What if…it had been worse?

Lloyd’s of London recently published a useful paper (https://www.lloyds.com/news-and-insight/risk-insight/library/understanding-risk/reimagining-history) on counterfactual risk analysis- a topic that will appeal to viewers of “The Man in the High Castle”, or readers of the novel Fatherland.

Counterfactuals, or “what ifs?” are interesting, because they require an individual to consider how even a small change can have a significant impact. After all, the “Russian Revolution” succeeded almost in spite of its primary actors; but what if it had not?

Turning to the more prosaic world of (re)insurance, the world of NatCAT is full of “what ifs?”- for example, the track of Hurricane Irma being 20 or so kilometres east, such that it hit Miami directly?

As the Lloyd’s paper quite properly (and importantly) points out, there are both “upward” and “downward” counterfactuals- the former asking what would have happened if things had turned out better; and the latter if they had been worse. One does not really want to operate on the basis of the “upward” approach!

Thinking about and modelling different potential outcomes, while now carried out on an industrial scale, both inside and outside (re)insurers, is still prone to bias and the lure of “commonality”. Paradoxically, if a regulator requires those it supervises to model the outcome of a series of standardized scenarios, it may create for itself a useful comparison of relative vulnerabilities or weaknesses across it charges, yet at the same time run the risk of causing them (and itself) to be constrained in thinking about risks that fall outside the dataset used.

Therefore, it becomes important to think about risk with less constraint, because “out of experience” or “unmodelled” events have the unfortunate habit of occurring rather more often than they “should”. Modelling the probability of defined risks to a 1-100- or 1-in 250-, or even 1-in 10,000-year standard is all very well, but what if it is the “wrong” risk, or the estimate of probability or consequence is seriously flawed? What if it is “not in model”?

Of course, some risks are inherently constrained or obviously bounded. For example, if one is an unleveraged equity or debt investor, one can only lose 100% of one’s investment; whereas, the risk of loss from, say, a rapid series of sequential and inter-connected defaults by large, highly-leveraged financial institutions can wreak damage far beyond anyone’s or any then extant model’s expectations.

In the realm of (re)insurance, managements will also argue that they have controls over aggregation of risks; set careful limits based upon rigorous technical underwriting; and, naturally, have a carefully-crafted programme of reinsurance and/or retro in place. However, given that each (re)insurer is an autonomous actor, which tries to protect the proprietary nature of its risk management protocols, what if all the assumptions about network linkages and effects are wrong and the “Big One” (whatever it is) occurs? Having focused on first-order effects, they potentially miss the second- or third-order ones.

Interestingly, the issue with counterfactual analysis is not that something could not have happened, but more often that it was not conceived of as capable of happening; or a necessary connection was not made; or an event forgotten. Intriguingly, the Lloyd’s paper also makes the point that many European languages do not have any expression equivalent to English’s “counterfactual history”. As Wittgenstein said: “The limits of my language mean the limits of my world”, which begs the question of vocabulary as a constraint upon conceptualization.

In the world of NatCAT, post-event analysis often tends to be limited to understanding what happened and why; but gives little, if any consideration, to what might have happened, which is unfortunate because, yet again, it means that thinking and modelling become self-limited. One has to believe that, in an era where the resources available to model and develop scenarios are becoming ever more powerful, it should be possible to generate counterfactual scenarios and outcomes with more frequency than appears currently to be the case.

At Awbury, we do not pretend to be believe we are infallible. However, we do believe that our thinking should be as unconstrained as possible, so that we minimize the risk of downward counterfactuals.

The Awbury Team

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Innovate effectively, or become a Zero…

The news of the creation by Google’s DeepMind unit of an enhanced and self-taught AlphaGo Zero, which trounced its own progenitor AlphaGo, and appears to play not only differently, but at a different level from human experts, set the Awbury Team thinking about the topic of innovation and change.

FinTech and InsureTech are all the rage, with more and more (re)insurers announcing “venture” units that seek access to new ideas and technologies externally; while predictions are made constantly about the industry being yet another one to be “disrupted” (another newly-fashionable term). Executives may wish to ponder the meaning and consequences of the word, and the fact that it implies that they are in danger of losing control over the destiny of their own businesses to others- disrupt, or be disrupted, because business as usual is not an option for most.

