AQR: No, not the investment group!

In our acronym-laden world, the 3 letters, A..Q..R, are now putting fear into the hearts of bank executives and boards across the EU’s Eurozone- the dreaded Asset Quality Review is now in full swing, with the ECB having published its “modest”  285-page (of course, a mere jotting compared with Dodd-Frank’s monstrous corpus!) Phase 2 Manual giving guidance to the national regulators and their support crews of consultants on how to go about the process of ensuring that each of the banks targeted for review is screened and judged by late summer, so that the ECB can take up its new “super-regulator” role by November 2014.

Based on the muttering emanating from those subject to AQR, much time and energy will be expended on assuaging the assessors, detracting from the running of an actual bank- hardly conducive to enhancing the Eurozone’s supposed economic “recovery”. And already banks are trying to front-run the possible outcomes by announcing sudden and significant increases in provisions- witness Unicredit’s recent announcement of a modest EUR 14BN net loss for 2013 stemming from goodwill impairment and significant increases in loan loss provisions- and still its cash cover for impaired loans is only 52% (by its own accounting.)

In Awbury’s view, there will be much haggling between banks, regulators and the ECB before all is done, because the ECB has really only one chance to demonstrate its credibility ab initio, while the banks will want at least some ability to prepare for the consequences of what, in some cases, we are sure will be bloody outcomes.

Why do we at Awbury take such an interest in such European goings-on in the banking sector? Because we believe that the major, diversified (re)insurers with whom we work are potentially a significant source of new and standby capital for the beleaguered; and, therefore, have begun discussions with potentially affected banks about ways in which Awbury may be able to help structure capital support mechanisms tailored to a bank’s specific needs.

So, give as a call.  You will be glad you did.

-The Awbury Team”

Who’d-a-thought-it?!

The recent UK budget provided a salutary lesson in the consequences of unforeseen event risk and of being an undiversified “monoline”.

The proposed, radical, “once-in-a-lifetime” changes to the UK’s pensions regime, appear to have completely blind-sided the industry and all the commentators and experts- so, kudos at least to HM Treasury for not giving any hint of the potential carnage beforehand.  Of course, shareholders in specialist annuity providers, Just Retirement and Partnership Assurance (who saw gut-wrenching share price drops of 46% and 61% respectively) are probably not that happy…especially in the face of predictions that the annuity market may reduce by up to 90% (sic).

Event risk is the stuff of risk managers’ nightmares; and we at Awbury try to keep a weather eye out for factors or trends that may affect the risks we structure and underwrite. The number of scenarios in which bad things can happen is vast, but what happened in the UK was an abrupt and extreme version of political risk, in the sense that a party in government made a conscious decision, without prior consultation, to make a radical policy change that will have material consequences on a long-established, if widely disliked industry. Some industries just seem to be more vulnerable to such things- cf. mining, oil & gas, gambling/gaming, energy utilities (German nuclear power anyone?) and, of course, finance (in spite of its supposed cozy relationship with political power).

Therefore, when we underwrite any risk, we try to understand and analyze all the factors that could have a material adverse effect on any of our policies. Some risks are probability based, some are not. It is the latter that cause most concern, for they are difficult, if not impossible to price properly; but every time an event happens (say, BP’s Macondo tragedy, or the UK annuity debacle), we learn more and can factor it in.

The other key lesson from the annuity debacle is that it is dangerous to be dependent upon only one type of revenue stream, especially one that is so closely entwined with public policy issues, because then one becomes vulnerable to a single action severely damaging or even destroying one’s business model. We believe that one of the strengths of Awbury’s business model is that the broad panel of reinsurers which backs us are not only substantial businesses, but also diversified; which significantly reduces the risk and probability of any one event having such an impact as to damage their financial strength and payment capacity.

We are not so foolish as to believe or claim to be omniscient, but we do believe that our seasoned and experienced team is sufficiently knowledgeable and diverse to be able to manage and mitigate appropriately the risks of our FinCAT business.

Is Separatism a returning trend?

The Peace of Westphalia and European colonialism, have a lot to answer for; having reinforced the concept of the “nation state”, while in the case of European colonialism, creating some arbitrary and nonsensical “countries” which most assuredly were not, nor are, “nations”.

This thought came to us in light of the furore over the Crimean secessionist referendum; the pending Scottish referendum; continuing unease between Catalonia and the Spanish polity; and the potential resurgence of Quebec separatism as a potent political force within federal Canada. Of course, the sorry recent history of South Sudan and the question of Kosovan viability as a truly viable independent state reinforce the point that “self-determination” may be a principle, but its practical outcome can be decidedly unfortunate!

