Baden-Baden Blues…

The recent reinsurance industry conclave at Baden-Baden provided further examples of an industry which remains unsure whether its glass of Riesling is half full, or half-empty; and whether it should be studying existentialism or remain Stoic in the face of adversity. Of course, given the setting, we are sure that the Epicureans were also well-satisfied!

More seriously, it seems to us that certain trends are becoming ever clearer:

Pricing in NatCAT is likely  to continue to soften

  • Reinsurers are increasingly seduced by the so-called hedge fund investment model, but are not wholly convinced about the extent to which they should embrace it; or how doing so will affect their ratings
  • The multi-channel capital delivery mechanism is here to stay- traditional, alternative, ILS, sidecar…
  • The continuing surfeit of capital means that even a “megaCAT” of USD 100MM may not be sufficient to cause a sustainable hardening market, because attempts to increase pricing will attract yet more, non-legacy capital
  • Capital may be considered relatively cheap at present; but, for most, the returns on it are likely to be in single digits
  • Everyone considers themselves to be a better than average underwriter, able judiciously to accept or reject a risk; which, of course, is nonsense
  • If you ain’t in “cyber”, you ain’t a player. We can only imagine such enthusiasm at some point ending in tears for many participants, given the potential scale and impact of a serious breach
  • Apart from “cyber”, there is an anxious hunt for new products and new geographic markets.

This evolving paradigm leads all of us at Awbury even more convinced that our focus on underwriting complex credit and related risks, indifferent to the perils of NatCAT, but well aware that there is significant untapped potential in our E-CAT (Economic Catastrophe) space, is the right way to go, as long as we remain adaptable and disciplined. As always, we will continue to deliver solutions to our clients’ real issues, in a way that is no commoditized or price-driven, yet provides our Insureds with clear and capital- and cash-effective benefits, and our partners with excellent risk-adjusted revenue streams.

-The Awbury Team

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“My heuristic is better than your model…” (Part II)

In our previous post, we made the point that, while financial models are an essential part of decision making, nevertheless (as pointed out in a recent Bank of England paper), they can often be surpassed in usefulness in unstable or chaotic markets by relatively simple heuristics, or so-called “fast-and-frugal” decision trees (FFTs).

Such an approach can be particularly useful in circumstances where there is concern about systemic failures and which institutions are most likely to fail; or when, as in the case of capital ratios, financial models tend to smooth out the tail distributions, such that a risk might be considered a “1-in-1,000 year” event (i.e., assessed at a 99.9% confidence level), whereas experience teaches that, for example, highly leveraged institutions such as fractional-reserve banks, experience stress and risk of failure with a much higher frequency. One only has to look back at the financial history of the past 7 years, let alone past century, to know that reality conflicts with theory!

The Bank of England’s researchers reviewed the performance of the relatively crude risk-weighting measures of the Basel I and Basel II Standard models and compared their robustness with the results of the Internal Rating Based (IRB) approach used by most of the supposedly sophisticated banks; and found that in most cases (particularly using Basel II), the Standard model was a much better basis for calculating the levels of capital needed to withstand actual default experience. Naturally, we at Awbury are shocked (shocked!) that banks would seek to minimize their capital needs. Of course, the advent of Basel III and all the other regulatory measures currently being promulgated and imposed are intended to minimize the probability of future failures, or at least to ensure that they do not come at significant expense to the public purse.

One of the key conclusions of the exercise undertaken by the researchers was that complex models work best when information is plentiful and robust, and data-generating processes generally stable. Intuitively, this seems rational; which tends to emphasize the need for experience and the maintenance of longer “institutional memories” in order to counteract the blandishments of quants trying to fit outcomes into their models.

Another instructive analysis undertaken was to create a possible FFT for assessing the vulnerability of banks to failure, to complement the complex regression analyses beloved of economists and analysts for such purposes. In essence, the researchers tried to determine which relatively simple metrics might be used to flag a higher potential for failure. Perhaps not surprisingly (and, again, intuitively), they came up with 4 metrics: one for “raw” leverage; one for risk-weighted capital; and two related to liquidity (percentage of wholesale funding and loan to deposit ratio.) Of course, the choice of these metrics may explain why bank regulators are introducing a similar combination of key metrics under Basel III and its equivalents. No one approach is foolproof, but the research demonstrates that a fairly simple FFT is generally as robust as much more complex models; and, importantly, does not need significant amounts of data to be effective, thereby assisting in swift decision-making; while their relative simplicity makes them much more difficult to game.

The lessons that we at Awbury take from this are that in analyzing risk one needs to strike a judicious balance between financial models and relatively simple heuristics; that a combination of the two produces a more robust outcome than either in isolation; and that experience matters, because only with experience comes the ability to recognize and understand need for such judgement.

-The Awbury Team

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No peace in Westphalia…

The concept of the nation state assumed its classical and current form after the Peace of Westphalia (actually a series of treaties) ended the destructive Thirty Years War in 1648. Since then it has generated other concepts such as the “balance of power” and “sanctity of borders”, which have become part of the interior furniture of geopolitics and diplomacy.

And yet, in a post-colonial, potentially multi-hegemonic world, it is becoming increasingly obvious that the idea of what is a nation state, which probably reached its apogee at the turn of the 21st Century,  and of who has the power to define one are beginning to change, with potentially serious consequences for stability and the many freedoms that most in the so-called West at least take largely for granted.

One only had to observe the extraordinary spectacle of the Scottish Referendum in mid-September when one of the most successful political and economic unions in world history came within 400,000 democratic votes of fracture (including those of 16- and 17-year olds), to know the world has changed and that the tension between maintaining existing borders and the perceived right of self-determination is one that is very unlikely to lessen and almost impossible to suppress absent a self-destructive ruthlessness of the sort currently exhibited in Syria and to a lesser extent China.

As a result, the art of assessing political risks in the medium to long term is becoming even more complex than it already is, because one now has to factor in an additional level of uncertainty in terms of determining whether the entity whose ability, willingness and capacity to pay are fundamental  stands a reasonable chance of actually surviving in a form that will provide a successor state that represents an acceptable risk. The United Kingdom without Scotland, or China without Xinjiang (to use a low-probability example) is one thing; but Spain without Catalonia, or Italy without “Padania” is very much another.

The problem is that these are perceived as “tail risks”; and so are rarely reflected in a rational calculation of risk versus reward, because analysts find it difficult to accept that such events, while rare, will actually happen- until they do! And, of course, political elites generally have an interest in maintaining the status quo because of the power and privileges they arrogate to themselves and a fear that these, and their “standing” in the world, will be diminished if they allow a segment of the deemed “national population” the right to decide upon whether or not it wishes to remain part of the same polity.

At Awbury, we recognize that, depending upon the nature of the risk we are being asked to underwrite, asking all the relevant questions may well include asking not only the Westphalian, but also the West Lothian Questions! Concepts and identities matter, even if they are often hard to factor into a risk assessment.

-The Awbury Team

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