Whether rightly or wrongly, there is also a perception that the (re)insurance industry itself is “out of ideas”; and at the mercy of the latest “fad”, as it seeks desperately to find revenues that will augment its current “zero-sum”, commoditized business lines, and tries to justify losing tens of billions of dollars as a result of the recent spate of NatCATs, wiping out years of profit accumulation.

One can see similar patterns in other industries, where the incumbents, having become complacent, find that they are no longer able to generate significant ideas themselves, and have to rely on third parties to do the basic research that they themselves used to do- “Big Pharma” now being a classic example. The glory days of Bell Labs and Xerox PARC are long gone, while many governments seem to regard funding basic research (other than for “defence” and “national security”) with disdain, because it does not serve the particular vested interests to which they are in thrall. Clearly, there are pockets of excellence such as DeepMind and various university research departments, but too much of what passes for innovation is merely disruption and a “re-hash” rather than original- such as Uber, or WeWork. The so-called “gig economy” is hardly a step forward in human progress.

This matters; because, while the “D” in “R&D” is also essential, without the basic research on which it builds, there can be no progress. Incrementalism is all very well, but Humanity’s welfare has historically improved because of step-changes resulting from different modes of thinking.

So, the (re)insurance industry needs to focus on how it can generate truly fresh ideas itself, that will enhance its offering and margins. If it does not, others will consume its premia, and it will become increasingly obsolescent, as investors lose patience with moribund returns that do not even meet the cost of capital. There is absolutely no reason why a Google, Amazon, or Apple cannot create (re)insurance businesses built upon new business models, and almost certainly using artificial intelligence (AI).

The ability to generate executable and scalable new intellectual property is a fundamental requirement for any business that wishes to survive and prosper. Note the use of the word “executable”. Paradoxically, while basic research and new ideas underpin progress, if one cannot then execute on them, the enterprise is pointless. One’s lunch will still be eaten!

At Awbury, while we regard ourselves as an integral part of the industry, our franchise depends upon both innovation and execution; and we have absolutely no intention of becoming “zeros” as we build for the long term.

The Awbury Team

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Homage to Catalonia…

George Orwell (who was badly wounded in the Spanish Civil War fighting against the fascist insurrection led by Franco) must be spinning in his grave in light of the Catalan regional parliament’s declaration of independence for Catalonia (or rather Catalunya- one of 17 Spanish regional governments) as an “independent republic” (no more Spanish monarchy for Catalans!)

Not surprisingly, the Spanish government has subsequently exercised its own “nuclear option”; and invoked direct rule over what it sees as a recalcitrant province, led by fantasists bent on destroying the Spanish state (for if Catalonia goes, one can be fairly certain that the Basques at the least will aim to follow.) For avoidance of doubt, the action of the Catalan government is considered a criminal act by Spanish loyalists, as the constitution provides no mechanism for secession. The difference from the UK is that the Scottish referendum on independence was a negotiated process, not unilateral.

One only has to look at the recent history of Europe to be concerned about the potential consequences of the Catalans’ actions; especially since, even within Catalonia, it is considered arguable that there was no true majority in favour of independence and that what was characterized as a referendum was a “democratic coup”. Not surprisingly, no other sovereign state has recognized the “Catalan Republic” as a lawful sovereign entity.

It should be said that Awbury’s interest in these events is “academic”, in the sense that we have no direct or even indirect exposure. However, as we have written before, we are always looking for second or third order effects beyond the obvious.

Of course, it is far too early to predict how the relationship between Catalonia and Spain will evolve, but the legal consequences are already becoming evident, as large corporations move their legal domicile outside the “republic”.

One can also imagine that a frisson of concern is moving across the investor, trade credit and political risk markets. What happens if Catalans resist the central government, such that the rule of law breaks down, taxes go unpaid and uncollected, or an economic blockade is imposed? What if a local Buyer wishes to pay, but cannot because the local banking system is not functioning for “external” payments?

