The Fat Tail and Feedback Loop at the End of the World…

In these somewhat strange times, we have been musing about how individuals and enterprises still have a habit of trying to avoid contemplating “the end of the world” (as opposed to coping with the “news”), even if the (re)insurance industry exists at least in part to mitigate extreme risks for it clients.

Nassim Nicholas Taleb has made a career out of pointing out the risks of “fat tails” and unexpected events, with a series of books which remain essential reading, even if one does not agree with all of his views or conclusions. In addition, Mr. Taleb has run investment vehicles intended to protect against scenarios in which systemic fragility overwhelms the financial markets.

And now, in a more easily accessible form, Algebris Investments (a UK-based investment manager) has announced the launch of its own “end of the world fund”, officially a “Tail Risk Fund”.

The firm points out, quite reasonably, that after a decade of a generally benign overall investment climate in which those adding risk have been rewarded, a number of large investors have begun to seek mechanisms to limit potential portfolio losses. As Hyman Minsky wrote: “Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.”

Given all the noise around the likes of Argentina, Turkey and Italy; Middle East conflicts; the recently failed G7 summit; US/PRC trade tensions (we could go on!), one might well ask: “But how can you say the markets are stable?”

This is a fair question. However, it remains the fact that there have been no real market breaks, nor stampedes for the exit as yet, minimal “tantrums” (outside country-specific ones), and the appetite for risk shows little sign of abating, which begs the question of what happens when sentiment changes (as it surely will at some point.) At that point, George Soros’ Theory of Reflexivity is likely to get another workout, as the thinking (panic) of market participants feeds on itself, creating negative feedback loops and further increasing instability, uncertainty and volatility.

The Great Financial Crisis is beginning to recede into memory, and one is led to believe that regulatory and macro-economic steps taken since then have significantly reduced the probability of a recurrence. While it may be reasonable to assume that the causes of the next GFC will be different from those of the last, to assume that there will not be another extreme financial crisis (whether or not correlated with a political one) is the height of foolishness.

At Awbury, of course, our business is based around our E-CAT franchise (providing protection against high severity/low frequency credit, economic and financial risks). So, we are always scanning the horizon for the first signs of factors that could generate the next GFC, as well as idiosyncratic and seemingly isolated events that can cascade into something systemic. It is why our clients and Insureds seek out our bespoke coverages, backed by our diverse panel of (re)insurers, whose ability to withstand systemic shocks has been amply demonstrated over many decades, and why the Awbury team also works hard to build structural and economic mitigants into those coverages in order to continue to deliver a highly attractive risk/reward ratio to its reinsurance partners.

The Awbury Team

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The end of oil will/may arrive, but when/how…?

The Oil Age has had quite a run over the past 100 years or so, and its possible demise is a source of constant debate, as competing forecasts and scenarios try to illuminate when and how such factors as alternative energy sources; non-ICE*-powered vehicles; and concerted action on “climate change” will cause a significant decline in use of oil-derived fuels.

What seems sometimes to be overlooked is that a) forecasts are usually wrong in terms of timing and scale; b) one has to have the appropriate assumptions; and c) there are often unexpected linkages or factors that can significantly affect actual outcome(s).

So, let us think about some of the variables involved, and how they might affect the supposed outcome:

Firstly, while the rise of the EV** may seem inexorable and rapid, Bloomberg recently forecast that the displacement of oil usage by EVs would be some 7MM bpd by 2040. Compare this figure with current global oil production of c. 100MM bpd. An incremental change over the next 20+ years will not happen in isolation, and it is hard to take into account how demand for more ICE vehicles in so-called emerging markets may rise over the same timeframe, offsetting likely declines in terms of generating capacity and industrial processes. Yet even in the case of industrial processes, demand for petro-chemicals is likely to continue to rise for the foreseeable future, absent a radical re-think or rapid replacement of those same processes.

Secondly, the rise in demand for EVs is unlikely to be smooth, as it creates its own economic and geopolitical consequences and risks. Consider the days when the Middle East completely dominated oil production, and the fact that now mining house Glencore is seeking to expand production of cobalt (essential for most EV batteries), when over 50% of reserves come from the chronically unstable DRC; or that it seems quite clear that the PRC has set its sights on controlling the supply of the lithium (another essential component) needed to support its own push towards EV usage. And what of copper? While its mineable resources may be more widely spread geographically, the amounts required to create clean energy infrastructure are so large that it seems likely that there will be a push to consolidate that market.

