But what if I’m wrong?

This phrase should be emblazoned on a plaque placed on every risk underwriter’s wall, and used as a mantra to guard against the complacency and the smugness that can come from being far too comfortable with one’s intellectual prowess, and the knowledge which one has gained through long experience.

As Socrates is supposed to have said (as attributed in Plato’s Apologia): “…he thinks he knows something when he does not, whereas when I do not know, neither do I think I know”.

We seem to live in a world in which it is essential to have an answer (the answer- and immediately) to every issue, problem or question; with any uncertainty or hesitation being seen as a sign of weakness. All too often, underwriters and senior executives can become caught by the fear of seeming weak and indecisive if they do not project certainty and confidence, when everyone else thinks “X” is a good risk. After all, if “everyone” thinks so, it must be, mustn’t it?

It takes courage to admit doubt and to go “contra the herd”.

So, we have a paradox. On the one hand, being self-questioning is a key attribute in developing sound judgement; yet, on the other, one is expected to move rapidly towards an effective decision.

In this context, it helps to establish a framework of mental models and techniques that one can apply to overcome both the hubris of certainty and the spectre of decision paralysis, while minimizing the risks of a really poor outcome. Call it a form of mental triage.

The legendary Charlie Munger is a vocal proponent of the need to have a framework of mental models readily available in order to maximize one’s ability to make the right decision. And, as his partner Warren Buffett also said: “Outstanding long-term results are produced primarily by avoiding dumb decisions, rather than by making brilliant ones.”

Of course, the catalogue of such models is very extensive. However, at least in the realm of (re)insurance, a handful would appear particularly relevant.

Firstly, inversion. Rather than asking what is the best or most likely outcome; ask instead what would automatically produce the worst outcome and try to avoid it. One would hope that any risk manager considering aggregations would find this approach useful, in fact essential. A corollary of this is maintaining objectivity by challenging one’s initial opinion by seeking evidence that would disconfirm it.

Secondly, emergence. The interaction of lower-order factors or components can often lead to the emergence of an outcome that is non-linear, and not easily predictable from its component parts. One could, in a sense, refer to these as tipping points, where the rate of change rapidly increases with potentially disastrous consequences. So, one has to look for linkages that may not be obvious.

Thirdly, irreducibility. While the goal of simplification is an admirable one, at some point continuing the attempt becomes counter-productive and potentially misleading, because the model for a risk and its components have become irreducible.

Fourthly, Bayesian updating. This has a formal mathematical model; but, for practical purposes, requires one to take into account new information as it arrives in order to update one’s assessment of the probability of an outcome. Given that the world is largely non-deterministic, this is essential if one is not to become “stuck” in an outdated and potentially fatal model.

There are, as we said, many more, and we aim to return to the topic in a future post. None of this is exactly “rocket science”, and it will be seen that there are overlaps between the four models briefly described. Nevertheless, it is surprising how often individuals fail to analyze and reflect upon why they should or did make a certain decision. At Awbury, we debate constantly how we can make an effective and rational decision based upon the information available to us, being well aware that no single approach can or should be considered the “only way”. “Received wisdom” can easily become a trap.

The Awbury Team

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Kafka and insurance…or, I’ll have a manuscripted poem with my policy…

Readers will, no doubt, be familiar with at least a couple of the works of Franz Kafka- The Trial and The Metamorphosis- but may not realize that he spent much of his short working life in insurance- in particular for the “Worker’s Accident Insurance Institute” of the then Kingdom of Bohemia, from which he retired because of ill-health in 1922. Workers’ Compensation insurance is not exactly a new concept!

We mention this because the world of (re)insurance is often regarded as a soulless, dispiriting space. This is unfortunate, because its existence underpins much of what enables modern societies to function. In essence, the industry has to try to navigate through chaotic systems and manage the risks that flow from them, often with imperfect information. Its existence underpins the ability of economies to create value, because risks of loss are mitigated through the medium of (re)insurance.

Much closer to our Greenwich, CT base, Wallace Stevens, a highly-regarded, Pulitzer Prize-winning 20th Century American poet (“Money is a kind of poetry”), spent his career at The Hartford, even turning down the offer of a professorship at Harvard. Make of that what you will, but clearly Stevens’ poetic abilities were in no way constrained by being a lawyer in the insurance industry. As research, we read perhaps his most famous poem (from the collection “Ideas of Order”) entitled “The Idea of Order at Key West” (https://www.poetryfoundation.org/poems/43431/the-idea-of-order-at-key-west). Even the title creates an interesting juxtaposition, given the poem’s focus on “The ever-hooded, tragic-gestured sea”.

