The Italian Job…?

With apologies to film fans (we prefer the original 1969 version) , we thought we would consider the conundrum presented by the state of the Italian banking system, which has become “collateral damage” post-Brexit.

The basic problem is that, in an economy that barely manages any real economic growth; where the level of government borrowing can crowd out private investment; and where there are many obstacles to restructuring loans and businesses in default, the banking system is choking on a very high level of non-performing loans (NPLs), which makes it very difficult to focus on supporting promising and profitable businesses with new funding.

Compounding the problem is the tension between the supposed constraints of the EU’s new Bank Resolution and Recovery Directive (BRRD), which is intended to remove the need for taxpayer-funded bank rescues by “bailing-in” bank creditors in a pre-determined sequence, and the fact that Italian banks have an unusually high level of such “bail-inable” debt owned by individuals, rather than institutions. When the Bank of Portugal re-ordered Novo Banco’s obligations to “haircut” foreign bondholders, the result was a legal dispute and questions about Portugal’s “reliability”. However, domestic politics were largely unaffected. The situation in Italy is very different. The government and the Banca d’Italia are rightly concerned that, with an important constitutional referendum due in the autumn, any action against an Italian bank that caused losses to individual debt holders would cause a political firestorm, with potentially adverse consequences for the continuing attempts to restructure a sclerotic economic and political system.

A further issue is that the European Banking Authority is due to release the results of its latest stress-tests of the largest European banks on July 29th (during the mid-year reporting season for publicly-quoted institutions and just before the business and political elites go on holiday in August). The outcomes of previous exercises proved somewhat controversial, widely regarded as giving many institutions a “false positive” and thus understating the weakness of a number of banking systems, including Italy’s. With that in mind, one would hope that this year’s outcome will be somewhat more rigorous. However, if it is, the concern has to be that a number of Italian banks will be found wanting and in evident need of restructuring and recapitalization.

There is just one small problem with that. EU state aid rules now make it difficult for a government to be seen to supporting an entity on anything other than arm’s length commercial terms. In Italy, we have already seen the political “fudge” that is the Atlante mechanism for back-stopping capital-raising by banks- and its resources are now almost exhausted. The Italian government has threatened to use what amounts to an “exigent circumstances” exception to re-capitalize its banking system directly; but that has drawn the ire of both the European Commission and the German Federal Government. The ECB stirred the pot by suggesting a “bad bank” approach; but that in itself pre-supposes the strict resolution of a failing bank, which will likely exacerbate the political problems alluded to above.

The root cause that needs to be addressed urgently is the lack of a mechanism for clearing the system of its overhang of NPLs. This is an area in which Awbury, with its expertise in melding techniques from insurance, banking and the capital markets stands ready to help, as we have long been studying and researching ways in which we can help our clients manage and work through their existing NPL and bad debt portfolios.

So, rather than being bemused and baffled by the Italian Job, call us- and come enjoy “A Room with a View”, and a return to “La Dolce Vita”…

The Awbury Team

Standard

Suit Up and Turn the Map Around: Cyber-risk

In an environment in which sustaining premium income from “traditional” business lines remains a considerable challenge and being disciplined enough to walk away from mis-priced business is easier said than done, many (re)insurers are looking for the “next Big Thing”.

At present, one could reasonably argue that is “cyber-risk”- a product line which apparently generated some USD 2.75BN of annual premium for the US market by the end of 2015- a number forecast by PwC to triple by 2020- with more and more carriers eager to capture some of the premium flow.

Without doubt, there is both a need and a demand for such protection, as the scale and severity of the incidents reported (which probably comprise only a fraction of the actual total) continue to increase. The business and reputational consequences of a cyber-attack can be severe, let alone the societal impact from a state-sponsored attack on, say, critical infrastructure.

However, there are significant issues with assessing and pricing the risk; because there are, as yet, little reliable historical data on losses; nor understanding and evidence of a particular Insured’s ability to prevent a successful cyber-attack, or pro-actively manage and mitigate the consequences. Meanwhile, governments (which, as we have seen, often have significant vulnerabilities of their own) are beginning to impose onerous requirements on businesses- for example, the EU’s General Data Protection Regulation (GDRP), which is due to become effective in May 2018- requiring them to “provide sufficient guarantees to implement appropriate technical and organizational measures” to protect data.

While perhaps controversial, it is arguable that cyber-risk has analogies with terrorism (in its physical forms), because it is all too easy to conceive of scenarios in which the scale of the consequences are so large, or so systemic as to be potentially uninsurable, even by an industry supposedly awash in surplus capital looking for a profitable home. This then begs the question of whether, in its eagerness for premium and faced with the temptation of increasing demand, the traditional “CAT” industry will over-reach and fail to assess or aggregate risks in a way that could ultimately gut its capital base.

