Beyond the Marshmallow Test (Orwell would be appalled…)

Intuitively, most of us would understand that those human beings who have a low level of self-control are more likely to indulge in riskier behaviours and may become a greater threat not only to themselves but others. Of course, in our messy and inconsistent world, some behaviours are considered less acceptable than others and so are subject to greater legal sanction or moral opprobrium- consider drugs vs. alcohol, or smoking vs. over-eating.

However, because of advances in neuroscience and the insurance (re)insurance industry’s rising obsession with “cybersecurity”, the issue of an individual’s self-control is becoming somewhat more relevant.

No doubt many of our readers will have come across the Marshmallow Test, considered iconic in the field of psychology; and undertaken by Walter Mischel in the 1960s: could a pre-school child delay gratification for a short period (and receive 2 marshmallows as a reward), or not (and grab the single marshmallow nearby.) The test was regarded as one of self-control, or the ability to exercise will-power.

So, what you may ask, have marshmallows to do with cybersecurity and insurance?

The world has moved on since the 1960s (and from the publication of Orwell’s “1984” in 1949); so, not only are there now batteries of psychometric tests for such factors as self-control, but neuroscientists are better able to map brain functions to behaviours.

In a recent study, said to be the first of its kind to be documented, conducted by a team led by Professor Qing Hu of Iowa State University, a test group of volunteers who had been screened and then  selected to be at either the low- or high-self control ends of a spectrum were given various scenarios describing system security breaches; and had their brain activity monitored while they decided how to respond. This methodology helped overcome the probability that at least some low-self-control individuals would seek to mask their true intentions (something considered a feature of traditional criminology studies). According to the results, it seems that those with low-self-control made decisions about major security breach scenarios more quickly, as if they were not considering the consequences as deeply as their more self-controlled peers.

Naturally, this has led to suggestions that those in particularly sensitive positions, should not only be subjected to the more traditional psychometric tests, but also to an “EEG Test”. The problem, of course, is that such testing cannot provide definitive conclusions about likely behaviour; and may condemn perfectly acceptable candidates to be labeled as “untrustworthy”; and, therefore, bar them from a particular role. It begs the question as to where one can or should draw the line in trying to predict human behaviour. Those already concerned about intrusive, and perhaps hidden, surveillance will become yet more vocal about the need for boundaries; yet the research raises a question for (re)insurers of cybersecurity risks as to the nature and level of controls an Insured should have in place if it wishes to place cover, particularly in critical systems.

At Awbury, we do not provide such covers; but we are always interested in trying to understand the consequences of human beings’ thought and decision-making processes; and how they may affect behaviours and risk.

Just pay no attention to the EEG machine in the corner of our offices. It is there merely to encourage appropriate, risk-aware behaviour…

– The Awbury Team

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Vanity Capital – Is that your new alternative reinsurance provider…?

In a world seemingly often focused on the ephemeral and transient, it was probably only a matter of time before, a “new investment asset class” was attempted. Goodbye to alternative investments; say hallo to “Vanity Capital”.

We could not resist writing a note about this. The definition used by BoA/ML in a recent inaugural piece is enough to pique curiosity: “… the pursuit of, and the accumulation of, attributes and accessories to augment self-confidence by enhancing one’s appearance and prestige. It is self-actualization through self-improvement and self-focus.” In other words, a modernized and updated Narcissism as a potential source of investment returns.

The concept, while meant seriously (and we would not disagree with the underlying logic given the seemingly inexhaustible ability of individuals to find themselves fascinating), is one that lends itself to parody along the lines of: “My Giacometti is bigger than your Giacometti”, or: “I suppose that is your everyday private jet; and you left the customized 747 at home?”, or even: “Damn! Down to my last case of the ’45 Lafite.”

So, why would we, serious folk at Awbury even pay attention to this? Well, we read broadly; and, occasionally, we do like a bit of light relief from the serious business of originating, analyzing and closing business in our E-CAT space. However, the more important point is that the creation of such “asset classes” seems to us to be a symptom of a world that is uncertain about its values (let alone valuations!), and one where those who eschew appearance, or the latest fad; and, instead, focus on substance and solid research remain able to identify and generate sustainable long-term returns; which is, of course, our goal at Awbury.

As the latest quarterly financial reports from the (re)insurance industry demonstrate, there is no sign of any reverse in the downward trend in reinsurance pricing on NatCAT business; while business being placed is also becoming more concentrated, with secondary markets being increasingly ignored and discarded.  Naturally, industry participants are putting a brave face on this, but it seems clear to us that, as we have stated before, the need to generate premium that will justify corporate cost bases is becoming more pressing, as the NatCAT “cake” is not expanding and more people are trying to take a piece of it for themselves. The industry as a whole has cost ratios which are becoming unsustainable in the face of declining revenues.

At Awbury, our goal continues to be providing revenue streams, where the underlying risk is primarily credit, or structures that allow access in more efficient ways to long-term investment returns or deployment of capital, that are not correlated with other insurance markets. Thus, we enable our partners to benefit from returns which are generally much less market- or price-sensitive than in most other insurance lines, focusing on our clients’ specific needs, and delivering specifically tailored solutions to them.

