Risk, what is that?

We have long been admirers of the investment skills and thoughtfulness of Howard Marks, co-founder of Oaktree Capital Management. Like Warren Buffett’s Annual Shareholder Letters for Berkshire Hathaway, Mr. Marks’s periodic Memos, which now date back almost three decades, are always worth reading for their thoroughness, and intellectual diversity and depth.

Anyone who wishes to understand what the nature of risk is would be well advised to read a Memo from 2015- Risk Revisited Again in which Mr. Marks (as one should) updates and describes not only what he considers to be the true nature of risk, but provides a useful starting checklist for those risks which one should consider in an investment and business environment.

So, what exactly is risk? As the Memo points out, it should not be confused with volatility (which is a tendency that is still prevalent.) Academics and model-builders like to use volatility because it is a property that can be recorded and measured- just think of Value at Risk (VaR) and the use of such concepts as standard deviations. However, volatility is a fluctuation and is simply a property of most exposures or investments. Risk is something else. As Mr. Marks points out, what investors and risk managers are really concerned with is the possibility of permanent loss. Of course, volatility can expose one to that risk if one is unable to manage it and absorb it, which is why lack of liquidity is such a killer of companies and of investors’ hopes and expectations.

The problem with this is that (to quote the Memo): “The probability of loss is no more measurable than the probability of rain” (which reminds us of Andre Brink’s novel “Rumours of Rain”). Like volatility, one can model it and estimate it, but it can never be fully known ex ante- nor even ex post. After all, just because there was no permanent loss, does not mean that there was no risk. Too often people confuse dumb luck with skill when it comes to identifying, assessing and managing risk.

The Memo wryly quotes JK Galbraith: “We have two classes of forecasters: Those who know- and those who don’t know they don’t know”. Being in the latter category, is never a good idea. Ignorance is not bliss. In the real world, it is far better to recognize that, because the future is unknowable, one can never be certain of how much risk truly exists in a particular investment or exposure, or as a consequence of one’s decisions. Humility is an essential virtue for any risk manager! Far too many things that should not or “cannot” happen actually do. Therefore, one must focus on trying to ensure that the worst possible outcome (the real risk) is not such as to also cause ruin.

In reality, the future is always a range of possibilities. One can try to identity scenarios and assign probabilities to create a distribution, but in the end only one thing will happen (putting to one side the fascinating topic of quantum mechanics!) The probability of that causing a permanent loss may be remote, but the risk will always be there until such time as an obligation has expired. Of course, the entire concept of an “insurable risk” depends upon there being an expected minimum level of risk and thus of loss.

At Awbury, we aim to be assiduous students of risk both as a concept and as an inevitable factor in all that we do. Our business model and franchise depend upon never being self-satisfied or complacent about its existence, nor believing that we must be right. A healthy skepticism and paranoia are also essential virtues for the Team.

The Awbury Team


As the world turns…

The phrase “the Pacific Century” is now something of a trope, while the probability of a recurrence of the so-called Thucydides Trap in the context of rivalry between the US and the PRC causes furrowed brows and debate amongst geo-political scholars and military analysts.

This is not surprising given the re-emergence of economic power across Asia. The two-century dominance of the European and North American economic and political systems tends to cause many to overlook (assuming they are aware), that such domination is something of an aberration in the period since the fall of the Roman Empire (which, even then, was part of a multi-polar world.) At the end of the Seventeenth Century, Europeans were the ones admiring the influence and cultures of Asian powers (Asia constituting some two thirds of GDP and three-quarters of its population) such as the Middle Kingdom Chinese Empire and the Mughal one of India; and as late as 1820, Asian economies constituted an estimated 60% of global GDP at Purchasing Power Parity (PPP). Jared Diamond’s now iconic book “Guns, Germs and Steel” chronicles what changed the “natural order”.

The United States and the EU may still constitute the world’s largest economic blocs, but their dominance is beginning to fade. They may still be rich and militarily powerful (in the case of the US), yet Asia now has more than half of the world’s population and the majority of its largest conurbations.

