Look Back in Anger…

No, we are not evoking nostalgia for the famous John Osborne play, the perils of exotic options, or the mis-spent youth of a generation of “angry young men”, but rather referring to the risks of making a fundamentally wrong call on certain future trends by evoking the past.

Of course, the above statement sounds like a paradox. However, it is not.

Most large financial institutions have a mechanism for identifying and assessing so-called “emerging risks” within their risk management functions; and, periodically, the (re)insurance markets fixate upon a particular one- with “cyber risk” being the front-runner at present. The problem is, of course, that if a risk is truly “new” how does one measure its potential probability and impact?

Standard approaches tend to rely upon datasets of previous experience as the basis for predicting future frequency and severity, leading to the “1-in-100” and “1-in-250” year exposure tables and graphs that pepper (re)insurers’ reporting and are meant to soothe policyholders, investors and regulators that everything is under control and manageable. However, these are really analogous to the Value at Risk (or VaR) calculations that almost destroyed the banking system; so, how does one address a risk for which large, accurate, consistent and long-term datasets do not exist?

“Cyber risk” is used as a term of art, as is “climate change”; but what do they really mean; and how does one measure them? Cyber risk is a “clear and present” danger, whereas climate change (assuming one can get past the politicized rhetoric) is a much longer term one. The former can certainly have serious consequences; but the latter is potentially an existential threat.

Returning to the title of this note, at Awbury we are concerned that the industry will find itself looking back in anger (and chagrin), or at least the survivors will, because it was unable to assess the dangers it faced from these emerging risks, and found it difficult to frame the questions; make appropriate assumptions; and build robust models that would enable it to ensure that it did not over-reach its claims-paying capacity. And there is, in our view, a real risk that, because of the continuing dearth of premia available in traditional “natCAT” product lines, underwriters will be so eager to capture business in new product lines that they will mis-price the risk.

And as for climate change, the subject is one which we keep under constant review, because its complexity and potential impact mean that businesses and risks that would once have been considered predictable may suddenly experience a dramatic shift, largely because of political or societal decisions. This means that it is critical to maintain constant vigilance in order to detect such shifts and factor them into our risk-selection and –pricing.

So, do not ignore those who are often mocked as “Cassandras”. Remember what happened to her. It did not end well.

The Awbury Team

Commodities: can’t live with them; can’t live without them…

While money may make the world go round, and our lives seem to be becoming increasingly de-materialized in a number of ways, there is no escaping the fact that we are all still dependent upon the availability of many commodities.

As we mentioned in a previous post, the price of many commodities has declined significantly over the past few years, with that trend accelerating over the past year, causing increasing pain across, inter alios, the global mining industry, in the same way as that suffered by the O&G industry; because costs (having risen significantly) are not as flexible as prices, and hedging is a very difficult art that many have avoided or deliberately eschewed. Knock-on effects then extend into support and service industries, as well as shipping.

When companies of the size of Glencore have to scramble to reassure shareholders and debt investors that they are not facing insolvency, with extreme volatility in its equity and bond prices, one knows that something has changed in terms of risk perceptions.

Even though it is a truism that commodity-based businesses are inherently cyclical, nevertheless a view had developed that demand would continue to rise, primarily because of Asian (read, Chinese) demand continuing for any foreseeable future (7% forever…); and, in a number of sectors, even in the face of declining demand and prices, the development of new capacity continued (vide iron ore.) Major mining houses believed that they could bring on-stream massive low-cost operations and force out higher cost capacity. This approach has been mirrored in the O&G business, with an existential battle now under way between the “traditional” swing producers such as Saudi Arabia and the “upstart” ones of the US shale-based fields.

In one sense, those who consume commodities, or are large net importers, clearly benefit from lower prices; but there is, of course, a destabilizing “mirror” effect for those who produce, or who depend upon commodity exports for revenues and foreign exchange.

All of these factors lead to heightened uncertainty; lower levels of international trade; and an increase in geo-political risks as commodity-dependent sovereigns react to yawning current account deficits; reduced levels of import cover; and restive populations that have come to expect a certain level of income and job security.

And, as always, debt, deflation, leverage, liquidity and the availability of cash assume increased importance- just ask Glencore’s management! However, as long-term observers and analysts of risk “in the real world”, Awbury remains comfortable that managing the contingent risks related to commodities is a solid business opportunity, in spite of the volatility and “fear and loathing” being exhibited in the markets. Commodity-based businesses are not going to disappear; nor will the need for them and their banks and finance houses to manage and hedge risk.

We are never complacent; we are simply pragmatists, who focus on the real, not the (mis-)perceived.

So, give us a call.

The Awbury Team

Follow the money…

Given the critical importance of flows and liquidity in ensuring the proper functioning of international economies and markets, the history of financial crises teaches that the old adage “follow the money” does not lose its relevance.

