Risk management in light of exceptional events
Our annual Ortec Finance User Conference last week started with a keynote address by professor Vincent Icke. He explained to the audience how in astronomy it is possible to make very precise predictions regarding future events. This seems in stark contrast to predictions in politics, society, the economy or financial markets. Take, for example, the recent U.S. presidential election. Only a few polls predicted that Donald Trump would win the election, and the impact of a Trump victory is still very difficult to assess as well. The equity markets did not show the ‘consensus’ view of a short-term correction, but rather the opposite. Interest rates and currency movements were more in line with the expectations. From a historical perspective the nearly 40bps increase in the yield of long maturity US Treasuries in only one day was definitely an outlier. Both asset managers and risk managers therefore experienced a few eventful days, to say the least.
Exceptional types of risk
Do ‘exceptional’ events like the electoral victory of Trump or the Brexit a few months earlier form the main risks for a pension investor, whether it be an institutional or individual one? Coming back to Vincent Icke’s speech once more, one could argue that there are potentially numerous events like these. One example he talked about concerned the collision of a meteorite with our planet. This would not only create instant disaster of epic proportions, but also cause darkness across the entire globe for several years. While the impact of such an event is huge, and could never be covered by any monetary savings, the likelihood of it actually happening is quite low and, as said before, fairly easy to predict. In other words, we could see it coming and probably be unable to avert it.
“I disagree with people who say that such a fundamental review of the pension system is not needed.”
Are there other examples of these exceptional types of risk? Yes, there are, and they are not restricted to space either. Cybercrime is a case in point. Based on recent reports of Milliman and Allen & Overy cybercrime constitutes a great risk to both the pension and insurance industry. Speaking at the World Pension Summit Lloyd Komori, risk manager of the Canadian pension plan Omers, ranked cybercrime in the top 3 of his risk shortlist. Cyber-attacks are much more likely to occur than a meteorite collision and their impact can still be huge. And there are other huge risks out there. Think about the impact of climate risk on assets returns. Longevity risk, which we discussed in an earlier post, is another example. Ongoing technological developments will make it possible to better cure or halt important diseases, thereby extending our life span considerably, with obvious consequences for the pension industry. Closer to the actual financial markets is the possibility of new black (or grey) swans on the scene. In a recent interview with The Guardian Steve Eisman, an analyst who predicted the financial crisis of 2007-2008, warned for a new European banking crisis, based on the ‘improperly valued loan books’.
The need for proper risk management
Although some of the above-mentioned risks are more likely to materialize than others, they will all put the current defined benefit schemes in a difficult position. In the Netherlands, like in many other developed countries, the pension system has come under close scrutiny, exactly for the way they are dealing with potential large risks. I disagree with people who say that such a fundamental review of the pension system is not needed. Later this week we can expect an update on potential policy changes for Dutch pension funds. Under the current financial framework the Dutch are close to making a cut in benefits for a substantial amount of pensioners. Shorter-term financial risk and return management is essential in order to avoid this. All of this makes risk management a very exiting field of expertise: we have exceptional risks with very low probability but tremendous impact and at the same time ‘normal’ day-to-day risk. Both can impact the future benefits of large groups of retirees. In my view, the only way to address this is to be as consistent as possible in your risk management approach.