Perhaps equally surprising is the fact that Dashiell Hammett (creator of Sam Spade) was a private investigator for insurance companies- “I don’t mind a reasonable amount of trouble” makes one wonder about his investigation techniques.

The fundamental point of these three facts (which are referred to in Mihir Desai’s’s “The Wisdom of Finance”) is that while, as with much of finance, (re)insurance is somehow perceived as being separate from the real world, with an often poor reputation, in reality its existence helps rebuild shattered businesses and lives by providing protections, and solutions to needs. One has only to consider Shakespeare’s “The Merchant of Venice” to understand the consequences of the lack of a decent Marine policy.

So, next time you feel like complaining about the cost of your insurance protection, bear in mind that, without it, you would not be willing, nor would even be permitted to run a business; and that in the commoditized NatCAT area it is still probably far cheaper than it should be!

Of course, there is an art to understanding and addressing a client’s needs; and at Awbury we believe strongly that being creative in designing and executing on carefully crafted solutions is an essential part of our franchise. We may not be poets (and shall refrain from subjecting you, Dear Reader, to any specially-composed doggerel), but we know that what we do requires imagination and creativity.

And we shall finish with a quotation from Kafka: “Start with what is right, rather than what is acceptable”.

The Awbury Team

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Born to be Wild…(with apologies to Steppenwolf)

This year, it will be 50 years since the Summer of ’68 (Here’s to you, Mrs. Robinson…), when red bandanas were the height of street-fighting fashion, access to a ready supply of cobblestones essential, the cocktail du jour was a Molotov, MAD was not just a comic- and the Viet Cong’s Tet Offensive provided clear evidence that the Viet Nam War was not necessarily going America’s way.

Why should we mention this?

Because, while 1967 was the Summer of Love, soon thereafter, in 1968, the world appeared to be a more dangerous, restless and uncertain place; and yet, in spite of all the fears expressed then for the future, we are still here.

Of course, it had become rather difficult to find much sense of the positive in 2017, given all the governmental oppression being inflicted in too many parts of the world; and it is clear that the “mood” within many unfortunate polities remains dark and full of foreboding; whilst the series of fires, floods hurricanes and earthquakes in the second half of the year simply added to a feeling of malaise.

So, in the face of all this gloom, we thought we would point out a few items that may give one some hope for Humanity at the start of a new year, if only in the short (non-geological time) term. We hasten to add that the Awbury Team has not suddenly begun self-medicating with hallucinogenics. Rather, we always try to take a measured view of risks in terms of both their probability and severity, even if we cannot quite bring ourselves to subscribe to “world without end”.

– The US and the EU economies are growing robustly in real terms, with no immediate signs of a recession
– Real interest rates remain at close to historically low levels, yet in most major economies inflation remains relatively in check
– While still quite volatile, the price of crude oil has settled into a range that most producers and purchasers can tolerate
– At the same time, the shift towards less carbon intensive fuels gathers pace
– The (re)insurance markets have demonstrated their robustness in face of a significant deterioration in NatCAT loss experience
– The Brexit negotiations have not yet gone off the rails, and there are signs that some sort of rational negotiation will finally take place
– The majority of the planet has begun to take the threats posed by global-warming seriously
– Developments in analytics, machine learning and AI continue to generate potential new paradigms and opportunities
– The number of people globally moving out of abject poverty continues to rise
– Star Wars: the last Jedi shows that all is not lost…
– Winter may be coming (in the Northern Hemisphere), but it will end

And while at Awbury we are never complacent, we continue to have a robust pipeline of business across our franchises, which we aim to execute upon and continue to build with the support of all our valued clients and partners.

With best wishes to you, Dear Reader, for good fortune in 2018.

The Awbury Team

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It seemed like a good idea at the time…

At Awbury, our business model is built on the concept of adding value in providing solutions to the credit, economic and financial issues which our clients bring to us- a very different approach from the flow-based, commoditized, cost-plus one which still tends to prevail in much of the (re)insurance industry (let alone elsewhere.)

Scale may be a wonderful thing, but only as long as it creates sustainable value. This is why it seems odd to us that large-scale M&A activity designed to create scale rarely seems to manage to improve Combined Ratios; with the attrition of cost bases and reserve releases only serving to beat back the impact of softening pricing and the disruption coming from “InsureTech”, as the industry struggles with excess capital (even after Q3/17) and the unwillingness of many participants to “walk away” from pricing that is below the so-called “technical reserve” level. Although the events of Q3/17 have raised hopes that pricing trends in the affected NatCAT markets will turn upwards, the evidence remains mixed as the renewal season approaches its end.