Taking the scenario further, what if Spain as entity begins to unravel, as the former Yugoslavia did some 25 years ago (without the bloodshed one sincerely hopes!)?

Under the conventions of international law, sovereign debt passes to successor states. Spain currently has approaching EUR 1TN of obligations. Apportioning that across a fragmented range of successor states would be a nightmare. It is somewhat ironic, that less than 5 years ago there were legitimate concerns about the ability of Spain to meet its obligations, as it suffered a wrenching recession, from which it has begun to recover; and now, when that concern should have been obviated, it may begin to return because of the political acts of a recalcitrant minority. Compounding the issue is that much of Spain’s sovereign debt is held by offshore investors, including the European Central Bank (ECB). While the risk of dissolution and default is still remote, the fact that the possibility now exists is telling, because a year ago it would have been considered laughable.

And bear in mind that Spain is not the only major European state with a separatist movement (leaving aside the UK). Italy has long had a north-south rift politically; and one can imagine that the Lega Nord is watching events in Catalonia and Spain with some interest.

The overarching point here is that risk can appear out of a “clear blue sky”, and that one has constantly to update one’s knowledge and understanding of the risk terrain and the possible ambush sites. The risk of Catalan secession was not an “unknown unknown”, but we are quite sure that it feels like an ambush to many.

The Awbury Team

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Nudge, nudge…

As the recent award of the Nobel Memorial Prize in Economics to Professor Richard Thaler demonstrates, ideas that seem absurdly simple can cause a significant change in behaviour and, thus, outcomes.

For someone of whom his thesis adviser said: “We didn’t expect much of him”, Professor Thaler has had quite an impact by incorporating better understanding of how human beings (rather than the idealized homo economicus beloved by most of his peers) actually make decisions, and applying that to improving public policy. As he himself said after the award was announced” “In order to do good economics, you have to keep in mind that people are human”. How shocking!

All of this matters because, rather than just showing that people are irrational (obvious, but not exactly helpful), he was able to demonstrate that they tend to be irrational in consistent ways, so that reality can be modelled and channeled. Perhaps the most famous, and potentially far-reaching example is in the design of enrolment systems, such as for pension schemes, changing them from “opt-in” to “opt-out”, and thus significantly increasing the level of involvement.

Of course, the world being what it is, such actions are dubbed “libertarian paternalism”, with the emphasis on “paternalism”, which must be a bad thing because it deprives us of our “free will” and the right to make a mess of our lives and futures. And the world also being what is, such an approach can and is used to manipulate people into continuing to pay for services that they do not want- the “Free 30-day trial, auto-renewal” approach. As always, the use to which an idea or technique is put can often be ethical or unethical.

Professor Thaler also demonstrated that we humans are prone to the endowment effect. We are reluctant to part with something we already have unless we receive more for it than we would have to expend to acquire the same item if we did not already possess it. What we have is considered more valuable.

Perhaps less well known is Professor Thaler’s suggestion that (following the work of psychologist Gary Klein, and Thaler’s fellow Nobel Laureate, Daniel Kahneman) “premortems” (yes, you read that correctly) be used more widely in the context of particularly important decisions as a means to counteract the dangers of “groupthink” and overconfidence. In essence, people are required actively to contemplate the consequences of failure before it can happen. Such an approach is not intended to lead to decision-making paralysis, but may help avoid overreach and the fact that, by the time of the postmortem, it is a little too late! At Awbury, we are always trying to ensure that we avoid the dangers that stem from the “usual approaches” to decision-making, because we would rather not be the subject of a postmortem!

And one finding of Professor Thaler which is particularly dear to the Awbury Team is that people place a high value on fairness. They will penalize behaviour that they consider unfair, even if doing so is to their own detriment. As we have written before, a fundamental tenet of Awbury’s business model is that interests must be properly aligned and the economic outcomes and benefits of any transaction or structure be allocated fairly to create an actual “win-win” outcome. This is not always easy, but it is not altruism (we are a business after all!), but simple common sense. No-one likes to think that they have been “ripped-off” or taken advantage of, and it is detrimental to building a sustainable franchise.

So, how can we help you?