Similarly, because there is, as yet, no standard language or wording for policies covering “cyber-risk”, there is ample scope for there to be a significant mis-match between an Insured’s understanding and expectation and the Insurer’s actual offer and coverage. The potential for claims disputes would appear significant.

We are not, of course, saying that clients should not purchase such protection; nor that (re)insurers should not provide appropriate coverages. We are simply saying that there are material risks for both parties that there is not, in fact, a true meeting of the minds, leading to unfortunate outcomes.

At Awbury, we are known for the bespoke and carefully-crafted nature of the large-scale credit, financial and economic coverages that we provide to our clients; but we remain wary of situations in which it is difficult, if not impossible, to “box” a risk and to define and price a cover properly, with triggers that are clear and unambiguous, so that the client is in no doubt that the policy will answer in the event of a legitimate claim.

However, we like a challenge!

The Awbury Team

Standard

So, would you like poutine with that cod? The hash is also good.

As it becomes ever more obvious that the drama post-Brexit is going have several, if not many acts, commentators keep trying to square the circle in terms of describing any “settlement” with the EU should Article 50 actually be invoked, while those who engineered the Leave outcome flail about uselessly, trying to deal with the consequences that some of them at least may well not have actually wanted.

However, if the referendum’s message was that a significant segment of the UK’s population wanted “control”, where does that leave anyone trying to negotiate a post-Brexit compact with an EU political and bureaucratic establishment that is demonstrably caught between not wanting the UK to leave, yet also not wanting to be seen to be “soft” and thus capable of being “blackmailed” by any other member that takes it into its collective head to “re-negotiate” its terms of membership.

The irony is that, with its various “opt-outs”, the UK already has a somewhat more flexible arrangement than most other members, yet benefits from the freedoms of movement of capital, labour, goods and services with the Single Market..

Still, let us suppose that Article 50 is invoked and the 2-year timeframe envisaged by it begins. What then? What are potential permutations?

In reality, they comprise a spectrum from Modified Full EU (MFEU- which would currently be improbable in the circumstances) to Basic WTO.

MFEU would probably amount to having access to all the components of the Single Market, but some form of control over immigration and movement of labour, but without having the element of control that EU membership permits. A commonly-cited variant is the “Norwegian model”, whereby membership of the European Economic Area (EEA) gives broad access, but at the price of contributing the EU budget and submitting to its acquis of laws and regulations- friends with benefits, but no control.

A step down from that would be the “Swiss model”, whereby as a member of the European Free Trade Area (EFTA), and subject to multiple bilateral and EU agreements (but not passporting), Switzerland has broad access, but also no control and still has to make contributions to the EU budget. Crucially, it also has to allow free movement of labour- something which is causing potential conflict, as the Swiss seek controls and the EU threatens to suspend its market access. Not promising!

Canada recently concluded a free trade agreement with the EU, although it has yet to be ratified and implemented and does not encompass all goods and particularly financial services. Again, less than ideal.

And finally, if all else fails, and no agreement can be reached with the 2-year timeframe required (absent unanimous agreement to extend) by Article 50, the UK (assuming it still was the UK by then!) could fall back on mutual membership of the World Trade Organization (WTO), with some protection against tariffs, but facing the risk of little or no access for services as well as the often effective and discriminatory “non-tariff barriers” beloved of petty bureacrats.

All in all, the term “hash” is about right when it comes to the current consequences of the Brexit vote. In truth, at this stage, no-one knows the likely outcome, because there are no real precedents; and the parties involved are not only divided into the EU and the UK, but also fragmented within themselves, as factions jostle for advantage and everyone dusts off their game theory textbooks.

From Awbury’s viewpoint, we are comfortable that the Group’s position remains sound; and continue to research the opportunities that are likely to flow from the current uncertainty and dislocation.

The Awbury Team

Standard

Bloody Thursday…or Piketty’s Revenge?

To the catalogue of days with the epithet “Bloody” must now be added Thursday June 23rd, 2016, after the shock outcome of the UK’s “Brexit” referendum; and the resulting market and political turmoil.

The debate on who should be blamed; and what the likely consequences will be- and not just for the United Kingdom- has begun, because the potential second order effects are likely to be more damaging in the longer term than the immediate and obvious first order ones.

