Let me tell you a story…

As any anthropologist will tell you, human beings love stories and narratives, because they help us make sense of the world and our place within it.

Over recent years, economics has become increasingly focused on mathematical models, often to the detriment of comprehensibility; with charges being levelled by some that the approach is designed to obfuscate and to hide the fallibility of an underlying hypothesis, because the riposte to criticism is “But you clearly don’t understand either economics or mathematics.”

Fortunately, there are now signs that economists have begun to realize that, shocking as it may seem, it actually helps if people at least understand, even if they do not subscribe to a particular conclusion or forecast. Comprehension leads to dialogue.

Of course, this begs the question about the extent to which either “number-crunching” or “storytelling” should be the predominant mode of approach to the issues inherent in finance and economics. We have all seen the consequences of flawed modelling and “marking-to-myth”, as well as how extrapolating trends without introducing a significant dose of common sense can lead to absurd outcomes and flawed decision-making. On the other hand, a narrative that is not grounded at least to some extent in an appropriate probabilistic or Bayesian framework can just as easily veer off into the realms of unchecked fantasy.

In reality, to be able to make, and have key constituencies subscribe to one’s views and recommendations one has to be able to blend both strands of approach. Most individuals tend to be biased towards one or the other in terms of aptitudes, interests and capabilities; so a key factor in building successful and effective teams, including in (re)insurance underwriting and risk management, is to ensure that it contains individuals with the requisite and complementary skills.

While we suppose in this age it is conceivable that a new financial model could “go viral” and become a term of art, it is likely that its audience will be confined to a relatively small cadre of specialists, rather than the public at large.

In the world of finance and investment, narratives and how people react to them are crucial. One of the strengths, so-to-speak, of Berkshire Hathaway (apart from its legendary financial capacity) is the ability of both Warren Buffett and Charlie Munger to deliver and project a consistent, credible narrative over what now amounts to generations. One can argue that the Sage of Omaha is now entering the realm of myth and legend, but the effectiveness of the approach speaks for itself.

At Awbury, because our business is based fundamentally upon our ability to create often complex, value-added solutions for our clients, and to ensure that our partners understand and subscribe to what we are trying to achieve as we continue to expand our franchise, the construction and combination of both financial models, and solid and credible narratives are core skills. As a niche and specialist business, we believe that this is what differentiates us from the world of the commoditized, “narrativeless”, increasingly low-margin business lines prevalent in much of (re)insurance.

We would be more than happy to tell you a (true!) story…

The Awbury Team

Cap that! Or, It’s all about the claims…

The P&C (re)insurance industry has been roiled recently by the massive transaction between AIG and Berkshire Hathaway’s (BRK), National Indemnity Company (NICO) announced last Friday. The size of the transaction dwarfs anything seen before. As such, while in the context of BRK/NICO it is more than manageable, so far as one can tell it is by far the largest legacy and reinsurance transaction ever conceived. The USD 34BN “headline” number, representing essentially all of AIG’s US long-tail commercial reserves for the accident years 2015 and prior, is remarkable, but consider: a limit of “USD 20BN XS USD 25BN”, with NICO paying 80% of claims above USD 25BN, up to the cap. There are almost one hundred countries that an annual GDP measured in USD that is smaller than USD 20BN!

So far, very few details have been released by either party, but the timing seems to have been linked to a comment tucked away in the AIG press release that it would be taking yet another “material adverse reserve adjustment” when it announces its Q4/2016 after market close on February 14th (sic. Now that’s interesting timing…) Given AIG’s recent history (contrary to that of most of its peers) of such “adjustments”, it begs the question of whether this transaction will finally signal an end to such actions.

Interestingly, AIG’s share price barely moved on the day, so we wonder whether the market is making the calculation, given Ajit Jain’s almost legendary status, that NICO would never have done the deal if it did not believe that AIG’s adverse reserving experience was over.

Of course, another attraction to BRK/NICO is that it gets the opportunity to invest the float on the underlying reserves of USD 34BN.

The “margin of error” on the deal (as so far described, and ignoring BRK’s earnings on the float) is not that large for a company of the scale of BRK. In theory, if ultimate losses remain unchanged, BRK will make a gain of USD 2.6BN on the USD 9.8BN fee AIG is paying; while AIG will break even if its losses subsequently rise by a further USD 3.25BN on the underlying reserves.

Given that this transaction relates to a US long-tail book, another aspect which is getting a lot of attention is claims handling. Unlike a previous deal which AIG undertook with NICO some 6 years ago in respect of its asbestos liabilities, where NICO had responsibility for handling claims, in this case AIG asserts that it will have control of claims, although NICO will have “various access, association and consultation rights”. Naturally, this has made some observers concerned that AIG will not be able to resist NICO’s views and influence, with a detrimental impact on the payment of otherwise valid claims. The “devil will be in the detail”.

