It is not a game…

We are loath to add to the column-miles (sic!) that must, by now, have been expended on the long-running Greek default and “Grexit” drama, but we have watched the endless posturing and theorizing of the “experts” with something akin to fascinated bemusement.

Much has been written about how “game theory” must be playing a significant role in the negotiating positions of the various parties, especially given that Yanis Varoufakis, the Greek Finance Minister is a co-author a book entitled “Game Theory: A Critical Introduction” (first published in 1995!) and bearing in mind his wry, alleged recent comment lamenting “the absence of a skilled game theorist on [the other] side”.

However, what strikes us most about much of the debate is that it is conducted at a level and in a manner that tends to ignore the fact that there is a population of some 11 million who are largely pawns in a contest of high- (or more probably, low-) politics and who have experienced real hardship over the past few years, because of the EU’s (and, in particular, Germany’) obsessive focus on “austerity”. Of course, we understand that those in Cyprus, Ireland, Portugal and Spain, who have had similar experiences, would look askance at what would be portrayed as yet more forbearance for those who supposedly have nobody to blame but themselves.

And yet…

The idea that the Greek economy can have further burdens imposed on it in terms of retrenchment and a requirement to run significant primary surpluses, is a bureaucrat’s fantasy, given the carnage that has already resulted in terms of output and unemployment levels over the past 5 years or so. Of course, structural reforms are essential; and corruption and rampant clientelism must somehow be rooted out, but the current government has no electoral mandate for much of what the EU and its co-creditors are trying to impose; which makes it somewhat difficult to expect compliance, even if reforms are agreed upon at governmental level, because to be seen to do the political bidding of the infamous “troika” (IMF, ECB and European Commission) would be “political suicide” for the governing Syriza party; and few politicians, let alone those who show little sign of pragmatism, have the courage to act against their own perceived interests.

Matters appear to be coming quickly to a head, because June 30th is the expiry date of the current “bail out”; and on that date Greece also has to make significant payments to the IMF, with a clear risk that it cannot or will not do so, because it will not have the available cash or access to liquidity. It is already struggling to meet its domestic “functional” obligations such as payrolls, services and pensions.

And the Bank of Greece itself has now raised, for the first time, explicitly the possibility not only of default and “Grexit” (from the Eurozone), but even from the European Union itself. That the relevant sovereign’s central bank should believe that it has to issue such a warning should give all those involved pause for thought, because it presages a disorderly collapse of the Greek banking system (which is haemorrhaging deposits) ; the withdrawal of ECB support; the likely imposition of capital controls; and the potential introduction of a domestic “scrip” to replace the Euro.

Consideration should also be given to the fact that, although Greece is a “rounding error” in economic terms, it has geopolitical significance on the eastern marches of Europe and is embedded within the inherently unstable Balkan region. The risk of such a country becoming de-stabilized, ungovernable and potentially a failed state (as a tail risk), especially if still part of the EU (as absurd as that might now seem), should concentrate minds on finding some form of compromise that avoids a disorderly default.

At Awbury, we spend significant resources on ensuring that we can underwrite, execute on and manage economic and financial catastrophe risks (E-CAT). It is fundamental to our business model; and a core competence- and most certainly not a game! So, we monitor carefully the geopolitical environment, because it is essential to be informed and “ahead of events” and their consequences.

– The Awbury Team

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It is not a game…

We are loathe to add to the column-miles (sic!) that must, by now, have been expended on the long-running Greek default and “Grexit” drama, but we have watched the endless posturing and theorizing of the “experts” with something akin to fascinated bemusement.

Much has been written about how “game theory” must be playing a significant role in the negotiating positions of the various parties, especially given that Yanis Varoufakis, the Greek Finance Minister is a co-author a book entitled “Game Theory: A Critical Introduction” (first published in 1995!) and bearing in mind his wry, alleged recent comment lamenting “the absence of a skilled game theorist on [the other] side”.