Thirdly, all those new EVs will require a network of charging stations in the same way that ICE vehicles now have gas/petrol stations, leading to disruption in real estate markets as those seeking prime locations (which cannot be replicated) are constrained by lack of supply. The ICE re-fueling network is hardly going to be re-purposed that easily. And more EVs will lead also to increased (not lower!) demand for reliable 365/24/7 electric power generation from baseload sources. While oil itself may form a smaller part of the fuel for such capacity, its “sibling” natural gas is likely to see demand rise.

As Sanford Bernstein pointed out in a recent report (The Future of Oil Demand) “…the pace and the path of ending an extractive industry [i.e., oil] are measurably slow and uncertain.”

Therefore, it seems that the probability of any near-term “death of oil” has been greatly exaggerated. Decline over the forthcoming decades may at some point become first relative and then absolute, yet many of us are likely to be in our dotage (or worse!) before the end of oil arrives.

As always, the Awbury team constantly assesses key scenarios such as the future demand for oil to ensure its ability to make appropriately-informed judgements on existing and future portfolio risks and opportunities.

The Awbury Team

*Internal Combustion Engine
**Electric Vehicle

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Vollgeld or Fool’s Gold…?

On June 10th the good burghers of Switzerland will vote in a federal popular initiative (referendum) that is causing some consternation amongst the country’s banking institutions, including the Swiss National Bank (SNB), the central bank. The proponents of the referendum seek to end the system of fractional reserve banking within Switzerland, through which local banks (as in all other major global banking systems) in effect create so-called “private money” when they create new assets through lending, and hold only a fraction of their reserves in “central bank money” as created by, e.g., the SNB (or the Federal Reserve, ECB, or Bank of England) and backed by the full faith and credit of the sovereign.

This may all seem rather arcane, but the reality of the modern world is that most “money” in an advanced economy (often over 90%) does not consist of notes and coins, but rather exists because of the activities of its banking system as it makes loans and takes deposits. “Runs” on banks occur (with the film It’s a Wonderful Life being the paradigm in popular culture) when a bank’s customers all want “their money” back (in the form of true cash) at once- something which no modern bank can do because of its inherent leverage. The entire system is based upon confidence.

The idea of having at least some sectors of the banking system (usually those which deal with individuals or small businesses) operate more as utilities with a “full reserve” model is not new (President Roosevelt rejected the Chicago Plan in 1933, creating the FDIC instead), but the Vollgeld referendum proposal represents an extreme version in that it would require the SNB to become the sole provider of Swiss Francs to the financial system, as all Swiss Franc sight deposits (some CHF 555BN at end-March 2018) would be required to be held at the SNB. This has caused the usually apolitical institution to characterize the referendum as a “dangerous experiment”.

In effect, if the referendum were to pass (which still appears unlikely, although certainly a “fat tail” risk in an era of populism), the SNB would determine the amount of money provided to the Swiss economy, effectively controlling directly one of its key levers. Of course, historically, central banks have used various mechanisms to control money supply and lending (who can forget the Bank of England’s “corsets”?), but have stopped short of being the sole source of money, allowing regulated banks to create the above-mentioned “private money”.

While implementation of the Vollgeld Initiative would be unlikely to cause the Swiss banking system or the economy to seize up, it would increase friction with unforeseeable consequences, as the “experiment” has not been tried before in a developed economy. As such, in a world in which economic stability is often hard won, and easily disrupted, the Initiative represents another factor potentially adding volatility and uncertainty.

At Awbury, the existence of the Vollgeld Initiative counts as a “known unknown”- an observable potential event, but one with as yet uncertain parameters in terms of outcomes. As such, we shall continue our monitoring of it as another factor in the ever-changing risk matrix that makes life as underwriters of credit, economic and financial risks so “interesting”!

The Awbury Team

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Italy- Dolce Far Niente…NOT!

