A different lens…

We wrote recently about the World Economic Forum’s 2018 Risk Report. Now along comes another favourite, the US intelligence agencies’ annual “Worldwide Threat Assessment” (WTA), as perceived from a US-centric viewpoint. Of course, given that this is a public document, one might wonder what is left undisclosed. However, the document is instructive as, if nothing else, a signaling document.

Along with the now customary invocation of North Korea’s possession of nuclear weapons as an “existential threat” to the US, and the frequent mention of the various threats posed by Russia and China, some additional items are worth noting.

The lead-off topic was “Cyber Threats”. While much of the concern relates to criminal, state, and non-state actors trying to influence behaviour or policy, it is worth noting that attacks on commercial targets are also expected to increase significantly, as malign capabilities develop and spread (and this is in a world in which the Internet Of [connected] Things is becoming a reality). Therefore, while (re)insurers desperate to increase premium flows are focused on building their “cyberrisk” books of business, it is probable that the frequency and scale of losses will continue to increase, leading to the question of whether companies will be able not only to price for the true level of risk, but also identify and manage their aggregations effectively.

Another topic which is given less prominence, but is also of considerable interest to the (re)insurance industry is “emerging and disruptive technologies”, such as Artificial Intelligence (AI), biotechnology (e.g., artificial gene synthesis) and the creation of advanced materials, including nanotechnologies. While of great potential benefit, the scope for misuse and the lack of controls or understanding are likely to lead to new types of “events”, causing difficulties in realistic pricing and the management of such risks. There is going to be a premium upon underwriters with “hard”, specialist knowledge for those companies intending to make a serious commitment in these areas.

Interestingly, DNI Coats also went on the record expressing concern that the level of US government debt and the rise in the fiscal deficit as a result of the latest Federal Budget, coupled with political “fractiousness”, represent a serious threat to the long term ability of the US to defend itself and achieve its policy aims. “Unsustainable” was the term used. Of course, this is hardly a new sentiment or criticism directed at Congress, but the language used is unusually blunt. And one should bear in mind that, arguably, the demise of the former Soviet Union was hastened by its rising economic instability. No-one is suggesting yet that the US is going to “implode”, but the warnings are instructive; and, naturally, the outcomes that such a trend can create, if not addressed, are of considerable interest to (re)insurers, including Awbury, who are focused on credit, economic and financial risks.

Naturally, at Awbury, our focus on longer tenor business means that we are constantly conducting our own threat assessment, aiming to winnow the “interesting but implausible” from the “real and probable”, so that we can avoid “fat tails”, and continue to provide our clients and partners with value-added solutions to complex issues that benefit from the application of a different lens (or approach) to the industry.

The Awbury Team

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Nothing lasts forever…

Which former US corporate icon was founded by a legendary inventor in 1892; almost failed to survive its first year; and had been, until recently, an admired stalwart of US business? It is, of course, GE.

Yet, during the Great Financial Crisis, this corporate behemoth, once an “undoubted AAA”, had to be supported by the Federal government, and the Warren Buffett imprimatur (which helped save a few more institutions during the panic and turmoil), because its financial “evil twin”, GECC (which was backed by the holding company) had become so large and over-extended that a sudden liquidity crisis threatened to cause it to implode, dragging down the industrial businesses, and threatening corporate bankruptcy. The truism that “lack of liquidity kills companies” almost claimed another victim.

Such an outcome would have shocked the entire US corporate establishment, because, if anything, GE was associated with the quality, longevity and “interoperability” of its executive cadres, graduates of the company’s famed Crotonville management training centre, whose approach and seeming success others aspired to. The belief was that a GE management education equipped one with the ability to manage anything. Perhaps, someone should have pointed to the example of Robert McNamara (one of the products of Ford Motor Company post-WW II “Whiz Kids” generation) as an indication that there are limits to such capabilities, and that very few individuals are true “practical polymaths”.

In fact, one could argue that, partly because of the lack of trenchant criticism of its conglomerate approach, and the intimidating reputation of GE leaders such as Jack Welch, those who should have questioned the rate of growth and over-leverage of GECC, were unwilling to do so: the facts spoke for themselves, until they didn’t.

And now, following the recent debacle of its need to create billions of dollars of reserves and charges in respect of its legacy reinsurance exposure to US long term care obligations (GECC strikes again- a sting in the tail, if ever there were one!), the once unthinkable is being contemplated- the break-up of GE into 3 or more businesses.