So, why do such events matter to Awbury? We are in the business of structuring and writing “FinCAT” insurance; and we would prefer it if the “tails” in risks we write were definitely “thin” and the risk/reward relationship reasonably predictable. Not for us “fat tails” and nonsensical concerns about the expected standard deviation being demonstrably inadequate for the facts!

All of the above-mentioned examples, create the potential for outcomes that require one to revise one’s view of potential scope, probability and range. They increase risk, which can be priced, but also uncertainty- and it is uncertainty that is the real problem.

For example, there is a game of “cat and mouse” going on between Her Majesty’s Government and the Scottish National Party (SNP) over use of the Pound Sterling; access to the Bank of England; and responsibility for sovereign debt should Scotland achieve true independence as a new (old!) independent state.

No-one seriously believes that the United Kingdom, even if shorn of Scotland, would refuse or be unable to honour the “Scottish portion” of the National Debt should a newly-independent Scotland seek to repudiate its deemed obligations, but the discord and posturing raise the level of uncertainty for an already stressed UK banking system, much of which, for reasons of history or legal quirk, just happens to be domiciled in Scotland. So far, we do not believe that this uncertainty has been priced in; but what if the unexpected does happen and there is a clear vote for independence? One would expect disruption and re-pricing as the implications are quickly factored in.

Therefore, we should all pay attention to the unfolding of events in some seemingly distant and unconnected places. They can produce unpleasant surprises.

-The Awbury Team

Who’s in charge here…or the new Masters of the Universe?

For those of us who have some knowledge of orders of chivalry (republicans look away now!), there is an old joke about the true meaning of two of the designations of the British Order of St. Michael and St. George- “KCMG” means “Kindly Call Me God”; and “GCMG” (the most senior rank below the Sovereign) means “God Calls Me God”.

So, you may well ask, what has this to do with our world of Financial Catastrophe, or FinCAT? For a start, the term “Act of God” is not exactly unknown to insurance underwriters; yet, on the other hand, we at Awbury believe firmly that God has nothing to do with the risks we analyze; and that the policies we structure and issue are based upon identifying and understanding all the factors and data that may affect an outcome or cause an adverse event.

That said, we certainly do not believe we are omniscient or infallible; and definitely have no “God Complex”! We know that our world is a volatile and uncertain place; and that calculations of risk vs. reward are ones of probability, not certainty.

What concerns us is that we do believe that there are those among us who are beginning  to believe that they “know better”; are not subject to the same rules and constraints as “mere mortals”; and have a “divine right” to whatever advantage they can accrue.

You may  think that this could be the case with certain bureaucrats within, say, the US NSA of the UK’s GCHQ; and clearly governments, republican, monarchical or tyrannical, often believe that they can act as they wish because they have the coercive power of the State behind them (until they do not…), democratic accountability be damned.

Yet, in our data-driven, relentlessly “on” world, could it be that the new class of Masters of the Universe (they are still culturally and genetically mainly male) are to be found within a number of dominant technological and financial franchises? We will mention no names, because we do not wish to target any entity in particular- but you know who they are- and they probably know it too!

Our point is that our industry depends upon the quality, accuracy and reliability of data; data we can verify and trust; and whose sources may not be disinterested, but whose motivations and weaknesses we can take into account. These sources are increasingly concentrated so far as “raw” data are concerned, even tho’ there are countless businesses that generate products and profits derived from those data. However, what if the data are manipulated or distorted, because those who provide them have motives that are hidden? Governments have a long history of doing such things (Argentine inflation statistics anyone?), but the increasingly dominant for-profit providers remain generally untested- and the distortions would not have to be material to have an impact. For example, any life actuary knows how a relatively small change in mortality assumptions can generate a significantly different outcome.

Therefore, it behooves us all to retain a skeptical disposition; and not to believe that those providing essential data are necessarily idealistic and altruistic. Some may have begun with that outlook; but power and wealth have a tendency to corrupt…

-The Awbury Team

The Dark Lord Ascendant…?

Recent and continuing events in emerging markets and in the Ukraine have demonstrated clearly how irrationally and emotionally markets, whether equity, FX, bond or credit, can behave in terms of assessing and pricing perceived risk. “Risk On/Risk Off” appears to have returned with a vengeance;  while the S&P and other indices scale new heights.

