BEYOND RISKBEYOND RISK MEASUREMENT: ESTABLISHING A PROACTIVE RISK MANAGEMENT CULTURE
Presented by Claude Bergeron, Executive Vice-President and Chief Risk Officer Canadian Investment Review’s14th Annual Risk Management ConferenceAugust 23, 2012
022007-08 Crisis
01The Caisse
03Post Crisis
05What's Next?
04Risk Management Process
06What should you do
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THE CAISSE
Mission
“The mission of the Caisse is
THE CAISSE
to receive moneys on deposit as provided by law and manage them with a view to achieving optimal return within the framework of depositors’ investment
li i hil t thpolicies while at the same time contributing to Québec’s economic development.”
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More Than 46 Years of Investing
Founded in July 1965 by an Act of Québec’s National Assembly
THE CAISSE
Initial mandate to manage the assets of the Québec Pension Plan (RRQ)
Mandate broadened over the years to include funds deposited by other Québec public- and private-sector pension and insurance plans
25 depositors had net assets of $159.0 billion as at December 31, 2011
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Main DepositorsQuébec public and private sector pension and insurance plans
As at December 31, 2011
$B %Government and Public Employees R ti t Pl (RREGOP)
42.0 26.4
THE CAISSE
Retirement Plan (RREGOP)
Retirement Plans Sinking Fund (RPSF) 36.4 22.9
Régie des rentes du Québec 34.9 21.9
Supplementary Pension Plan for Employees of the Québec Construction Industry
13.2 8.3
Commission de la santé et de la sécurité 9.9 6.3du travail
Société de l’assurance automobile du Québec
7.4 4.7
Pension Plan of Management Personnel (PPMP)
7.1 4.5
Other 8.1 5.0
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Changes in Asset Allocation
2 41 3 160 Total net assets
(in billions of $)10 24 36 50 88 122
Asset allocation
THE CAISSE
100
77 71
79
66
17 19
13 28
28 27
25
14 12
8 12
27
22 24
5 9 8 5 5
3 2
5 4
2 5 4 7
9 12
5 10 4
4 Other
Infrastructure
Private Equity
Real Estate
Real Estate Debt
Gl b l E iti
Constant reduction of Fixed Income and increase in Equities and Alternative Investments
Early Private Equity (1971) and Real Estate (1980) investor
Diversification from Canadian Equities into Global Equities
66
53 54
38 36 34
1966 1970 1975 1980 1985 1990 1995 2000 2005 2011
Global Equities
Canadian Equities
Fixed Income
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Geographic Breakdown
As at March 30, 2012
Geographic breakdown of total assets
THE CAISSE
15%
16%
26%
58%
E i
Europe
UnitedStates
Québec
Canada The Caisse has a significant Canadian and Québec bias
We are increasing our exposure to emerging markets
We currently have $2.6 billion invested in Brazil
0.1%
3.9%
7.1%
Other
Asia, Australia
Emerging markets
billion invested in Brazil and $2.1 billion in China, mostly in Equities and Real Estate
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The Caisse in the Global ArenaDirect investments and partnership strategyAs at March 30, 2012
THE CAISSE
An investor active on five continents in all asset classes:42% of depositors’ total assets is invested outside Canada, mainly in industrialized countries7 1% of depositors’ total assets is invested in emerging markets including Brazil7.1% of depositors total assets is invested in emerging markets, including Brazil, India and China
A sought-after partner on global markets:Extensive global market in line with partnership strategyAccess to a large volume of major projects worldwide, particularly in real estate and private equity
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Organizational Structure
As at December 31, 2011CHAIRMAN
BOARD OF DIRECTORS Human Resources Committee Governance and Ethics Committee
THE CAISSE
BOARD OF DIRECTORS Human Resources Committee Governance and Ethics Committee
Audit Committee Risk Management Committee
PRESIDENT AND CHIEF EXECUTIVE OFFICER Internal AuditManagement Committee
Depositors and Strategic Initiatives Investment Management Private Equity Real Estate
Risk
Finance
Fixed Income
Equity Markets
Ivanhoé Cambridge
Otéra Capital
Operations and Information Technology
Talent Management and Organizational Development
Legal Affairs and Secretariat
Public Affairs
Overlay Strategies
Economic Analysis and Asset Allocation Strategies
Hedge Fund of Funds
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The Caisse vis-à-vis Its PeersA major institutional fund manager
One of the largest institutional fund managers in Canada and North America
THE CAISSE
One of the world’s 10 largest real estate asset managers
Leading Canadian private equity investor
Shareholder in more than 4,000 companies globally
One of the few North American entities with the highest credit ratings: AAA from DBRS and S&P, and Aaa from Moody’s
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2007-08 CRISIS
2007
Context• Volatile equity markets• Rapid appreciation of the Canadian dollar
2007-08 CRISIS
