Calibrating Risk…

It is axiomatic that the business of (re)insurance is all about understanding risk, and being able to analyze, price, structure and manage it in such a way as to be able to meet any and all valid claims as and when they are made.

So, one would think that establishing what a company’s appetite for risk actually is would be fairly straightforward. In reality, it is not, because it is practically impossible to establish a comprehensive framework simply through the creation of a set of rules. Rules and limits are merely the starting point.

Paradoxically, an over-emphasis on “risk management” can even increase the potential for an entity to accept risks that are beyond the level it should be willing to take because of the “not seeing the wood for the trees” bias. Any CRO worth the title will be aware that it is identifying the possible aggregations and unexpected links which is the problem, even if one has established a carefully layered set of individual risk limits.

All of this stems from the fact that the real world is not just complicated, but complex- and it is the complexity that creates the issues. One can try to “corral” the complicated within a reasonably sophisticated rules-based system; but complexity resists such an approach, such that rules can engender a dangerous complacency that an entity’s risks have all been defined and “boxed”.

One area in which ignoring complexity can cause real problems is in terms of whether risks behave in a linear way. In a complicated system linearity governs; in a complex one a tiny change can have a massive impact (the butterfly wing effect). After all, events such as hurricanes are not linear in their consequences, even though the scale used gives that impression. A Category 5 is much more destructive than a Category 4.

Similarly, one can de-compose a complicated system into its component structural parts, but in complex systems the components interact with and influence each other in unexpected ways, making it difficult, if not impossible, to calibrate all potential outcomes. Of course, many systems have boundaries defined by natural laws in terms of scale, but in other areas, such as frequency, the boundaries are much less defined, if at all- just consider the current North Atlantic hurricane season and the frequency of “named” storms. Yes, a more active season was forecast, but we doubt that anyone foresaw just how active that meant.

Complicated systems are also usually controllable, whereas complex systems are not, exhibiting so-called emergence tendencies. Trying to act upon them can have disproportionate and unintended consequences.

Any seasoned CAT modeler will riposte: “But we know all this!” And that is true. However, that does not mean that one can calibrate with any real certainty what the true scale of the risks of loss are. The charts that one sees in annual reports are estimates, not limits, and, as we have seen over the past few years, the trend in frequency and scale of natural catastrophes is increasing, which begs the question of whether the risks are truly “controllable”.

At Awbury, we recognize that we are always operating within a complex system, which evolves and changes, sometimes rapidly. No fixed set of rules or limits would be able to cope with such a dynamic environment. Therefore, successful organizations must have risk management systems that are also dynamic and adaptive.

The Awbury Team

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CEO Survivorship Bias…

Within the US and elsewhere, for the past several decades there has existed what can only be called the “Cult of the CEO”. This has been reflected in the disproportionate way in which their compensation packages have diverged from those of lesser mortals as well the often undue deference paid to their statements and public musings, let alone what may happen within the confines of the businesses which they run. Of course, there are exceptionally-talented individuals, who demonstrably add value and make a difference. No doubt each of us involved in the realm of finance and (re)insurance has a view on that- and we are not going to “name names” here.

However, each and every one of them is merely mortal, with individual flaws and biases just like the rest of Humanity. The characteristics of successful CEOs, and how they are identified and selected, has its own sub-discipline within the study of behavioural corporate finance, so we read with interest a recent paper by Marius Guenzel (Wharton) and Ulrike Malmendier (UC Berkeley) entitled “The Life Cycle of a CEO Career”.

Wrapped within the academic prose are some interesting insights into the real world of CEO advancement, selection and firing.

Firstly, and quite logically, as in many other areas of business and finance, there is an inherent survivorship bias, particularly when it comes to assessing and hiring external candidates. After all, if one has failed in a previous role, one is unlikely to be top of the candidate selection list! Conversely, confident and apparently successful individuals have a distinct advantage. In fact, the paper posits that over-confidence in one’s abilities is actually an advantage at that stage, because a Board or selection committee will not have had the opportunity to observe an individual’s true nature, as it would have done with an internal candidate. It is also well understood (and not just at the CEO level!) that hiring managers have the tendency to hire those with whom they identify, and whom they believe they “understand”.