At Awbury, we believe that, while one cannot ignore what the market “thinks” is the appropriate price for a particular risk at any point in time, one has to remain focused and rational and try to avoid being distracted by the noise that often corrupts or obscures what the true risk/reward calculation should be.

Of course, our world of Financial Catastrophe (FinCat) insurance is, by definition, one in which an underwriter has to be very sure that his/her assumptions and risk modeling are robust, rigorous and defensible; and that what is being priced is risk, not uncertainty, as we have commented before.

Rather than obsess over what seems increasingly a misleading distinction between Developed, Emerging and even Frontier markets (which can lead to all sorts of framing issues), one should focus on the true nature of the risk; the context in which it is being underwritten; and the legal and institutional protections that surround it. Which would you rather have: Greek bonds under local law, or under English law? Is Greece a Developed market, or (re-)Emerging?

Thus, to be able to price a risk properly, one must consider it dispassionately and rationally; because, in doing so, one is much more likely to make a decision that is proved correct and avoids loss. To paraphrase Benjamin Graham, in the end the Market is a weighing machine and will find you out.

Of course, the Dark Lord can be your friend, when he prevents you from becoming part of the casualty list of those left exposed by underpriced risk, weak terms, and unenforceable contracts, because the market “thought” it knew better, misunderstood correlations and probabilities, or viewed QE and central bank behaviour as rational (the Eurozone is “an island of stability”) and predictable.

Awbury’s view is that one needs to understand that emotion does have an often-unacknowledged influence in decision-making and that one needs to factor that into one’s underwriting analysis, trying to determine the extent to which it may affect outcomes or events.

-The Awbury Team

Everything, including the kitchen sink…

We read RSA’s recent 2013 year end announcement and presentation with considerable interest, because it proved to be what we consider a classic example of “kitchen-sinking”.

Firstly, we should state that we believe that the appointment of Mr. Hester was a masterstroke, given his previous experience at RBS and British Land; and his access to government, regulators and the City. Plus, he is a Yorkshireman, with a deep love of trees!

That said, so far as RSA is concerned, what happened in 2013 was clearly a bit more than a “little local Irish difficulty”, given the size of the Rights Issue (GBP 775MM) and the elimination of the dividend.

If one looks at the key factors for 2013, apart from the well-publicized issues in Ireland, not much went right for the group- underwriting results, the Combined Ratio and investment income all deteriorated overall, with 2012’s PBT of GBP 448MM being transmuted into a loss of (GBP 244MM) –i.e., a swing of almost GBP 700MM on NWP of GBP 8.7BN, after unusual items and provisions.

That said, premium levels held up well; and the Group clearly has some solid businesses outside the UK, particularly in Scandinavia and Canada. However, one should note that GBP 356MM  of Reorganization Costs were slipped in, including GBP 110MM of goodwill impairment in Argentina and Poland, and a somewhat surprising GBP 221MM of “software impairments” in the UK business. So, it would appear that the opportunity has been taken to get as much bad news and negative adjustments taken care of at the start of Mr. Hester’s appointment; which, as we said above, looks very much like a classic corporate “kitchen-sinking”, such that Mr. Hester is not impeded by misfortunes from the past and can manage RSA’s turnaround as he sees fit.

Of course, the other classic usage in the announcement is that of showing what outcomes should have been in “normal circumstances”; which, naturally, demonstrate that things are not really so bad! While we can understand that, when one is about to tap the City for a reasonable amount of cash in order to restructure, nevertheless, we hope that those taking up the rights will look closely at what was published and make an informed judgement as to whether the assumptions made are reasonable.

Quite clearly, the PRA and other regulators, will be watching closely whether the Rights Issue is a “success”; and must hope that there are no more “negative surprises” that have yet to come to light. We are sure that there have been numerous “full and frank discussions” between the parties concerned; and that a person of Mr. Hester’s calibre and experience will have insisted on full “warts and all” disclosure before agreeing to take on his new role. We wish him and his team success, because it is always unfortunate to observe a venerable and respected market participant in distress.

From Awbury’s point of view, RSA’s recent experiences simply demonstrate that one should never assume that the first news is the worst news; and that institutional survival usually depends upon a combination of factors, including franchise, open relationships with regulators, the willingness of a Board to take prompt action, and the ability quickly to identify causation and realistic remedial action.

There will be other “RSAs”. There always are.

-The Awbury Team