Profitability? How quaint!

One would think that achieving profitability would be the goal of any business model, including that of a start-up. However, at least in some quarters, it seems that this is becoming a somewhat genteel relic of a simpler past- as Uber’s latest results emphasize.

Of course, one could understand how the founders of some form of truly-advanced technological concept or process might focus on gaining sufficient scale to become “prey” for serial acquirers such as Google, Amazon and Facebook, and, more recently, Softbank via its Vison Fund (now going through a second iteration).

However, when the CEO of a company which is supposed to be a regulated bank can comment that profitability is “not a core metric”, one begins to wonder how this can be equated with any economic system resembling capitalism. The CEO in question was Maximilian Tayenthal, co-founder of N26, supposedly one of Europe’s most valuable “fintech” companies. Apparently, he is so sanguine because N26’s financial backers “have very deep pockets… and are willing to support the company for many years to come.” Perhaps he has visions of being the last bank standing? We doubt that BaFin, the German financial regulator, would be entirely comfortable with a supposed bank that does not see the ability to generate capital as important.

It may be that those of us who have been through decades of business cycles, including the GFC, in which both liquidity and the ability to generate a profit most certainly mattered, are somehow no longer conversant with some modern form of economic and financial theory. After all, before the Great Dotcom Crash almost 20 years ago, profitability had been superseded by “clickthroughs” and “ARPUs”, and those who then stated that profitability mattered were derided for their lack of vision about the “potential” of the businesses that subsequently failed.

One could be facetious and label what exists now as the “Greater Fool” theory, yet there is no doubt that we live in an economic environment in which supposedly sophisticated investors somehow persuade themselves that there will always be someone else who will provide a “liquidity event”, so that they can make a return on their investment, even if the underlying business investment has never generated a profit. After all, a surprisingly large percentage of companies that undertake IPOs currently (at least in the US) can properly be labeled as being still in the “pre-profit” stage. Yet this seems to represent little or no obstacle to entering their public equity markets.

We suspect that Amazon’s 25-year growth and track record has a lot to do with this reality- an economic version of “build it and they will come”. Yet, we would argue that Amazon (or Google, or Facebook) is the exception that proves the rule, in which a disciplined, long-term business model that provides something to its clients that never existed before will create a sustainable, profitable franchise that will endure and prosper until something even more effective comes along. Many hitherto lauded businesses have simply faded away, or proved to be fool’s gold.

At Awbury, we believe very strongly in the virtues of sustainable profitability. We have built our business and franchise on disciplined underwriting of carefully-sourced transactions that provide sound risk/reward ratios. “Loss-leading” pricing does not really play well in the (re)insurance realm, as risks are transferred to the true “greater fool”. Eventually one goes bust, which is not the ideal outcome for an industry built on the fundamental premise of meeting all its obligations when they fall due!

The Awbury Team


Model Simple and Think Complex…

Earlier this year a man died who had been a low-key, relatively unknown (to the wider world) RAND researcher (where one of his peers was Daniel Ellsberg) and the US Department of Defense (DoD) official leading a highly-secretive unit called the Office of Net Assessment (ONA). The man was Andrew Marshall, who established the ONA in 1973 and officially retired 42 years later at the age of 93.

Of what possible interest could this man’s work be to the world of business, including (re)insurance? After all, he was not involved in game theory, strategic planning, or systems analysis, and was focused on advising the senior echelons of the DoD on a highly-classified basis. He did not even make recommendations upon courses of action.

Consider the fact that, as the economist Herbert Simon said: “Short term thinking drives out long term strategy, every time”.

In other words, individuals, organizations and bureaucracies (such as the DoD, or large multinational corporations) become so caught up in the perceived need to make countless short term decisions, many of which seem incremental or insignificant in isolation, that they utterly fail to think deeply about anything. Cursed by “departmentalization” and the rivalry it engenders, they ignore creating a comprehensive, integrated assessment of the net position in which they are likely to find themselves over the longer term. In decomposing large, complex problems into manageable, smaller ones, they are rarely equipped to re-assemble them back into a coherent whole that can drive key decisions. In theory, the CEO or Board should perform the integrative function, as the Secretary of Defense would do in the US DoD. However, if reliance is placed upon an assessment (in terms of asking the right questions and thinking deeply about them) which is itself flawed, the decisions are also likely to be flawed.