One other aspect that bears consideration is whether “freeing” itself of such a significant component of its legacy reserve risk will cause AIG’s management to make further changes to the product mix in its US commercial book; and we can imagine some level of nervousness on this score amongst its staff and client base, offset by anticipation on the part of its peers and competitors (including, perhaps, Berkshire Hathaway Specialty Insurance.)

Overall, however, the transaction appears to benefit both parties, so we wonder how many other carriers will now be beating a path to Mr. Jain’s door!

The Awbury Team

Faites vos Jeux, Mesdames et Messieurs…

As they assemble for this year’s meeting, one wonders how many of the denizens of that meme called “Davos”, or the World Economic Forum (WEF) actually read its annual “Global Risks Report” (GRR- http://www3.weforum.org/docs/GRR17_Report_web.pdf) given all the other matters which such a group has to deal with such as the quality of the après ski, or whether their entourage will be properly housed.

However, while it is easy to mock such documents as “window-dressing” or merely “worthy”, the GRR still serves as a useful reminder of the world in which we may find ourselves living; as well as, importantly, how people currently perceive and react to it, because perceptions and beliefs drive actions and decisions, even if the benefit of hindsight is a wonderful thing.

The plots on the Probability vs. Impact graph in Figure 3 are interesting as a summary. Perhaps not surprisingly, in a world beset by Kim Jong-Un and Vladimir Putin, “Weapons of Mass Destruction” just about wins the Impact prize from Extreme Weather Events (after all, contemplating Humanity’s self-immolation in terms of probabilities is still rather dispiriting), but the latter is considered by far the most dangerous threat in terms of Probability, which brings up the question of intertemporal responsibilities. Nuclear weapons exist, and no rational actor would consider using them as a “first strike” because of the likely immediate consequences in terms of retaliation; but denial of climate change risks can be contemplated, because the irreversible impacts may not occur for generations. There is a problem of the proper alignment of incentives familiar in the corporate and financial world.

Of course, one of the ironies of “Davos” is that is can reasonably be considered the epitome of the increasingly-discredited, self-referential elite (at least for those not making the cut for the Bilderberg Club) and one may rightly wonder whether any of it matters “in the real world.” The FT’s Alphaville column provided a rather sarcastic comparison of references to particular topics (e.g., Trump or Brexit) in the 2016 GRR versus that for 2017. As foreseeable risks, both Trump and Brexit gained the legendary “nul points” (zero), beloved of the Eurovision Song Contest, in 2016; which rather begs the question of the competence of the more than 750 “experts” who supposedly contribute to the GRR.

Another visual representation worth perusing is Figure 2, “The Evolving Risks Landscape, 2007-2017”, as its illustrates quite vividly how perceptions change. So, for 2008-2010, Asset Price Collapse headed the Likelihood charts, with Extreme Weather Events a parvenu for 2017. Asset Price Collapse was also the “winner” of the Impact assessment from 2007-2010, while Weapons of Mass Destruction has been sneaking up the charts for the past 3 years. Perhaps tellingly, no financial risk makes the Top 5 for 2017 in terms of Impact or Likelihood; it’s the NatCAT and Terrorism underwriters who should be really worried according to the GRR!

Naturally, at Awbury, we take all such “assessments” with a large pinch of salt. Not because they have no value, but because there is no individual accountability or consequence of being wrong. 750 “experts” constitute rather a large herd; and none of them has anything truly at risk if wrong (unless, of course, if Weapons of Mass Destruction proves to be a little too prescient!)

With its focus on credit, financial and economic risks, the close-knit Awbury Team demonstrably has accountability to its partners and clients for its decisions; and with our own capital at risk, we most certainly have “skin in the game”. Quite clearly, we do not ignore non-financial risks, because many of the them have direct financial consequences; and it is perhaps the judgement of the interplay between the financial and non-financial that needs to be emphasized more amongst those who analyze and assess any (re)insurance risk. In homage to John Donne, “No Risk is an Island entire of Itself”.

The Awbury Team

”That which does not kill me makes me stronger”…

The above quotation comes from the Maxims and Arrows section of Nietzsche’s 1888 tract “The Twilight of the Idols, or How to Philosophize with a Hammer” (sic). To state that Nietzsche’s views were and still are controversial is an understatement; and he remains anathema in many quarters.

However, as is often the case, it is instructive to look beyond the trite, sensationalized level, and consider what the statement is trying to convey. Interestingly, the phrase which precedes it is usually forgotten: “From Life’s School of War…”

Nietzsche was trying to convey that in the real world (rather than the “apparent” world, which he mocked), life is a struggle and one will face risks and setbacks, but that if one survives one will emerge stronger and more robust. It is a form of resilience.