With Italian President Mattarella effectively refusing to grant a mandate to Prime Minister designate, Giuseppe Conte, because of the coalition of Five Star Movement (5SM)/Lega Nord (LG)’s choice of an avowedly “Euro-skeptic” Finance Minister, and granting a mandate to another “technocrat”, there is renewed turmoil within Italian politics, particularly as the President’s decision has no apparent precedent in post-1945 Italian politics.

To say that this latest outcome of the elections held earlier this year was unexpected would be an understatement- as current financial market reactions emphasize. On the face of it, the origins, core support and political platforms of each of 5SM and LN “should” have made their ability to agree on forming a governing coalition implausible to say the least, which just shows that there are plenty of “fat tails” still lurking in the democratic process- as further demonstrated by the Italian president’s subsequent actions.

Therefore, it is worth examining some issues which may arise, not just for Italy, but for the EU, should a 5SM/LN government ultimately take power, as may still happen after another round of elections likely to be called for later this year.

Firstly, both parties are demonstrably skeptical of the value to Italy of being a (founding) member of the EU, as well as of the Euro as its currency. As is now a matter of some notoriety, a leaked earlier draft of a purported coalition agreement suggested not only leaving the Euro (and even the EU), but also asking the European Central Bank (ECB) to “forgive” some EUR 250BN (sic) of sovereign debt.

Secondly, the Prime Minister designate, Giuseppe Conte, assuming he gets a second chance, is an academic, which begs the question of exactly who would be in charge of a 5SM/LG coalition government. How the supposed head of government would actually be able to enforce policy, when faced by two party leaders used to their own way remains to be seen. Conte was a compromise, and clearly “disposable”.

Thirdly, a 5SM/LG government would be likely to have very fraught relationships with both the European Commission and the ECB, as its coalition members regard themselves as “fac[ing] continuous attacks from unelected Eurocrats” and seek overtly to overturn the BRRD governing how bank insolvencies are managed, while suggesting that recovery of debts from retail debtors should require judicial sanction. In a context in which the EU is already faced with Brexit, as well as the increasing illiberalism and defiance of the Polish and Hungarian governments, the addition of Italy to the “defiant” category would serve only to increase instability. The rejected first-choice Finance Minister amply demonstrates the point.

Fourthly, while 5SM wishes to introduce a basic income for all citizens, the LN wishes to slash and consolidate tax rates, aiming to grow out of austerity and somehow manage to avoid increasing Italy’s budgetary deficits and borrowing levels. As the phrase goes, “something has to give”.

Of course, the Republic of Italy has a decades-long history of problematic governance (as well as, more recently, economic underperformance), and it would be easy to dismiss the latest events as “no worse than before”. Perhaps they are. However, there does appear to be an increasing risk that a new coalition government, led by two parties who do not subscribe to many of the expected norms, and have minimal to no track record of responsible and pragmatic economic management, would create a climate of increased confrontation with its EU peers, and engage (because of Italy’s importance to the “European Project”) in a dangerous game of seeing who would “blink first” in order to achieve its goals. Pretending that somehow the norms will prevail has echoes of the Weimar Republic.

The Awbury Team are long-standing students of political instability and its potential consequences, bearing in mind that such scenarios bring opportunity as well threats, so we shall be watching closely as the drama continues to unfold.

The Awbury Team

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Geo-politics and the art of randomness…

Trying to predict trends across the geopolitical landscape is always interesting, particularly when there is so much noise around, which makes determining what is material and potentially threatening into an exercise in probability-weighted scenario analysis.

Some examples:

Italy: will the pending coalition government of Five Star Movement and Lega Nord, become a comedy of errors or commedia dell’arte?

Malaysia: will Dr. Mahathir Mohamad really be willing to curb his hitherto autocratic tendencies and cede his role to his former protégé and nemesis, Anwar Ibrahim?

Argentina: a call for help to the IMF. Will it result in stabilization, or political defeat for economic reforms?

North Korea: who knew that a hitherto hermit hereditary dictator could be so charming, as well as deeply paranoid (not without reason)?

ZTE: political target; collateral damage; or the excuse for a rapprochement between the US and the PRC?

