Are investors ready for the next black-swan event?

Risk management is an area that is expanding to include longevity risk and resilience management, a group of panellists noted at AsianInvestor’s recent investment summit in Hong Kong.

The risk management and governance panel was moderated by Nick McDonald, who is responsible for transition management consulting at Mercer in Hong Kong. He noted that risk oversight is an area that investors now take seriously following the financial crisis.

“Risk management is like inviting an old uncle to the wedding,” he jokingly said, adding it was an obligation for asset managers. “Risk is inherent to any investment that you make. You have to take risk in order to have a return.

He outlined three goals in risk management governance:  identifying the risks, determining the tolerance of those risks and controlling them. “The ultimate goal is to manage the unexpected risks, or the undercompensated risks,” says McDonald.

Equally as important is identifying weaknesses, and outsourcing certain functions where necessary to reduce risk, according to Philip Cheng, adjunct associate professor at the department of finance at Hong Kong University of Science and Technology.

There are about 10 major risks that the investment industry deals with on a daily basis, including counterparty and interest rate risk, says Cheng. “Don’t try to push yourself to be an expert in all 10 areas.”

Cheng outlined an example from his previous experience at a financial services firm which acknowledged that it lacked sufficient in-house expertise for investments in emerging market equities. A mandate was subsequently given to an external manager specialised in the field.

No portfolio manager can be an expert in all risk areas, Cheng notes, adding: “To admit to yourself that you don’t know something is very important.”

Aside from admitting vulnerable risk areas, portfolio managers also need to be on the alert to identify new ones.

One area of risk that has not received enough attention is longevity risk, says Yunsoo Cho, chief researcher at Samsung Life’s Retirement Research Center in Seoul, who notes that it could be a more significant source of risk than interest rates or inflation.

Longevity risk refers to the risk associated with the increasing life expectancies of retirees. It translates into pension shortfalls or higher-than-expected payouts by insurance companies.  

The most common industry measures for combating longevity risk include raising the retirement age, reducing pension benefits and increasing pension contributions. “These actions only add burden to the individuals and retirees, so capital markets solutions are needed,” she points out.

Longevity swaps – derivative contracts that offset the risk of pension scheme members living longer than expected – are increasingly being used in the UK, but are scarcely employed in other countries, says Cho.

Institutional investors should create long-term demand for tradable instruments relating to longevity risk, she says, adding that the capital risks associated with longer life-spans is a global issue.

“The median age of the total world population was 28 last year. It will go up to 38 in 2050. Analyses by the United Nations says the number of people over 60 will exceed those under 15 for the first time in 2045,” says Cho.

Another emerging risk area is resilience management, says Dennis Lee, chief risk officer at National University of Singapore's office of risk management. “It’s managing risk, but in a very adverse situation.”

Resilience management refers to a firm’s ability to operate amid a major crisis or severe unexpected disruption. It is a buzzword in Australia and New Zealand, which have had to contend with floods and earthquakes in the past year, but is relevant globally, says Lee.

The aim is to integrate risk, crisis and business continuity management processes. Lee sums up the key question that is the crux of resilience management: “When a black swan event comes, are we ready for it?”