Secondly, and this would apply to internal candidates as well, the need to be seen to perform can lead to a willingness to take on more risk to try to create leverage to the upside (which is often also influenced by the structure of compensation packages), thus actually increasing the risk of failure in adverse circumstances. Of course, by definition, in the absence of a monopolistic advantage, a business has to accept an element of risk in order to grow and prosper. However, there is the  question of whether the risk-taking is proportionate, or might expose the business to a material risk of ruin. The selection process and its own in-built “skew” may inadvertently increase the risk of future failure, or, at best, underperformance when truly tested. Ironically, it is the individuals who are more self-aware and more humble who may perform better long term.

And finally, when it comes to the firing of an unsuccessful CEO (who is still likely disproportionately to be male- just look at the (re)insurance industry!), the authors find evidence that the more “male” a Board is in terms of its composition, the greater its reluctance to fire “one of its own”.

None of the above is particularly surprising. However, it is useful to see the issues examined in a more rigorous and less anecdotal way. It suggests the need, as always, to distinguish between the truly capable and the clever “bluffers”; and to look at a business’s past performance in context and on a risk-adjusted basis, trying to assess how much it reflects the skills of the CEO.

At Awbury, our whole business model and operational approach is built around deploying a cohesive team, which believes fundamentally in measured, incremental growth. Aiming to “shoot the lights out” is most certainly not of any interest, because, particularly in the (re)insurance business, it is axiomatic that excessive risk taking is, frankly, stupid.

The Awbury Team

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Almost nine years in, and it should still be Day 1…

As Awbury approaches the ninth anniversary of its founding (which, in the wake of the time distortion caused by the pandemic, seems a “lifetime” ago!), it is worth addressing how one can continue to be productive, remain relevant and generate value.

The term “Day 1” has been made famous by Jeff Bezos, founder of Amazon, who, by any definition, has built an extraordinary business since starting Amazon some 25 years ago. In essence, Day 1 is defined as the antithesis of Day 2: “Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1.”

Day 1 means moving and deciding quickly. It requires constant experimentation and adaptation, running the risk of the failure of a particular idea, and, if necessary, discarding concepts or products which are not, or no longer, fit for purpose. It involves identifying themes and trends, and following, rather than resisting them.

It does not sound that complicated, does it?

Yet, the apparent simplicity often becomes overlooked and overwhelmed as businesses scale and mature, because their managements fail to grasp that:

– Being obsessive about meeting and exceeding clients’ expectations
– Resisting the dead hand of process
– Identifying and responding to external threats; and
– Rapid, targeted decision-making

ensure not only the creation of an effective and valuable business franchise, but also sustain its long-term viability.

Unfortunately, as has long been evident in many industries (including (re)insurance), and has been made evident in the wake of the pandemic, businesses (as represented by their supposed “executives”) tend to slip into a seemingly comfortable “middle age”, when really they have become senescent, deluding themselves that they are still youthful and effective. They may just about earn their cost of capital (in a “good” year) and when the economy is expanding; but their irrelevance is revealed when their fitness and adaptability are tested. Their stasis leads to paralysis, and one begins to hear their “death rattle”, as they flail and grasp at anything that may stave off the end. Nothing lasts forever, but squandering the advantages gained by focusing on the attributes described above amounts to a reckless disregard for the Darwinian framework of any competitive environment. Adapt or die.

Of course, there is always the risk that, when something such as the concept of “Day 1” achieves what amounts to cult status (compare “The Warren Buffett Way”) and becomes “received wisdom” it can become a problem in itself, because no-one questions its premise any more.

At Awbury, we are very well aware of this and the so-called “framing” issues that limit or constrain thinking and exploration. So, we take great pains to avoid believing that one approach will always work. (Re)insurance and the world in general are far too complicated and complex for that. Nevertheless, adopting the approach that it is always Day 1 is a valuable part of our intellectual toolkit.

