I am so stressed…!

The US Federal Reserve recently published the results of its now annual assessment (Comprehensive Capital Analysis and Review, or CCAR) of the capital adequacy of the 31 largest Bank Holding Companies (BHCs) in the US, under its stress and adverse stress scenarios.  Interestingly, all the banks involved passed the first, quantitative, stage; but two, the US BHC’s of Deutsche Bank and Banco Santander, failed the second, qualitative one, no doubt leading to further gloom and angst in Frankfurt and Madrid.

Not surprisingly, the Fed is deliberately coy about the criteria it uses to assess compliance with CCAR, thereby causing much pre-announcement nervousness amongst many senior bank executives. Of course, if the details of the qualitative criteria which the Fed uses to make its determinations were public knowledge, those subject to CCAR would doubtless find ways to game the system, using their disproportionate resources to try to overwhelm the regulatory system.

That said, while it may be satisfying to take out the odd bank and metaphorically shoot it pour encourager les autres, the continuing and continuous pressure on banks remains a significant distraction to many of them; and beg the question of how much attention they are really paying to managing their businesses; assessing risks in the real world; and determining how to continue to generate satisfactory risk-adjusted returns.

The arguments about whether fractional reserve banking is a viable business model for the future will, no doubt, continue, as non-banks and alternative financial models continue to be created and expanded. However, it does seem likely that the days of the universal banking model are numbered, as the supposed benefits of “diversity”, capital and “reach” are called into question by falling returns and not infrequent “accidents”, let alone periodic exhibitions of the difficulties of ensuring compliance with appropriate legal and ethical standards. This is likely to lead (pace Mr. Dimon!) to increased demands for simpler structures, legal separation of retail banking and payment systems from, in particular, wholesale and investment banking platforms, and further restrictions on the ways in which a bank is permitted to put its capital at risk- even in the face of the fact that, for the largest US banks, their capital ratios have actually doubled in the past 5 years.

Of course, we are not stating that banks are inherently unstable or necessarily existentially threatened; but it does seem clear to us that, as their model evolves, they remain in need of assistance in managing their capital, assets and liabilities in the most efficient and effective ways, so that they can continue to provide the essential, utility-like services without which no modern economy can function properly.

So, in an environment in which regulatory demands are still rising (CCAR being almost child’s play compared with creating a “living will” that will satisfy a regulator that it can “resolve” a failing bank in a non-disruptive manner), Awbury continues to develop and refine techniques for assisting its banking clients with managing and mitigating the risks to their capital and balance sheet, taking account of the latest regulatory and industry developments, as well as looking forward in an attempt to predict and interpret longer-term trends.

So, give us a call. We can help.

– The Awbury Team

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Only believe…

We have long admired and followed the performance of Warren Buffett as the manager and capital allocator of Berkshire Hathaway. His track record speaks for itself, both in absolute and relative terms; and, of course, he (and his partner, Charlie Munger) are justly celebrated. However, we become concerned when prudent admiration gives way to behaviour akin to a cult; not because we do not believe that Messrs. Buffett and Munger deserve the praise heaped upon them, but because it demeans the quality of their thought and ability as risk managers, not just investors.

We read with relish Mr. Buffett’s recently-published annual Shareholder Letter- a special 50th Anniversary edition, so to speak- but were even more interested to come across and read his letter to the partners in the Buffett Partnership Limited (BPL); published in early 1966 and reviewing BPL’s performance during 1965, the year in which he acquired control of textile company Berkshire Hathaway (ironically, one of his poorer investments). And the rest, as they say, is history!

Reading the letter is a trip down Memory Lane, to a world in which there was a “$35 billion investment company industry” and active fund management was underperforming the Dow. Some things have changed; some have not!

So, why would we consider a 50-year-old letter, written by an investor focused primarily on equity and private capital investment, relevant to our world of E-CAT and (re)insurance (leaving aside the fact that Mr. Buffett wrote the book on using insurance reserve “float” as a source on longer-term capital)? Partly because it contains the usual examples of Mr. Buffet’s clarity of purpose and thought; and partly because, as is now expected and widely anticipated, it contains the aphoristic style of “Buffetisms”- “in the lyrical words of Casey Stengel, “Show me a good loser, and I’ll show you a loser.””

Amongst a number of topics, the letter focuses on measurement; the sometime siren call of “[over-]diversification”; the need for quality of thought rather than quantity; and ensuring that one looks at outcomes and opportunities on a risk-adjusted basis, such that a particular opportunity offers significant potential upside, with a very low risk of a downside- a classic positive skew of risk- often sought, but not so easily found; and very much in line with Awbury’s approach.

We would not have the temerity to “out-Buffett” Mr. Buffett (and while an experienced team, we are not yet eligible to draw Social Security!). However, we do firmly believe that much of what underlies his success can and should act as a guide to building and maintaining a successful business. We focus carefully on a number of areas, or themes, where we believe we can demonstrate that the risk-adjusted returns are both highly attractive and scalable; we do not presume to venture beyond our areas of competence and understanding; and we are very careful to ensure that we can devote sufficient attention and resources to actions that have a measurable and significant positive outcome. We are well aware that one of the mantras in the (re)insurance industry is now “diversification” in terms of product lines and sources of premium. This is rational if one is trying to offset revenue concerns, excessive competition or declines in a particular area of one’s business, such as NatCAT, and the additional lines are non-correlated and significant (as the opportunities that Awbury provides demonstrably offer). Equally importantly,  (re)insurance industry CEOs and CFOs need to focus (as does Mr. Buffett) on the most effective allocation of capital to generate both significant underwriting revenues, but also low-cost, high-return, high-quality net underwriting income. That is what builds long-term value.

