Extreme Risk Planning: Towers Watson Reveals Research and Ranking for Managing "Known Unknowns”

Sovereign Default has risen four places to second position in global professional services company Towers Watson's (NYSE, NASDAQ: TW) ranking of the top 15 extreme risks, while Depression retains the top position and Hyperinflation moves to third. The company's ranking¹ categorises events that would have a high impact on global economic growth and asset returns if they occurred and incorporates the degree of certainty in assessing the risk. The bottom three in the ranking are the end of fiat money, infrastructure failure (replacing a major global conflict, which has which has moved up in the ranking) and a killer pandemic.

In this edition of the research entitled Extreme Risks – the 2011 Update, Towers Watson has updated its likelihood and impact assessment to reflect the disappointing economic recovery in the developed world during the past two years which it believes increases the likelihood of further economic shocks. Accordingly, it has moved sovereign default from ‘Medium’ impact to ‘High’ impact and recent developments – both economic and political – in the euro area suggest that a break-up of the euro is more likely, so it has moved this risk from ‘Very low’ to ‘Low’.

Tim Hodgson, head of Towers Watson's Thinking Ahead Group, said: "The global economic environment continues to be characterised by significant imbalances and consequently is not in good shape to withstand any further major shocks. This ranking lists a number of concerns that could disrupt the recovery and long-term economic developments and aims to help asset owners consider and manage their investment risk beyond the conventional VaR₉₅ level. It should however be noted that even with the best analysis, we will not be able to anticipate all risks. While we have a list of 15 extreme risks, by definition they are ‘known unknowns’ and what might harm asset owners even more are the ‘unknown unknowns’. The important thing is to build our ability to adapt and learn, enhancing the resilience of the system.”

Since the first edition of Towers Watson's ranking, published in 2009, the company has added two new extreme risks resource scarcity and infrastructure failure (ranked 11 and 14 respectively) which replace the end of capitalism and excessive leverage.

According to Towers Watson the concept of resource scarcity is broad and includes energy, metals, water or arable land. It assesses the likely mismatch between the linear evolution of the supply curves for finite resources and the exponential change in demand curves given population growth and increasing living standards. It suggests that much of this increased demand is expected to come from the two most heavily populated countries - China and India - which have been experiencing very fast economic growth in recent years and are expected to maintain that pace going forward.

Tim Hodgson said: "Technology optimists argue that the contribution of technological advancement can help meet the increasing demand, but certain resources – such as water or arable land – have no easy substitutes and the extreme risk lies in a scenario where technology fails to rescue us, or comes too late. While this extreme scenario may be beyond the 10-year window of this research, the fear of running out of resources could lead to price spikes in major economic inputs and increased volatility – neither of which are good news for the economy or markets.”

Towers Watson refers to infrastructure failure as the risk posed by the dependence of modern economies on computer networks and power grids. The cost of such a failure would rise exponentially the longer the networks remained un-operational.

Tim Hodgson said: "The wide use of computing technology means that all critical infrastructure networks, whether power plants or financial clearing systems, are vulnerable to security breaches and cyber attacks. The malfunction of a major infrastructure network for a relatively long period could severely disrupt human activity, threaten lives in critical facilities and raise the possibility of social unrest and law-breaking behaviours for survival.”

The company observes that not all of these extreme risks are hedgable and that any hedge used is likely to be very imprecise. It cites the example of the outcome of a killer pandemic being highly uncertain and therefore its impact on assets and liabilities unknowable. But suggests that it will be useful to be in a position to decide how effective the hedge is required to be based on how much loss is acceptable. It concludes that the more loss that is acceptable the easier it is to hedge smaller proportions of the portfolio.

Tim Hodgson said: "More complete hedging increases complexity and is almost certain to require the use of derivatives, so thought needs to be given to whether the counterparty would be willing and able to pay out should that extreme event happen. In addition, the carrying cost of such a hedge is likely to be higher the more complex it is. On the positive side, derivatives provide much greater flexibility and the more precise targeting of risks. They also don’t require much capital therefore leaving the bulk of the portfolio untouched.”

The research suggests that of all of the things to be considered, public policy issues should be a priority as they will both influence the risks and be shaped by the shifting likelihood of the different risks through time.

Notes to editors

*Towers Watson groups the 15 extreme risks into one of three areas financial, economic and other.

Financial extreme risks revolve around solvency and whether a financial institution is able to pay its debts with available cash. The research describes the interconnected nature of the modern financial system and that high levels of leverage mean insolvency for one institution can quickly become a systemic problem. It suggests the primary triggers for financial risks are falling asset prices and falling incomes or they can be generated by a recession in the real economy and transmitted to the financial sector through a default on loans. The extreme risks included in this category are another banking crisis and future insurance crises.

Economic extreme risks are less homogenous than the financial risks and range from a deflationary depression to hyperinflation and a return to a gold standard. The deflationary depression risk implies that government actions will prove incapable of returning the economy to sustainable growth, while the other economic risks essentially assume that government actions are successful, but at a price. The other economic extreme risks are currency crisis, sovereign default and the resource scarcity.

Other relates to environmental and political themes. Towers Watson considers that the way the environment is handled and the absence of political structures for dealing with it adequately, as well as with the financial and economic issues gives wide scope for negative outcomes. Political crisis, major war, climate change and a killer pandemic are included in this group.

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 and investment manager selection. It is a division of Towers Watson’s Risk and Financial Services business, has over 700 associates worldwide and assets under advisory of over US$2 trillion.

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 employee benefits, talent management, rewards, and risk and capital management. Towers Watson has 14,000 associates around the world and is located on the web at www.towerswatson.com.

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.