The Best Capital Allocating Underwriter…

The Best Capital Allocating Underwriter…

A certain amount of controversy has recently been stirred up in the realm of investment management by a recent paper written by a team at Bernstein entitled “The Silent Road to Serfdom: Why Passive Investing is Worse than Marxism”. No doubt there is an allusion in there somewhere to von Hayek’s classic tract first published in English in 1944: “The Road to Serfdom”, one of the “foundation documents” of what now pass for “free markets”. In essence, the paper equated passive investing with Marxism.

Matt Levine, a Bloomberg commentator, then wrote an excellent note, entitled: ”Are Index Funds Communist?”, in which he posited the concept of the Best Capital Allocating Robot (BCAR- fancy that!), a robot that will vanquish all other competing robots in the field of allocating capital, leading investors to throw money at it, because no rational person would invest with the second-best robot. Of course, Mr. Levine was careful to state that this was “all nonsense”, because “The market is the best algorithm ever developed for allocating capital. So far!” We all know what happened to an economy “run” by Gosplan, and that the PRC is not really a centrally-planned economy in the true sense, even if the CCP cadres tend to be rather more involved than in a market economy. And even in the Land of the Free and the Home of the Brave, the mortgage market has become a socialist construct (the horror…!)

So, at Awbury, we thought we’d introduce the concept of the Best Capital Allocating Underwriter to the world- a true Mechanical Turk of the (re)insurance industry, to whom questions can be posed, which will be answered “automatically” (and it won’t be aeons to get to “42”.)

Just think of the benefits. No real marginal cost once the creature has been created through machine learning and the mysteries of quantum computing. Negligible running expenses. Not prone to fatigue, nor tantrums. Impervious to brokers’ blandishments, with no interest in the social niceties or Yankees tickets. Guaranteed to give a quick decision once all the inputs have been provided… In truth, a paragon of risk-adjusting and pricing excellence, able to meet attempts to influence decisions with a casual “Make my day!”

Of course, the real world is somewhat messier. As we have written before, there are quite clearly some lines of business that could and should largely be underwritten by dispassionate, self-learning algorithms, given a sufficiently large and diversified pool of Insureds; and perhaps, as data mining, pattern recognition, model construction and machine-learning continue to advance, the number of such lines will expand, while quite clearly the (re)insurance industry as a whole could benefit from a more ruthless approach to expense control.

However, as matters stand, not everything in the world of (re)insurance can be reduced to an algorithm; and we humans still tend to prefer that there is, ultimately, a human agency responsible, even if much or most of a transaction can be conducted without direct human contact or intervention. In particular, true creativity and innovation are two key areas that have not really been touched so far by AI. Yet, the vast majority of the real value in any human endeavour is created by those two activities- and Awbury’s enterprise mission is exactly that: creativity and innovation in the realm of (re)insurance.

So, while we suspect the Best Capital Allocating Underwriter’s shadow will overwhelm an increasing share of the (re)insurance markets, where there is little differentiation and the products are, in reality, fully commoditized, the Awbury Team intends to continue to develop and hone its ability to provide its clients with bespoke, value-added solutions to complex problems (while still maintaining a suitable level of paranoia about the threat horizon!)

The Awbury Team

It’s life, Jim, but not as we know it…

Aficionados of the weird, will know that the above quotation comes not from the legendary original Star Trek TV series, but from a 1987 song entitled “Star Trekkin’”, whose lyrics can be somewhat insidious when listened to…”Boldly going forward, because we can’t find reverse…”

The phrase came to our mind as we surveyed the increasingly surreal economic and financial landscape being created by the actions of the world’s central banks- a landscape in which, by one count, roughly half of all debt originated in the developed western economies now has a negative yield, while asset managers are continuing to hoard cash because of their uncertainty about “what happens next”; and banks make plans to warehouse banknotes to avoid negative yields from maintaining their reserves at the central bank.