The corporate world in general is littered with spectacular examples of value-destruction (leaving aside the truism that the majority of mergers or acquisitions fail to deliver on their supposed benefits)- AOL/Time Warner and Rio Tinto/Alcan come to mind. Both were considered “good ideas” in their time, but turned out to be spectacularly bad in terms of creating value. It will be interesting to see how the AT&T/Time Warner and Disney/Fox transactions turn out. And consider that Shell has accepted the fact that its purchase of US “tight oil” assets near the height of the last oil-price peak was a very poor decision, and now seeks to unload them in some way that at least saves face.

So, why do such events occur with monotonous regularity, when patience and discipline in building one’s existing business would be more likely to preserve and create value?

There can be no single answer to this, but it seems reasonable to assume that senior executives and Boards are susceptible to the blandishments of bankers and other “advisers” who have an interest (and need) to generate business in order to earn fees (and keep their jobs.) Of course, this is something of a caricature. However, there seem to be few investment banks which have the ability to resist providing a “valuation letter” that magically demonstrates that the price for “Xco” bid target is fair and reasonable.

In reality, the success of a transaction depends upon many factors, both tangible and intangible. And some demonstrably work (witness Ace and Chubb), while others do not (Travelers and Citibank).

We suspect that one of the issues that leads to frequent failure and value destruction is “groupthink”; as, once an “idea” gains traction, more and more of those involved are sucked into the belief (because that is what it is) that “buying Xco” is a very good idea, and that the naysayers are the ones who are irrational. All complex organizations develop a culture over time, which is a major indicator of their long-term viability and success, because, unless it is fit for purpose, open and adaptable, it is likely to lead to poor decision-making and an unwillingness to change a decision in the light of further information. In such circumstances, those who challenge the orthodoxy are likely to find themselves ignored, or worse.

At Awbury, our approach has been, and will continue be, to grow organically (avoiding delusions of grandeur) and to provide carefully constructed, bespoke, confidential and value-added products and solutions to our range of clients. Our ideas should not merely “appear” to be good ones; the products and structures we create must demonstrably be valuable, with the actual outcomes being the objective evidence.

The Awbury Team

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Coining it…or just Untethered?

The Awbury Team’s members have been around long enough to have observed, lived through and survived multiple financial bubbles, crazes and crashes. However, we have looked on at the current frenzy surrounding the rise in the value of bitcoin (lower case, as opposed to the upper case Bitcoin payment system) with bemusement, which we shall use as a proxy for analogous “crypto-currencies”.

While the company behind the South Sea Bubble was a fraud, one could at least plant tulip bulbs and console one’s self with the beauty of the flower after that mania ended (Fun fact: in 1637, the Dutch East India Company was worth USD 7.9TN in today’s terms). In the case of bitcoin, it seems that what was once considered a curiosity and subsidiary component on a blockchain-based system has become the focus of the most extreme rise in “value” in recorded history. Having started life with what, in hindsight, is probably the most expensive pizza purchase in history in May 2010, and reaching a price of USD 1 in April 2011, bitcoin was supposedly quoted at a price of over USD 19,000- in early December. To say that the price is volatile is a serious understatement, as it becomes increasingly difficult to discern what, if anything, is “real” about it.

This begs the questions of what exactly bitcoin is; what purpose it serves; and what impact it is having or will have on the financial system, including (re)insurance. Classically, a currency is a medium of exchange, (one hopes!) a store of value and a unit of account. How does bitcoin measure up?

Frankly, as bitcoins are simply entries in a Bitcoin blockchain ledger and there is no-one who guarantees that a bitcoin has any particular value, such value depends entirely on supply and demand. Given that bitcoin is designed in such a way that there are only ever supposed to be 21 million of them in existence, and that creating new ones (up to the limit) costs increasing amounts of both computing power and (literally) energy, one can see how, as the desire to own a seemingly scarce item increase, demand can lead to the sort of frenzy seen in the past few weeks.

In theory, one can transact using bitcoin, assuming that the other party has both the desire and ability to accept them. However, the frictional cost of doing so keeps rising, and the time required to complete and validate a transaction also continues to increase, leading to the risk of “double-spending” of the same bitcoin. So, as a medium of exchange, bitcoin is far from optimal; and, of course, the volatility in its price also militates against that use. While, theoretically, bitcoin could be used as a unit of account for book-keeping purposes (and after all, Bitcoin is supposed to be a distributed ledger), that purpose seems to have become obscured by the frenzy surrounding whether or not bitcoin can be considered a store of value.