Of course, statistics and trends can be manipulated by selective use and interpretation of data, but the rate of economic growth within Asia is such that, in relative terms and at UNCTAD-defined PPP levels, The Financial Times (FT) estimates that the size of Asia’s collective economies will surpass those of the Rest of the World within the next year or so. Even at market value (as the FT also points out) Asian economies account for 38% of global output (up from 26% in the early 2000s). The PRC alone, at PPP, now probably has a larger economy than that of the US.

Such projections can be disrupted or even reversed. However, given the trends, one should not ignore the contingency that eventually Asian economies will again become dominant economically. That does not mean that all of them will, or even wish to project power beyond their borders, with the obvious exception of the PRC. India probably wishes too, but is a good example of scale in terms of economic potential and population failing to equate to global influence.

Naturally, in a world of Make America Great Again and the desire of some within the EU for “Ever Greater Union”, there are those who would deny current reality and future possibility. While such intellectual avoidance may be comforting for those who hold such views, ultimately it is likely to prove counter-productive, because it prevents consideration of how to adapt to, or even challenge, reverse or guide outcomes.

At Awbury, we are both realists and pragmatists. We thrive by thinking strategically, while being tactically flexible, recognizing that denial and wishful thinking are simply foolish. Our world is constantly changing, and is a mixture of volatility, probabilities and certainties.

And we are very certain that the trends and potential changes described above will continue to present opportunities, as those affected try to manage changes in risk.

The Awbury Team


Jaded, Distracted, or just Overwhelmed…?

In our world of potential “information overload”, in which attention spans are supposedly becoming ever shorter, and the tendency in some quarters to misrepresent, distort or simply repeatedly lie seems ever more prevalent, there is a danger that one’s mind (the System 2 part in Kahneman terms) can suffer what amounts to processing paralysis.

Not only is there too much data masquerading as information, but one has to exercise great vigilance and maintain abundant skepticism in order to be able even to function. One has to practice a form of informational triage, deciding what matters and what does not in terms of the particular decision at hand- and one has to know when to stop. It is always possible to ask another question or examine another factor, but is it relevant or material? Does it supply new information or a different perspective?

Of course, much of the skill behind effective decision-making is a product of both experience and constant practice. Theory is all very well, but it is essential to have seen the outcome of one’s own decisions, as well as observing and learning from those of others.

In the (re)insurance underwriting context (as in others), there is the danger that familiarity can breed contempt, as well as complacency- both of which run the risk of causing decision errors- because, while some factors are largely unchanging (e.g., lack of cash kills companies), others may be new and unexpected. For example, the “Softbank effect”, in which an early stage, or even relatively mature business is essentially “forced” to accept far more money than its principals know what to do with or can deploy effectively may lead to them changing the very behaviours and processes which made the venture promising in the first place. Paradoxically, there can sometimes be something such as having too much cash.

Therefore, any underwriter has to be able to adapt his or her mental models when circumstances and new information dictate, including the heuristics which we all use, often subconsciously (System 1 behaviours in Kahneman terms.)

At the same time, as stated above, one has to be able to ensure that your System 2 thought processes are able to filter sources in terms of their accuracy, relevance and “weight”. Going back to primary sources is usually essential (i.e., reading the actual accounts; interview transcripts; and regulatory filings) is essential. Just reading pre-digested pablum such as presentations means that one is already dealing with someone else’s filter and motivations. Often those may be harmless, but equally they may deliberately distort or deflect. US GAAP or IFRS may be far from perfect, but “adjusted” numbers almost invariably only go one way in terms of their purpose, which is to make things look favourable- unless a new CEO is using the “kitchen sink” approach to clear the decks for his or her new regime.

The Awbury Team has by now getting on for a couple of centuries of relevant combined experience. However, that does not mean that we have succumbed to the “seen it all” fallacy. We know that there are, and always will be, new factors to take into account in our underwriting of the large, complex risks in which we specialize. Jaded we are not! As for being overwhelmed, our carefully focused approach enables us to filter out the informational dross and distraction that constitute an increasing problem.