One can also see the impact of central bank policies in the continuing decline in the reported “run rate” net investment yields of the (re)insurance industry, as one can only harvest capital gains for so long; and reinvesting cash in equivalent assets inevitably generates a lower running yield.

In theory, central bank actions are intended to re-ignite Keynesian “animal spirits”; and cause both banks and (re)insurers to support productive investment. Yet, quite clearly that is not happening; as, with few exceptions, rates of GDP growth are below trend and total factor productivity languishes.

Investors are desperate for yield, but are faced with a diminishing supply of new securities issuance from traditional sources, while regulatory capital constraints paradoxically give CIOs pause for thought when deciding upon the allocation of capital on a rational risk/reward basis.

So what is an anxious CIO to do?

Well, he or she could do worse than talk to the Awbury Team. Apart from providing our range of clients with bespoke ways in which to manage and mitigate credit, economic and financial risks, and our partners with attractive, non-market-correlated returns on their capacity, we have developed a suite of products that can enhance both the efficient use of capital and risk-adjusted returns on and yields of investments. There are still attractively-priced assets “out there” for those with both the patience and the capacity to perform appropriate levels of due diligence, and to negotiate robust terms.

The somewhat lazy shorthand for this area tends to be “Alternative Investments”, which can induce a rolling of the eyes. In reality, in a world in which central bank policy has almost certainly created a series of “financial bubbles” just waiting to implode, and where too many now seem willing actually to pay to have their money “kept safe”, it is debatable what exactly is “alternative”. Surely it is worth spending some time looking beyond the “safety” of cash and “fixed income” to consider allocating at least part of an investment or, in fact, liability portfolio to opportunities beyond the obvious?

The Awbury Team

Beware the self-referential elite…

As we have mentioned before, the so-called “experts” got the outcome of the Brexit referendum badly wrong, as did the financial and prediction markets.

Now, of course, the post mortems are (quite rightly) continuing about how that could have happened; and what the implications may be for scenario and risk analysis and selection in the future. The model-builders are, no doubt, feverishly tweaking their assumptions and inputs; as the risk managers wonder what may happen next.

One topic which they may wish to think about is that considering one’s self an “expert” carries, in itself the risk of facile misjudgment! Of course, the work of Philip Tetlock, inter alios, on the ability to assess and forecast outcomes is well known by now. His work tends to focus on how there are certain traits that those with a demonstrably superior forecasting skill tend to possess- individuals whom he dubs “superforecasters”. Nevertheless, even those with such superior skills are still only able to produce incrementally better assessments of probabilities; and much depends on the careful definition and framing of the question being posed.

However, what happened in the case of the Brexit referendum may raise an additional nuance, which (as with so many matters) should have been obvious with the benefit of hindsight: ironically, almost all of those “professionals” or “experts” involved in forecasting or predicting probabilities and outcomes tend to share certain characteristics which, in this case, almost certainly constrained their ability to conceive of the likelihood of the outcome which occurred, namely a “no” vote.

In essence, they found it hard to identify with an outcome that appeared irrational and potentially harmful to the economic wellbeing of those who voted ‘no”, as evidenced by the consequences to date in terms of the fall in the value of Sterling and the political and economic turmoil that continues; and were seduced by the fact that the outcome of the previous Scottish referendum had been a vote that appeared to reinforce the importance of economic self-interest as votes were cast. So, of course, in the case of “Brexit”, the same outcome (for the status quo ante) was “inevitable”- except it wasn’t! One could argue that the individuals and organizations involved were victims of their own “framing” issues, because they found it difficult to conceive of the fact that such a large component of the English (and the Welsh) voting population was so disenchanted with the elite and the perceived problems of “immigration” that it was willing to register what amounted to a protest vote.

At Awbury, we had already made the point in a previous post that the risk of a “no” vote was more than a remote tail risk, and had, therefore, factored it into our scenario analysis and risk management. The outcome was yet another example of the truism that “tails” are often “fatter” than a predictive model anticipates.

