking this year are Global trade collapse (+4) and Global temperature change (+3). Extreme risks that, in Towers Watson’s view, are less of a threat than in 2011 include Sovereign default, which has fallen five places, as has an Insurance crisis, while a Currency crisis and a Banking crisisfell three and two places respectively.

Towers Watson’s research and ranking¹, entitled Extreme risks 2013, categorises very rare events that would have a high impact on global economic growth and asset returns if they occurred. The top 15 Extreme risks now for the first time include: Stagnation, Health progress backfire, Nuclear contamination, Extreme longevity and Terrorism, while those that have dropped out of the top 15 this year are: Euro break-up, Hyperinflation, Political crisis, Major war, End of fiat money and Killer pandemic.

Tim Hodgson, head of Towers Watson’s Thinking Ahead Group, said: “There has been a high level of turnover in the top 15 this year. This is largely due to us expanding our research into the non-financial extreme risks so that we now have a full list of 30. So while on the face of it, it’s good to see the likes of Killer pandemic and Major war dropping out of the top 15, they are only just below the cut off (at 17 and 18 respectively). New entrants to the top 15 include the likes of Terrorism and Extreme longevity which rise up the rankings either due to our assessment that they are more likely (Major terrorist attack rather than World war III) or there is less uncertainty as to the impact (Extreme longevity vs. Killer pandemic).  This illustrates the challenge facing institutional investors, of how they should actually adapt to changing assessments of extreme risks. We would suggest that time should be spent on ‘pre mortems’ which are about trying to determine in advance what could, colloquially, ‘kill you’, that is permanently impair an investor’s mission.”

According to the research such ‘pre mortems’ should identify which extreme risks matter and which can be ignored. For the former, Towers Watson asserts that the right thing to do is to pay up for the insurance (if available and affordable), given that the prioritisation exercise has shown the investor cannot afford to self-insure. Then an investor should do the simple things: ensure the portfolio is as diversified across as many return drivers as possible; diversify within asset classes; and create a strategic allocation to cash to provide optionality. Thereafter, it suggests that greater complexity can be added over time, assuming these steps pass a considered cost/benefit analysis, such as adding long-dated derivative contracts in a contrarian manner, that is, when they are cheap rather than popular.

Tim Hodgson said: “While interesting in its own right, we believe the consideration of extreme risks can be useful in helping to design more robust investment portfolios and more robust risk management processes. The starting point to building a robust investment portfolio and reducing (but not eliminating) tail risks is to introduce greater diversity. The next step is to explore some hedging strategies.”

The Towers Watson research suggests, broadly, there are three hedging strategies available to institutions:

• Hold cash. The option value of holding cash increases in periods of market stress, allowing investors with cash to buy truly cheap assets.
• Derivatives. It is worth mentioning that cost and usefulness are often in opposition. The cost of derivatives protection can often be reduced by specifying more precise conditions – but the more precise the conditions, the greater the chance that they are not exactly met and hence the ‘insurance’ does not pay out.
• Hold a negatively-correlated asset. There is no single asset that will work against all possible bad outcomes. Further, there is no guarantee that the expected performance of the hedge asset will actually transpire in the future event.

Tim Hodgson said: “We believe that being adept at ‘pre mortems’ means being a better risk manager, and being able to react more flexibly in the event of an extreme event happening, particularly as the event is unlikely to evolve precisely as predicted. Consequently, the obvious application of extreme risk thinking is in stress-testing or scenario planning, but it is also constructive to consider whether the thinking can be incorporated within the process for managing an investment institution’s balance sheet.

“Naturally, we would advocate establishing some sort of early warning system to closely monitor what could develop into extreme events. While this is probably one of the areas where things are easier said than done, the science (and art) of predicting the seemingly unpredictable has advanced significantly during the global financial crisis.”

¹ A subjective scoring system to derive a ranking of these risks, and the change of ranking reflects a change of view regarding both impact and likelihood of each individual risk.

TOWERS WATSON’S EXTREME RISKS RANKINGS OVER TIME

RANK	2013	2011	2009
1	Resource scarcity*	Depression	Depression
2	Stagnation	Sovereign default	Hyperinflation
3	Global temperature change	Hyperinflation	Excessive leverage
4	Depression	Banking crisis	Currency crisis
5	Global trade collapse	Currency crisis	Banking crisis
6	Banking crisis	Climate change	Sovereign default
7	Sovereign default	Political crisis	Climate change
8	Currency crisis	Insurance crisis	Political crisis
9	Deflation	Protectionism	Insurance crisis
10	Health progress backfire	Euro break-up	Protectionism
11	Nuclear contamination	Resource scarcity	Disunity in Europe
12	Extreme longevity	Major war	End of capitalism
13	Insurance crisis	End of fiat money	End of fiat money
14	Terrorism	Infrastructure failure	War
15	Infrastructure failure	Killer pandemic	Killer pandemic

