Time to re-assess CAT models?

As is now customary, Munich Re released its annual overview of CAT losses (https://www.munichre.com/en/media-relations/publications/press-releases/2019/2019-01-08-press-release/index.html).

While the “headline” numbers of USD 160BN of losses and USD 80BN of insured losses were by no means as severe as the trauma of 2017 (USD 350BN and USD 140BN respectively), nevertheless, the insured losses were almost double the 30-year, inflation adjusted average of USD 41BN.

Of course, one can debate the validity of using simple “inflation adjustments” as a metric for what a “normalized” and average CAT year should produce; and there will be those who, quite reasonably, say that 2 years of results do not constitute a trend.

However, as the world’s population continues to increase and climate volatility seemingly rises, resulting in changing and increased patterns of severity, it would be a foolish risk manager who dismissed the outcomes of 2017 and 2018 as merely an aberration.

Unusually, the event that caused both the largest overall losses (USD 16.5BN) and largest insured losses (USD 12.5BN) was not a windstorm but a wildfire- the so-called Camp Fire in California. This followed a combination of drought, strong winds and difficulty of access to the affected area. Including other large wildfires, such overall wildfire losses in the state in 2018 were USD 24BN, of which USD 18BN (or 75%) was insured- the worst on record, for a second year.

Not surprisingly, Munich Re commented that the greater frequency of “unusual” events and possible links between them should cause insurers to question whether such events were already built into their CAT models. We would hazard that it is improbable that models in place at the start of 2018 included the possibility of 2 very severe wildfire seasons in a row; which begs the question of how quickly and rigorously such events can and will be incorporated and thus flow through to technical pricing models.

The other factor to notice is that, in the most severe events that occurred, the ratio of insured losses to overall losses showed an increasing trend- i.e., the scale of claims for the most severe events was proportionately higher than those seen historically overall in previous CAT years. One could argue that this was happenstance (i.e., California just happened to be the key epicenter in 2018). However, if climate change is leading to new patterns of risk, and these happen to become more concentrated (at least for now) in geographical areas with both a higher economic value and a higher insured loss percentage (because insurance penetration is much higher for that type of risk), changes to models will surely also have to include new assumptions on insured percentages. Otherwise, “negative surprises” will occur.

So, CAT modelers (and their clients and colleagues) will have to decide how to adjust and re-weight their PMLs and EMLs. Not to do so would expose underwriters to the increasing probability that their technical pricing models were no longer fit for purpose, which is hardly helpful in a market that is still struggling to achieve sustainable price increases to compensate for the CAT losses of the past 2 years.

Of course, Awbury does not write any form of property CAT risk. However, we are very much part of the overall (re)insurer ecosystem. As a result, it would be irresponsible of us to pretend that the CAT events of 2017 and 2018 have no relevance. At first order levels, they do not. However, our aim is always to look beyond the obvious to “further order” effects, including how behaviours and risk appetites may change. We would be remiss ourselves in not updating our own expectations and models.

The Awbury Team

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Bleeding Edge or Leading Edge…battling entropy…

In this world of constant competition and disruption, everyone needs an “edge” to survive and prosper. This is the received wisdom.

There are too many mediocre businesses that somehow survive, limping along, waiting to be put out of their misery- either by their lenders and capital providers, or through the cleansing effect of bankruptcy. As a result, capital and resources, real and intellectual, are misallocated, with a cost to the economy and society.

Of course, it is easy to say that one needs and has an “edge”- both individuals and organizations like to believe that they are above average and more effective than their peers or competitors. However, that is not only mathematically impossible, but patently untrue. Just look around at any industry.

The Second Law of Thermodynamics states: “as one goes forward in time, the net entropy (degree of disorder) of any isolated or closed system will always increase (or at least stay the same)”. In other words, lives, businesses, our planet and the universe all tend towards disorder.

As the Shane Parrish of the excellent Farnam Street blog (www.fs.blog) said in a recent post (entitled “Battling Entropy: Making Order of the Chaos in Our Lives”) “Uncontrolled disorder increases over time”, as systems, societies and businesses have a tendency to dissolve into chaos.

So, in order to move forward and maintain or increase one’s “edge” over one’s competition, one has to make inputs that, when combined, increase control, combat disorder, and provide a net positive value to one’s clients and partners. Most new businesses fail over a relatively short period of time after they are established- even in the S&P 500, comprised of the US’s largest companies, the rate of disappearance has increased over time.

