Despite years of investment in the development of the function, risk management at pension funds and insurance companies still fails to deliver on the promise. A number of fundamental issues are to blame and there is a fix, but it requires different set of skills.
There is plenty of reporting, of course, but it falls short in two areas:
- counterintuitive pro-cyclicality of any action based on the reporting
- the difficulty of interpretation of day-to-day numbers
The combined effect renders nearly all reporting not actionable, which defies the purpose of risk management. The long-standing ambition to make investment risk management more holistic and multi-faceted is left unaddressed, as ever rising regulator demands for technical and routine statistical data manipulation leave little time and resource to see the forest for the trees.
The Default Outcome is No Action
The problem of pro-cyclicality has been widely publicized of course (Youngman, 2009). Returns are negatively correlated with volatility, with the latter being highly clustered (Figure 1). This means that acting on volatility (VaR, CVaR or any similar) measure would mean progressively increasing risks as the markets become more expensive and cutting exposures as the markets contract, thus cementing the losses.