The calm before the storm?

We have been monitoring the stream of Q1/14 quarterly reports coming from the publicly-quoted (re)insurance markets. Our overall impression is that the well-managed and well-capitalized players are performing will, with improved combined ratios and good capital retention.

However, we believe that there are a number of factors that mean that, as we have said before, significant restructuring is likely within the industry over the medium term- with Endurance’s contested bid for Aspen simply a foretaste of things to come.

Firstly, the flood of non-traditional and alternative capital in the (re) insurance market continues unabated, with CAT bond issuance in ever-greater size, where demand is driving price down, such as for Florida windstorm.

Secondly, the interest rate environment remains difficult for anyone trying to generate decent running yield on their Invested Assets, with returns grinding down as assets are re-priced. So, portfolio managers are forced either to “reach for yield”, which may well mean exposure to asset classes or valuations that are volatile and not really a proper match for P&C liabilities; or, their colleagues on the underwriting side should consider if there may be ways in which they can gain exposure and generate premium income more appropriately using the liability side of the balance sheet.

Thirdly, prices in many of the more “generic” or “better understood” risk classes continue their seemingly inexorable descent, which makes generating an adequate return on traditional capital increasingly difficult; and is beginning to lead to a 2-tier market, split between the “haves” and “have nots”- those who can and will be able to take such risks, and those who are simply storing up trouble.

Fourthly, some of the recent underwriting results have been flattered by continuing reserve releases, and the absence of any major, industry-affecting catastrophe events. On the former, we would simply say that, by definition, release of reserves is a finite resource and can quickly need to be reversed; while on the latter, we hesitate to say “it’s too quiet out there”, but we all know that there will be another “Big One”, of whatever sort.

So, at Awbury, we keep a weather eye on industry trends and developments, recognizing that we inhabit a dynamic environment, where being nimble, proactive, rational and flexible are virtues.

-The Awbury Team

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The impact of Piketty

In this post, we thought we would consider the potential impact of the recently-published and seemingly controversial book by the French economist, Thomas Piketty (now close to achieving Michael Lewis-like “rock star status”), entitled: “Capital in the Twenty-First Century”. This work has been reviewed by the most illustrious economists, by some more favourably than others; Piketty has been debated by Nobel Prize-winning economists; and been attacked by the US “conservative faction” (putting it no more specifically than that!)- all signs that a single book may be changing people’s perceptions about topics such as wealth-allocation and accumulation; income distribution; and fair taxation policies. Of course, the allusion to Marx’s Das Kapital, also engenders foaming at the mouth in certain quarters!

By now, our readers are probably rolling their eyes; and wondering what this all has to do with the world of (re)insurance: a fair question.

To compress many hundreds of pages into one sentence: the rise of a more equal, income-based society post World War II, was an aberration, in the long term domination in most societies of so-called “patrimonial capitalism”- i.e., wealth accumulated and controlled by very concentrated segments of a society.

Why does this matter to (re)insurers? Because Piketty’s thesis leads to the thought that if wealth is increasingly “patrimonial” and not as widely-shared as expected, consequences may include not only rent-seeking, inefficient allocation of capital, and the increasing domination by oligarchic elites, but also the potential for disaffection and agitation, rather than a steady evolution of more equal societies.

Again, perhaps more rolling of the eyes!

Then consider this: (re)insurance is a regulated industry and that regulation is of increasing severity and complexity ((re)insurers being “collateral damage” for the malfeasance of much of the western banking system).  Who controls the regulators; and who controls those who control the regulators? We have already seen comments that the SEC turned a blind-eye to certain demonstrably illegal actions by exchanges in the context of high-frequency trading (HFT), which clearly enriched a lucky few at the expense of the great multitude. What would happen, if regulation was controlled by those whose interests were entirely selfish and self-interested? Adam Smith’s “invisible hand” would start to twitch and become palsied.

And then there is rent-seeking and mis-allocation of capital. (Re)insurers depend upon the ability to invest and allocate capital as they see fit to earn rational, risk-adjusted returns. What if regulation and markets are distorted in ways that are covert and designed to benefit a narrow oligarchy that believes it knows best. We have spared the reader visions of future property and casualty risks!

Perhaps we at Awbury are paranoid; but being paranoid may help one survive somewhat better than those who dismiss something out-of-hand as being irrelevant or “not my problem”. If nothing else, think about the issues we have raised; and decide for yourself.

-The Awbury Team

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Herding and Pro-Cyclicality – The Antidote

Andrew Haldane, Executive Director, Financial Stability at the Bank of England, and one of our favourite iconoclasts, recently gave a speech entitled “The Age of Asset Management?” (http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech723.pdf), which is worth reading in its entirety.

It contains a number of interesting and thought-provoking observations; but the one that particularly caught our eye was how the behaviour of asset managers, and of those who appoint them as their agents, may have a greater influence on the pricing of risk than often considered in a world in which rounding up “the usual suspects” generally means taking a bank or banks behind the woodshed for a good, old-fashioned, regulatory beating.

Bankers are not the only ones who have a herding instinct. Fund and investment managers do too, because self-interest means that they are loth to make themselves vulnerable to significant underperformance against the benchmarks or indices against which those who appoint them tend to judge them. It truly is the unusual and the brave who are willing to take the career risk of sticking to their convictions and pursuing a consistent, rational, risk-adjusted investment thesis. Too many fund managers are “dedicated followers of fashion”, which results in a form of pro-cyclicality in which many try to invest in the same asset class at the same time.