The following quotation (from Roger Zelazny, in Doorways in the Sand) sums up this reality very well: “…there is a law of evolution for organizations as stringent as anything in life. The longer one exists, the more it grinds out restrictions that slow its own functions. It reaches entropy in a state of total narcissism. Only people sufficiently far out in the field get anything done, and every time they do they are breaking half a dozen rules in the process.”

Consider the above in the context of any large, bureaucratic organization. In theory, the order created by systems, procedures, committees and oversight is beneficial and essential for the organization to survive. However, over time, in the absence of constant and diligent re-assessment and intelligent adaptation, organizations’ abilities to get things done and add value decay; and, when the inputs in terms of capital and labour exceed the value (profit exceeding cost of capital) generated, an organization is on borrowed time in terms of its ability to survive for any length of time.

Order is essential, but it must be balanced by creativity; and there is a constant dynamic interplay between these two forces: an organization left to its own devices trends towards entropy, so it needs organizing structure and systems. However, too many structures and systems lead to stagnation and ossification and eventually kill the organization, so it is actually important to maintain a degree of chaos and disorder, and focus on staying far out in the field in terms of innovation to battle complacency. The leading edge is never far from the bleeding edge, and maintaining a balance is hard.

At Awbury, even after 7 value-creating years, we are well aware that we cannot afford to be complacent; nor can we become consumed by the “beauty” of bureaucratic and systemic order. If we do not constantly renew and adapt our capabilities, balancing control with creativity (intellectual property creation) we will run the risk, like every other entity, of succumbing to entropy and decay.

We have no intention of doing so.

The Awbury Team

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Earth Wind and Fire,

Readers of a certain age will recognize the title as a reference to a legendary, genre-spanning music group created in 1969. One could alternatively go back a few thousand years to the Ancient Greeks, who believed that the world was made up of 4 elements, Water, Air, Fire and Earth.

(Re)insurers have long taken earth(quake), wind(storm) and (flood)water seriously in their CAT models, but have tended regard fire as a less likely catastrophic risk, with lower PMLs. This is slightly ironic in the context of the fact that most of the original insurance companies, in the UK and the US, were established to cover fire risks, including Benjamin Franklin’s The Philadelphia Contributionship for the Insurance of Houses from Loss by Fire, founded in 1752.

All that will (or should) now have changed, as estimates for losses from the current spate of wildfires in California run to USD 19BN and are still rising- not, in itself, a threatening amount for (re)insurers’ capital, but nevertheless approaching the levels seen in the other categories. Equally disturbingly, frequency has increased as well as severity.

We are sure, therefore, that firms such a RMS, AIR and Eqecat are rushing to review and update their models, as are the modelling teams in all the major CAT (re)insurers and brokers. It will be interesting to see whether and how events affect pricing and capacity during the forthcoming 1/1 renewal period. Not only that, but it will surely cause corporate risk managers, particularly for power utilities, to re-assess the size of limits they need. After all, one only has to look at the impact of the California wildfires on PG&E’s share price and credit spreads.

So, what lessons and observations can be taken away from such events?

Firstly, that “old” risks, such as fire, that were, no doubt, thought be well understood, can still mutate and cause surprises.

Secondly, if a combination of forest management practices, changing weather patterns and human encroachment can cause such devastating outcomes as in California, which other concentrations of economic value could be vulnerable now and in the future?

Thirdly, tensions between regulators, insureds and (re)insurers are likely to increase. To cover potential losses, rates should increase, but (like flood insurance) homeowners, at least in the US, believe they have a right to build even in areas known to be vulnerable.

Fourthly, the lack of long-term data points is going to make building effective models more difficult, because no-one really knows what reasonable parameters should now be.

Fifthly, new technologies and management practices are likely to evolve to address both the risk and the opportunity.

The overarching point is that even experts can become complacent that the boundaries of certain risks are well understood and so vigilance perhaps wanes. People obsess over “emerging” risks, while overlooking the fact that long-standing assumptions are just that- and need the same periodic re-assessment as any other CAT or (re)insurance risk. Catastrophic fire risk should be a white swan amongst the grey and the black, not a surprise.

As we have said before, to survive, prosper and avoid ruin, one has constantly to re-examine, re-assess and test one’s models and assumptions. Being paranoid helps!

