The Productivity Paradox – Part 3

In our two previous posts on this topic, we tormented our Readers with a discussion of the current debate over the concept and paradoxes of productivity; and how a concept that seems obvious is actually rather difficult to define and can obscure the realities of this world.

Now, in this third and final post on the topic, we thought we’d turn our attention to the (re)insurance industry; and how the concept of productivity may apply to it and have an impact on its future.

So, in an unfriendly world, in which premium levels remain under pressure and investment returns constrained (in the absence of accepting greater risk and volatility), the goal is to be able to maintain underwriting discipline, so that one’s Combined Ratio remains as far below 100% as possible. Yet, such an approach, particularly in the NatCat arena, would and does rationally lead to turning away business and premium income, with implications for whether a (re)insurer’s cost base is sufficiently flexible to adapt. Implicitly, the entire industry faces the requirement to “do more with less”, and thus become more productive, or face disruption from those with a new, different or better business model.

However, the question arises as to what does improving “productivity” really mean in our industry? Cutting headcount? Rationalizing organizational structures? Investing in “Big Data” and AI? Pursuing transactions with higher “value”?

And what is the true measure of success? Higher return on capital? Lower Combined Ratio? Less volatility in losses and reserve development? Higher revenue per capita?

As always, one could provide a complex, well-reasoned argument, fit for the appropriate academic and industry journals; but would that really add any value or make a difference? At Awbury, we are, above all, pragmatists, focused on the appropriate approach to generate the best, high-value, risk-adjusted returns. In such an environment, many things can be productive as measured by their ultimate outcomes: focused research; market education; product development; improving our “hit ratio” for converting opportunities to real transactions; and honing our structuring, pricing and execution capabilities. To us, equating “efficiency” with “productivity” becomes self-defeating, because it confuses short-term, “hard” outcomes, with longer-term value creation and franchise-building. In reality, innovation is a fundamental component of productivity, being focused on creating and adding value for a business or economy, while “efficiency” tends merely to re-distribute value. At Awbury, innovation is a key component of our business model.

Being candid and open with our partners, so that they understand that our and their interests are always aligned; or being transparent with our clients about how we structure and price a transaction would never pass academic muster as being “productive”, yet each is fundamental to creating economic value for those involved and the wider economy. We do not deny that one also has to focus on revenues and costs, and ensuring that resources are deployed as efficiently as possible; but we are also convinced that emphasizing the obvious and “measurable” at the expense of the less tangible ways in which value is actually created in our complex society, for everyone’s benefit, is a much more rational and effective way to view “productivity”- and not just in the (re)insurance industry.

It, therefore, saddens us when we see short-term, reactive approaches, which seem to be “productive” because they may, perhaps, increase earnings per share, or squeeze out another 1% higher return on capital, yet ultimately lead to value destruction because the truly productive elements are somehow confused with a need for “efficiency”. Of course, duplication and process inefficiencies should be eliminated; obsolescent and commoditized businesses culled; reporting lines and organizational structures adapted to meet changed circumstances; and talent focused on generating sustainable revenue streams. However, too often the endemic management consultants’ approach overlooks the fact that, in a knowledge-based industry such as ours, focusing on the numbers and “productivity” improvements can actually be counter-productive in the longer term.

So, when you are told that your team, department or company needs to be more “productive”, ask whoever makes the statements: : “What do you mean by ‘productive’?” With a bit of luck, they will blanch!

The Awbury Team

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The Productivity Paradox- Part 2

In our previous post, we described how productivity is of fundamental (and often overlooked) importance to humanity; and that the rate of economic growth did not really begin to accelerate until the 18th Century and advent of the First Industrial Revolution. We also pointed out that the very meaning of the term, and how to measure it, remain surprisingly controversial.

There is much debate as to whether there is a “natural” or “normal” rate of productivity growth (or Total Factor Productivity- TFP) for a particular economy, e.g., the US, China, or Japan- each of which is perceived as having a very different set of factors which affect TFP. More recently the focus has shifted to whether we are in the midst of an extended cycle of “secular stagnation”, in which, no matter the policy tools which governments and central banks deploy, economies remain mired in a trough of low growth and the ever-present risk of deflation. Where are “animal spirits” when one needs them?

While the latest PRC Five Year Plan may now set a range, rather than a minimum target level of real GDP growth, it remains to be seen whether and how what is still an astonishingly high level (6.5 to 7% per annum) can be achieved and sustained- and at what cost. Will the “growth” really be productive in the sense that not only does it improve people’s standard of living, but also that the resources employed are used efficiently and not wasted for the seek of achieving a “headline” success? After all, Japan reached a point in its own growth post-WW II in which there was a notorious level of waste. “Productivity” may have been high, but roads and bridges to nowhere, or the concreting of the land served no productive purpose.