The Awbury Team


Banks fail (or have to be rescued), but P&C (re)insurance companies just soldier on…

In most financial systems (with Bermuda being an interesting exception), banks dominate the financial landscape in terms of their absolute and relative scale and economic importance. We witnessed the potential consequences of that during the Great Financial Crisis, when highly-leveraged, under-capitalized banks had to be bailed-out by public money (i.e., the taxpayers) on a huge scale- something whose effects still linger even now.

Of course, over the past 10 years, regulation and re-capitalization have significantly strengthened many banks’ financial position, even if sustainable business models still elude quite a number of mainly European banks. However, the fact remains that, in the fractional reserve banking system which is still the dominant model, any bank needs to maintain a highly-leveraged business structure in order to generate the returns which shareholders expect and is inherently subject to the risk of a “run” if confidence falls.

There are now increasing signs that regulation fatigue, political amnesia and pandering to vested interests are leading to pro-cyclical, rather than the necessary anti-cyclical behaviour amongst regulators in the world’s largest financial market- the US- at a time when both the credit and businesses cycles are potentially approaching a reversal, even if not another “crash”. In fact, changes in regulation can fuel a boom- consider what happened after the repeal of the Glass-Steagall act.

As we are seeing now, risk also tends to migrate away from the regulated to the unregulated components of the financial system- as the rise of so-called “shadow banking” and “FinTech” demonstrates, further obscuring sources of potential trouble. If regulators do not pay attention and “follow the money”, they are, in essence, condoning a rise in systemic risk.

And while the phrase “This Time is Different” is not yet being uttered as a general mantra, the longer time passes without even a recession, the greater the risk that people, including “experts”, will start to believe that the beast of the Business Cycle has finally been tamed, with excuses being made to justify that belief, even in the face of contra-indicators. One can already observe this is the debate going about the “meaning” of the recent US yield curve inversion.

Compare that scenario with that of the (re)insurance industry. While (re)insurers may carry some leverage (usually at the holding company level, not at regulated subsidiaries), the cost of, or risk of withdrawal of funding is rarely an issue. Similarly, they are not subject to liquidity puts, nor deposit outflows. What happened to AIG in 2008 is the exception that proves the rule, yet its core insurance businesses were able to continue to meet their obligations without stress, in an environment that was potentially chaotic.

In reality, in the absence of fraud or serious mismanagement of pricing, aggregations and reserves, diversified P&C (re)insurers very rarely fail. This is not a reason to be complacent, nor to assert that such a thing cannot happen. However, the evidence built over many decades and business cycles is clear. Companies’ business models may become obsolete, or they may have reserving issues, but even then the consequence is usually an orderly run-off, rather than precipitate failure.

The key distinction between banking and (re)insurance is that duration mismatch is a necessary element of any banking system but not present in the re/insurance industry. While both industries have to pay close attention to their ability to cover realized losses and ensure adequate levels of risk capital (equity or the equivalent), only banks have to deal with the embedded liquidity risk that comes from that duration mismatch.

At Awbury, even though the quality of our partner (re)insurers is very high, and they are all large, diversified P&C businesses, we constantly monitor their financial performance and condition, because we believe that one should never assume that “received wisdom” cannot change; and we would be doing our clients a disservice if we did not maintain vigilance.

The Awbury Team


Fragile Five or Shaky Six?

Readers may be beginning to think that we are a little obsessive about oil. However, while money may make the World go round, without oil the global economy would also come, literally, to a grinding halt. It pays to keep a close eye on what is happening in the oil markets, because surprises and “shocks” have a tendency to reoccur with some frequency, often as the result of a geo-political event or trend.

There is much debate about whether supply and demand for crude oil will be in balance in the near to medium term and perhaps maintain some sort of floor under the current pricing of both the Brent and WTI benchmark crude oil blends. One thing we know is that any forecast of oil prices is usually wrong because of all the factors which can influence that all important supply/demand balance.