The Awbury Team

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It’s all in the price…?

It is probably a truism by now that P&C (re)insurers’ portfolios of Invested Assets (comprised mainly of Fixed Income securities) have suffered from relatively meagre returns because of some ten years of post-GFC interest rate suppression by the major global central banks.

So the fact that the Federal Reserve has gradually raised its benchmark rate (and is expected to continue to do so) and that 10-year US Treasuries now yield around 3% is often considered a precursor to higher portfolio NII, which is a good thing.

However, it is not as simple as that.

As Stuart Shipperlee of ratings-advisory firm Litmus Analysis recently pointed out, for reinsurers in particular, and especially for those with significant casualty books, expected investment returns on reserves are already built into reinsurance pricing models- and the brokers and their clients know that.

Therefore, if the reinsurance market is competitive and functioning as such, a dollar of premium booked which can be invested (and which is expected to provide a higher yield) becomes more valuable, leading to more competition for that dollar.

Of course, if reinsurers were operating in a generally hardening market, one might argue that they could be less aggressive on investment return assumptions and achieve better desired pricing. Unfortunately, and to state the obvious, that is not really happening except in particular loss-affected lines (and even then not to the necessary extent). The effectiveness of CAT pricing models has also gradually improved over time, so the risks of significant under-pricing should be receding. Unfortunately, that does not of itself lead to the ability to improve underwriting margins- only a truly “hard” market like 1992/1993 can do that.

So, as reinsurers approach the important 1/1 renewal season, one is beginning to hear the now-old refrain that the industry needs higher rates on line and to maintain “discipline” in the face of a broker market that has been used for years to shaving a little off the price every year. This is coupled with a hope that, if investment returns elsewhere begin to “normalize”, perhaps peak-ILS will eventually happen, and the industry’s chronic over-capacity for available business will gradually abate. This seems more hope than likely experience in the absence of some other radical catalyst. Capital will flow to where it perceives that sound non-correlated returns may be obtained- and the ILS market is one of them.

Furthermore, and somewhat ironically, a rising rate environment is likely to drive up reinsurers’ own cost of capital, as investors seek higher returns in that sector. This may give some impetus to a firmer holding of the line on necessary rate increases, but still only creates a “zero sum outcome.”

What reinsurers really need are premium revenues that are non-commoditized and offer strong, non-correlated returns when compared with CAT lines. Some think they have found that in covering “cyber” risks. However, given the inherent difficulties in modelling and setting boundaries to both the nature and the quantum of the constantly-mutating threats, we suspect that some are likely to be suddenly and severely disabused of that expectation.

At Awbury, our focus on underwriting bespoke, value-added credit, economic and financial risks readily provides a more attractive risk/reward scenario, which has generated significant returns for our partners since inception 7 years ago- a situation which we believe is both sustainable and scalable through careful risk selection across a wide range of opportunities.

One should always look well beyond the price and simple rate on line, and instead focus on the long-term risks and value of any (re)insurance business line. That is something we do every day.

Call us.

The Awbury Team

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CRE Can be Really Expensive for Lenders (and Investors)…

As we enter what may well be the late stages of the current economic cycle (with uncertainty exacerbated by looming trade wars and Brexit), we read with interest a recent report entitled somewhat provocatively “The CRE Lending Black Hole”, published by the UK’s Property Industry Alliance Debt Group.

The thesis of this document is that (in the context of the UK), if Commercial Real Estate (CRE) lenders (and investors for that matter) properly analyzed the complete “through the cycle” realised profitability of their CRE lending, they would begin to comprehend that, as the title suggests, it has recently been something of a “black hole”; because all the profits they believed they would make and had booked were negated (and more) by the losses from subsequent write-downs and write-offs. It is important to note that the particular period on which the report focused was 1992-2008; for which the authors calculated that write-offs (GBP 19.3BN) exceeded gross profits (GBP 7BN) by almost 200%- and this ignores losses from equity real estate investments.

We are sure that there will be those who quibble with the numbers and challenge the methodologies used (which are carefully explained). However, the difference between supposed profit and realized loss is simply too great to be dismissed. Furthermore, the authors argue that latent losses were potentially much greater at the bottom of the cycle, with lenders being “rescued” from even worse write-offs by being able to “hang on” and wait for values to recover as the economic recovery took hold. Nevertheless, it needs to be pointed out that the particular time period documented encompassed what was the worst downturn in several generations, and so was something of an “outlier”.