Similarly, the measurement of productivity is increasingly controversial. The UK’s Office of National Statistics (ONS), recently published a report which pointed out that, when it comes to identifying and measuring the output and TFP used to produce “things”, data tend to be remarkably detailed and granular, but when its comes to the services and intangibles which undeniably now comprise the great majority of most developed economies, the quality and reliability of data leave much to be desired, because the mindset that most statisticians use remains grounded in another age (in reality that of war production in a command economy.) We are probably being rather unfair to that estimable profession (after all- if one cannot measure it, does it exist?), but the basic point stands. Should one measure something as a “cost” (say, a new computer or cloud-based system), or as an “investment” (say, R&D)? They both cost money, which is quantifiable; but how “productive” are they? Is it “productive” to replace 10 jobs with one that manages a new expert system? How “productive” is R&D, if, in pharmaceuticals, its costs billions of dollars to produce compounds that may or may not improve the human lot? And is the amount of money lavished on “defence” really, when added to GDP as it is, productive? The more expensive the weapon the better…

Having teased and tormented our Readers, with yet more paradoxes, what should we say about “productivity” and the outlook for it in the (re)insurance industry? Well, we have decided to sustain the suspense, and leave that for a third and final post on this fascinating topic!

The Awbury Team

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The Productivity Paradox- Part 1

If we look at the long arc of recorded history (even though we humans are but parvenus in terms of our existence), it is generally accepted that the rate of economic (and population) growth did not really begin to accelerate until the 18th Century, as a consequence of the First Industrial Revolution. And now we are supposedly going through the Third Industrial Revolution (although “Industrial” is really a misnomer), with inklings of a Fourth as Artificial Intelligence becomes more prevalent (and feared.)

So, as a cohort, Humanity is undoubtedly far better off in material terms than ever before (with arguments about the spiritual, psychological and emotional consequences being entirely separate, of course!).

Yet, in spite of that seemingly obvious fact, there is persistent hand-wringing over whether we are really as productive as we think we are; and whether all the additional resources now available to us in terms of inventions and intellectual property have actually increased the so-called “Total Factor Productivity” (TFP) beloved of economists.

As we have written before, some of the Awbury Team are sufficiently long in the tooth to recall the pre-computer, Analogue Age; yet now we habitually use technologies that simply did not exist when we started our working lives (even if some of us are more dexterous than others!) We have lived through, and survived, the Revolution; and certainly feel that, individually and collectively, we can accomplish far more than a team of the same size and composition even 20 years ago could have. How to measure that objectively is a different matter, which brings us to the paradox of productivity, and the debate that continues to rage about whether prospectively we are going to be able to maintain the same rates of growth as over the past couple of centuries or so.

Naturally, there is no universally agreed definition of exactly what “productivity”, TFP and “growth” actually are, nor, in particular about how they should, can be and are accurately measured. After all, it is a truism, that if you cannot measure something, does it really exist? And, in obsessing about such matters in the credit column, do we properly factor in debits such as environmental degradation? Perhaps we should create the concept of Net TFP, with appropriate offsets?

Furthermore, the intellectual framework surrounding the concept of productivity tends to see it as a continuum; yet there are numerous examples of what might be called “step-changes” (the controlled use of fire, the wheel, automobiles, transistors, quantum mechanics…), following which things were never the same. They were not inevitable developments; and, as the sayings goes, in many cases you could not have made them up, even if you had tried.

So, productivity, its meaning, consequences and future direction are both controversial and of fundamental importance to all of us, even if we tend to take them largely for granted.

We shall develop this topic, and what it may mean for the (re)insurance industry, in our next post.

The Awbury Team

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CoCo Loco

While many markets have been subject to volatility and turmoil during the early part of this year, one sector has taken what can only be described as a “systematic beating”, namely that for contingent capital bonds (fondly referred to as CoCos, and usually forming part of a bank’s Alternative Tier 1 capital, or AT1) issued by banks as a part of their regulatory capital base.

Readers will recall that CoCos are a creature of the Great Financial Crisis, during which regulators discovered that many capital instruments that were supposed to be loss absorbing were in fact nothing of the sort, and one factor in the series of systemic or individual “bailouts” that took place at the expense of taxpayers.

Their premise is theoretically quite simple in that their terms are supposed to ensure that if a bank which has issued them becomes seriously stressed and approaches what is now happily termed the “Point of Non-Viability” (PONV), the instrument will either convert to equity or be written-off in part or in full to absorb losses.