And just to cheer you up, Dear Reader, we shall leave you with a quotation from Kierkegaard’s diary (from 1846): “…because the minority is generally formed by those who really have an opinion, while the strength of a majority is illusory, formed by the gangs who have no opinion.” We are not sure that the Brexit “Leavers” would be happy with being characterized as “gangs”, but post-Brexit, their lack of any coherent planning for the consequences of their vote certainly brings to mind an illusion of strength.

The democratic process and the behaviours of voters are full of paradoxes.

The Awbury Team

So, how was it for you…?

Late on Friday evening, the EBA published the much-anticipated results of its latest stress test on the 51 largest EU-based banks.

As anticipated, the world’s oldest surviving bank, Monte dei Paschi di Siena (MPS), drew the “short straw”, with a stressed outcome that rendered it insolvent. As we predicted in our last post, there was a last-minute scramble by the Italian government to put together a bail-out that would minimize the risk of falling foul of the EU’s State Aid rules, or of the bank having to be “resolved”. So, a JP Morgan-led consortium is to provide an EUR 5BN re-capitalization and a mechanism intended to address MPS’s overwhelming non-performing loan (NPL) burden.

The MPS result, while very much “in the tail”, was only one of a number of interesting components of the stress test which, apart from the EBA, involved an acronym-fest of other institutions. It was meant to apply a common set of criteria and a consistent methodology to the chosen sample of 51 banks from 15 jurisdictions across the EU and EEA, with a view to assessing the impact of a number of so-called “risk drivers”, such as credit and market risk; but also, this time round (as part of operational risk) “conduct risk”. The minimum size criterion was EUR 30BN equivalent in consolidated assets. However, just in case smaller institutions thought they might escape unnoticed, the EBA is also going to conduct what it calls a Transparency Exercise this December of a wider sample of 100 banks.

One point to note is that there was no “pass” or “fail” outcome. The EBA took the view, not unreasonably, that with the EU banking sector’s average CET1 ration now above 13%, it was more important to assess banks’ forward capital planning (cf. the US Fed’s CCAR approach.)

Not surprisingly the “Brexit” scenario received an honourable mention; but the EBA took the view that its 3-year macro-economic stress scenario was sufficiently onerous in terms of the assumed shock to GDP that there was no need to adjust for “Brexit”.

While the average impact of the scenario was a (380bp) fall in CET1 from 13.2% to 9.4%, 14 institutions showed a swing of more than (500bps), including MPS with a swing of (1400bps)- a true outlier. Almost all that impact was driven by credit losses.

In terms of banks which were deemed to have the weakest “fully-loaded” CET1 ratios in the Adverse 2018 scenario (and ignoring MPS), there were 4 banks with a ratio below 7%, Raiffeisen (6.12%); BP Espanol (6.62%); AIB (4.31%); and Bank of Ireland (6.15%). The outcome for the 2 Irish banks does, of course, raise potential questions about their robustness, particularly in the context of the impact of “Brexit” on the Irish economy.

The stress test also calculated leverage ratios in the Adverse 2018 scenario; with 5 banks (excluding MPS), falling below the minimum 3% ratio: BayernLB (2.80); Deutsche Bank (2.96%); NordLB (2.99%); ABN AMRO (2.94%); and BNG (2.08%). While the leverage ratio still tends to receive less attention than capital ratios, it is important as a statement of unweighted capital strength.

While it might be argued that the overall outcome is a reason for having confidence that the European banking system is now much more robust than it was before and during the Great Financial Crisis (and in terms of available capital that is true), the process is, of course, stylized. It may have highlighted a few outliers and potentially more vulnerable institutions (with MPS in a class of its own); but its scenarios were not institution or country specific. Therefore, in Awbury’s opinion, while a useful exercise in terms of providing a consistent “ranking”, it is unlikely to identify the institutions most likely to fail in the real world, because events have a tendency to unfold in ways that stylized models do not predict.

The Awbury Team