However, what strikes us most about much of the debate is that it is conducted at a level and in a manner that tends to ignore the fact that there is a population of some 11 million who are largely pawns in a contest of high- (or more probably, low-) politics and who have experienced real hardship over the past few years, because of the EU’s (and, in particular, Germany’) obsessive focus on “austerity”. Of course, we understand that those in Cyprus, Ireland, Portugal and Spain, who have had similar experiences, would look askance at what would be portrayed as yet more forbearance for those who supposedly have nobody to blame but themselves.

And yet…

The idea that the Greek economy can have further burdens imposed on it in terms of retrenchment and a requirement to run significant primary surpluses, is a bureaucrat’s fantasy, given the carnage that has already resulted in terms of output and unemployment levels over the past 5 years or so. Of course, structural reforms are essential; and corruption and rampant clientelism must somehow be rooted out, but the current government has no electoral mandate for much of what the EU and its co-creditors are trying to impose; which makes it somewhat difficult to expect compliance, even if reforms are agreed upon at governmental level, because to be seen to do the political bidding of the infamous “troika” (IMF, ECB and European Commission) would be “political suicide” for the governing Syriza party; and few politicians, let alone those who show little sign of pragmatism, have the courage to act against their own perceived interests.

Matters appear to be coming quickly to a head, because June 30th is the expiry date of the current “bail out”; and on that date Greece also has to make significant payments to the IMF, with a clear risk that it cannot or will not do so, because it will not have the available cash or access to liquidity. It is already struggling to meet its domestic “functional” obligations such as payrolls, services and pensions.

And the Bank of Greece itself has now raised, for the first time, explicitly the possibility not only of default and “Grexit” (from the Eurozone), but even from the European Union itself. That the relevant sovereign’s central bank should believe that it has to issue such a warning should give all those involved pause for thought, because it presages a disorderly collapse of the Greek banking system (which is haemorrhaging deposits) ; the withdrawal of ECB support; the likely imposition of capital controls; and the potential introduction of a domestic “scrip” to replace the Euro.

Consideration should also be given to the fact that, although Greece is a “rounding error” in economic terms, it has geopolitical significance on the eastern marches of Europe and is embedded within the inherently unstable Balkan region. The risk of such a country becoming de-stabilized, ungovernable and potentially a failed state (as a tail risk), especially if still part of the EU (as absurd as that might now seem), should concentrate minds on finding some form of compromise that avoids a disorderly default.

At Awbury, we spend significant resources on ensuring that we can underwrite, execute on and manage economic and financial catastrophe risks (E-CAT). It is fundamental to our business model; and a core competence – and most certainly not a game! So, we monitor carefully the geopolitical environment, because it is essential to be informed and “ahead of events” and their consequences.

The Awbury Team

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Well, that’s a disaster…or is it?

The Awbury Team presented last week at both the Insurance Day 2015 Bermuda Summit and the Bermuda Captive Conference. We discussed our E-CAT capabilities and the fact that so-called “alternative capital” is really not so “alternative” now; and is not going to disappear. All those active in the (re)insurance markets had better learn to adapt and innovate, or they will run the risk of becoming simply “price-takers”, doomed to trying to earn an acceptable return on capital.

And bear in mind that refugees or insurgents often displace the established order- consider Rome, Venice and the United States- so the advent of new money in the guise of “alternative capital” may create such a turning point.

Nevertheless, current industry sentiment (which tends to combine angst within an element of existential fear) strikes us as both misguided and self-defeating. The need for (re)insurance in an increasingly complex and inter-connected world is not going to go away. Clients still need to protect themselves against risk; and there remain not only many underserved markets, but also risk categories where the potential and the parameters are still to be defined. And on the investment side, the curse of a low return environment in fixed income, means that generating anything remotely reasonable in sustainable terms is also very challenging. One can only “harvest” capital gains on one’s existing bond portfolio once! Reinsurance may be suffering from a surfeit of capital, but that seems to us to stem more from a “framing” issue stemming from a continuing focus on the traditional areas, such as NatCAT, instead of developing and pursuing new markets in product and geographical terms.