However, anyone who feels a touch of schadenfreude at such a potential outcome, would be remarkably foolish. Adapting to change and carefully managing risks are essential for long term survival in any entity; and GE has survived at scale and through successful adaptation for far longer than most (although it is not remotely the world’s longest surviving business). However, its more recent history shows that, when there is a loss of focus and discipline, bad things can happen; with seemingly invincible enterprises forced to face the possibility of painful restructuring, fragmentation, or even demise. Their executives no longer have the unquestioned “magic touch”.

Awbury Group is only in the second half of its first decade as a business, and we certainly have no illusions of grandeur. Rather, in order to create a sustainable business model, we are relentlessly focused on honing what differentiates us from commoditized (re)insurance businesses, recognizing that adaptable specialization is one way of maintaining an edge, yet remaining paranoid about avoiding complacency and shifts in our operating environment.

The Awbury Team

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Retaining mastery is not easy…

It seems so long (1987!) since Tom Wolfe mordantly mocked the then “Masters of the Universe” in his novel “The Bonfire of the Vanities” (which in turn derived from an event that Savonarola instigated in 1497 in late Quattrocento Florence, in which objects considered sinful were burned. Ironically, he ended up burnt at the stake). Of course, Masters of the universe come and go; and the term these days would probably be considered to refer to those controlling huge pools of hedge fund or alternative capital.

Whatever their origins, these individuals seek to exploit economic, market and other discrepancies to compound wealth over time. Some opportunities last for years, if not decades, while others disappear almost as soon as they arise.

However, any Master of the Universe would have to be foolish to believe that change will not come; even as the economics on which they rely is still struggling with the fact that its models very often do not accord with reality. Even the acolytes of the dismal science cannot agree upon what exactly it is a “science” of, and which are the most appropriate models to create and use.

At least part of the problem would seem to be that, rather strangely, money itself (and, by extension, much of finance) is often largely ignored- almost as if the “Masters” hardly existed- while economic models also tend to be linear.

It is certainly arguable that in the real world the economy is quantum and indeterminate in nature (until measured), with many discontinuities.

Interestingly, some 90 years ago, Keynes himself (JMK Vol 10, p262) wrote: “…the whole is not equal to the sum of the parts, comparisons of quantity fail us, small changes produce large effects, the assumptions of a uniform and homogeneous continuum are not satisfied.” It would seem that he recognized that economies are inherently subject to discontinuities and dislocation. Bear in mind that this was stated before the onset of the Great Depression.

The situation is compounded by the fact that economic theories generated by those seen as being authoritative can become quite pervasive, particularly if they seem to benefit a powerful constituency- Neoliberalism and Monetarism being prime examples in. This can lead to them persisting, little questioned, until the onset of the next discontinuity or heterodoxy (which brings to mind The Byrds’ iconic anthem “Turn, Turn, Turn” from 1965) leads to them being overturned. As Max Planck famously said: “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”

To continue to prosper, the Masters must constantly refine their business and economic models, as their environment changes. Complacency is the “kiss of death”.

At Awbury, we would in no sense regards ourselves as Masters of the Universe. Instead, we sustain and build our franchise by understanding that, while our product lines are designed to retain their value for the long term, there will always be discontinuities; and that we need to maintain our vigilance at all times in order to avoid disappearing into the proverbial black hole.

The Awbury Team

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It’s All Connected…Grey Rhinos and Black Swans…

Of course, we could be referring to Gaia Theory, but we are not. Rather, it is the time of year when the World Economic Forum’s (WEF) Global Risks Report (GRR) appears (http://www.oliverwyman.com/content/dam/mmc-web/Global-Risk-Center/Files/the-global-risks-report-2018.pdf), containing graphics that look like bricks in a wall or psychedelic mandalas.

In fact, the document is a useful one in a number of ways. Firstly, it provides some evidence of how others are thinking about risk; secondly, it contains an extensive catalogue of risks in terms of their potential impact and severity; and, thirdly, it allows the reader to consider not only whether he or she agrees with what is set out, but also what may have been missed or mis-categorized. There is always the danger of being caught by “framing” issues and failing to think beyond the Report’s contents; but, at Awbury, we aim to challenge the “usual approaches” and assumptions.

The Report does emphasize a key point; namely that one should not look at risks in isolation. This may be a truism, but the tendency towards “silos” within the (re)insurance industry (and many others) appears to be as strong as ever. In one sense, that is rational, as focused expertise should produce better outcomes in a particular business. However, an unwillingness also to consider factors beyond those clearly a component of a particular risk can lead to unfortunate outcomes, as connections or linkages are missed, often because of our cognitive biases.