The Awbury Team

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What a world, or what world…?

There is much debate, not surprisingly, about the ways and extent to which the current pandemic will change people’s behaviour and assumptions. The phrase “the New Normal” is much used, which we find interesting, as one could argue that the world has never been “normal”, because it is ever-changing through processes of what one might term natural, economic and political selection. Normal for whom exactly?

Be that as it may, clearly there will be changes- some of which are already evident, and some of which are still speculation.

For example, the Chinese Communist Party (CCP) in its guise as the government of the PRC has clearly used the “opportunity” of a distracted world, and in particular the internal contradictions of its only serious rival, the US, to increase its control over Hong Kong, pretend that its actions in its “Far West” are to reduce the risk of terrorism, test Indian military and political resolve, and enhance its surveillance and coercive capabilities both internally and externally. That is quite evident. Actions speak. And so, far, there have been few material consequences for PRC.

Elsewhere, new approaches to managing and deploying labour are being widely tested (of necessity), but their final configuration or scope remains unclear, as the true balance of advantage versus the “old ways” is as yet unclear.

The balance of power in the financial markets has clearly shifted. No longer do “bond-market vigilantes” over-awe any but the feeblest central bank; while there is more capital available to be deployed than most investors know what to do with, and savings rates have spiked, at least temporarily. The important question, to which the answer will only be obvious ex post facto, is whether that capital will be invested productively, or wastefully. When major central banks are “hoovering up” their own governments’ bonds (or the Eurozone’s in the case of the ECB) and depressing yields, being able to analyze and price risk adjusted returns will be a distinct competitive advantage, because there really is little, if any, “easy money” to be made.

What is also evident is that politicians are extremely poor allocators of capital. Think of how many trillions of dollars, or the equivalent have been “thrown” at economies almost indiscriminately (and sometimes corruptly given the largesse available), when, reportedly, only tens of billions have been applied to research on vaccines. There is a clear absence of a coordinated Manhattan Project” for vaccine development, no matter what all the rhetoric would have one believe. Of course, the current disorganized “competition” may quickly result in a safe, effective and rapidly deployable vaccine. Let us hope that the capitalist approach to health policy works in this case, while recognizing that the “obvious” approach is often known only with the benefit of hindsight.

As we stated above, “normal” is the wrong term to use for any historical period. The arc of recorded history shows that becoming complacent, or assuming that certain things simply will not happen (even though they clearly can) is an approach which leads to dislocation, and often disaster. Crises occur regularly. They just come in different forms.

Much of the population of the world has been (and in many cases still is) the subject of an economic and social experiment of epic proportions through enforced “lockdowns” of different degrees of severity. That may be feasible once (the shock of the new), but it is highly unlikely that, in the absence of authoritarian repression, the experiment can be conducted at scale repeatedly. Even dictatorships end, because they require the acquiescence of the governed or repressed. At some point, that no longer works.

All this may seem a little abstract, but consider what the world has become and how it may have to adapt in the absence of an effective vaccine.

At Awbury, we work on the assumption that one always has to adjust one’s mental and analytical models in the face of new information. The current situation is simply another example, albeit one with potentially broader implications.

The Awbury Team

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What happens when the music stops…?

As Jim McCormick, of NatWest Markets, recently pointed out in a Financial Times article, in spite of the negative economic impacts of the pandemic to date, credit markets have been remarkably buoyant, with many indices actually positive year-to-date, and borrowing costs for companies perceived as creditworthy falling to very low levels.

The perception is that central bank actions (whether by the Fed, Bank of England, ECB or Bank of Japan) have been the key factor underpinning this outcome. In some senses, this is accurate, as markets perceive that the central banks have significantly widened the scale and scope of their operations and so will continue to “underpin the bid”.

However, while central banks can create liquidity, they cannot fix solvency. After all, eventually debt has to be repaid or re-financed, and that requires a business that has the ability to survive the pandemic and “come out the other side” in a viable (even if changed) form. Only governments can address solvency on an economy-wide basis.