The Awbury Team

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Quantum Mechanical CDS…

Credit Default Swaps (or CDS) have been around for over 20 years by now; and their use has waxed and waned over time. One of the arguments that has been used to assert their superiority over other credit risk mitigation or management techniques has been that the nature of their triggers and documentation (under various ISDA protocols) provides “certainty” of payment as long as the fee for protection has been paid.

The title of this blog is homage to an excellent post on the Dealbreaker website entitled “Schrödinger’s CDS”, which alluded to Heisenberg’s Uncertainty Principle and the famous thought experiment about whether, in the weird world of quantum mechanics, a cat could be both alive and dead at the same time; making the point that, in the world of CDS obligors there are supposed to be only 2 possible states- either “normal” or “defaulted”- i.e., no payment due, or payment due.

However, a recent controversy involving the ailing Noble Group has called into question the validity of this binary assertion about state. To sum up, when Noble Group extended loan payment terms on some of its debt parties who had bought protection on the company’s debt asserted that the action triggered payment on their CDS contracts. Given that there are apparently some USD 1.2BN of CDS contracts written on Noble Group’s debt, involving many different parties, the potential claims could be significant (with the FT quoting a figure of “up to USD 157MM”).

The question of whether a trigger had occurred was meant to be determined by the Industry Determinations Committee (IDC) mechanism managed by ISDA, in which 15 members (10 sell-side and 5 buy-side) vote on whether or not a “credit event” has occurred and, thus, payments triggered.

In the case of Noble Group, for reasons which have still not been properly explained (hence Dealbreaker’s mocking post) other than a statement that there was “insufficient information”, the relevant IDC was unable to make any determination at all. Naturally, this resulted in confusion, and no little amount of disbelief and frustration all round, as a mechanism that was supposed to end the practice of bilateral “flurries” of notices of claim and create certainty singularly failed to do so. ISDA has been at some pains to distance itself from the shambles, claiming that it is only the secretary and administers the process: “…we don’t have a vote and we don’t make decisions”.

The IDC then re-considered 2 formal questions posed to it by counterparts involved in the saga; and gave a narrow ruling that any attempts to trigger a payment had to be accompanied by “publicly available information” confirming the existence of particular language. It is unlikely that the CDS market’s major participants will be satisfied; and it has not gone unnoticed that the composition of the IDC creates inherent conflicts, rather than alignment of interests.

And in a further blow, the ICE (owner of the NYSE and LIFFE) has now stated that it will no longer oversee the administration of the DCs, because it cannot agree indemnification from the member banks and investment groups in the event of litigation, which puts ISDA itself as the Secretary of the IDC structure in the position of needing another third party to replace ICE.

At Awbury, our goal is to create and issue contracts which provide carefully-crafted, clear and unambiguous protection against a particular risk or risks, in ways which not only properly align interests, but provide certainty; because creating the potential for an ambiguous and disputed outcome such as occurred in the case of Noble Group’s CDS contracts helps no-one.

The Awbury Team

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That’s the good news?! How about the bad?

So, major hurricanes are like buses- you wait for ages for just one, then 3 or more of them come along at once.

Of course, the human and economic cost of Hurricanes such as Harvey, Irma and Maria (or of the Mexican earthquakes) has been devastating; and those affected deserve all the support available.

However, while the (re)insurance industry thought it had had a narrow escape when Irma’s path managed to miss Miami, Maria’s impact brought home with a vengeance how Nature often manages, once again, to prove that CAT models are simply that- models, making a mockery of stated Risk Appetites or Tolerances. The growing catalogue of profit warnings and earnings revisions demonstrates that point very clearly, with rumours that some retro markets may see loss ratios that will make their managements wonder why they ever thought writing such business was a good idea.

The first half of 2017 has already been a relatively weak one in terms of industry profitability and underwriting results; and, while the range of loss estimates for Q3 CAT is still broad, if claims payments reach the USD 150BN level, that will be roughly the equivalent of 1 year’s gross premia for the global reinsurance industry, as a senior Scor executive recently pointed out- and multiples of annual net underwriting income.

So, what is the good news? That the industry has ample capital of some USD 600BN (although that is distorted to some extent by the size of Berkshire Hathaway’s capital base), even if certain markets (such as Lloyd’s) are likely to be disproportionately affected.

