Investment risk - questioning your way to more effective risk management

Transcription

1 Investment risk - questioning your way to more effective risk management Ravi Rastogi, Towers Watson Neil Chapman, Towers Watson September 2013, Brussels 2013 Towers Watson. All rights reserved.

2 The new normal greater complexity and interconnectivity Insurance crisis Banking crisis Major sovereign default War Climate change Fracking GM food Cyber terrorism Nanotechnology Energy Water shortage Food shortage Rare earths Endogenous risk Macro factors Killer pandemic Sustainability Insurance crisis Complexity New beliefs Technology Environment Self-inflicted disease Finance Capital Markets Society Minor sovereign default Debt Demographics Ageing Underfunded pensions Healthcare Currency crisis Economics Imbalances Hyperinflation Inflation Protectionism End of fiat money Politics Short-termism Fairness Two-tier economy Depression Emerging wealth Double dip Two-speed world Political crisis Future of Euro End of capitalism Social unrest Default War Multipolar world

3 The same old problem all models are flawed Unknown model limitations Reality Known model limitations Accurately modelled risks

4 Our agenda for today market risk questions risk managers should be asking in the new normal 1 Can we make more efficient investment decisions? Questions 2 Can we better quantify risk? 3 Are there new and emerging asset risks?

5 Good investment decisions should be based on a coherent and consistent framework Strategic Principles Know Why IM Excellence (Portfolio Construction) Enablers Know What, Where, Know How When Execution Know What, Who Mission and goals Values and beliefs Governance and resources Asset allocation and risk Culture Value chain Manager capability Often static and not a focus area Client delivery Actions and decisions Measurement and Often the review main focus areas Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 5

6 Common issues and outcomes that separate the good from the great Dysfunctional organisation 1 Ignoring assets because they are HARD-to-model Sub-optimal processes Roles and responsibilities unclear Slow decision making The impact of suboptimal investment beliefs and processes 2 3 Chase (eg) LIQUIDITY to the detriment of (eg) YIELD Capturing emerging trends after they have emerged

7 Encouraging good investment behaviours Allocation of capital and diversification Rewarding diversification Good investment behaviours Understanding of limitations Expert holistic risk assessment Link to remuneration

8 Better risk quantification 2013 Towers Watson. All rights reserved.

9 Fit for purpose models and calibrations are required Spectrum of model sophistication Standard Formula 80/20 point Average point Leading pack Best-in-class Best-of-breed Bank prop desk Theoretical zone of acceptability for internal models A consistent and coherent calibration framework is needed combined with appropriate expertise Risk type Data Analysis Expert Judgement Benchmarking Market/credit risk Insurance/ operational Investment professionals are the experts of choice for investment (market and credit) risk Actuaries are the experts of choice for insurance and operational risk

10 When calibrating beware of regime changes Per cent Euro Spreads over 10yr German Bunds Ireland Italy Portugal Spain Debt to GDP ratio for different US borrower types (%) Household Sector Financial Sector Non-Financial Business Sector Government Sector 6 4 Finland France Greece (rhs) Source: Bloomberg Source: DataStream 1 2 3

11 and future trends Historic sovereign default and restructuring rates Prospective sovereign credit rating distribution % default/restructuring # of countries (rhs) Hard currency Local currency Hundreds % of DM sovereign countries 100% 90% 80% 70% 60% BBB Speculative grade Source: Reinhardt/Rogoff, Towers Watson % 40% 30% A 20% 10% AAA AA 0% Source: Standard and Poors

12 Case Study: modelling complex asset classes Challenges Carrying out an independent review of an EC model Capturing different hedge fund styles in the model Challenging client assumptions around the use of equities to represent hedge funds in their model Approach Key risk analysis extensive modelling of equity and hedge funds relationships in different market conditions Use of left tail multipliers based on 2008 experience Separation of market sensitivity(beta) and manager skill(alpha) to enhance use of benchmarks in the model Application of subjective judgement to further improve market distribution vs blind benchmark approach Beneficial outcomes The client had a higher level of confidence that risks were appropriately captured and modelled in economic capital We shared the findings of the review with the regulator, who accepted the conclusions confirming the adequacy of the firm s capital requirements Breakdown of sensitivity of hedge fund returns to global equities Alpha (manager skill) Beta (HF index)

13 New and emerging asset risks 2013 Towers Watson. All rights reserved.

14 Asset managers are always looking for better opportunities ECA loans Infrastructure debt Insurance linked securities Direct Lending Social Housing Loans Equity release mortgages Hedge Funds Structured credit which results in new assets and risks that risk managers need to understand and quantify

15 Case Study: Investing in new asset classes Challenges for the risk manager Understand, managing and monitor new classes Upgrading economic capital models for new classes Limited data and role of expert judgement Excess return Excess return vs risk/capital 3.0% 2.5% 2.0% 1.5% 1.0% Current Portfolio A 0.5% Portfolio B Portfolio C 0.0% 12.4% 12.6% 12.8% 13.0% 13.2% 13.4% 13.6% VaR 99.5 inc LP, % of best estimate liabilities (adjusted for LP) Beneficial outcomes Return enhancements of 50+ bps Reduced economic capital Suitable illiquid / alternative credit assets identified Assets to be transitioned over time as opportunities emerge Empirical Fitted Fitted CDF KS test central KS test upper and lower bounds 15

16 Investing in more illiquid assets will require more robust liquidity management Liquidity risk limits and tolerances e.g. coverage ratio and extent of loss Governance, processes and controls Aligning investment strategy, liquidity facilities and management actions with limits and tolerances Monitoring, MI and scenario testing Understanding cash outflows, encumbrances, price sensitivities and asset sale criteria / order

17 and better management information

18 and an understanding of emerging liquidity risks European Markets Infrastructure Regulation (EMIR) EXPECTED CHANGES FOR OTC DERIVATIVES CASH REQUIRED FOR VARIATION MARGIN for derivatives traded by central counterparties BILLATERAL COLLATERALISATION REQUIRED for derivatives not centrally cleared IMPACT Derivatives with a long duration may further INCREASE LIQUIDITY REQUIREMENTS or require arrangements to access liquidity at short notice GREATEST IMPACT ON: Annuity writers that make use of interest rate swaps With-profits funds that use OTC derivatives to hedge guarantees and options

19 Conclusion: the new normal will present risk managers with new market risk challenges and questions they need to ask IMPROVING Investment decision taking BETTER USE OF EXPERT JUDGEMENT Improve risk quantification UNDERSTAND New/emerging asset risks e.g. liquidity C H A L L E N G E S

20 Proprietary and Confidential. For Towers Watson and Towers Watson client use only.