To date, while varying in form, governments have provided support on a hitherto unprecedented scale through subsidies, rebates, deferrals, forgivable loans and outright grants. They can do all this because they can borrow (currently at very low, or even negative interest rates) and have the coercive power of taxation. Of course, that ability to borrow at such low rates is only feasible because of central bank policies and the continuing belief of investors that those same governments will be able (and willing) to honour their obligations when due. If that belief and confidence changes (likely to be tested if inflation eventually returns) governments will face a challenge. Modern Monetary Theory (MMT) posits that government spending can be paid for by the creation of money, with the purpose of taxes being to limit inflation, by controlling the money supply, so spending should not be determined by deficit levels. It may have suddenly become “fashionable”, but its robustness has yet to be tested.

And, as Mr. McCormick quite reasonably points out, what if “fiscal policy fatigue” sets in? Most politicians have short attention spans, little real understanding of economics and markets, and are driven by a desire to be re-elected. If electors’ own attention moves on to a different focus, will fiscal policies be maintained, or adapted to meet new needs, setting to one side the issue of funding all the commitments made? Once what one may call “solvency support” it taken away, or re-directed, then what?

Given the level of uncertainty which still attends the timing and likelihood of the pandemic being brought under control in many large economies, there is an increasing risk that at some point what amounts to a precarious equilibrium (created by central bank expansion of the money supply, ultra-low interest rates and trust in the current system) will come to an end, whether as the result of a change in capacity, or because of policy fatigue, even if economies are not “back to normal” in terms of activity and demand.

While we would not be so foolish as to make specific predictions on a macro-economic scale, it seems to us that at some point there will be a “winnowing” across a range of industries (including (re)insurance), which will separate the “prospering survivors” or beneficiaries of the pandemic from those who are not viable without continuing solvency support and/or a significant and swift rebound in demand for their products. Of course, as specialists in credit, economic and financial risks, our aim is to continue to make appropriate assessments and decisions at the micro level, and ensure the integrity of our existing portfolio and business model, while sourcing new business that will prove robust in the face of all the uncertainty.

Not straightforward in the current circumstances, but one we are confident it is achievable with appropriate caution.

The Awbury Team

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Risk is in the air…

As readers of this blog will appreciate by now, at Awbury we are thoroughly paranoid about properly identifying, understanding and controlling risk in all aspects of our business. To that end, we try to keep an eye on what others may identify as “emerging” risks. Of course, such a task is meant to be part of the job description of any self-respecting CRO (and team). However, much of what one reads still resembles little more than a consensual box-ticking exercise: “We’ve thought about is, so everything is now OK”.

In reality, what tends to happen is that a document is created, and then filed away somewhere; to be brought out, when necessary, as evidence of diligent behaviour.

As such, it is worse than useless, because it provides a false sense of security. And if we have learned nothing else in this world, we know that one should never feel secure when it comes to risk management! The advent and outcomes of the pandemic amply demonstrate that!

Another perennial problem within risk management is what we would term “compartmentalization”, meaning that one can neatly classify risks into discrete categories, and so produce labels to summarize them. Checklists do have a value, as we have written before, and are sometimes essential, as long as they are seen as the start of a process, and not an end in themselves. Unfortunately, labelling can also lead to the problem of “framing”: we have defined the risk, and neatly labelled it, so it must fit, and we now understand it fully. As Wittgenstein said: “The limits of my language stand for the limits of my world”. (Die Grenzen meiner Sprache bedeuten die Grenzen meiner Welt). I have “named” it, so that is what it is.

However, the real world is messy, not neat; and one has to be comfortable with managing disorder and often indeterminate continua of outcomes, and acting accordingly. Interestingly, we suspect that in many organizations this may lead, paradoxically, to decision-paralysis in the face of uncertainty, or, conversely, to precipitate action, because: “We must do something!”

