Innovation and Intellectual Capital

We attended the recent InsuranceDay 2014 Bermuda Summit and were fortunate to be able to give a presentation about E-CAT (Economic Catastrophe Insurance), the core of our business model-  which generated a positive response and feedback.

A key theme of the conference was how innovation remains essential in the (re) insurance industry (as it does in any other that wishes to remain competitive) across a broad range of areas, from underwriting, to data acquisition and management, to risk selection and pricing. We at Awbury could not agree more. After all, “CAT bonds” are not new technology, nor is “alternative capital” something that suddenly appeared “ex machina” in recent years. If any (re)insurance centre has a history with being such a source, Bermuda does!

From our point of view, supported by our partners and in conjunction with our clients, we believe that we are living proof that a combination of innovation and intellectual capital, unconstrained by bureaucracy or the need to serve “higher purposes”,  can build and sustain a viable financial business, in an environment in which many parts of the industry (banks in particular) have lost the ability or will to create new businesses and business models. In fact, it is becoming a truism, that much of the innovation being seen is in so-called “shadow-banking”, which in fact denigrates many who wish to have nothing to do with banks!

The audience at the Bermuda Summit understood our thesis (and that or other speakers) that there are secular changes under way, which will lead naturally to a vast range of opportunities in E-CAT for those willing and able to recognize and seize them across a range of themes. We know from experience that product and business development never quite turn out as one might have expected, but also that as long as one does not become trapped in a “framing” mentality, opportunities do and will continue to arise, as many financial markets grapple unsuccessfully with the intended and unintended outcomes of regulatory behaviour, political bias, commoditization and geopolitical trends.

Being nimble and able to “dance between the raindrops” remain essential to Awbury’s continuing success; and we remain committed to helping our clients address issues in a way that protects their own franchises in financial and economic terms.

-The Awbury Team

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Liquidity: The Risk that dare not speak its Name…

There seems to be a general belief that, because of central bank actions in keeping interest rates at or close to the “zero bound”; practicing various forms of “quantitative easing” (including monetizing government debt); and stuffing banks with cash via deposits maintained at the central bank, the financial world is awash in liquidity.

Certainly, with the burgeoning “credit bubble” being generated by desperate return-seeking “investors” and the influx of “alternative capital” into traditional insurance markets, such as NatCAT, many might argue that this has become a truism. However, capital is not liquidity. In theory any investment that carries risk and has an element of maturity transformation (banks being the locus classicus), should include assessment of liquidity risk in how the return or spread is determined.

However, financial history demonstrates time and again that liquidity risk is ignored and mis-priced. Banks are “ticking bombs” in terms of liquidity risk, because, when confidence in their solvency vanishes, they are never able to meet a sustained run by depositors demanding cash or the equivalent in a deposit transfer; yet they are now the main creators of what amounts to private money beyond the Note Issue supported by the “full faith and credit” of a central bank or other monetary authority. One only has to look at what happened during the Great Recession in various jurisdictions to understand how vulnerable banks are.

Similarly, in capital markets, liquidity risk is often ignored in reality, because investment managers have the repeatedly demonstrated tendency to crowd, herd and panic together, often making a mockery of supposedly “liquid” markets, so one always needs to consider who is the “market-maker of last resort” and can provide liquidity in all conceivable circumstances.

Conversely,  diversified (re)insurance companies, such as Awbury and its partners, are not really vulnerable to liquidity risk, provided they have managed their exposure correlations and concentrations proactively; and their Invested Assets on General Account are of appropriate quality, diversity and maturity. A key point is that policies of insurance, such as Awbury’s, focus on payment of realized losses, which is intended to avoid the liquidity risks inherent in transactions or products which are subject to market prices or forced liquidation at market.  With a bank, a depositor has the right to demand cash; with a (re)insurance company there has to be an Event covered by a policy of Insurance: the risks are not the same.

At Awbury, we are somewhat paranoid about ensuring that there can never be any shadow of doubt that one of our policies will answer in a timely manner and in accordance with its terms whenever there may be a valid claim.