p pp• Global credit crunch• Liquidity crisis in Canada’s third-party asset-backed commercial paper market
$12.6 billion of ABCP reclassified as non-liquid assets
$1.9 billion (15%) unrealized decrease in value of ABCP l d th C i ’ ll t f 2007 b 1 3%lowered the Caisse’s overall return for 2007 by -1.3%
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2008
Context• The subprime mortgage debacle of 2007 set off a chain reaction that led to the
events of fall 2008
2007-08 CRISIS
• The investment bank Lehman Brothers declared bankruptcy• A sudden increase in risk aversion caused credit spreads to widen to an
extraordinary degree• As market volatility soared, financial institutions responded swiftly by cutting off
credit to preserve their liquidity• The value of the Canadian dollar fell sharply• With such extreme events, asset class correlation increased dramatically and
reduced the diversification effect
Caisse’s overall return: -25% versus -18.5% for the benchmark and a loss of $10.2 billion relative to the
benchmark
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Lessons Learned
Stay away from complex derivatives and structured productsAll products must be well understood and integrated into all systems
2007-08 CRISIS
systemsNo portfolio manager or investment can be above the risk management processTransparency: portfolios, investments and risks are reviewed at all levels of the organizationA robust new product process is essentialA centralized risk management function ensures an integrated view of all risksThe risk management team should be part of the investment process and should monitor the risks associated with the Caisse’s portfoliosThe compensation program should reward risk-return balance in decision making
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POST CRISIS
A Plan to Enhance the Caisse’s Risk Management
The ABCP episode and the 2008 financial crisis prompted the Caisse to strengthen its risk management capabilities
POST CRISIS
the Caisse to strengthen its risk management capabilities
1. Enhance the Caisse’s risk management culture• Business Unit Risk Managers (BURMs)• Review the mandate and composition of internal risk committees
2. Upgrade stress testing practices3. Strengthen the new product approval process4. Increase resources dedicated to risk management
• Double the head count• Invest in risk systems
5. Review risk methodologies
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Review Risk Methodologies
D il l l ti f k t V R ith 99% l l f fid
POST CRISIS
Daily calculation of market VaR with a 99% level of confidence
Liquidity risk calculation methodology
Implementation of credit VaR
Counterparty risk
C t t i k l l ti th d lCounterparty risk calculation methodology
Credit ratings for countries and sovereign entities
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Market Risk Methodology
General approach to market risk measurement• Historical 99% daily VaR computed from a sample of 1,500 days• Computed and published daily for public markets, monthly for private markets and the aggregate portfolio
POST CRISIS
portfolio• Reported numbers are annualized
Public markets• For public equities, each individual stock’s historical return series is its own risk factor• For fixed-income products, interest rate curves are built in-house and used as risk factors• For optional instruments, historical volatility surfaces are used in our modelling
Private markets• We use public proxies for real estate (REITs) and private equity investments• Each investment is assigned a specific set of proxies• The series are adjusted to take into account the leverage of the proxies and the actual investment, but also liquidity and diversification effects
• For infrastructure investments, we are working on an approach based on the risk factors tied to the valuation of a given investment rather than the proxy-based approach
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Review of Processes and Changes in Governance
Review investment policies
POST CRISIS
Implement oversight for new investment activities
Adjust the portfolio managers’ incentive compensation process and the strategic planning process
Ensure investment and portfolio transparency with the risk-return report and presentations to the Risk Management Committee and the Executive Committee
Reorganize teams and enhance analytical capability
Involve the risk team in hedging and investment monitoring
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Risk Reduction
Reduce active market risk by 56%
POST CRISIS
Reduce ABTN market risk by 54%
Reduce absolute market risk by 10%
Reduce credit and counterparty risk
Reduce liquidity risk with term funding
Reduce leverage from 36% to 17% (2008-2010)
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RISK MANAGEMENT PROCESS
Transparently ensure a risk-return balance for the Caisse by assuminga second level of control, by employing effective risk management
Risk Management Model
RISK MANAGEMENT PROCESS
tools and providing support with investment strategy development,while promoting a sound risk culture within the organization