What Marshall and his small team did was to create a process in which they asked unusual questions (often before anyone else had even thought there was one to ask), and harnessed inter-disciplinary skills and knowledge to provide an essential perspective for policy makers and those tasked with making strategic decisions, both in terms of threats and opportunities. One could almost argue they were the intellectual equivalent of Lockheed Martin’s Advanced Development Programme- the legendary Skunk Works. It should also be noted that the goal was to produce a net assessment- i.e., a comparison of two or more sides in interaction with each other dynamically, rather than a one-way assessment at a static “point in time”.

If one reviews the processes which businesses use as the basis for strategic decisions, these often involve the creation of complex mathematical models, based upon certain assumptions, which are then overlaid by a further qualitative process. In theory, this is reasonable. However, in practice, such an approach tends to cause framing issues, because the model becomes the basis for the decision- yet models are often notoriously flawed or misleading (with the benefit of hindsight.) In net assessment, the models are simple, and the thinking complex- and that is the point. There is no pre-ordained outcome, but rather a comprehensive and reasoned assessment of factors such as the economic, technological, political, societal and cultural that have and will continue to have a bearing upon the issue being analyzed.

At Awbury, we certainly do not have the resources of the DoD to hand. However, we are constantly seeking to expand the approaches and lenses through which we can undertake not only short term, pragmatic assessments of our environment, but also those which we believe will continue to give us an edge far into the future. Using just “standard” or “accepted” methodologies alone is, in our view, not sufficient in any complex and variable environment over an extended period of time.

Therefore, using Marshall’s framework of a net assessment provides another tool for strategic planning.

The Awbury Team


This is getting really weird, or when did interest-bearing debt become an oxymoron…?

In the “olden days”, when money was borrowed (and ignoring the impact of usury laws and religious prohibitions), it was customary for the debtor to pay the creditor a rate of interest based, inter alia, on the perceived risk to the lender of making the loan, or the lender’s perception of how desperate the borrower was. To say that this was axiomatic would be understating the point.

Those of us who are old enough can, of course, also remember when even the US Treasury had to pay double-digit interest rates, even if, in real terms, the rate was much less.

Yet, now we seem to have stepped Through The Looking Glass and fallen down a Rabbit Hole into some form of parallel universe, in which one begins to wonder what “interest rate” means any more.

Economics has the concept of the Zero Interest Rate Bound (ZIRB), also called the Zero Lower Bound (ZLB), which posits that nominal interest rates (as opposed to real ones) should not become negative. This “certainty” was shattered, first in Japanese money markets some two decades ago and again in the wake of the Great Financial Crisis (GFC), in which yields on a wider range of sovereign bonds, such as Bunds, became negative. As the global economy has gradually recovered and grown since then, one would have thought that “negative yields” would have been consigned to history. However, some USD 12.5TN equivalent of debt now has a negative yield, including (according to Deutsche Bank) some USD 600BN of corporate debt. Not only does one have to process the fact that apparently all the Czech Republic’s Euro-denominated debt now trades at sub-zero yields, but also cope with the reality of even some “high-yield” bonds yielding less than zero. It is almost Orwellian doublethink when “high yield” = <0!

One can, of course, debate whether we are increasingly the victim of that old central bank and governmental favourite called “financial repression” (in a new guise), or of misguided attempts to “keep the economic music playing”. Nevertheless, the reality is that such circumstances can have strange and surreal consequences.

Consider the tale (as related by Charles Gave of Gavekal Economics) of the Dutch pension fund manager who was reminded by his regulator that he needed to reduce his cash holdings (cash being regarded as “risky” for a pension fund) and buy more long-dated bonds. When he remonstrated that, as most high-quality Eurozone bonds had negative yields, he was bound to lose money, the response was the Dutch equivalent of: “Them’s the rules”. Perhaps even more surreal is the idea of Danish mortgage lenders offering borrowers a mortgage that pays the borrower interest.

Look at the world from the point of view of a life insurance company. If it is forced to lock in a negative yield on increasing components of its Invested Assets, what steps can it take to mitigate this embedded risk to its P&L and capital accounts? Raise its premiums, scale back business, or go hunting for assets that do actually demonstrate a reasonable chance of generating a positive interest return? None of this is straightforward.

