Linear thinking is potentially lethal

We have written before about our concerns over the dangers of “framing” in respect of risk analysis. So were heartened to read a recent article by Olivier Blanchard (http://www.imf.org/external/pubs/ft/fandd/2014/09/blanchard.htm) who is the IMF Economic Counsellor and head of its Research Department in which he admitted that the economics profession had been lulled into what amounted to a sense of false security by the seeming fit that its largely linear models (based upon rational expectations) had for the so-called Great Moderation.

As the Great Financial Crisis and subsequent Great Recession which began in 2007-8 proved definitively, assuming that the period of volatility and erratic business cycles was an artifact of history was not only wrong, but very dangerous. Even in 2008, it was being argued as a matter of “faith” (!) that US house prices could not decline in nominal terms- and we all know how wrong that was!

Even supposed experts fail to grasp that, while many causal relationships, trends or probable outcomes are linear or bounded within certain parameters, many are not;  such that being constrained to think in such a way, or base one’s analysis and risk assessment upon models which are fundamentally flawed and fallible precisely because they have been constructed using a linear mindset leads to results that are “unexpected”, but should not be.

Of course, thinking in ways which are non-linear is not easy; and models tend to be linear because constructing ones which are non-linear is very difficult. Nevertheless, simply recognizing that “past is not prologue” and that just because certain outcomes are rare or have not yet been observed, does not mean that they can and will not happen.

In the world of natCAT modeling, there are various conventions (but seemingly no consistency) in terms of modeling the probability and severity of 1-in-50, -100, or -250 year events, which naturally is supposed to drive pricing and risk capacity. This helps to some extent in terms of aggregations and estimating relative risk appetites; but, in reality, such an approach is based upon heuristics and past observations. There is always the concern that an event will occur that has never been observed; and that, therefore, additional conservatism should be built into assumptions and pricing. Unfortunately, as current market experience clearly demonstrates, the idea of building in buffers seems to be an alien concept, as participants compete to retain “market share” or generate sufficient “top-line” revenues to justify their cost structures.

In Awbury’s E-CAT business model, our aim is to build our risk models from scratch, without relying upon “received wisdom” or past experience unless it can clearly be demonstrated that they provide an appropriate framework. Yet, even then, we go through a process of challenging each key assumption, asking ourselves: “but what if we are wrong? How bad could the outcome be; and does it still support rational pricing of risk versus reward?”

Exploring beyond the obvious, the linear, the expected outcomes may just maintain your solvency and viability.

-The Awbury Team

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Are you being creatively destroyed or systematically devastated?

We are sure that our readers are familiar with Schumpeter’s concept of “creative destruction”, now over 70 years old, in which a capitalist economy goes through various cycles, during which businesses are created and destroyed, unless they can adapt, in an unending and brutal process of value-destruction and creation, which has historically usually produced a net benefit to societies.

The P&C or general (re)insurance industry in its traditional forms is an ancient one, that has survived decades, if not centuries of change, conflict and turmoil; and gradually become embedded in the fabric of all developed economies, being able to adapt and create new products and serve new needs. However, it is now subject to a sustained challenge, not only from external sources of capital and some non-standard business models; but potentially from those who dominate other industries outside finance.

So, we believe it behooves industry participants to think deeply and without constraint about how they can adapt all aspects of their business (capital structure, product offering, pricing, cost structure) to meet threats that, in our view, are more systemic and systematic than many realize; because, like the ratings agencies who have long procrastinated in acknowledging the extent of the challenges that many industry participants face, seemingly successful managements are often reluctant to adapt until a threat is potentially existential.

After all, if one has a combined ratio firmly below, say, 90%,; a solid capital base; quiescent investors; and conservative investment policies, what can possibly be a problem? Well, what if demand simply migrates elsewhere and price competition becomes such that so-called “technical levels” are breached? If you do not have alternative sources of income and are unwilling to consider new business lines, or approaches that are “not the old, tested ways” in existing ones, you may find that you have no business and that someone else has walked off with your stamp! Opportunities, customers and capital will simply migrate elsewhere, even if the industry (or pockets of it) remains ostensibly profitable, because it is increasingly seen as irrelevant or ill-adapted.

At Awbury, we have learnt that we have to spend considerable time researching and anticipating threats and opportunities to our own business model and goals; and that “adapt or die” is not a trite, pseudo-Darwinian tag, but a fundamental component of being able to build a sustainable business. We would not be so naïve as to pretend that we have all the answers; but those in our industry who do not give serious thought to their environment, may find that they do face devastation, not just creative destruction.

-The Awbury Team

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Risk a is a 4-letter word…

The recent, very public lament by Doug Flint, Chairman of HSBC (and thus head of one of the largest and most complex financial institutions on the planet) that his colleagues were becoming too risk-averse and that the bank had 24,300 (sic) or about 10 percent of its staff “specialized” in risk and compliance, set us thinking about the management of risk- and how it seems to be becoming a “4-letter word” in certain quarters, while in others (such as the equity markets) “risk-on, risk-off” continues as before.

Quite clearly, when a bank has such a high proportion of its employees engaged functionally in risk management and regulatory compliance, there is something strange going on. Some of us at Awbury have been around long enough to remember a world when compliance departments did not exist; ERM was a throat-clearing exercise; and risk management was a relatively straightforward process, intended to make sure that loans were repaid on time. Halcyon days…

Now, of course, “risk” is everywhere; yet paradoxically it remains diffuse and often hidden. As the spectacular, but so-far relatively contained, implosion of Portugal’s Banco Espirito Santo demonstrates, risk can appear out of a seemingly clear blue sky: the bank was not brought down by its basic banking business or Portugal’s protracted economic problems, but because of its exposure to the collapse of a number of holding companies within its single-largest shareholder, the BES Group- the regulators’ “group risk” indeed!