One can enumerate a catalogue, including:

– US shale or “tight” oil production levels continuing to grow, and whether the US will become structurally a net exporter of crude oil
– The transition away from internal combustion powered vehicles
– Alternative energy sources, such as solar and wind
– The price levels petro-states need to balance their budgets
– OPEC’s (and its allies such as Russia’s) willingness and ability to enforce production level quotas
– Economic slowdown in the PRC and elsewhere
– Political crises in the Middle East and Persian Gulf

Geopolitics is always in the mix, which is where the Fragile Five and Shaky Six come in. The former comprises Angola, Iran, Libya, Nigeria and Venezuela. The latter adds Algeria, a surprise late-comer in the wake of the political disturbances set off by the supposed determination of the ailing Bouteflika to run for a fifth term as President (on behalf of Le Pouvoir, or Deep State) and then his abrupt withdrawal. Bear in mind that in 2017, these 6 countries exported some 8MM barrels per day, or just over 8% of global production according to ENI’s 2018 World Oil Outlook. While, the 6 may not all see significant reductions at once, Iran’s exports are being constrained by US sanctions; Nigeria is increasingly unstable; Libya is anarchic; and Venezuela’s PDVSA is in freefall. Stable they are not.

Yet, the US, in the guise of the EIA, apparently blithely still expects a global surplus through until the end of 2020- and the forward curve for WTI is essentially flat out to the end of 2020, if not in slight backwardation- presumably relying on growth forecasts for US shale oil production and increasing exports.

Such lack of expected volatility and “received wisdom” always makes us skeptical. Of course, life would be easier if the forecasts were accurate. Historically, the US could generally lean on key allies such as Saudi Arabia, to “do the right thing” and turn on the taps. However, that relationship is now dysfunctional (being polite) and the Saudis have a new (entirely self-interested and untrustworthy) “friend” in Russia, which is more than happy to be given the opportunity to administer another “poke in the eye” to the US’s perceived interests. This is compounded by the fact that the Saudis see themselves as in a potentially existential battle with the US shale oil industry over who is the “swing producer” and at what price levels. In fact, the shift in the US’ overall position from a net importer to a potential net exporter is already beginning to have “second order” effect in terms of its policy decisions affecting the Middle East, including the State of Israel. And, in the meantime, the opaque policy- and decision-making process in the PRC always has the potential for the unexpected.

At Awbury, we take the view that one should never assume stability and predictability in crude oil prices (or those of any other commodity, for that matter), and that it is essential to closely examine and stress any risk that involves a direct or indirect exposure, to ensure that one is not “negatively surprised” when volatility returns. To do otherwise would be remarkably naïve.

The Awbury Team


The wrong way to approach risk identification and assessment

The World Economic Forum’s (WEF) annual Davos global elite “love-in” is now behind us, and life goes on. As usual, just prior to its convening, the WEF published its “Global Risks Report”- a document we have written about before. This is intended to act as a mechanism to identify and publish a Top 10 list of risks in the categories of “Likelihood” and “Impact” by canvassing the views of those who form part of the self-same, self-selected elite at the WEF.

While the document is full of colour (and confusing diagrammes), and is supposedly the product of much effort, its value in any real sense is becoming debatable. The FT’s Alphaville column used the telling phrase that the product was the result of “conference room homeopathy”- so diffuse as to have no demonstrable efficacy. And we doubt the “placebo effect” works on risks!

The Report’s content does demonstrate what its creators are most concerned about. However, as one reads through the lists, one notices that the wordings used are so vague and broad as to be practically meaningless, or laughably obvious- “Extreme Weather Events (#1 in Likelihood), or Weapons of Mass Destruction (#1 in Impact.)The “insights” are stunning in their banality.

We are quite sure that, individually, there are many deep-thinking and original minds within the group surveyed. Unfortunately, assessing risk by survey of a self-referential “elite” has completely obscured their existence, to such an extent that there is nothing controversial or thought-provoking in sight.