In our view, the real question that an (re)insurance executive should pose is: “Where should and can I allocate my capital so that I achieve the best risk adjusted returns; maintain pricing power; face low competition; and have negotiating leverage?” Naturally, anyone should respond: “But that is a statement of the ******** obvious!”- and indeed it is. However, it is remains a fact that many (re)insurers still seem to struggle with executing on that axiom, even while consolidation increases and the new mantra becomes “diversification”.

So, what to do? What if we have the capital, but not the expertise?

Successful companies spend a great deal of time and money building infrastructure and acquiring expertise in their areas of focus; but run the risk of finding themselves burdened by sunk costs and “stranded assets”. Yet, “betting the firm” on building everything de novo, when one is not sure that an opportunity or market is sustainable, is also somewhat risky.

Fortunately, there is a third way; which is to partner allocators of capital (reinsurers) with subject matter experts who have the required presence in areas of new opportunity. In fact, the (re)insurance industry already has a tried and tested “virtual model” in the form of MGAs/MGUs and lead (re)insurers, which gives ready access to origination and expertise in areas that are promising, but without having to disrupt what may well be a complex and interdependent corporate structure.

So: “If there’s somethin’ strange in your neighborhood
Who ya gonna call?”

– The Awbury Team

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Are you sure you ERNed that…?

As readers may know, at Awbury we are always interested in reading new financial research; so a recent article in The Economist,  on the subject of Equity Recourse Notes (ERNs), piqued our curiosity.

Since the financial crisis, it has become received wisdom that banks need to have more capital, and that such capital should be primarily true equity, or instruments that provide loss absorption in the event of financial stress or insolvency. This has led not only to banks raising more equity capital, but also to the rise of the “CoCo”, or Contingent Convertible bond, as well as the concept of “bail-in-able” capital, as regulators attempt to create instruments and approaches that do not “promise” and then “fail to deliver” the intended loss absorption, as was all too common during the depths of the 2008/9 financial crisis.

Of course, CoCos have yet to be tested in combat; although the Republic of Austria is doing its best to show that the “bail-in” concept within the recently-implemented EU Bank Recovery and Resolution Directive (BRRD) does have “teeth” as it goes about liquidating the HETA structure that was created out of the Hypo-Alpe-Adria bank fiasco.

In the midst of continuing complexity and uncertainty, a suggestion has been made by 2 academic economists, Jeremy Bulow and Paul Klemperer, in a paper entitled “Equity Recourse Notes: Creating Counter-cyclical Bank Capital”, that consideration be given to an alternative form of what amounts to “bail-in-able” capital- the ERN.

In essence, ERNs are a form of debt, whose currently-due payments convert into equity if the issuing bank suffers a substantial decline in share price- i.e., below a trigger level set at the time of issuance and applicable on the date when any payment under the ERN is due. They are a form of contingent capital (an area in which Awbury has expertise), but not of the “all-or-nothing” form that CoCos take (whether by conversion to equity, or write-off of principal), except in bankruptcy when they are intended to convert fully into shares (with the number issued being equal to the face value of the ERN divided by the pre-set trigger price.)

It is axiomatic that an ERN converts based upon a market trigger; whereas CoCos approved for bank capital convert based upon regulatory triggers. CoCos address regulatory capital; ERNs address economic capital. CoCos are vulnerable (strange as it may seem) to forbearance by a regulator; whereas ERNs would convert automatically, but gradually. Regulatory behaviour can be a “wilderness of mirrors” because of concerns that forcing recapitalization can potentially exacerbate a potentially delicate situation. ERNs also remove the incentive for a bank to manipulate regulatory measures, as the conversion is independent of its regulatory capital position.

ERNs can also act as counter-cyclical buffers, as they create new capital in an environment when raising traditional capital may be impossible, or viewed as prohibitively expensive by a bank management “hoping for the best”.

Of course, as always, the “devil is in the detail”, but it is our view that having a further mechanism for providing banks with capital in times of stress, which is transparent and gradual in its impact, is something to be welcomed; and rational bank managements, as well as regulators, should give serious consideration to adding ERNs to their inventory of capital and risk management tools.

– The Awbury Team

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