Integrate risk managers
Incorporate risk component into our processes
Develop effective analysis tools
Strategies
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Asset allocation
Overview of Risk Management Model
Fixed Income
Equity Markets
Private Equity
Real Estate
Business Unit Risk Managers
(BURMs)
RISK MANAGEMENT PROCESS
Market risk analysis, stress testing and concentrations
Credit, counterparty and liquidity risk management
Data management
Risk management intelligence and policies
Activities associated with
quantitative measurement and analysis
Risk management intelligence and policies
Geopolitical risk analysis
Operational risk management
Activities associated with
qualitative analysis
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Focus of Our Strategy
Knowledge and challenge
• In-depth knowledge encompassing investments, the portfolio and interrelated investments
• Constructive discussions on strategies and
RISK MANAGEMENT PROCESS
challenge
Guidance and discipline
Co st uct e d scuss o s o st ateg es a dopportunities
• Define policies that reflect the risk management philosophy
• Establish clear, shared risk management processes• Develop structured and shared investment
processes
Development of effective analytical
tools
• Develop quantitative and qualitative tools• Ensure communications are complete yet
synthesized and straightforward
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Basic Enterprise Risk Management (ERM) Process
•Decide on the acceptable level of riskD l d
•Anticipate major risks•Prioritize risksM it t ti l i k
1. Identify3. Mitigate
RISK MANAGEMENT PROCESS
•Develop and implement a mitigation plan
•Monitor potential risksDialogue:
Market update, rebalancing
committee and risk-return
report
•Measure risks using systematic tools, e.g. VaR, stress tests, concentrations and indicators
•Analyze risks using quantitative and qualitative methods
2. Assess
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Response to Risk Is Modulated
Impact of risk on the CaisseIllustrative probability distribution
RISK MANAGEMENT PROCESS
"Major" risk "Usual" risk
Potential event characterized by:•Major impact
Potential risk characterized by:•Significant but less critical impact
•Generally low frequency•Typically not central to investment strategies
•Dialogue intended to mitigate risk
•Higher frequency•Deliberately accepted to generate returns
•Dialogue intended to optimize risk-return ratio
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Prospective Risk Monitoring ProcessStep Activities
1. Risk detection(ongoing)
• Business experts monitor the portfolios and the basic indicators in consultation with the teams of portfolio managers
• Risk experts monitor transversal risks, e.g. Caisse concentrations, liquidity and counterparty
• Members of the risk management team monitor the markets
RISK MANAGEMENT PROCESS
2. Prioritization of major risks(~ weekly)
• The Risk Management Committee conducts a roundtable discussion to address emerging risks and prioritize major risks–First item on the agenda of each committee meeting–Input from business experts and risk experts–Updating of the mapping of prospective risks–Designation of an officer for each major risk
3. Monitoring of major risks(ongoing)
• The risk officers monitor each major risk and its specific indicators
• The officers play a monitoring role, tracking risk development–Communication to the portfolio managers, senior management
d h B d f Di d dand the Board of Directors, as needed
4. Accountability (monthly)
• Accountability with the risk-return report–Prospective risks included in the Caisse report–Basic indicators included in the portfolio-based reports
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Synthesize: Risk-Return Scorecard
Market risk indicators
RISK MANAGEMENT PROCESS
Return indicators
Indicators for credit, counterparty, operational and main concentration
Main prospective risks
risks
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Simplify
Appendices co er the indi id al risks in
RISK MANAGEMENT PROCESS
• Appendices cover the individual risks in greater detail and are consulted as needed
• The analysis presents the issues succinctly and simply
• Tables and charts illustrate the status of the risk and its developmentthe risk and its development
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Communicate: Risk-Return Reports
•The reports are discussed at meetings of the Board’s risk management
RISK MANAGEMENT PROCESS
of the Board’s risk management committees
•In several pages, they summarize the Caisse’s various risks and the actions taken
•The appendices provide more detailed information as neededinformation as needed
•Twice a year, specific reports for each specialized portfolio facilitate in-depth discussion of risks incurred
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The Caisse’s ERM has two components
Enterprise Risk Management (ERM) at the Caisse is a disciplined process designed to promote integrated management of its major risks