So, what could possibly go wrong?

One issue that has become evident during the recent pounding that many banks’ CoCos experienced is that of what one may call “regulatory tweaking”. Because of their purpose, many CoCos contain terms that give the relevant regulator (say the ECB or Bank of England) the ability to decide not only whether a coco should be converted or written down, but also whether or not the coupon payable on a particular bond should be paid. Recent announcements from both the ECB and the European Banking Authority (EBA) have given investors pause for thought as they imply that coupon deferral may occur sooner than originally anticipated. No investor enjoys seeing such ex post facto uncertainty, with Deutsche Bank’s capital instruments taking a particularly brutal beating because of the relatively obscure basis on which payment capability is determined.

Of course, once clarifications are issued and banks demonstrate (and analysts confirm) that the situation is not quite as dire as markets believe, calm is restored and prices recover. Nevertheless, the episode is further evidence of how vulnerable large, complex and relatively opaque institutions such as regional and multi-national banks are to market panic and “runs”, because no investor wants to be left holding an instrument that just might become impaired or worthless in circumstances different from original expectations. Therefore, one should expect nervousness to continue.

Paradoxically, in trying to “clarify” the circumstances in which a CoCo might convert or be written down, regulators have actually made the situation worse, because they have made it clear that, ultimately it is their decisions and exercise of discretion which will affect outcomes. There is nothing new in that, but clearly it was not what investors had focused on.

At Awbury, we pay close attention to such matters, because we have a significant franchise in helping banks manage their risk exposures and capital. So, if your CoCo has recently gone “loco” and you wish to consider some less volatile alternatives sources of capital and contingent capital, you should give us a call.

The Awbury Team

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Recession, what recession?

While we at Awbury are not professional economists (Discuss: “Is economics a profession, vocation or discipline?”), naturally we pay very close attention to economic matters, as they can have a material impact on not only our existing book of business, but also on our appetite for and pricing of new E-CAT business.

The R-word is beginning to creep back into the collective consciousness, as a result of a perceived slowdown in the Chinese economy; the knock-on impact of the decline in oil and natural gas prices; evidence of decline in volumes of cross-border trade; policy disorder in the EU; “Brexit” risk; US political dysfunction…One could go on!

Linked to the rising concern about the risk of recession in the US and other major economies, is one that questions whether the world’s major central banks, having been seen as “propping up” demand through the use of ultra-low interest rates; quantitative easing and suspicions of sovereign-debt monetization, still have the means at their disposal to steer their economic charges away from the recessionary abyss. There is even talk of “helicopter money”.

So, when fear stalks the land, it is worth pausing and trying to assess what exactly the word means and when it matters.

After all, it is worth pointing out that recessions and recoveries are a normal part of the economic cycle across recorded history, as “animal spirits” and “irrational exuberance” give way to existential despair. The Great Moderation was an anomaly and a Chimaera. The world economy is complex, interdependent and prone to periodic fits.

Secondly, what exactly is a recession? As usual, economists cannot agree. Is it two consecutive quarters of real decline in GDP, or growth over the same timeframe that is 2 percentage points below a country’s trend (as suggested by Robin Harding)?

Clearly, many middle eastern economies, whether because of turmoil or the impact of depressed oil and natural gas prices are in recession. The same applies to Brazil and Russia. As for China, the argument is about the true level of GDP growth, not outright decline; and India is certainly not in recession. Japan and Germany are not exactly growing fast, but they are not in recession; nor is the UK.

In reality, the world’s economy is like the proverbial curate’s egg- good in parts; and it is naïve and counter-productive in any assessment of the risk to make sweeping judgements simply because it seems easier. As always, one should examine the particular factset and specific risk one is being asked to structure, price and accept; and then, as part of a rational and informed analysis, determine the extent to which the nature and quality of the risk will be impacted by declines in economic output in a particular economy or sector. Clearly, there is a big difference between the current outlook for a manufacturer of oil drilling equipment, or a shipyard producing dry bulk carriers, and that for a large-scale food and pharmaceutical retailer in, say, the US, or Germany. In other cases, say in Brazil, the rate and breadth of decline impacts a much broader swathe of economic output. As usual, it all depends on the specific risk; not some unreasoned expectation.

At Awbury, we are always surveying the “horizon” for potential risks, or the potential changes in the level of existing ones. However, we have learnt from long experience that all one can expect is that economic cycles will continue, and that it is very dangerous to over-generalize, or “assume”. As always, targeted, properly-informed analysis is what matters.

The Awbury Team

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