Such an environment will favour those who are able both to think through the consequences beyond the first order, and can understand and manage the risks and opportunities that it poses and offers; because, where there is risk there is usually opportunity.

The Awbury Team


Power Laws and Probabilistic Strategy…

It is well understood that some relationships in terms of how one factor affects another are linear, while others are non-linear (so-called power laws). As Albert Bartlett said:

“The greatest shortcoming of the human race is our inability to understand the exponential function”.

In business, many managerial approaches are based on an incremental, essentially linear approach, aiming for a gradual increase in revenues accompanied by a similar growth in profits. This is a symptom of strategic inertia; of accepting mediocrity. In some areas, such an approach may enable a business to survive for a long time, although its end may come swiftly if its environment changes.

McKinsey recently published an article (How to win in insurance: Climbing the power curve) which should give the incrementalists serious pause for thought. In studying the economic profit (total profit less cost of capital) of 209 insurers (being all insurers with revenues above USD 1BN in 2017) from 2013 to 2017 McKinsey identified what amounts to a “power curve”:

– The top 20% generated an annual average economic profit of USD 764MM equivalent
– The middle 60% produced an average economic profit of USD 26MM (i.e., they just about broke even in nominal terms)
– The bottom 20% suffered an economic loss of USD 976MM per year (i.e., they rapidly destroyed value)

Visually, the data looks much like a two-ended Allen Key held horizontally- essentially showing that most of the wealth creation and destruction are in the tails.

Of course, when challenged about under-performance (re)insurance company managers (like those in any other industry) will state that they are undertaking a “strategic review” which will transform the fortunes of an underperforming business. Unfortunately, as McKinsey points out, not much changes in reality: the odds of a bottom quintile company moving to the top quintile between 2003 and 2017 were 17%; and those from the middle 3 quintiles into the top no more than 10%, which in some ways reinforces the dangers of complacency exhibited by the “great middle”.

As with many things in life, outcomes are usually probabilistic, not deterministic; and so it is with strategy. There are no certainties of success. However, McKinsey’s research highlighted 5 areas which were the most likely to enhance a company’s positive trajectory and move it up the power curve:

– Dynamically shifting resources between business units
– Reinvesting material amounts of capital in organic growth opportunities
– Pursuing thematic and programmatic M&A
– Enhancing underwriting margins
– Making “game-changing” improvements in productivity.

It would be easy to say that these are “obvious”. Yet, if they are, why do so few (re)insurers seem to make a serious effort to implement one or more of them? As McKinsey points out, what differentiates outcomes is the magnitude and intensity applied to escape from the “usual” approach to change. Materiality matters at least as much as direction.

To comment on an area near and dear to the hearts of the Awbury Team, if the key goal of any (re)insurer is to generate a high risk-adjusted return on capital (and to stop seeking the “safety in numbers” of a Combined Ratio of a little below 100%), enhancing underwriting margins should be an obsession, with an equal focus on more efficient processes, higher margin and non-commoditized product lines, and lower loss ratios. Unfortunately, for many, this often requires going outside their “comfort zone”. Yet the behaviour described is not reckless, but rather involves analyzing where the most value is likely to be created, and refusing to be distracted by the siren call of simply a larger premium flow.

To sum up, management teams need to be bold, focused, and know how to apply “leverage” within their business model in the ways that will truly make a difference. Being “comfortable” is not really a valid option.

The Awbury Team


Come the Revolution…

In 1972, Larry Greiner (Professor Emeritus of Management and Organization at USC) wrote a seminal article which was published in the HBR and entitled “Evolution and Revolution as Organizations Grow”. In it he posited a model (now called the Greiner Growth Model, or the Greiner Curve) describing how organizations grow and prosper (or fail) over time through a cycle of evolution and revolution (or crisis).

In essence, Greiner stated that the idea that any organization could, after being founded, continue to grow and be managed in some stable, essentially linear fashion was deluded; and that, while the precise order, length and nature of each phase might vary depending upon the nature of the business and how prescient and adaptable its management was, each organization would go through periods of “crisis”.

One only has to observe the effects of the passage of time across multiple industries to recognize that the underlying premise is valid. Business model, structure and management style either proactively adapt, or changes are enforced by multiple factors. Trying to “stay the same” leads to ossification, irrelevance and potentially extinction.

