This news service is looking at risk management and how and why the wealth industry should learn from insurance about mitigating - and profiting from - risk as properly understood. We will consider a number of themes in coming months.
If wealth managers have a version of the doctor’s Hippocratic Oath (“Do no harm”) it might be “Protect the client”. And protecting clients from risks has been thrown into sharp relief as never before by COVID-19.
Risks are everywhere. Writing these words in the second week of October, with the 3 November US Presidential elections looming, it seems remarkable that the world has contended with a pandemic all these months. Work, education, leisure and family life have been massively disrupted. Weddings have been cancelled or reduced to a handful of guests; citizens have endured the heartbreak of not being with loved ones in their final hours. Meeting friends and business contacts has become more difficult, Zoom and other digital wizardry notwithstanding. As a result of all this tumult, planning ahead is hard. Policy change and sudden moves on lockdowns in countries such as the UK, for example, have arguably stymied investment and business planning.
“Regime uncertainty”, like the unknowns about health, market volatility, business disruption and socio-political conflict, create a set of risks that have to be measured. And arguably risk management is or ought to be central to what wealth advice is about. Advisors need to frame conversations with clients about the sort of risks they’re prepared to run if bearing those risks earns a commensurate reward.
To put it another way, there’s no point exposing yourself to risk – such as that of capital loss – if you’re not paid a premium for shouldering it. So one early point for wealth managers and their clients to ask is why shoulder risks if you’re not compensated?
The risk management/mitigation mindset that’s so central to insurance is one that ought to be more widely embraced in wealth management than it is. Of course, insurance already plays an important part in the wealth toolbox: firms such as Lombard International Assurance, Swiss Life and Singapore Life, to give just three, craft specialist life insurance-based structures in which people can hold, shield and transfer wealth. But it is far more than just this. For HNW clients, they should perhaps take a “helicopter” level view of all the risks they run and try to either make a profit or mitigate: capture a risk there, hedge or remove another risk over there. To use a modish term, this is what “holistic” wealth management should be all about.
Already, wealth management has a set of risk management tools, some of which are so old and taken for granted that they’re almost overlooked. A starting place is diversification (“Don’t put all your eggs in one basket”) and we’re familiar with established approaches such as the 60 per cent stocks/40 per cent bonds portfolio, or notions of insuring portfolios with gold. Diversification is, well, diverse: in the wealth management space, it covers a range of alternative, illiquid areas such as hedge funds, private capital markets, property and precious metals. Some of these diversification ideas remain very much alive. A problem, as this publication was told recently by Deutsche Bank, is how can conventional portfolio risk management work when bond yields are so low as to offer little buffer if equities fall?
Banks and other financial players have to find new ways to hedge portfolios – this brings up tools such as put options (giving the holder the right to sell a security and protect from market declines), for example.
The coronavirus crisis also rams home how health and wealth risks intersect. COVID-19 disrupted work and business revenues; it also reminded us why critical illness cover is an important – and often under-appreciated – insurable risk. There’s no point in piling up wealth only to get so sick that you cannot enjoy it, or spend time with family and friends. A reference to health also reminds us about risks such as Alzheimer’s. (A tool used to handle such cognitive decline risk is the lasting power of attorney used in English Common Law; there are parallels in Civil Law codes. And like certain risk management tools, LPAs must be used correctly.)
The pandemic’s disruption also makes us more reliant on digital communications, increasing the risks from digital, rather than biological, viruses. In turn that makes cybersecurity insurance more important than before. Other knock-on effects from the pandemic include an exodus by those who can afford it from densely populated cities to suburbs and countryside. But what if a tech entrepreneur moves to a remote house surrounded by forests and fires break out? He or she has swapped one set of risks for another. These trade-offs arise when people try and shut down one risk without considering newer ones. That’s why there is a constant need to understand the “risk budget” as much as possible.
Risk management ought to be a big part of conversations that advisors have with clients. And, as we will see in a few articles that we will run in these pages in coming days, there is plenty of interesting thinking about risk (what risk actually is, is not, how to measure it, etc). To some extent, risk management, particularly if it is linked to insurance, still seems to be compartmentalised. (Your correspondent asked several banks for their views about insurance-influenced ways of thinking about risk, and few banks seemed keen to discuss it.) The rise of financial technology in all its forms could be a boon here: new tools for client reporting and engagement might help people learn about risks more rapidly and express their tolerances more accurately.