Of course, history is littered with examples of events that, while noteworthy, did not seem that important at the time, but turned out to have momentous consequences:

– Germany facilitating Lenin’s return to Russia in 1917
– Just another political assassination in Sarajevo in 1914
– Nixon’s visit to China in 1972
– The fashion for garage workshops in the Bay Area in the 1970s

As Kierkegaard said: “Life can only be understood backwards, but must be lived forwards”- at least in this universe. Discerning those events or factors which are truly important is far from simple.

All this makes the life of an underwriter an exciting one, as he or she tries to decide whether what is happening is just a sideshow and distraction; a mask for hidden trends; the first order in a subsequent cascade; or the emergence of a new category of risk.

The ZTE situation is worth pondering. While supply chain risk is not exactly something new, the fact that a significant PRC manufacturer was essentially put out of business overnight through unconstrained executive diktat, and then potentially given a stay of execution on further whim, is evidence that applying logic and rational thought to risk assessment is not always enough. Arguably, there should now be a “ premium” (and not of the beneficial sort) applied to any obligor that is a potential hostage to political fortune and caprice, and not just in relation to the US, as other governments are more than capable of such actions.

And what is one to make of underwriting the risks of exposure to a company, Tesla, whose CEO and dominant shareholder decides that “joking” very publicly about impending bankruptcy, or refusing to answer “boneheaded” questions is an appropriate exercise of management discretion? This may seem containable in risk terms- but, given the Cult of Elon, the failure of Tesla would almost certainly have not just direct industry impact, but also reverberate well beyond the United States, for example potentially calling into question market assumptions for cobalt demand and pricing (and thus affecting the DRC).

Amidst all the cacophony, the Awbury Team continues to focus on originating, analyzing, structuring and pricing risks that are highly unlikely to be “side-swiped by randomness”; ensuring that returns contain an ample safety margin; while constantly scanning our environment for changes that could be material with a view to keeping well ahead of the arc of creative destruction.

The Awbury Team

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Red Dragons and Bald Eagles…

The range of conflicts and confrontations between the US and the PRC seems ever present in the news headlines, with reaction following action in what seems like an endless loop. Of course, Russian revanchism; machinations on the Korean peninsula; and the various potential “flashpoints” in and around the Middle East add further layers of distraction.

However, the tensions between the US and the PRC amount to rather more than headlines, “sound bites” and political posturing- it is all much more serious than that, as the US, a constitutional democracy, is dealing with an unconstrained autocracy, which does not even subscribe to the rule of law.

A contest is clearly under way between the world’s two largest economies for supremacy over whatever global power structure they wish to create, or allow to exist. After World War II, the former Soviet Union and its satellites clearly lost a prior battle with the US, no matter what President Putin and his sycophants and fellow travelers may think, during a period when the PRC was first walled-off from the wider world and then internally-focused on re-building its industrial base and infrastructure. Until quite recently, the PRC had adhered to the approach formulated by Deng Xiaping of “keeping a cool head and maintaining a low profile”; and even the PRC’s current President (and now paramount leader) Xi Jinping would state that the PRC was no threat to anyone.

Now, in a scenario exacerbated by the “zero-sum” approach to international relations adopted by the current Administration, the PRC’s leadership is starting to push back, seemingly confident that it has the support of its vast population (over which it is re-exerting ever more control); knowing that the entangled supply chains and expansion plans of many US businesses lead back to the PRC; and relishing the fact that, through its treatment of them, the US seems now to go out of its way to weaken the support of its supposed allies.

Of course, this is not to say that a direct “kinetic” confrontation is inevitable; nor that the PRC seeks an outright “trade war” with the US (which any rational person realizes benefits neither party, nor the wider world economy). Nevertheless, the tone has changed, with both sides increasingly testing and probing the other to understand how far a particular course can be followed before provoking a reaction. A prime example of this is the increasing “fact” that the South China Sea is now a maritime buffer zone for the PRC, which clearly intends to force the US’s Pacific Fleet out of being able to control the area in the event of war (say, provoked by a PRC decision finally to “incorporate” Taiwan into the Middle Kingdom). No doubt, many interesting war games are being conducted by the general staffs of both the PRC and the US.