It is not an exaggeration to state that global regulators and central banks have become obsessed with discovering where “risk” may have gone, or the form into which it may now have mutated. Is it still hiding in plain sight in the opacity of banks’ balance sheets; or lurking in the under-regulated “shadow-banking” systems? Will BlackRock and its ilk be responsible for the next financial crisis; or the failure to get macro-prudential policy right? Naturally, no-one really knows; yet everyone is supposed to have any opinion.

At Awbury, we are firmly of the opinion that one must be aware of and understand the fact that it is not usually the “obvious” risks that are likely to cause the most harm, but those that may seem  improbable or inapplicable; the nightmare of unforeseen “event” risks. This requires a flexible and unconstrained approach to risk-identification, trying to avoid the dangers of mental “framing” and being ever-vigilant about the risk of the improbable becoming the possible, then the likely. It also requires the use of what might seem “old-fashioned”, but are in fact axiomatic risk management tools- such as ensuring alignment of interests and the avoidance of adverse selection; full disclosure; careful structuring; and attention to detail. We believe strongly in focusing on a few transactions at a time, so that we can devote the appropriate level of attention to due diligence, remaining within our core competences.

So, risk is a 4-letter word.  It requires respect.

-The Awbury Team

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It’s a strange, strange world we live in…

The above line, from 1968’s Master Jack, came to mind as we surveyed our risk environment. Of course, in the realm of risk, situations may appear to change and new risks arise, but in reality much is the same, because the nature of risk bears a great resemblance to that of physics’ laws of energy conservation- risk may appear in different forms, but it is still risk; and it can and will harm you if you are unobservant and unprepared.

For example, could the Ebola outbreak in West Africa become a pandemic? Nothing new there. Pandemics are as old as humanity- just consider those from 1918/19, or mid-14th century Europe, dead in their tens and hundreds of millions from influenza and the plague. The difference today is that the rate of dispersion and speed of transmission may have increased.

Similarly, the risks from geopolitics may appear to mutate, but in many ways they are subject to the same factors that have had an impact on human events throughout recorded history- great power rivalries, religious intolerance and dogmatism, competition for scarce resources, clashing ideologies, megalomania and greed. The differences today are that Humanity now has the ability to destroy itself through nuclear weapons and that there are many more human beings competing for resources that, in certain areas, are becoming ever scarcer on a per capita basis- water, arable land, habitable environments. As for climate change…

And yet, we do live in a strange world now- a world in which central banks are trying actively to encourage the taking of risk through the maintenance of ultra-low interest rates and variations upon the theme of quantitative easing, while the paranoid amongst us keep looking for the next Minsky Moment and the collapse of asset values, as the investing herd stampedes for the exits, having been spooked by something that finally caught its members’ attention as “really bad”.; and one in which the substantial is increasingly replaced by the intangible in ways that make the consequences uncertain, because human behaviour may also be being changed.

At Awbury, we know how strange the world is, having seen the irrationality of regulators and the self-serving, incentive-addled behaviour of many of their supposed charges. We know that tipping-points exist; and that one has to assume that bad things can and will happen to the innocent and the unprepared. And we use such knowledge, experience and observation to try to design and craft products that adapt to our strange world and the needs of our clients; and protecting them from bad things happening to them, closely supported by our partner (re)insurers, who know a risk when they see one!

And now, back to our summer reading (of risk)…

-The Awbury Team

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The risks of August…

As students of risk and history, we cannot let the centenary of the formal start of the Great War (“the War to End all Wars”) pass without comment.

Many articles have been written and debates held recently in recognition of this anniversary; and the epithet, attributed to Mark Twain, that “History doesn’t repeat itself, but it does rhyme” had been frequently quoted.

As Christopher Clark’s brilliant book “The Sleepwalkers” makes clear, none of those who “caused” the war, actually intended the outcome, yet by their collective actions and decisions, they were responsible for what occurred. So, it is worth asking, at a time when markets have generally ignored the several geopolitical fault-lines on the Eastern Marches of Europe and along the Chinese littoral, why that might be- and why we at Awbury might think it important to raise the question.

In our view, there is a tendency in the markets to price perceived risks on a continuum (e.g. the “credit curve” and “expected losses”), as if the distributions are normal and always easily predictable. Often they are; and we would not disagree with that view in general.

However, we are in the business of providing Economic Catastrophe Insurance (E-Cat), protecting our clients against risks that are low probability but high severity, or franchise-threatening; so we have to try to understand, price and protect against risks which are, almost by definition, “in the tail” and where there are often few observations that are truly analogous to the risk being analyzed and assessed. Therefore, we are somewhat obsessive about researching not just the “simple economic” variables, but also how to design and structure our policies of protection in ways that align the interests of all the parties involved so that the actions (or inactions) and decisions of one party do not have an adverse impact on all the others. Naturally, this involves much debate and scenario analysis by the team, as well as discussions with and inputs from our partners; and we are paranoid about falling victim to “groupthink”. To use the diplomatic code, this involves “full and frank discussions”; and, to complete the circle back to start of World War I, it is arguable that, if the chancelleries and ministries involved had been better equipped for internal debate and less constrained by their own processes, the outcome might have been different.

Of course, the fact that, in the Northern Hemisphere, August tends to be a time when decision-makers try to take time away (and thus can be harder to reach, delaying the process of managing crises that arise) simply compounds the risk of an unforeseen or unexpected outcome.

Enjoy your August!

-The Awbury Team

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