– The Awbury Team

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The Googling Illusion..

We know that the title sounds like that of an episode from the long-running hit comedy “The Big Bang Theory” (and, after all, recent financial history is littered with a few “big bangs” and a lot of theory!), but we are, in fact, referring to one facet of the rising argument that the creation of the Internet and the World Wide Web, while undoubtedly beneficial to humankind as a whole, may well also making us “dumber”; because it is reducing the need to store and process information within the human brain, while at the same time potentially overwhelming the same supposedly diminishing faculties with data “noise”.

As luck would have it, the Awbury Team comprises a spectrum of what we would term the pre-, inter- and post-web generations (and don’t even mention computers…), so we were interested to read about recent research published by a group of academics from Yale University that at least suggests that simply using an internet search engine (Google, for sake of argument, which is already a  verb) to obtain information leads the user to believe that he or she thereby knows more about the topic than is actually the case. Using a series of calibrated experiments, the researchers found that in each scenario, those who had been permitted to use a search engine, even if the topic of the search had nothing to do with subsequent questions posed to them, rated their abilities higher than those of a control group that had not been permitted to use such an internet search. So, somewhat ironically, the act of “Googling” may make you think that you know more and are smarter than you are!

In reality, the world’s economy and the financial services industries could not function at the speed and level at which they now do without the ability to obtain information and research with the speed and breadth now feasible; and we are certainly not advocating a return to a pre-Internet world. History teaches that the Luddites always lose; or that elites can only hold back broader human progress for so long. These are good things.

However, taking  the (very) long view, bear in mind that above the entrance to the Temple at Delphi some two and half thousand  years ago was inscribed the phrase “Know Thyself”; and that in several of his Socratic Dialogues, Plato has Socrates refer approvingly to the thought underlying the phrase; namely, amongst other things, being sufficiently self-aware to realize that the mere knowledge of something does not make one superior.

In reality, it is not the knowledge of something that matters in itself, but how one applies that knowledge; and the ability to discriminate between the material and the trivial. Trivial Pursuit may be an interesting diversion, but it measures memory, not intellectual capacity.

At Awbury, we try to ensure that we maintain a little intellectual humility; while understanding that what really matters is our ability to process, analyze and assess information, so that we can judge properly the risk of a particular transaction or structure, and provide our partners consistently with superior risk adjusted returns.

– The Awbury Team

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The paradox of liquidity

It is a truism that ultimately businesses (and even governments)  fail because they lose the ability to meet their obligations when due; which in reality means that they run out of cash or the equivalent means of settling their debts promptly. Financial history is littered with examples of such events too numerous to mention; and such occurrences are an inevitable consequence of the capitalist system, as businesses that once prospered fail.

However, that same truism masks a number of paradoxes that bear further examination in an environment in which central bank actions have supposedly created a world “awash” in liquidity; driven down returns on cash and debt securities; and created the feverish and inevitable “search for yield”. We are sure that such issues keep many a thoughtful CFO and Treasurer awake at nights. And, of course, financial alchemy is beginning to become visible again: RIP sub-prime mortgages and auction-rate securities; hail to sub-prime auto securitizations and to high-yield and leveraged loan ETFs!

So, what are some of these paradoxes or misconceptions? Firstly, just because an asset is publicly-traded and can be bought and sold at any time during market hours, does not mean that it is really liquid. True liquidity would mean that an investor could sell his or her entire position instantly at a price that reflected at least  the valuation placed on it in the relevant account. Obviously, size matters; as, with few if any exceptions, no market is able to absorb an immediate sale by its largest investor without the price moving. Secondly,  the direction of the market at the time of a proposed sale is also crucial: It is much easier to sell into a rising market, where buyers outnumber sellers. Thirdly, sometimes the market literally panics and seizes, so that there is no price discovery and so no ability to trade at all- events during 2008 and early 2009 provide ample evidence of that.

It seems to be regularly forgotten (institutional memory being increasingly rare) that the liquidity of a particular structure (being able to sell in size without an adverse movement in the price) cannot really exceed that of its underlying assets. Thus, we would argue that many a so-called “liquidity alternative” (say, a Money Market Fund, or leveraged loan ETF)  is exactly that; it is an alternative to truly liquid assets and will almost certainly not meet the test when most needed, because its structure is not really designed to provide liquidity, but rather to provide the chimaera or the illusion for as long as normality prevails. In moments of market stress it can and will fail- and too many participants will claim that this was “unexpected”, or “unprecedented”. It isn’t and it won’t be!

In the world of (re)insurance investment management, addressing the core premise and promise of the business model, being as certain as one can be of having sufficient liquidity available to pay any conceivable valid claim in a timely manner, is fundamental. Without it, there is no business. So, the current environment creates real challenges in terms of actually being able to generate adequate positive risk- and capital-adjusted returns on investment, with minimal balance sheet volatility, while generating the premium income streams that underpin not only viability and business growth, but also support the valuation of the business.

At Awbury, we have some thoughts and suggestions on that.  Give us a call!

– The Awbury Team

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