Naturally, we are not saying that any of this is easy. It is not. However, it is possible to be better prepared through constant research, wide reading, and continuing dialogue and discussion, with a view to risk identification, scenario planning and gaining an understanding of the realistic boundaries of risk.

The pandemic has been an object lesson in “real world, real time” risk management and mitigation, because it combines scale, speed, reach and uncertainty with behavioral impacts. It is truly a “messy” and evolving event; and one which cannot simply be categorized and “boxed”. Although it is now possible to create some parameters for cause, effect and consequences, one also has to recognize that believing that one fully “understands” the risks is foolhardy.

So, at Awbury, we constantly update our assessment of the risks which the pandemic poses (as well as of the opportunities it may provide in terms of creating new products for our clients) to ensure that we are prepared to deal with any realistic scenarios as the evolve and appear- hence the paranoia!

The Awbury Team

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What could possibly go wrong…?

Being in the business of helping our clients manage complex credit, economic and financial risks, perhaps not surprisingly we the Awbury Team has a certain necessary fascination with how to understand and analyze the material risks any Obligor faces.

Over time, a number of attempts have been made to provide a systematic classification of such risks, the latest (and most comprehensive of which) is the (Cambridge Taxonomy of Business Risks), which uses what one might call a quasi-Linnaean system involving 6 Primary Classes, 37 Families and 175 (sic) Types.

The results are useful because they provide what one might call a checklist (cf. Dr. Atul Gawande’s “The Checklist Manifesto”) for any risk analyst or underwriter to set against the nature and complexity of the entity she or he is reviewing and assessing.

Of course, it is easy to mock a list that contains 175 Types as being far too complicated to be useful. However, the mere fact of its existence should at least compel an analyst to look at the risks which a business faces holistically, and consider which ones are material; or, if they arose, could potentially lead to failure and default. And bear in mind that many regulators require companies to maintain Risk Registers- which, in reality, are analogous to a basic taxonomy of risk.

The Taxonomy does not weight the risks, because, quite clearly, that (and their relevance) varies from entity to entity. However, the authors do comment that, of the 6 Primary Classes (Financial, Geopolitical, Technology, Environment, Social and Governance), Governance risk is often underestimated; while “Geopolitical risks and possibly Financial, [may be] being overestimated. And, yes, “Infectious Disease” is in there as a Family!

The “art”, therefore, lies in looking at an entity and determining the material risks to which it is subject, particularly the potentially “existential” ones. As the pandemic has brutally demonstrated, the trope “lack of cash (and liquidity) kills companies” has never been more true, even if no business executive is ever likely to have planned for revenues to fall to (perhaps) zero for what was hitherto considered a viable and well-run business.

This just serves to emphasize that it is not the “usual” risks that are likely to cause systemic issues (although they may have an idiosyncratic impact), but rather the ones thought to be out in the tail of any distribution. Perhaps ironically, one could clearly argue that the pandemic was a 1-in-100 year risk which should have been factored into (re)insurer risk models (as it surely will now be!), as other 1-in-200-, 1-in-250- and 1-in-500-year risks habitually are for NatCat programmes. This is not, in any sense, to denigrate the (re)insurance industry, because it was governmental behaviour and actions that caused the most harm in economic and loss-exposure terms, not the disease- in other words, a second- not a first-order effect- and that clearly now belongs in any taxonomy of risk under “Government Action”!

The pandemic also demonstrates the fact that world of risk is not Aristotelian and fixed, but evolves and changes as forces and events act upon it- the SARS-COV-2 pandemic simply being the latest example. Checklists are useful, but only as a guide, not as an expression of the limits of risk. As we have written before, it is usually the risks that you do not foresee that cause the most harm.

The Awbury Team

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Don’t just think about it, apply it (quickly!)…

Since the Industrial Revolution, the rate of growth of the world’s aggregate economic output has been extraordinary (https://ourworldindata.org/grapher/world-gdp-over-the-last-two-millennia), with the slope of the graph going from the almost horizontal to the almost vertical. There are many reasons for this, but a key one has been the increase in productivity, as fundamental scientific discoveries were converted into an iterative series of technological and process applications that enabled capital to be transformed into ever growing wealth, even if often unequally. In essence, most of the world “levelled up”.