* Food/Water/Energy crisis

2013 EXTREME RISK RANKING, DESCRIPTIONS AND POTENTIAL HEDGING INVESTMENTS**

RANK	RISK	DESCRIPTION	WHAT TO INVEST IN
1	Resource scarcity*	A major shortfall in the supply of food/water/energy	Securities providing exposure to resource in shortage or beneficiaries of substitution
2	Stagnation	A prolonged period of little or no economic growth	Globally-diversified long-dated sovereign nominal bonds
3	Global temperature change	Earth’s climate tips into a less-habitable state (hot or cold)	Land (in the ‘right’ place)
4	Depression	A deep trough in economic output with massive increase in unemployment	Globally-diversified long-dated sovereign nominal bonds
5	Global trade collapse	A worldwide protectionist backlash against cross-border trade	Short companies with high reliance on global trade
6	Banking crisis	Banking activity halts due to lack of liquidity	Short bank equity, long nominal sovereign bonds (medium duration)
7	Sovereign default	Non-payment by a major sovereign borrower	Country insurance (for example CDS)
8	Currency crisis	Extreme movement between exchange rates	Foreign assets, currency hedging derivatives, gold
9	Deflation	Goods and services prices fall for an extended period	Deflation swap, nominal bonds
10	Health progress backfire	Massive rise in morbidity or mental ill-health, antibiotic resistance	Health care providers
11	Nuclear contamination	A major nuclear disaster, leading to large radioactivity release and lethal effects	Short uranium
12	Extreme longevity	Significant increase in life expectancy overwhelms support systems	Longevity swap
13	Insurance crisis	Insolvency within insurance sector	Short insurance equity, long CDS (with the ‘right’ counterparty)
14	Terrorism	A major ideologically-driven attack	Defence companies
15	Infrastructure failure	An interruption of a major infrastructure network	Tinned food, bottled water, generators

* Food/Water/Energy crisis
** Our subjective measure based on the intensity and scope of the impact, the likelihood, and the degree of uncertainty in assessing the risk level.

NOTES TO EDITORS

The irreversibility of time – Or why you should not listen to financial economists further explores the subject of risk management and asserts that a potentially complex debate can be considerably simplified by invoking a rock-solid physical law. The aim: to bring clarity to a potentially difficult subject and provide a positive contribution to the understanding and management of risk.

TOWERS WATSON INVESTMENT

Towers Watson Investment is focused on creating financial value for the world’s leading institutional investors through its expertise in risk assessment, strategic asset allocation, fiduciary management and investment manager selection. Towers Watson’s Investment business has over 750 associates worldwide, assets under advisory of over US$2 trillion and around US$60bn of assets under management.

About Towers Watson
Towers Watson (NYSE, NASDAQ: TW) is a leading global professional services company that helps organisations improve performance through effective people, risk and financial management. The company offers solutions in the areas of benefits, talent management, rewards, and risk and capital management. Towers Watson has 14,000 associates around the world.

October 30, 2013, 6:30 AM ET

A Risk to Consider: Alien Invasion

GREGORY J. MILLMAN

Don’t ignore the possibility of an alien invasion when doing your risk assessment. Towers Watson didn’t.

A new report from the consulting firm identifies and ranks “extreme risks,” those arguably unlikely to occur, but with a big impact on the economy if they do. “For example, we believe that an alien invasion is a potentially existential risk, with high uncertainty, very unlikely (one in every 100+ years) and with impacts affecting all future generations (pan-generational),” Towers writes in the report, titled Extreme Risks: 2013. Although alien invasion doesn’t make the firm’s final list of the top 15 extreme risks, Towers discusses it in the report as an example of “scanning the horizon with an open mind.”

The report ranks extreme risks based on likelihood, uncertainty, intensity and scope of impact. Number one is a major shortfall in the supply of food, water or energy, and number two is stagnation, a prolonged period of low or no economic growth.  Both are relatively likely to occur, the report says, and the consequences are reasonably certain, with the impact of the first described as “locally crushing” and that of the second, “endurable.”

This is the third in a series of reports on extreme risks initiated by Towers in 2009 and updated in 2011, under the firm’s Thinking Ahead Group, whose job it describes as “to identify and develop new investment thinking and opportunities not naturally covered under mainstream research.”

There have been some changes in both methodology and risk ranking, with formerly top-ranked risks falling while formerly low-ranked risks ascended in the scale. Economic depression was the top risk in 2009 and 2011, but has fallen to fourth place in 2013. Similarly, in 2011, the number two risk was sovereign default, and in 2009 it was hyperinflation. Sovereign default has fallen to number seven this year, and hyperinflation doesn’t even make the top 15.

The exercise of considering extreme risks can be useful in guiding corporate capital allocation and risk management, explained Matt Stroud, head of investment strategy-Americas for Towers Watson. “We think it applies to anyone who is an allocator of capital,” he said, “If you are a corporate fiduciary allocating corporate capital, what you are trying to do is have a good investment allocation decision for your shareholders.”

In this context, he noted that stagnation risk merits consideration in light of the low levels of corporate investment despite historically high corporate cash balances and rich margins.  ”There’s a real risk that corporates are spending or investing in a way that many do not see the opportunity for sales growth or for economic growth,” he said. Therefore he suggested risk managers ask: “Are we in a regime where we have a strong likelihood of economic performance resembling the economic performance of Japan?”

Similarly, a consideration of resource scarcity could figure into assessing an Asia-investment strategy.  ”We all know the Chinese don’t have enough water or nearly as much as they like and they are a rising economic and military power.  For example, this is one of the things you keep coming back to when you ask ‘is this useful’ —  when we take into account the behavior of a nation state, the balance of risks in a region, etc.” he said.

There seemed to be one notable omission from the report, especially considering the season. While giving due weight to the prospects for an alien invasion, the report completely ignored the likelihood of a zombie apocalypse.  So Risk & Compliance put that “what if” question to Stroud, who replied, “If you think about it, the consequences would be severe.”

(Gregory J. Millman is a senior columnist with Risk & Compliance Journal  He is the author of The Vandals’ Crown: How Rebel Currency Traders Overthrew the World’s Central Banks, and several other books. He can be reached at +1 (212) 416-2352 or by email at  gregory.millman@wsj.com)