In his model, Greiner suggested that there are up to 6 stages or phases in the process, with an attendant “crisis”, or catalyst for change between each:

Phase 1: Creative growth from founding, leading to a crisis of leadership as the business scales and becomes more complex structurally

Phase 2: Growth based upon an adapted leadership style (perhaps with new leadership) emphasizing more formal processes and direction, leading a crisis of autonomy as employees chafe against what is seen as over-centralization

Phase 3: Growth under a delegated structure, in which the autonomy of employees and teams is recognized, and they have broader decision-making authority. This leads to a crisis of control, as senior management and directors begin to sense that they are losing control of the business

Phase 4: Growth continues via greater use of co-ordination in which the business puts in place structures through which senior managers take more direct responsibility for business units, while creating a “staff structure” to maintain consistency across the entire organization. Eventually, this can lead to friction between “line” and “staff” functions, in the guise of a “red tape” crisis

Phase 5: To counteract “red tape”, senior management emphasizes a more collaborative approach, in which problem-solving through team action or through collaboration across teams is used to manage what by now is likely to be a large and complex business. The potential major issue becomes one of growth itself, as employees become overwhelmed because of the demands made on their time, and the pressure to grow

Phase 6 : In this phase, concerns about the ability to continue to grow, lead to an attempt to create broader alliances, M&A, networks, or the use of outsourcing.

Whether and how quickly each stage or phase occurs depends upon a combination of industry dynamics, growth rate and management quality. Viewing the model as deterministic is, in our opinion, misguided. However, it does provide a useful framework for thinking about how to manage organizational structures as a business grows, and to ensure awareness that over time these have to adapt to stand any chance of surviving long term. Of course, not all businesses make it through the phases described above, victims of “creative destruction” or an inability to adapt. If one looks at the (re)insurance industry, one can see that it contains members which exhibit the characteristics of the various phases, from start-ups to global businesses, as well as those which have somehow become “stuck”, which brings into question whether the might succumb to the next “revolution”.

At Awbury, we have deliberately grown carefully and incrementally since being established some 7 ½ years ago, while adapting our business model to changes in markets and opportunities; and we are very well aware that we will have to continue to adapt and evolve over time to meet the challenges and disruptions that face all businesses in a complex industry such a (re) insurance. We have no intention of being overrun by any revolution!

The Awbury Team



Over time, most corporate (and other) entities develop their own culture- ways of doing things or behaviours that in some way differentiate an entity from its competitors and peers. These can be both external and internal, with the former the “face” it shows to those outside it, and the latter the norms to which its managers and employees are expected to adhere or subscribe.

This is not to say that corporations somehow resemble the Borg Collective into which minds are absorbed and assimilated, but there are certainly what one might term “expected levels of adherence” which vary across organizations.

A corporate culture that grows and adapts is heathy as long as it does not begin to impinge upon the lives of its members to an extent that degrades their quality of life and personal autonomy.

It is perfectly reasonable for individuals to be told the company has established that, for its business model, a certain way of doing things has been found to be the most efficient and effective, and that, therefore, they are expected to follow such an approach themselves. However, sometimes such expected behaviours can veer off into what becomes something akin to a cult.

The standard definitions of a cult tend to involve “excessive devotion” to a particular person, object or belief; with the underlying implication that such “devotion” is misguided, unwarranted or potentially harmful.

In the business realm, there are some entities where it is arguable that the term “cult” should be applied- Apple (under the late Steve Jobs) and Tesla being examples where suspension of rational thought has been visible at times.

So, what characteristics should one look for in determining whether or not a corporation might also be a cult?

Terminology matters. Particular words or phrases take on a meaning that, elsewhere, might induce the “cringe factor” in an observer. Are Disney employees really “cast members”?

Similarly, the creation of company-specific rituals to which all employees are expected to subscribe is another characteristic. The Friday afternoon beer wagon is all very well, if it is simply an opportunity to unwind and socialize; but if attendance is, or is felt to be mandatory, it becomes a method of coercing behaviour.