If one adds to that the “interconnections” maps, showing the supposed key links between various risk categories, one is then left with a presentation of information that has essentially lost any value. It conveys nothing other than visual noise- cognitive dissonance, not cognitive diversity.

Of course, it is easy to mock such earnest and well-meaning efforts, but one has to ask whether any policy-maker is going to have an epiphany as a result of reading the document, thus leading to a significant shift in behaviour or actions.

Turning to the real world (something whose existence seems to escape many Davos attendees), to have any value, risk assessments have to be specific, concrete and probabilistic in terms of timing and scale. The contrast between the approach of the WEF and that of, for example, Philip Tetlock’s Good Judgment Project is quite telling. While the latter also uses the “wisdom of crowds” it asks very specific questions and seeks probabilistic answers which can then be analyzed ex post facto to identify so-called “superforecasters” who have a demonstrable capability in assessing risk, even if only in relative terms.

As “ground up’ underwriters of very specific risks, the Awbury Team recognizes that it is much more effective to focus carefully on what actually matters in a particular set of circumstances rather than worry about nebulous concepts that provide no additional value to the process of trying to obtain a deep understanding of the risk being underwritten. Contexts, connections and correlations truly matter, but only to the extent that they are relevant to the matter at hand.

Reading the WEF Report itself is merely an exercise in witnessing “groupthink”, because an unexacting consensus is the goal- not a reasoned dissent, a difference of perspective, or true originality.

The Awbury Team


Information is alpha- as long as you know what to do with it…

In a world that often seems to be drowning in data masquerading as information, how is “alpha” or an “edge” to be found?

There seem to be two main alternative routes: one either has to have better information than one’s competitors; or, with the same information, a superior ability to identify and exploit patterns in it to identify both risks and opportunities.

It is obvious that there is an escalating “arms race” in acquiring “better” information, with the term “alternative data” now widely used in business and financial circles. For example, the use of data from commercial satellites is becoming increasingly common for hedge funds and others as a means to acquire “non-public” data. Yet, paradoxically, this simply leads towards a scenario in which all those who can afford it, have it. The edge is increasingly blunted. This then leads to the search for the next “alternative” source, but begs the question of whether “the next big thing” has any real value.

So, what about superior pattern recognition? Human beings are, after all, programmed by evolution to look for patterns in what their senses perceive as a means to avoid the lion lurking in the underbrush. What began as a mechanism necessary for survival has become a dominant trait, with the ability to recognize patterns, for example, visually/spatially considered an essential component of intelligence.

In the world of credit and risk analysis, the ability to understand and forecast what may happen in respect of a particular obligor or scenario is essential. To a large extent, this involves the ability to discern patterns that one knows from experience and acquired knowledge are likely to lead to a particular outcome, good or bad- for example, over-leverage, or insufficient liquidity. However, it also involves being able to distinguish between patterns that are meaningful (a signal) and those which are merely distracting noise, as well as to recognize that there may be a new pattern or paradigm, because one can be lulled into a false sense of comfort by failing to question what one perceives or “knows”.

Naturally, the growth of AI has led to something of a frenzy in terms of interrogating data for patterns that no-one else has yet discovered. Within certain parameters, specialized AI (for that is all that exists at present), backed by ever-rising processing and computing power has the potential ability to see things quicker, or differently from human beings, no matter how experienced or skilled. One only has to look at the fact that AI systems can now overwhelm even the best human players of chess or Go (to mention only two examples) to understand that.

However, the world is a complex, non-linear place, which means that, for now at least, even if the existential risk from AI to the role of (re)insurance underwriters in high-volume, commoditized product lines looms ever nearer, in the more complex areas in which being able to understand causation, correlation, constraints and the nuances of game theory and human behaviour are critical, the pattern-recognition abilities of human operators should prosper for much longer.

While we are eternally paranoid at Awbury about mistaking noise for a signal, or to our thesis being simply wrong, we believe that there is hope for us yet, given our relentless focus on complex, non-standard risks!

The Awbury Team