Of course, the “bitcoin billionaires” (yes, they now exist) would argue that it most certainly does. However, in reality, one can only realize that value in the real world by converting it into a more conventional and widely accepted currency, such as the US Dollar. Couple this with the thinness of the market; the fact that it would appear that holdings are quite concentrated; and the continuing reluctance of major banks to become involved in trading and clearing bitcoin transactions (in particular the newly-minted CME and CBOE futures markets), and one begins to wonder when and how bitcoin will become anything more than a speculators’ plaything and one more opportunity for the less salubrious fringes of illegal businesses to try to shield their profits from discovery and confiscation.

So, why, one might ask, should (re)insurers care about all this?

Well, consider the current obsession for growing revenues from cyber-risk coverages. Crypto-currencies are supposed to be free from the risk of “hacking” or misappropriation because of the underlying technology. Yet there are already numerous reported instances (and probably many more unreported) of bitcoins and their analogues “disappearing”, being misappropriated or simply stolen. If a (re)insurer had written a cyber-risk or even a standard theft and fraud coverage for a client who owned bitcoin, quantifying and pricing that risk might prove rather challenging, as might defining exactly what had been lost. Or consider covering risks relating to the default of a clearing broker or exchange involved with bitcoins. In theory, initial and variation margins should cover all but the most extreme loss scenarios; but, given the lack of reliable data and the brief history of the “asset”, what exactly is an “extreme loss scenario”.

At Awbury, we aim to maintain an understanding of complex risks and the opportunities they may bring, so we shall, of course, continue to monitor the evolution of the blockchain and crypto-currencies, while remaining a healthy skepticism about whether there is, as yet, sufficient data and market understanding to qualify and quantify the true nature and level of the underlying risks.

However, if you have a blockchain or crypto-currency risk that needs a solution, give us a call

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When is an “unknown unknown” really unknown? And have all the Black Swans gone Grey?

Donald Rumsfeld was once much mocked for his parsing of risks into categories such as “known knowns”; “known unknowns” and “unknown unknowns”. Yet he had a point. There is really no excuse for allowing known risks to overwhelm one’s capital or business model; while accepting risks one can identify, but which are difficult to assess or quantify, is somewhat inadvisable, as many financial institutions have found out the hard way through misaligned incentives and imperfect models.

So, what about “unknown unknowns”? Objectively, one does not even know that one does not know. Consider “cyber risk”. Fifty years ago, that would have probably counted as an “unknown unknown”, because the products, systems and software that have created the risk did not exist- even if some might have been foreshadowed in the works of various science fiction authors. And what of the still-running asbestos saga? One could lay reasonable odds that none of the original underwriters foresaw what would happen, or that the risk existed.

In a broader context, into which category should the recent actions of the Saudi Crown Prince “MbS” be placed? Expropriation for political or financial gain is nothing new, but the event was considered unforeseen, as could be gauged by the reactions. So, a Grey Swan perhaps, being charitable?

The point of all this sophistry is that the ability to survive and prosper in any business, including (re)insurance is based upon being able to detect, avoid and mitigate risks before they reach unmanageable proportions. However, the quality of risk detection capabilities appears to vary widely: it requires a willingness to be proactive in “thinking the unthinkable”; which, frankly, many find difficult because it can lead to some uncomfortable conclusions and requires being both contrarian and disciplined. FOMO is not a viable approach!

Consider the risk of nuclear confrontation- most likely involving North Korea (altho’ both India and Pakistan are nuclear powers, with muddled military doctrines and a long history of enmity and mistrust). Lobbing the odd low-yielding ICBM across the Pacific Ocean is not likely to be a good survival technique for the Kim dynasty, which leads into a consideration of the potential behaviours of other actors as they try to gauge responses. The risks of miscalculation are probably higher than they have been for more than a decade, made more dangerous by the rapidly-increasing nuclear weapons capabilities of the regime in North Korea, and they are no longer negligible. This then requires thinking about the consequences of a nuclear weapons exchange. MAD (Mutually Assured Destruction) might not apply in this case in the literal sense, although tens of millions of Koreans would rather not see the hypothesis tested, but the increased probability might cause underwriters to take another look at the wording of their Nuclear Exclusion clauses.

Of course, this is a “known known” risk, but it requires mental effort that many may not wish to take, which practically speaking could push it into another category.

Turning back to “unknown unknowns”, worrying about them is counter-productive. They are, by definition, currently “unknowable”. One should instead focus on risks that can be detected and then decide where they sit upon the spectrum of probability and severity; and whether they are sufficiently capable of being measured, and so priced and managed. At Awbury, while we are always surveying our environment for new and unexpected risks, we continue to emphasis our ability to provide our clients with products and techniques for managing their “known knowns” and “known unknowns”.

The Awbury Team

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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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