While the outcome was something of a shock to most, its likely causation is consistent with trends seen across a number of jurisdictions, including the US, France, Spain, Italy and the Netherlands- that in societies which still actually permit something resembling a free and democratic electoral process there is increasing mistrust between the actual or perceived “elites” (whether political or economic) and much of the voting polity. Couple this with a mendacious distortion by those seeking political office of the tenets of managing news content and political discourse set out in George Orwell’s 70-year-old classic “Politics and the English Language” and one has the makings of a series of “surprises” yet to come.

So, in such a world, what is any self-respecting (re)insurance underwriter or risk manager to do?

– Firstly, do not panic; nor run around shouting: “The sky is falling, the sky is falling (unless one is Her Majesty’s current Prime Minister and First Lord of the Treasury). If necessary, self-medicate
– Secondly, re-examine your entire portfolio of risk for potential “fat tails”
– Thirdly, re-assess the business environment and determine whether there are, or will be, any material shifts
– Fourthly, look for the opportunities that will undoubtedly arise from turmoil and dislocation

In such an environment, careful risk selection and rational pricing remain key to avoiding unmanageable losses. If, as the Financial Times reported, global stock markets can fall in value by USD 2.1TN in a single day, someone is going to get hurt; and, with the second fiscal quarter ending in a matter of days, valuation processes will need to be both robust and transparent to be credible when data are finally reported.

Already AM Best has expressed concern about the impact of the Brexit vote on (re)insurers, as the so-called market consistent approach under Solvency II will transmit market volatility into (re)insurers’ balance sheets. Of course, a price is simply that. It is not the same as intrinsic value (as Warren Buffett would, no doubt, confirm); and so there will now almost certainly be a disconnect in certain sectors and the volatility will expose previously hidden weaknesses and unexpected exposures.

As always, Awbury, with its expertise in providing protection against credit, economic and financial risks stands ready to support its clients in managing their franchises and in mitigating the tail risks in their businesses.

The Awbury Team

Standard

The Road to Hell is Paved with Coal…?

BP plc recently published its 65th annual statistical review of world energy (http://www.bp.com/content/dam/bp/pdf/energy-economics/statistical-review-2016/bp-statistical-review-of-world-energy-2016-full-report.pdf), commonly considered a treasure trove of data about all aspects of the industry, as well as trends within it.

As our readers will know, at Awbury, we like to keep ourselves as informed as possible about potential trends and risks across the financial and economic spectrum, because that helps us identify potential opportunities, as well as minimize the chances of errors of judgement in our risk acceptance and management.

So, what struck us as interesting in terms of themes or trends?

Clearly, much of the world constantly obsesses about oil, with some signs of recovery beginning to appear only now after almost 2 years of price declines; yet coupled with uncertainty about sources of demand, and whether a new “normal” pricing range will appear. The advent and growth of US “tight” oil and gas from shale formations has changed the balance of supply and demand, because it can respond to pricing signals much more quickly than “traditional” sources or those with large, long-term project horizons. Secondly, energy intensity (the average amount of energy required to produce a unit of GDP) continued in its longer term trend of declining at a rate of 2% per annum, meaning that, although’ the price of most hydrocarbons declined significantly, there was no offsetting behavioural change causing more flexibility in the use of energy inputs.

Another significant trend was that natural gas gained increasing market share as a source of energy vs. coal, while the rising availability of liquid natural gas (LNG) is likely to lead to a more globally integrated natural gas market, with pricing responding much more quickly, in the same way as in the oil market. As for coal, in presenting the review, Spencer Dale, BP’s Chief Economist, described 2015 as its “annus horribilis”, as consumption, production and pricing all fell. The effect of this was clearly visible in the US, when natural gas supplanted coal as the largest single source of fuel for power generation; while, one after another, the largest coal producers filed for Chapter 11 bankruptcy protection. Similarly, the question arises as to whether declining demand in the PRC will be offset by an increase in India (which is now the world’s second largest coal user after the US.)

The third clear theme is the continuing rapid growth (albeit from a relatively small base) in wind and solar power as energy sources. In particular, solar power production has increased 6o times (sic) in 10 years, including by 33% in 2015, driven by ever-declining costs per unit of output. Of course, for each source, the real test will come when and if it can (or is allowed to) compete on a comparable, non-subsidized basis with “traditional” hydrocarbon fuel sources (taking into account the significant costs for hydrocarbons which are usually not factored into standard accounting.)

We have written before about the risk of hydrocarbon assets becoming “stranded” and, therefore, economically non-recoverable. That risk would certainly seem to be rising in a number of sub-sectors; but, even so, the impact and likely timeframe are not consistent across all jurisdictions. As always, one has to look beyond the “headlines” and to analyze the actual risk being presented; because, in doing so, one may find opportunities that the “market” has overlooked or ignored; and those are the situations on which Awbury and its partners focus.

The Awbury Team

Standard