If one looks back over the recent decade, major financial dislocations have largely been the consequence of a rotation of global liquidity and capital (mis-)allocation, leading to mis-pricing of assets and risk: witness what happened in 2007/8 to the “Anglo-Saxons”; to the Euro-area in 2011/12; and now seems to be happening in the so-called Emerging Markets. Couple this with over- and mal-investment in China (and a credit “bubble”), followed by a slowing in demand for inputs and the resulting significant decline in the prices of many commodities, such as copper, coal, iron ore and, most recently, crude oil, and one has the makings of a “perfect storm”, exacerbated by rising economic instability in countries such as Brazil, Russia and South Africa.

It is no wonder that debate rages about the appropriateness of the US Federal Reserve Board raising policy interest rates and the outcomes that could flow from that, particularly given the level of Emerging Markets borrowings in US Dollars by corporates and other entities that do not have a natural hedge of US Dollar revenues. This “original sin” has, time and again, led to significant crises: and would now occur in an environment in which many of the sovereigns who would habitually try to engineer some form of rescue are themselves exposed by higher levels of debt and facing lower levels of expected growth. And bear in mind that these so-called Emerging Markets now account for some 60% of global output.

So, there is a demonstrable risk of a self-reinforcing downward cycle of reduced demand, leading to reduced prices, leading to reduced incomes, leading to weakened capacity to service elevated levels of debt. Such a scenario does not end well.

This environment, by definition, means that careful risk selection and acceptance become even more important than usual, because the probability of defaults increases, while the likely level of recoveries decreases. One can already see this trend in the US O&G space, where the frequency of defaults has increased dramatically during 2015, and is only likely to rise as borrowing bases are cut during the next month or so by banks that are now very nervous about all but their highest quality borrowers. Here too “following the money” is critical: if a company finds its revenues falling; the availability of bank liquidity reduced; and access to capital markets closed, it has to try to cut costs and curtail capex in an attempt to create free cash flow. Many high-yield borrowers have not had to do so for years, because banks and bond investors were willing to fund expansion and negative cashflows resulting from ambitious capex programmes, so it remains to be seen how many of them will survive without a restructuring. US regulators are also now much less forgiving of “extend and pretend”; and publicly disapprove of “leveraged loans” beyond relatively conservative levels, so there will be blood!

At Awbury, we are always focused on ensuring that, when we select, analyze and accept a risk, we can identify and understand the factors that will have an impact on the probability of a loss or claim over the timeframe of our exposure; but that does not mean that we believe that the current environment is simply a threat; because with disruption and fear come opportunities for those with the capacity to discern and price an acceptable risk/reward ratio.

The Awbury Team

If you don’t know where you are going, you might wind up someplace else…

In homage to the late and great Yogi Berra.

Now that the Rendez-Vous is over for another year (with the Awbury contingent having departed with livers more or less intact); and the nights are starting to draw in across the northern hemisphere, what is the mood in the (re)insurance market?

In Awbury’s view, while we had many productive meetings in Monte Carlo focused on our E-CAT, financial and economic catastrophe insurance franchise, all is definitely not well with the broader market; and the mood is subdued and apprehensive at best in many quarters.

There is no real sign of rates hardening; terms and conditions are being weakened; cost ratios are still too high and seemingly inflexible; and the primary market is buying less reinsurance from fewer markets. In the EU, Solvency II may provide some relief in terms of demand from lower-rated primary markets, but is unlikely to make a material difference to demand.

And the calm before the “CAT-storm” continues, as Aon Benfield pointed out: “2015 is on track to be the lowest catastrophe loss year since 2006”. Losses to date are seemingly running at barely 25% of the 10-year historical average, reinforcing a buyers’ market for NatCAT covers.

Reinsurers’ ROE’s have trended down, yet their returns have been flattered by persistent releases of prior years’ reserves, in an attempt, one would suspect, to offset further declines in investment returns. Reserve releases simply cannot continue for much longer at current levels, while reinsurer CIOs are tempted to seek higher returns, which may not turn out to be all they appear on a risk-adjusted basis and the value of bond portfolios is vulnerable to interest rate rises, awaited with bated breath. Some are also returning capital to shareholders in an admission that they cannot deploy it in ways that meet acceptable hurdle rates.

Add to this the various initiatives that, while laudably aiming to improve the efficiency of processing and documenting policies, will almost certainly lead to further commoditization in many business lines in terms of pricing as well as market dominance; and one can understand the lingering mood of uncertainty and doubt.

It seems to us that the market is clearly bifurcating. If, according to AM Best, the top 10 P&C reinsurers now underwrite over 70% of available premia, then there are likely to be two ways in which to survive and prosper (and thus avoid irrelevance and inexorable decline). The first, as evidenced by M&A activity, is to combine scale and diversification with improved operating efficiency. The second is to focus on non-commoditized, non-correlated lines of business, where intellectual capital and the provision of customized solutions to what clients actually need are fundamental; and for which pricing power had not been competed away.

It will come as no surprise to our regular readers that the Awbury Group is a steadfast proponent of the second approach, while maintaining a healthy level of paranoia to ensure that we never assume that there is only one “right way”, although we do try to have an idea of where we are going!

– The Awbury Team