For example, on the one hand we may obsess about a perceived risk because it comes immediately to mind and worry about Black Swan Risks which, by definition are not predictable, while on the other discounting Grey Rhino Risks (a term given recent currency by author Michele Wucker). The latter are risks which should be obvious (but are often neglected), can appear swiftly and are high-impact. The potential fragility of the PRC’s financial and housing markets is certainly one “rhino” that gives its government pause, but the question remains as to whether it will be willing to tackle the underlying causes effectively, or employ the tactics of another member of the financial menagerie, the Ostrich.

Rising income inequality is another “rhino” candidate. One can argue that the period following World War II was an aberration in terms of a more equal wealth and income distribution and the reduction in absolute levels of poverty. However, in our inter-connected world perceptions matter, because they can now be transmitted (and acted upon) almost instantaneously. Political systems appear to be stable and predictable (all those “checks and balances” and “social contracts”, or long-standing autocratic norms), until they are not.

And what of the fact that it is still “too quiet out there”? In the face of repeated surprises and shocks, one might expect financial market volatility to be higher, yet many measures remain at or near their lows, and equity indices march ever upward, beckoning more momentum trades, or Fear of Missing Out. If new narratives have to be developed to explain the “reasons” (remember the Dotcom Bubble?), it is unlikely to end well once sentiment changes, giving a different meaning to The Thundering Herd.

One needs to avoid availability bias (things that immediately come to mind, or are recent) and remember Sun Tzu’s aphorism: “If you know yourself and know your enemy, you need not fear the result of a hundred battles”. Risks do not usually exist in isolation, nor arise in convenient sequence, so one always needs to maintain vigilance and look for the connection between the seemingly disparate.

The Awbury team is definitely battled-tested, and we would welcome the opportunity to share our ideas.

The Awbury Team

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Look out for the Technicals…

No, we are not thinking of the improvised and brutally effective instruments of war popular in the Horn of Africa, but rather the ever-present issue of whether or not pricing in the (re)insurance markets adequately reflects the risks being accepted, or have sunk below the “technical” levels at which even the (re)insurers’ models say that a net underwriting loss is more than likely.

After the surge in insured catastrophe losses in the second half of 2017 (with Swiss Re Sigma and Munich Re tallying overall 2017 insured losses at around USD 135BN), there had been some hope amongst beleaguered and battle weary underwriters (suffering from PTSD- Premiums [are] Tanking Still, [we’re] Doomed) that the “1/1” renewal season would see sustained increases across the board in NatCAT pricing. However, this has proved to be largely a chimaera.

Ironically, the fact that ILS and other alternative capital sources (estimated by AON Benfield at some USD 82BN at end of Q3/17) responded in a timely manner, when coupled with more than adequate “traditional” reinsurer capital of some USD 518BN (so, USD 600BN in all), resulted in buyers often being able to call the bluff of underwriters holding out for significantly improved rates. There is now certainly a case to be made that ILS and other sources of “alternative capital” are to “traditional” (re)insurance as US tight (or shale) oil are to OPEC- i.e., the new form a swing producer, setting a cap on the ability of the market as a whole to sustain prices outside a range.

There were some exceptions, but most non-affected business lines appear to have stabilized at best in terms of pricing, with rates for severely-impacted North American policies managing to eke out increases, but even “double digit” increases hardly compensate for the loss of, in some cases, years of profits within such a short space of time.

Of course, NatCAT (re)insurance did exactly what it is supposed to do, providing capacity in an orderly, if at times, frenetic renewal process. However, that is cold comfort for managements and investors whose visions of the long bear market in rates ending appear to have been badly disappointed, as initial reports from leading brokers such as Willis, Aon Benfield and JLT have consistently emphasized- and this in an environment in which investment returns on the standard, fixed-income-heavy P&C asset base remain constrained; and in which the ability to continue with reserve releases is also diminishing.

All this then begs the question of how (re)insurers will respond. The search for new premium sources is likely to continue unabated; sub-scale businesses with no comparative advantage are likely to continue to be “prey”; and, yet again, executives will mouth platitudes about maintaining their “disciplined” underwriting processes, as they seek desperately to differentiate themselves from the average (which is still close to the median.)

New thinking and paradigms are desperately needed if the industry is to move, in developed markets, away from its strong correlation with overall GDP growth. Can Bitcoin Re be long in coming?

At Awbury, we are fortunate in having no “legacy” issues or processes, but our success continues to be based upon delivering to our partner (re)insurers, significant high quality, non-correlated premiums with excellent loss experience, and upon our ability not to be constrained by traditional approaches.

We cannot be a panacea, but we can help provide new sources of business.

The Awbury Team

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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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