So, why did all this happen? What behaviours were major contributory factors? Could it happen again? Is this just a UK phenomenon?

To the first point, the report makes it clear that the 1992-2008 cycle was a more extreme version of previous ones; which, anecdotally, tend to result in a “crash” roughly mid-way through the second decade of expansion. While not participants, some of the Awbury Team have been around long enough to remember the crash of 1974- not as bad, but one that left scars and caused a secondary banking crisis. As in many other areas of the financial industry, it does seem that memories fade, and those still around, who do remember can seem like Cassandras, and too easily ignored.

In terms of behaviour, as the infamous Chuck Prince quote from 2007 makes clear, no-one likes to leave the party while everyone else is still dancing. Internal and external pressures from peers and competitors mean that one needs significant fortitude to decide that actually now would be a very good time to leave, just as it seems that everything is building to the peak. In fact, one should have left some time before. In addition, each sophisticated lending organization is convinced that its policies and procedures, coupled with the quality of its risk management and governance mean that it will be able to “get out” before it is too late. They are almost invariably wrong.

Since the Great Financial Crisis, the amount and quality of capital held by traditional CRE lenders has increased significantly, regulators are more vigilant, and such key metrics as Loan to Value Ratios (LTVs) more conservative. However, there are signs that valuations are stretched in a number of sectors, while the retrenchment of banks has led to much CRE lending now being undertaken by non-bank actors, which are less transparent to the markets. While many, if not most, are experienced and use much less overall leverage, nevertheless, the concern has to be that there are pockets of vulnerability that could trigger a down-cycle.

As the report makes clear, all its data are from the UK. However, one only has to look at experience in the US, Spain, Sweden, Japan- one could go on- to realize that the experience in the UK is hardly unique.

As students of financial history, the Awbury Team believes that a critical component of managing risk successfully is avoiding succumbing to “market groupthink”; being willing to take a contrarian view and, if necessary, walk away from transactions where, no matter how tempting the economics may be, the risk/reward ratio is skewed to the downside, with too many things having to go right. Avoidance of loss and ruin is essential.

Investors may not fully appreciate the losses that can offset profits in CRE; and outcomes measured depend upon the timeframes chosen. Trying to time a market is inherently dangerous (and not just in CRE!). Investors and lenders need to model for the fact that cycles turn; and that, to avoid being forced to liquidate in a hostile environment, one must maintain sufficient flexibility and robust liquidity until markets recover.

The report, while seeking to prove a point, does still provide a salutary example of why “this time round” it is rarely different; and that behaviours need to change if the inherent CRE “boom to bust” cycle is ever to be broken.

The Awbury Team

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Integration is a good thing…until it isn’t…

Much is made these days of the risk of “cyber-attacks” on individuals, businesses and governments, with cyber insurance being one of the few growth areas in the (re)insurance industry. This is as it should be, because even the disclosed events (and the majority are likely not disclosed) show how damaging such attacks can be.

Of particular concern are systems and networks which provide essential services, such as power grids, or air traffic control systems. Yet there are also under-appreciated risks in industries in which there is clear competition, with no obvious monopoly characteristics; one example being the oil and gas business.

Earlier in the year Marsh published a Briefing entitled “Could Energy Industry Dynamics Be Creating an Impending Cyber Storm?”- a headline which should have been guaranteed to catch attention. Not surprisingly, the article highlighted the fact that 76% of executives surveyed believed that Business Interruption (BI) would be the most dangerous cyber loss scenario. Of course, one of the issues the (re)insurance market faces is how to categorize a particular event and which particular policy(ies) should answer- the so-called “hidden cyber” dilemma. Conversely, risk managers may find out that the coverage they thought they had is not there, or capped at much lower levels than expected. Causation and attribution may not always be self-evident in, say, the failure in a well-head pump.

That aside, a key issue that remains to be tested is the extent to which unexpected links and dependencies may show up as the result of a cyber-attack. One targeted at a particular O&G business may have a broad impact because of the fact that, for example, cost-cutting as a result of the 2014-2016 industry downturn has led to supply chains becoming more integrated, with fewer alternative suppliers and greater standardization. Might disruption that flowed from an attack on one oil major’s operations cascade through its supply chain and through that into the operations of other producers? At what point might the digital equivalents of firebreaks stem the attack? Do they even exist?