And the bad? That, contrary to hope and expectations, the combined costs of Q3’s CAT events may still not be enough to reverse trends and materially harden the market beyond an initial period, unless the sources of alternative capital (currently making up some 14% of the USD 600BN) take fright; decide that the “non-correlated-returns” thesis is no longer valid, and so pull back from replenishing their investments. This will mean a continuation of the uncertainty of trying to generate premium flow that has margins about technical levels.

However, if past behaviour is predictive, there are likely to be at least some new “Class of 2017” entities created to take advantage of potential changes, and, if rates do rise for any period of time, it seems highly likely that fresh alternative capital will be provided- yet its arrival may well cause a further softening.

As a result, all eyes will be on the January 1st renewals, and whether the industry’s underwriters will be sufficiently disciplined to impose rate increases that reflect the impact of 2017’s losses on profitability and capital- although that will only affect one business line, not all the other, commoditized ones where pricing is still deteriorating, or at best stabilizing at marginal levels.

Although Awbury does not write any NatCAT business, we shall be carefully looking for second and third order effects (such as whether there are still-hidden pockets of overly-concentrated retentions within the industry). Importantly, recent events should continue to reinforce the point that our core E-CAT (economic, financial and credit catastrophe) franchise remains the source of highly-attractive, truly non-correlated, risk-adjusted returns for our reinsurance partners.

The Awbury Team

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Sighs of relief all round…but is that appropriate?

To say that the latest Rendez-vous occurred at an interesting time, is probably an understatement- not one US-landfall hurricane, but two (and with potentially significant levels of insured losses), and the “record-breaking” (and not in a good sense!) Equifax data breach.

Of course, the outcome of Hurricane Harvey in particular could have been far worse- not many miles to the east and it could have made Hurricane Katrina look like a mere Tropical Storm in comparison.

Such events demonstrate, of course, that, as evidenced by the volatility in the share prices of many publicly-quoted (re)insurers, writing property CAT business tends to produce moments of sheer panic amidst long periods of calm; while many (re)insurers are probably thankful that individual line sizes on cyber covers are still not that large.

So, the “profit warnings” for the publicly-quoted (re)insurers have begun, with Munich Re bravely going first, even though its management can have no accurate way of knowing with any certainty exactly how great the impact of recent events will be on its P&L and hence capital account. However, it would be fair to say that those companies which focus heavily on property CAT and BI covers are going to have a poor end to the year, as their “catastrophe budgets” will be significantly exceeded after years of relative calm.

Given that aggregate Insured Losses could easily be in the USD 40 to 50BN range (estimates at present are simply just that), and the combined storms are up there with (or exceed) Katrina in terms of their economic impact, it still strikes us as astonishing that no-one is yet comfortable predicting a truly hardening market in the most affected product lines- merely conceding that that the decline in pricing may (may) finally come to an end, with perhaps a modest uptick. The January 1st renewal season will be interesting.

Simply put, there remains too much capital and too many enterprises chasing not enough premium and demand; and the fact that many Combined Ratios are likely to go over 100% for 2017 evinces barely a shrug, as long as everyone is suffering at the same time. The concept of a “catastrophe budget” is in some ways an odd one. If catastrophes can truly be modelled with a reasonable degree of certainty, should the “budget” not take account of that probability and reflect it in pricing and hence premiums? Perhaps there needs to be a new category introduced of a “tail-CAT”- i.e., an event of a scale that truly is exceptional: hard to model; and for which capital does what it is supposed to do, which is absorb unexpected losses. If it is in the “budget” it should be in the pricing!

Awbury’s core business remains providing its clients with protections against material, “tail” credit, economic and financial risks (E-CAT). Therefore, our success depends and will continue to depend on designing bespoke products, and achieving pricing that far exceeds the risks posed by the tail events covered, thereby generating large, scalable premiums flows which are not correlated with, nor impacted by NatCAT events.

Of course, the fact that we operate outside the commoditized realm and are value-added price setters, does help; although we would never be so foolish as to believe that we can never be wrong- but we have capital for that!

The Awbury Team

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