The reason for asset managers’ increasing influence is largely a matter of scale; because the largest, such as Blackrock, control more assets than the largest global banks and (re)insurance companies. Almost all of this may be managed on an agency basis, but the flows of funds that these firms have to invest will only continue to increase, with the result that how, why and for how long they invest will have a material influence in all major asset classes; while, if they light upon a “faddish” sector they are capable of completely distorting pricing versus risk and volatility. One only has to observe the relentless grinding down of so-called “hi-yield” spreads to historic lows over Treasuries, coupled with the regulatory impact of reducing dealers’ willingness to hold inventories, to realize that at some point, when sentiment and risk appetite change, many are likely to be trampled upon in the rush for the exits.

This is why, at Awbury, we are particularly fond of those managers who operate in asset classes such as private equity, where skill, knowledge, length of experience, market presence, relationships and patience are traits which tend to result in superior risk-adjusted long-term performance; and where adding our ability to structure complementary insurance solutions leads to an outcome which is mutually beneficial to the managers, and those banks and (re)insurance companies with whom we partner; and where the interests of all parties are aligned.

-The Awbury Team

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Strategy: Who needs it?!

The word strategy, derived from the Ancient Greek word strategos, usually translated as general or commander, is a very popular term in financial circles; and has become so layered and freighted with accretions of what those who use it believe it stands for that it can be used to mean many things. Yet no self-respecting bank or insurance company can afford to be without its “strategic planning” department, or “head of strategy”; and woe betide the CEO who cannot clearly articulate his or her firm’s “strategy”!

We could write many posts on what the word can mean, so let us confine ourselves here to the fact that it relates to ends, ways and means; identifying objectives and ensuring that the resources are available to achieve them. However, strategy in the real world involves dealing with conflict, threats and competing interests. It is not just an abstract concept.

The reader will have gathered that the title of our latest post is somewhat “tongue-in-cheek”; because, while it is easy to mock the “transforming” or “essential” strategies supposedly beloved of the myriad of consultants who make a living persuading senior managers and Boards of directors to implement them, in reality no enterprise can succeed or prosper without at least a basic, viable strategy and an understanding of how it may need to be adapted to the environment in which it operates.

Slavish devotion to a strategy can lead to very unfortunate outcomes: “No plan of battle ever survives contact with the enemy” (Helmuth von Moltke) is a favourite of ours, as is Churchill’s “However beautiful the strategy, you should occasionally look at the results”.

Of course, we all know that insurance is a “contact sport”, so the use of military metaphors may not be out of place…

A little more seriously, at Awbury, we have learnt from experience that a key attribute of success is the ability to design and implement a coherent and easily explicable strategy in the FinCAT arena in which we compete, while at the same time recognizing that, just because one has created a strategy, that does not mean that it is now fixed or inviolable.

(Re)insurance companies (as well as bank) are at juncture where many, if not most of them will have to re-examine many of the assumptions that they have made about their business models, competitive landscape and regulatory environment, if they are to survive and prosper, rather than join the ranks of the “living dead”, unable to compete, and subject to event risks that they are unable to avoid. We shall write about this topic further in future posts.

-The Awbury Team

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Models: Fit for Purpose…?

No, we are not talking about the catwalks of London or Paris!

We have mentioned before our skepticism about the unthinking reliance upon algorithms and financial models; and how such behaviour led at least in part to the recent Financial Crisis.

Now we are returning to the topic, because recently we read a paper written by Paul Pfleider of Stanford University, entitled “Chameleons: The Misuse of Theoretical Models in Finance and Economics”- the sub-title warmed our poor analysts’ hearts!

In very broad terms, the basis of Mr. Pfleider’s thesis is that many models on which those in economics and finance rely (models, which he terms “chameleons” and to which we at Awbury would apply the term “chimaera”) are based upon assumptions which may have little connection with the real world, or with the purpose for which they are supposedly intended: they have not gone through relevant and valid “filters”; in essence a process that incorporates experience from the real world- in many cases plain old-fashioned common sense and experience.

It is a cynical truism that if one “cherry picks” the data one can produce a desired result, which may appear plausible; but is, in fact, biased and misleading. In the scientific world, there are brewing and historic scandals about peer-reviewed papers that were, upon closer examination, or the failure to replicate outcomes, demonstrated to be negligently-produced (to be charitable), or simply fraudulent- “cold fusion” anyone?

Conversely, it is also possible to “cherry pick” assumptions in building a model; which can lead to equally, if not more insidious outcomes, depending upon use and prevalence. This is not to say that assumptions are problematic in themselves- they are essential, and no financial or economic model can reflect fully the complexities of the situations to which they are applied. One simply has to understand and accept that as a fact; and exercise the appropriate level of skepticism and judgement.

Of course, there are some outcomes which appear counter-intuitive, or downright odd. M. Pfleider uses the analogy of quantum mechanics. The crucial point here is that quantum mechanics has been demonstrated empirically to be a reality, even if it is one that many of us probably grapple with in terms of conceptualization and visualization.

At Awbury, we of course use models as part of our underwriting and analytical processes; but either we build them ourselves, or put those provided by external parties through skeptical review, based upon our long experience of financial and related models.

So, beware of models that seem too perfect, or which its creator is unwilling or unable to explain, or tries to treat you as an idiot because you are “not smart enough” to understand it. Usually, such condescension is a sign of weakness and the creator’s own uncertainties.

-The Awbury Team

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