-The Awbury Team

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The View from the Bridge…

We recently returned from a visit to London, where we met with as many of our (re)insurance and other partners as we could. It was time well spent, as it gave us the opportunity to present Awbury, what we are about, and what we are working on to those who make our business model possible; and whose support is a critical part of our franchise.

It seems clear to us that increasing interest in our E-CAT (Economic Catastrophe) business, where the retreat of the banks from a number of businesses is leaving whole areas of risk management underserved, is being driven by a combination of three factors: i), recognition of the sheer scale of the opportunity E-CAT presents; ii), in working closely with the Awbury team, the growing confidence of our (re) insurance partners in Awbury and the building of in-house expertise; and iii), the continuing, seemingly relentless pressures on pricing in traditional NatCAT lines . This creates the opportunity for the design and provision of solutions to complex issues and problems by those willing to engage with clients and work with them on tailoring structures and transactions which address real needs, thereby providing an economic benefit.

As a case in point, consider the fact that both the quantum and quality of the capital the banks are required to have is increasing inexorably, under both the Basel III and the Fed rules; with no real end yet in sight, as regulators compete to try to ensure that the level of fragility and instability shown by banks after 2007 does not return to undermine a still fragile global economic recovery. The intent may be admirable, but the consequences, whether intended or not, are already being seen in areas once considered to be core parts of any commercial bank’s business- such as the provision of Letters of Credit, Revolving Credit Facilities and even acceptance of Corporate Deposits. Such trends will only be exacerbated by additional regulatory requirements on leverage and liquidity due to come into effect over the next few years. As a result, a broad range of bank clients are increasingly receptive to considering different ways of addressing their risk management needs, recognizing that their banks may no longer be there for them. Paradoxically, regulatory behaviour runs the risk of creating the very instability it is trying to suppress.

We believe that this trend is secular and will prove enduring, generating attractive risk-adjusted returns for Awbury and its industry partners, while at the same time enabling us to address our clients’ needs.

-The Awbury Team

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From the beaches…

We recently attended the Bermuda Captive Conference at the beautiful Southampton Princess (tough, but needs must…!), which was notable for a number of factors- a record attendance for its 10th year; the breadth of representation from both Bermuda and overseas; and the overall optimism that the Island’s (re)insurers will continue to adapt and prosper in the face of the secular trends besetting the industry.

Bermuda is fortunate that, in the Bermuda Monetary Authority (BMA), it has a regulator which managed to achieve recognition as “equivalent” from both the NAIC and the EU’s regulatory authorities. This enables locally-incorporated (re)insurers greater freedom and flexibility in how they conduct business; and should demonstrate to the global financial markets that Bermuda has robust and respected regulatory framework.

Similarly, the Island’s government, in the form of the Premier, who addressed the Conference, made it very clear that it supports the (re)insurance and captive industries, recognizing the value to the local economy and workforce of the continued presence of financially-strong employers in whose interests it is to develop talent and intellectual capital.

That said, there are clear signs of stress in some areas of the “CAT” market, because renewal pricing continues its seemingly inexorable decline; and it remains to be seen whether and how underwriting discipline will be maintained, when revenue streams are being impacted to an extent that may begin to affect franchises and distort cost/income ratios.

What was also interesting was the increasing prevalence of reinsurance vehicles backed by hedge funds, where there is risk aversion on the liability side (allegedly CAT risk is avoided, and “boring” business preferred), but an expectation of returning 15%+ on the funds generated from premia and reserves: the mirror image of a traditional “CAT” (re)insurer. What happens if the investment algorithms do not work, is somewhat unclear. One wonders how patient the investors and capital providers will be. One also wonders what will happen if (re)insurers and captives start giving their reserves to the hedge funds to invest in the hope of higher returns, which subsequently do not materialize; or, worse, whose value is eroded by volatility or losses.

Of course, Warren Buffett has been following a float-investment based model for many years very successfully, as well as being willing to write “CAT” contracts in size; but there is, after all, only one Berkshire Hathaway, with its scale and immense financial strength.

At Awbury, we shall continue to build our E-CAT (Economic Catastrophe Insurance) franchise, indifferent to the vagaries of the NatCAT market, but always ready to adapt as markets and opportunities change, as we expect our peers on Bermuda will also.

-The Awbury Team

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