RISK MANAGEMENT PROCESS
Operational componentAccountability to the Operational Risk Committee
*
Fi i lCommittee Financial componentAccountability to the Investment-Risk Committee
*Strategic risk is handled by the Management Committee
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Basic Principles of the Financial Component of the Caisse’s ERM
RISK MANAGEMENT PROCESS
1.Aggregate and consolidate knowledge and insight available internally and externally
2.Develop a forward-looking (e.g. anticipation of the next crisis) and in-depth approach (e.g. use of quantitative and qualitative methods) to major risks
3.Identify transversal risks in the portfolios (liquid and illiquid)
4.Prioritize efforts to address major risks
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Basic Principles of the Operational Component of the Caisse’s ERM
1.Identify and assess the major operational risks using a self-
RISK MANAGEMENT PROCESS
assessment process
2.Determine an owner for each major risk
3.Identify mitigation measures
4.Monitor risk indicators and internal and external incidents
5.Follow up on major risks, indicators and incidents with the Operational Risk Committee
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WHAT’S NEXT?
Portfolio Risk Management: Our Toolkit Enables Us to Cover the Different Angles
Funding-liquidity issues• Funding-liquidity risk monitoring • Funding-liquidity stress testing
I l i f f di li idit i t i t i
Excessive concentrations• Concentration risk monitoring• Counterparty risk monitoring (including potential
f t )
WHAT'S NEXT?
• Inclusion of funding-liquidity impact in asset mix scenarios
future exposure)• Credit VaR (both active and absolute)
Excessive volatility• Historical market VaR (both relative and
absolute)• Stress testing (both relative and absolute)
Embedded correlation effects• Risk-factor decomposition• Concentration risk monitoring along several
axes using both VaR and exposure• Market-regime decomposition, including
extraction of correlation structures for eachextraction of correlation structures for each regime
Non-linear effects• Stress testing and sensitivity analysis• Inclusion of historical volatility surfaces in
market risk measures
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Risk Management in the Context of Absolute ReturnWHAT’S NEXT?
Identification and analysis of important risks and the support to the managers are central to the risk management strategy
Risk management related to investments
For the Caisse’s overall portfolioRedefine the risk appetite from active risk to absolute risk metricsIdentify all concentrations by issuer, industry and country or risk factors that may affect the overall performanceReview risk appetite for concentration level and emerging marketsD l t t ti f th t ti l ti d l tilitDevelop stress testing for the concentrations, correlations and volatilityPut in place a market intelligence process to identify and monitor major risksConduct stress testing related to major risks to support decision making
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Risk Management in the Context of Absolute Return
Risk management related to investments…
A well defined investment process that integrates the risk management team
WHAT’S NEXT?
A well-defined investment process that integrates the risk management team through the leadership of the BURMs
Identifying major risks that could lead to a permanent capital lossChallenging the project’s underlying assumptionsSimulating the impact of risk factors on the project’s expected return
For portfoliosProduce a risk heat mapExecute market intelligence for major risksConduct sensitivity analyses and stress testsConduct sensitivity analyses and stress tests
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Other RisksWHAT’S NEXT?
Maintain the current process
Liquidity riskMonitor liquidity risk daily with stress testingDefine the minimum holding in liquid assets
Credit and counterparty riskMonitor and analyze credit riskMonitor and analyze credit risk by counterparty, clearing broker and clearing house
Operational riskIdentify and mitigate major operational risksDevelop operational incident gatheringEstablish and monitor key risk indicators
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WHAT SHOULD YOU DO
Developed your risk culture
Someone should be responsible for risk management
WHAT SHOULD YOU DO
Someone should be responsible for risk management
Define your risk appetite
Put in place an ERM process adapted to your organizationA structured processKnowledge of all risks taken Transparency : Risks are reviewed and are weighted
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Know Your RiskWHAT SHOULD YOU DO
Identify your top risks
Where to look:
Your liquidity risk, the deadliest risk
Your highest concentrations that can generate huge loss
Your key risk factors where are your biggest risk expositionsy y gg p
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