As with reasons for growth, there is debate about why productivity varies over time and by geography. And vary it does. As economist Robert Gordon has shown, real US GDP per hour increased from an average of 1.79% per annum between 1870 and 1920, to 2.82% per hour between 1920 and 1970, only to fall back to 1.62% between 1970 and 2014.  A 1% annual variation may not seem much, but, because of the effect of compounding it matters.

And now, in the midst of a pandemic, there is much debate about whether a virtual and distributed workforce will be more or less productive. Frankly, it is too early to tell, as there is anecdotal evidence each way.

However that may be, productivity matters. It is clearly linked in some way to step changes or new directions in scientific knowledge; but pure science (which is undertaken for its own sake) has no economic value unless one does something with it. Knowledge has to be applied. In the supposed “golden age” of productivity, from 1920 to 1970, that was often through the medium of the corporate research laboratory, such as IBM, DuPont, Merck, Xerox PARC, and Bell Labs. Those milieu transformed basic science into technologies or products that have made the world what it is today, and which we now take for granted.

Nevertheless, there is a nagging sense that all is not well. Somehow quantity no longer seems to produce the same quality. Why is much debated, and is too large a subject for a blog post. What matters is somehow finding a better way to convert knowledge into applied intellectual capital. Without that, knowledge is just knowledge.

Consider, for example, the (re)insurance industry. Essential, knowledge-based, full of highly-educated and very smart individuals. And yet…

Somehow the industry is often still slow to incorporate, adapt and apply new knowledge, or to develop effective new products and processes. As a  result, it moves sideways, or improves incrementally at best, and sometimes goes backwards- at least so far as it appears to the outside world. As we have written before, according to a McKinsey study, many companies in the industry actually destroy, rather than create value, barely earning their cost of capital. Now the industry faces numerous challenges, some of which may prove existential if it proves unable to address, manage and mitigate them.

For Awbury, the creation and application of intellectual capital to create value-added products is a fundamental part of our “corporate DNA”. It is what our client base expects and demands. We do not pretend to be “better”, or that knowledge is an end in itself; but we do understand that thinking needs to be transformed into doing, rather than endlessly refined, discussed and debated.

The Awbury Team

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Fiscal insurance and the Reckoning…

Continuing the theme of our previous post (“Are you feeling (financially) repressed yet…?”), we now examine the issues posed by the pandemic from another perspective- that of fiscal policy and sustainable levels of government debt.

The level of fiscal support or “stimulus” to their economies being provided by governments  across much of the developed world already far-exceeds those seen in the wake of the GFC. Yet it is not really a “stimulus” (as HSBC pointed out in a recent paper entitled “Borrowing from the Future”): in reality it is insurance- a pay-out intended to help the recipient recover from an unexpected disaster, or economic CAT caused by an combination of a highly-contagious virus and subsequent government actions. However, the difference from insurance as such is that many governments do not have reserves set aside to address such an eventuality. Instead, they rely of the unique coercive power of the state to raise revenues through taxation, which, of course, ultimately depends upon the ability of its underlying economy not only to generate wealth sufficient to pay those taxes, but do so in ways that do not themselves inhibit wealth creation.

The general absence of a reserve means that in reality most governments (except those that have specific funds to act as a buffer against a decline in future revenues, such as most “petro-states”) raise the necessary funds in the short term through issuing debt in one form or another, to be repaid from future tax revenues.

The long-term downward trend in absolute and marginal levels of taxation across much of the world, coupled with rising (and now accelerated) ratios of government debt to GDP to levels not usually seen outside wartime, means that there is going to be a reckoning, because the pandemic will result in “economic scarring” in ways that are still unclear, but almost certain.

