At its Ideas Exchange conference held in Melbourne on 7 June 2011, Towers Watson challenged many of the established norms associated with risk management in the investment industry and encouraged institutional investors to develop a better understanding of the subject. The Ideas Exchange conference was centred on the latest research publication prepared by Towers Watson’s Thinking Ahead Group2. In the publication, entitled The wrong type of snow, Towers Watson asserts that the relatively young discipline of risk management has focused on the harnessing of technology for risk measurement rather than a deeper understanding of risk itself.
Graeme Miller, Director of Investment Services for Australia at Towers Watson, said: “It is time to promote better risk management over more measurement and we need to be careful not to mistake measurement for understanding. We have come to a growing conviction that better risk management can give competitive advantage. Institutions can achieve this by shifting their thinking to align risk with mission by modifying practices to adopt a better risk framework and by bringing these together through stronger risk governance.”
The research includes a study of existing practices, new ways of thinking about risk and some proposals for improving risk management by institutional funds. It also argues that risk should be redefined in the context of the mission.
“If you don’t understand your mission, then you don’t understand risk”, said Miller.
“We are increasingly defining risk as the possibility of ‘impairment to mission’, or as ‘surviving the whole journey’, and are introducing the concept of adaptive buffers3 into our advice. These buffers are mechanisms, both financial and non-financial, that are available to the investor to support them through adverse periods and can be used with a consideration of different potential future scenarios to evaluate how much risk a fund should be taking. We believe a risk ‘sweet spot’ exists whereby enough risk is taken to generate wealth, given the available buffers, but not so much that mission is likely to be permanently impaired.”
Miller gave the example of risk management in the airline industry, in which the “mission” is straightforward: fly customers safely from A to B.
Graeme Miller said: “In this industry risk is well-understood and monitored and there are plenty of adaptive buffers used to provide support during adverse periods. These include built-in redundancy (dual pilots, multiple engines etc) as well as contingency planning and stress testing. Highly sophisticated technology is used to help the industry achieve its mission, supported by regulation that is almost exclusively focused on safety standards and risk management.”
While one industry’s solutions cannot be transplanted on to another, Graeme Miller argued that the investment industry can learn from the airline industry, which has been forced by its circumstances to “do risk management a whole lot better” than the investment industry does – because all participants in the airline industry understand the mission, and the risks, explicitly.
Graeme Miller further argued that risk models in the investment industry have traditionally over-emphasised short-term success over long-term goals, and return over risk. In addition, Towers Watson suggested that risk models fail to deal adequately with complexity and in particular with endogenous risk4. Investing over multiple periods and taking account of the motivations of agents considerably complicates risk management.
Graeme Miller said: “Models have value, but only where they are employed with good understanding. By implication current practice needs significant enhancement.”
Following Miller’s remarks at the Ideas Exchange conference, Martin Goss Senior Investment Consultant at Towers Watson in Australia, considered how appropriate risk measures can be implemented through a new risk framework. This framework builds on Towers Watson’s existing work on governance and considers how asset owners need to organise themselves to implement best practice risk management. The framework includes a number of tools, such as a risk register and dashboard, for facilitating better frameworks and governance considerations.
Martin Goss said: “We argue that these frameworks require strong risk governance. As such organisations need to develop a risk culture where responsibility is shared appropriately and risk matters are given appropriate prominence on agendas and in communication.”