The optimistic scenario would have the US and the PRC realizing that co-operation is better than confrontation, particularly given how intertwined their economies truly are. A more pessimistic one would be the PRC’s leadership taking the view (not unreasonably) that its own population is far better conditioned to bear pain, than that of the US, and at some point no longer seeking compromise in the face of what it might consider provocations, or the attempted humiliation by one great power of another. So, the real question becomes: at what point does either party believe that it has the ability to “win” an outright confrontation, and what means will it choose to do so? A direct military confrontation is possible (as there is an increasing range of “flashpoints”); but a more likely scenario is a combination of economic “warfare”, cyber-confrontation, and proxy wars of the sort fought between the US and the former Soviet Union.

At some point, we are likely to find out.

Naturally, the Awbury team maintains a close watch on geo-politics and economic factors in order to assess how they may impinge on the risks we have or may choose to accept within our portfolio and to ensure that, at all times, the ratio of risk to reward remains acceptable.

The Awbury Team

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Cultural appropriation…

While any self-respecting (re)insurer would not be taken seriously without a risk management process that established a Risk Appetite, set Risk Limits, and carefully managed potential aggregations across various factors and product lines, there is one area in which it can be somewhat harder to discern a company’s approach- namely, its Risk Culture, whose purpose should be to ensure that the enterprise not only survives, but prospers and achieves its objectives.

Unlike Mission Statements, articulations of Risk Culture tend not to be published, so one is often left guessing. What is also interesting is that formal definitions of what a Risk Culture is tend to be value neutral- for example (from RIMS) : “values, beliefs, knowledge, attitudes and understanding about risk shared by a group of people with a common purpose…”; which begs the question of what such a statement can be expected to clarify or signal, other than some commonality.

In reality, of course, any such statement is pointless without an overlay of judgement, as well as effective transmission both within and external to an enterprise where appropriate- and its content has to be applied.

So, how does one inculcate and embed a Risk Culture?

Firstly, the tone has to be set at the top, as a Risk Culture is a sub-set of an entity’s overall culture (and, in fact, co-dependent with it): it amounts to a “soft” control. If the consistent behaviour of a Board and senior managers does not set an example, it is naïve to expect that anyone else will pay much attention. The individuals responsible have to have a clear idea of the standards they expect to be adhered to, including by themselves, and a mechanism for ensuring that they are adhered to.

Secondly, expecting that individuals will all act ethically and appropriately at all times in the absence of factors other than their innate sense of what is “right” can be misguided: not because anyone should be considered amoral a priori, but rather because external factors and influences are important. “Good” people can do bad things and still consider themselves “good” because their value judgements have been influenced by factors such as fatigue, the “slippery slope” from minor to more serious transgressions, misplaced organizational loyalty, or inappropriate incentives. Therefore, the rules and goals of what is acceptable or expected have to be obvious, even if they are not set out in detail.

Thirdly, how the “culture” is safeguarded and transmitted is also important. In a (re)insurer, this responsibility will usually be assigned to the CRO, who will need to employ different approaches depending upon circumstances, because no single technique will be sufficient. So, the CRO will need to coach and build relationships; offer expert advice; be a steward of culture and ethics; and be willing to challenge decisions or behaviours that may adversely impact the entity’s success or reputation. Therefore, the role, particularly in a large, complex organization, is a demanding one, requiring a broad range of skills and attributes.

Everyone likes to believe that their organization’s Risk Culture is “fit for purpose”, but this can be difficult to demonstrate, as the concept can seem rather amorphous. As Andrew Bailey, Chief Executive of the FCA commented; “Culture is “everywhere and nowhere”… [it is] an outcome more than an input”

At Awbury, we are fortunate to have, in essence, grown together as a cohesive unit in building our business and franchise. We all interact frequently and comprehensively, and so are direct custodians of each other’s actions, individually and collectively. Given that our reputations and livelihood are inextricably and directly linked to the group’s continuing success, we believe that our culture and Risk Culture have become innate and inseparable. Of course, being Awbury, we would never assume that our approach is “the best”, nor that we should consider it immutable. However, we do believe that it is fit for purpose.

The Awbury Team

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