The scale and persistence of such “scarring” matters, because the intention behind the “insurance payout” by a government during the pandemic is to preserve not just income levels but to avoid the loss of future productive capacity in the economy. If the “scarring” is worse than expected, this will lead, amongst other things, to lower tax revenues and fewer jobs, and so likely lengthen the period over which government budget deficits persist at elevated levels, leading to more borrowing. Of course, this issue also has to be viewed in the context of the level of nominal interest rates on sovereign debt, when set against the nominal rate of growth in the same economy. As long as the latter exceeds the former, debt servicing is sustainable.

The situation is further complicated by the fact that the shape and trajectory of any economic recovery from the pandemic is still unclear for most economies. Anything other than a “sharp V” or “truncated U” means that the “scarring” will be real, while the recent general decline in many economies’ productivity is also cause for concern, particularly if it proves to be secular rather than cyclical.

Taking all the factors into account, any forecasts are merely estimates of possible scenarios. It is far too early to make any robust forecasts, so one has to remain wary about the build-up of the risks within economies, which always arise when a sovereign’s ability to raise and service its obligations becomes impaired. For Awbury, this is just another component in our systematic and continuing assessment of all the potential risks that may have a material impact on our existing portfolio and future business.

As Morgan Housel recently said: “Wounds heal; scars last”.

The Awbury Team

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Are you feeling (financially) repressed yet?

One of the major conundrums in the wake of the GFC has been why inflation has not yet risen consistently from barely above c.1% in most major economies in the wake of all the central bank “pump-priming” and Quantitative Easing (QE). The catalogue of “experts” forecasting a doom-loop of rising inflation and even hyper-inflation is a long, and by now largely discredited one.

Of course, one can be very wrong for a very long time, and then suddenly right as the narrative flips. There is just the slight intervening problem of being thoroughly ignored and discredited, although usually without suffering the fate of Cassandra, beyond reputational “death”.

However, we have been reading an interesting note by the Man Institute, entitled (The Inflation Regime Roadmap) which discusses how inflation, and good old-fashioned “financial repression” may return.

One basic problem is that inflation can have a range of causes beyond the “money-printing” that tends to obsess monetarists, as well as be curbed by off-setting factors, as has almost certainly been the case since the end of the GFC. However, as the balance shifts, this can (apparently suddenly) cause inflation to spike upwards. Reasons can range from supply/demand imbalances in an underlying economy to changes in the relative bargaining power of labour versus capital, to commodity-based “shocks” (as in the early to mid-1970s). Unfortunately, focusing on what happened on the previous occasion, or a particular path is naïve because it is invariably the unforeseen or unexpected that triggers the shift.

And different constituencies suffer disparate outcomes depending upon both scale and direction (inflation, disinflation or deflation), which makes the situation even more complicated.

However, for major fixed income investors, such as (re)insurers, a particular concern is financial repression, accompanied by negative real interest rates- i.e., where interest rates are manipulated by governments and central banks to be low in nominal terms (or even negative, as we have seen post-GFC), in an environment in which inflation starts rising. At present, central banks are more concerned with deflation and aggregate levels of demand than they are about inflation, with the pandemic seeing remarkable levels of fiscal relaxation and the creation of available money in the system to try to mitigate or prevent economic harm. As a result, nominal rates are at or close to historically low levels across the EU, US and Japan and many other jurisdictions, which makes it very hard for any (re)insurer to generate levels of Net Investment Income (NII) to act as a buffer against recent and continuing weak underwriting results.

Whether in government bonds, munis or high-grade corporates, both yields and spreads achievable on the re-investment of income and maturing portfolio assets remain low, which means that it is ever harder to mask the volatility that also flows through the P&L and Equity accounts from changes in market values.

At Awbury, we have long been aware of both the issues and the need for a solution. Therefore, we have designed and successfully implemented for the past several years a range of products which specifically address a (re)insurer’s need both to generate high quality premium flows, and to remove volatility. We believe that these products are tailor-made for today’s environment, and are happy to discuss them further with those interested in solving a demonstrable problem.

The Awbury Team

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