The Fallacy of Diversification and Other Perils

(Re)insurance is as susceptible as other industries to fads and fashions, which can lead to the equivalent of “herding” and the “crowded trade”, as directors and managers seek to “keep up” with their peers and competitors.

One example is the return of the mantra of “diversification”, where once specialization was all the rage. The continuing wave of M&A activity in the industry largely stems from the belief that scale and diverse revenue streams are essential to survive in a soft market, still awash with capital. The danger is that, apart from execution and cultural issues, diversification will distract a business’ managers from those product lines in which it has a sustainable competitive advantage and lead to the sub-optimal allocations of capital and resources to areas which are more likely to produce weak returns or even losses. A related risk is that of the “winner’s curse”; in which, in a competitive situation, the “winner” overpays because it believes that it is uniquely placed to derive value from an acquisition. While this may occasionally be so, more often than not value is destroyed rather than created.

Similarly, being a dedicated follower of fashion can lead to entering areas in which knowledge and understanding are lacking, but management convinces itself that it has to be present and have a position “because everyone else does”. Cyber-risk, while clearly an area of growth, is a product line which, we suspect, is somewhat less understood than admitted, such that there will be “accidents” and negative surprises. Financial firms tend to experience unexpected losses in areas that are removed from their core business, or in which the Insured knows more about the true nature of the underlying risks than the Insurer, leading to an increasing probability of adverse selection.

Of course, product development is a fundamental requirement for any business to survive and prosper over the long term, as more and more areas of (re)insurance become commoditized, with marginal participants becoming increasingly irrelevant because their capacity is simply not needed. However, as “big pharma” has found, successful R&D is not simply a function of money and resources, but depends much more on intellectual capacity and flexibility, as well as having the appropriate culture and governance to facilitate the creative process.

At Awbury, we remain focused on our core E-CAT (Economic and Financial Catastrophe Risk) franchise, not only because it offers wide scope, attractive risk-adjusted returns and non-correlated risks, but because it is an area that we believe we understand very well and in which, therefore, we have a sustainable competitive advantage. Naturally, being also somewhat paranoid, we continually question such beliefs and assumptions, because being complacent and self-satisfied is another well-demonstrated route to finding one’s self irrelevant or uncompetitive- an outcome which we very much intend to avoid!

The Awbury Team

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