The benefits of closer and more extensive integration are significant, so it is highly unlikely that the threat of a cyber-attack will reverse that process. However, the ever-expanding “Internet of Things” (IoT) means that more and more components of a business’ critical infrastructure are inter-connected, such that the potential consequences of an effective cyber-attack also increase in magnitude.

Paradoxically, all this means that effective risk management may well need to re-consider the creation of redundancies in systems (compare how civil aircraft are designed) and supply chains in order not to suffer a catastrophic business failure- in essence “buying insurance” that the failure of one link or supplier can be contained, isolated and addressed. It is all very well seeking to be the most efficient and low-cost producer, but that should not come at the expense of potentially embedding the risk of ruin within the overall systems architecture.

Awbury does not write cyber-risk (and has no intention of doing so). However, one has to look beyond obvious first-order effects; and we believe that it is essential that we continue to study and learn more about the threats to otherwise robust and high-quality businesses, let alone to those with less capacity to withstand material disruption to their operations.

The Awbury Team

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A little malfeasance with that mille feuille…?

We wrote recently about the malfeasance that apparently occurred at jeweller Folli Follie; and how it eventually became clear that certain numbers simply did not make sense once tested.

Now comes another example, replete with irony and the potential for slapstick (of the pie-in-face variety) in the form of the near-collapse of publicly-quoted, UK-based café chain Patisserie Valerie (PV), whose original Soho premises some of the Awbury Team can remember visiting more decades ago than they care to remember!

To summarize recent events: on October 10, the company’s directors asked for PVs shares to be suspended, as they had discovered “potentially fraudulent accounting irregularities” in the company’s accounts. Subsequently, the CFO (who had been at the company since 2006) was arrested and bailed by the UK’s Serious Fraud Office, while the company’s major shareholder and Chairman, Luke Johnson, provided emergency loans to keep the business solvent. The Board has since called an emergency shareholders’ meeting for November 1 to approve a “rescue rights issue”, failing the success of which it warns the company may well go into administration.

One delicious irony is that Mr. Johnson, who is an experienced businessman and well-respected entrepreneur, had (a week before the news on PV broke) published an article in the UK’s Times newspaper entitled “A business beginner’s guide to tried and tested swindles”. If it were not true, who could make it up?!

While much remains to be revealed about what exactly caused PV’s near-failure, certain known facts do beg the question about corporate governance and the vigilance of the company’s auditors, Grant Thornton.

For example:

– On September 14 (i.e., almost 4 weeks before the Board’s actions), HMRC had filed a petition in the High Court in London to wind up PV’s key operating subsidiary for a significant unpaid tax bill (since apparently settled)
– The company had reported net cash in its balance sheet of c. GBP 28MM as at the end of its half-year in March 2018. However, it turned out that in fact it had 2 “secret” lines of credit at HSBC and Barclays on which it had borrowed some GBP 10MM, implying that a reported net cash position of GBP 28MM had somehow become a net borrowing positon of GBP 10MM, a “hole” of GBP 38MM, and this for a business that reportedly turns over c. GBP 120MM a year
– Same store sales were almost identical on an annualized basis for the past 5 years at c. GBP 600,000 per store
– Significant sales of shares acquired under incentive schemes were recently made by, amongst other, the now-suspended CFO. Some of the awards made had apparently not been disclosed

The Board professed (and there is absolutely no reason to disbelieve its members) that it was unaware of the HMRC petition and cash shortfall. However, this makes any outside observer wonder what sort of controls, checks and balances were in place to monitor the company’s financial and tax positions; and how, in a fairly unsophisticated business, with rapid turnover and minimal inventory or receivables, no-one, including its Board, bankers and accountants thought to verify its systems were fit for purpose. Was this negligence, or the consequence of a sophisticated and long-standing fraud?

Of course, as always, it is easy to perceive issues with benefit of hindsight and when one is looking for them (such as the remarkably consistent same store sales levels), but the fact that the HMRC had pressed matters to the point of taking the extreme step of filing its petition (and no-one on the Board professed to know), or that there was an almost GBP 40MM “hole” in the company’s cash position does strain credulity.

At Awbury, we “collect” such examples as a reminder that one should always assess key factors for credibility before making any material decision; and we look forward to learning more about what happened, how and why.

The Awbury Team

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