It should be axiomatic that any (re)insurer must be based fundamentally on a resilient business model, because the very function of the entity is to be able to withstand shocks that damage and destroy the assets or resources it is covering and still be able to meet all its claims and obligations as they arise or fall due.

And yet, resilience has to be based upon the realities of this world, not some expectation that “it will be all right on the night”. This requires constant vigilance to detect new risks, or changes in the nature or scope of risks. One still contentious area would, for example, be the impact of climate change on what can and should be considered insurable. It is frankly absurd that so many governments still permit building in areas at known risk of periodic flooding (as distinct from truly rare, catastrophic events).

Consider also, the burgeoning area of cyber risk covers- as we have written before, one of the “next big things”- seen by many in the industry as a way in which both to increase premium flows and to improve underwriting margins. While events surrounding the recent US elections have highlighted the potential non-monetary consequences of cyber attacks, and one would think that any self-respecting senior executive would be paranoid about the risk to his or her own business, a recent Lloyd’s survey of senior European executives showed a continuing disconnect between the fact that 92% of respondents had experienced a breach within the past 5 years, yet only 42% professed to be concerned about the risk of a future breach. Is that denial, or cognitive dissonance?

Conversely, it would appear that underwriters are still struggling to model the risks posed by writing such covers, with one specialist being quoted recently by the Financial Times as saying: “It’s a struggle trying to model risks where there isn’t 100+ years of data.” So, if one struggles to model the risk, how robust can the resulting model be; how confident can one be that it has identified the extent of the “tail”; and how realistic is the pricing?

Of course, we are not saying that providing such covers is foolish per se; rather that the industry needs to be very careful that it does not create another “death spiral” resulting from claims that far exceed the abilities of the market to absorb them.

At Awbury, we aim to diversify the underlying nature of the risks we write; to write only those which we can model and price effectively; and always to be in the situation in which, even if the worst case occurs, our financial capacity and integrity will not and cannot be compromised.

And finally, consider Maxim and Arrows’ aphorism #44: “The formula of my happiness: a Yes, a No, a straight line, a goal.” Quite relevant for the start of a new year.

Of course, not long afterwards, Nietzsche went literally insane…

The Awbury Team

That was the Year that was…

Well, we hope that by the time this note is posted we will all have made it safely and reasonably soberly into 2017! So, we wish all our Clients, Partners and Advisors, and you, Dear Reader, a prosperous and successful 2017.

As we look forward and consider the opportunities and risks that appear on the horizon, we bring to mind the song-poems of the late and incomparable artist Leonard Cohen; a man who lived a full and turbulent life, and even after severe setbacks fought until the end. One of his last songs “You want it darker” could be a suitable anthem for how many perceive the times in which we live, yet its bleakness should be set against the majesty of his song “Hallelujah”.

The fact is that the events of 2016 have cumulatively demonstrated that there are beliefs affecting a significant segment of the voters of many so-called democratic polities that once again threaten the stability of the geopolitical system that grew out of the Peace of Westphalia of 1648. Many consider that the forward march of ‘progress” is now threatened with reversal, while the rivalry of the United States and the PRC runs the risk of creating another “Thucydides Trap”, in which an existing hegemon feels the need to prevent the rise of a challenger.

And if you want it darker, you merely have to observe the war crimes being committed in the Syrian civil war, to name just one location where Man’s inhumanity to Man is self-evident, or to note that there is now a democratically-elected leader who boasts openly of being a murderer.

However, before we all decide to quaff the hemlock, consider also that news which catches attention tends to be negative, while most of the world gets on quietly with generating wealth and raising people out of poverty through adaptation and innovation. Malthus’ predictions have not yet come to pass!

Of course, in the world of (re)insurance, it’s all about the risks. On the one hand, there have been no major catastrophes that have significantly depleted the industry’s capital (in fact, it is awash in it), while pricing power in most traditional CAT lines remains weak; on the other hand, there are product lines such as cyber and flood (and those which will flow from robotics and AI) which have the potential to provide significant new revenue streams (as long as they can be analyzed and priced properly for the risk), while new geographic markets will also continue to develop.

In Awbury’s world of value-added E-CAT (economic, financial and credit) insurance, we have just successfully completed our 5th year. While our core values and business model do not change (altho’ we are constantly testing the latter for continuing “fitness for purpose”), we constantly refine and develop new products and techniques, as opportunities present themselves and those available change, because we understand that only entities that have the capability to anticipate and adapt will be able to sustain a competitive advantage in an environment where, as the cliché correctly states, “change is the only constant”.

The Awbury Team