An obsession with “fit”, or a certain set of personal characteristics, whether physical or intellectual, can be another clue. It is perfectly reasonable for a company that needs certain attributes in its employees (as long as they are not discriminatory) to emphasize those in its hiring processes. However, if everyone is a “clone” from whom identical behaviour is expected, one should begin to question what is going on. Discussion, differences of opinion and even open dissent (as long as reasoned and respectful) are essential characteristics of an adaptable organization. Cults depend upon stifling such behaviour.

So, one should always ask one’s self in a corporate (or, frankly, any other group environment), whether reasonable expectations have somehow crossed the line into coercion.

In the realm of (re)insurance, while there are certainly a number of towering and influential individuals, and entities that are widely admired for their single-minded focus, we would argue that there are no true cults. The Sage of Omaha certainly has cult-like status amongst the shareholders of Berkshire Hathaway, but a true cult requires an element of sanction for “disobedience”. No-one is compelled to own Berkshire Hathaway’s shares, nor transact with National Indemnity; and Mr. Buffett would, we are sure, scoff at the idea that anyone should feel compelled to follow his precepts.

Over the past seven plus years since it was established, those who know Awbury well would probably acknowledge that it has a distinctive corporate culture (as exists amongst our partners), with the points made above demonstrating the importance both of creating a proper balance between that culture and maintaining an openness to diverse opinions and positions. It is the blending of the two elements which is most likely to make and keep an organization successful; and is something that we at Awbury look for when assessing the non-quantitative qualities of our Obligors and Insureds.

The Awbury Team


The Art of the Deal…

We recently came across a piece which Michael Mauboussin (generally considered one of the more thoughtful and original analysts of financial topics) wrote while at Credit Suisse, entitled “To Buy or Not to Buy”. In it he reviewed the question of whether and how value is created in the course of mergers and acquisitions (M&A); how the “purpose” of an M&A transaction might affect the outcome; and factors to consider in evaluating M&A- all in the context of public markets, where the successor remained publicly-quoted.

What is interesting about the findings is that there are factors or reasons which make a demonstrable and empirical difference between whether a M&A transaction creates or destroys value; succeeds or fails, yet these are often ignored or overlooked.

For example, the management of the acquirer will often state that the transaction will be accretive to earnings per share, which sounds like a good thing. Unfortunately, this appears to have little to no bearing upon whether the transaction proves beneficial. As Mauboussin points out, value creation is based upon cashflows, cost of capital and true profitability, not some accounting construct, yet managements often obsess about EPS.

Anecdotally, it seems that many M&A deals do not create the expected positive value. This outcome is all the more likely if a buyer pays a premium for control which is too large, becomes vulnerable to competitors emulating its actions (but without M&A), or sees them taking advantage while it is distracted by integration. Of course, there is a relatively straightforward way of assessing whether or not a transaction should create value for the buyer (as suggested by Mark Sirower of Deloittes):

Net present value of deal to Buyer = present value of synergies – cost of premium

This simple formula highlights the fact that execution is the key to any successful M&A deal. This should be obvious, but management teams, unless they have demonstrable experience and a track record, can get caught up in the moment and excitement of a transaction, and lose sight of the fact that the real work begins once a deal has closed- “transformational” being a favourite term. Mauboussin groups the underlying premise of transactions into 4 categories:

– Opportunistic (e.g., a weaker competitor selling-out)- these have a high success rate
– Operational (bolt-ons, business extensions)- these have a better than even chance
– Transitional (to build market share)- these have mixed outcomes
– Transformational (large leap into new industry)- these tend not to end well

The way in which a transaction is financed also tends to matter. The use of cash and leverage helps focus minds better than the use of equity, as realizing synergies and operational improvements becomes an important factor in reducing the financial risks assumed.

Within the (re)insurance industry, the level of M&A transactions tends to be cyclical, with “soft” markets helping the stronger pick off the weaker, although one should always ask what the real purpose and benefit of any given transaction is. The industry still has great difficulty in using M&A to make significant cost reductions, or to improve operational efficiencies, while there is always the fear of paying up for expertise or client access which then melts away.

At Awbury, with our extensive and diversified panel of multi-line P&C partners, we naturally pay close attention to developments and trends in (re)insurance M&A, as ultimately one always needs to understand not just who can provide capacity, and is likely to continue to do so, but also exactly who we are dealing with. People matter as much as capital, and a badly-executed or misguided M&A transaction is disruptive, or can even materially damage an enterprise’s franchise.

The Awbury Team