And to use another, apposite salutation from a certain Vulcan: “Live long and prosper”!

– The Awbury Team

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Oblivion insurance, anyone? Or, when I said “CAT”, I was only joking…

In a world in which risks seem to appear, or return, more often than one might expect (cyber-risk, climate change, driverless cars, or War on Land, anyone?!), it is not sufficient, if it ever was, to maintain the view that “There is nothing new under the Sun”, but rather to consider that “There are more things in Heaven and Earth, Horatio, than are dreamt of in (y)our philosophy.”

Even if one is an underwriter narrowly focused on a standard class or product such as NatCAT, one still has to ask the question as to whether the models and assumptions one uses are sufficiently robust and predictive to enable one not only to price risk appropriately, but also deal with the consequences of extreme events.

So, we were interested to come across a recent report co-sponsored by the Global Challenges Foundation and a number of departments of the University of Oxford entitled: “Global Challenges- 12 Risks that threaten human civilization”. We won’t list them all, but, apart from the “usual suspects” such as climate change, nuclear war, artificial intelligence and major asteroid impact, we might mention synthetic biology and super-volcanoes.

Of course, in the end we are all dead (!), but we like to think that our institutions and societies will survive and prosper, assisted in part by the underpinnings of robust risk management and (re)insurance.

One aspect of the report that amused us was the fact that it excluded such matters where there are no effective counter-measures, or ways in which to mitigate the consequences- such as a near-space gamma-ray burst- something which, of course, we think about all the time…

However, what the panel that produced the report did attempt, where it believed it was feasible, was to assign a probability, or range of probabilities, to a category. Those of a nervous disposition should look away now! Bearing in mind that we are in a realm beyond even that of Nassim Taleb’s Black Swans in existential terms, anything less than zero may give pause for thought. Interestingly, the “winner” was Artificial Intelligence with a range of 0 to 10%. The following quotation, in the context of the next 100 years, gives an idea of the authors’ concerns: “Putting the risk of extinction below 5 per cent would be wildly overconfident”.

Many will, no doubt, dismiss such work and forecasting, as pointless and even scientific self-indulgence or grandstanding. At Awbury, we would not presume to venture beyond the arena on which we focus, namely E-CAT, or providing protection to our clients against economic or financial risks which can threaten or destroy their business or franchise. We would simply observe that the 1-in-100 or 1-in-250 year risk models common within the (re)insurance industry may provide false comfort; and that stepping back from  the mundane and the expected does have its value.

-The Awbury Team

 

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Help! How do I allocate my capital?

At Awbury, we believe that we need to combine the virtues of patient research and analysis, with those of prompt structuring and execution. So, we read with a interest, a recent speech by one of our favourite public intellectuals, Andrew Haldane, Chief Economist of the Bank of England, which presents a fascinating overview of the arguments for and against likely patterns of future growth.

One may well ask why an insurance company focused on E-CAT and helping its clients, manage their complex financial and economic risks would pay attention to such matters.

In a general sense, a growing economy, providing it is one based upon the creation of productive assets and the accumulation of capital for further investment, is a good thing.

If growth rates return to what are perceived as “normal” ones of 2 to 3 percent per annum in advanced economies, central banks are likely to have to raise their policy interest rates to prevent “overheating” and maintain low rates of inflation. Yet, nominal interest rates, particularly longer term ones, have been on a downward trend for some three decades; and, as we have written before, now stand at close to the “zero bound” in a number of key economies. And, as Mr. Haldane pointed out in his speech, real interests are signaling negative returns for 30 years out. To quote: “This pattern has no historical precedent”. It also begs the question of whether and where “normal” rates of economic growth will return.

Such seemingly arcane facts matter, because, (re)insurance companies, whether P&C or life, have historically used their investment returns to provide a cushion against weak underwriting results. Investing predominantly in bonds of relatively short duration, P&C (re)insurers in particular are increasingly finding “no hiding place” in that asset class- even the ability to harvest capital gains may be coming to any end.

Now, it is a fact that (re)insurance businesses are, and should be, rewarded by investors for their underwriting skills and ability to increase their volume of solid risk adjusted premiums from underwriting prudent liability business. Yet, in many traditional product lines, pricing and even available demand are reducing to levels which may make it difficult to continue to sustain reliable underwriting profits; and are driving a wave of consolidation. Couple that with  potential constraints on yields and  returns in the bond markets and one has an environment in which senior management needs to pay careful attention to deploying available capital in ways that generate the best, long-term risk adjusted returns, with low volatility.

The Awbury team has thought long and hard about such issues; and has developed a range of products that not only provide returns that are non-correlated with traditional product lines, such as NatCAT, but also enable (re)insurers to write attractive risk adjusted business in ways that provide exposure to non-traditional asset classes that are also highly capital-efficient.

You should call us; and let us explain how we can help address those Growth Constraint Blues…

– The Awbury Team

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