Sighs of relief all round…but is that appropriate?

To say that the latest Rendez-vous occurred at an interesting time, is probably an understatement- not one US-landfall hurricane, but two (and with potentially significant levels of insured losses), and the “record-breaking” (and not in a good sense!) Equifax data breach.

Of course, the outcome of Hurricane Harvey in particular could have been far worse- not many miles to the east and it could have made Hurricane Katrina look like a mere Tropical Storm in comparison.

Such events demonstrate, of course, that, as evidenced by the volatility in the share prices of many publicly-quoted (re)insurers, writing property CAT business tends to produce moments of sheer panic amidst long periods of calm; while many (re)insurers are probably thankful that individual line sizes on cyber covers are still not that large.

So, the “profit warnings” for the publicly-quoted (re)insurers have begun, with Munich Re bravely going first, even though its management can have no accurate way of knowing with any certainty exactly how great the impact of recent events will be on its P&L and hence capital account. However, it would be fair to say that those companies which focus heavily on property CAT and BI covers are going to have a poor end to the year, as their “catastrophe budgets” will be significantly exceeded after years of relative calm.

Given that aggregate Insured Losses could easily be in the USD 40 to 50BN range (estimates at present are simply just that), and the combined storms are up there with (or exceed) Katrina in terms of their economic impact, it still strikes us as astonishing that no-one is yet comfortable predicting a truly hardening market in the most affected product lines- merely conceding that that the decline in pricing may (may) finally come to an end, with perhaps a modest uptick. The January 1st renewal season will be interesting.

Simply put, there remains too much capital and too many enterprises chasing not enough premium and demand; and the fact that many Combined Ratios are likely to go over 100% for 2017 evinces barely a shrug, as long as everyone is suffering at the same time. The concept of a “catastrophe budget” is in some ways an odd one. If catastrophes can truly be modelled with a reasonable degree of certainty, should the “budget” not take account of that probability and reflect it in pricing and hence premiums? Perhaps there needs to be a new category introduced of a “tail-CAT”- i.e., an event of a scale that truly is exceptional: hard to model; and for which capital does what it is supposed to do, which is absorb unexpected losses. If it is in the “budget” it should be in the pricing!

Awbury’s core business remains providing its clients with protections against material, “tail” credit, economic and financial risks (E-CAT). Therefore, our success depends and will continue to depend on designing bespoke products, and achieving pricing that far exceeds the risks posed by the tail events covered, thereby generating large, scalable premiums flows which are not correlated with, nor impacted by NatCAT events.

Of course, the fact that we operate outside the commoditized realm and are value-added price setters, does help; although we would never be so foolish as to believe that we can never be wrong- but we have capital for that!

The Awbury Team

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It seemed like a good idea at the time…

At Awbury, our business model is built on the concept of adding value in providing solutions to the credit, economic and financial issues which our clients bring to us- a very different approach from the flow-based, commoditized, cost-plus one which still tends to prevail in much of the (re)insurance industry (let alone elsewhere.)

Scale may be a wonderful thing, but only as long as it creates sustainable value. This is why it seems odd to us that M&A activity designed to create scale rarely seems to manage to improve Combined Ratios; with the attrition of cost bases and reserve releases only serving to beat back the impact of softening pricing, as the industry struggles with excess capital and the unwillingness of many participants to “walk away” from pricing that is below the so-called “technical reserve” level.

The corporate world in general is littered with spectacular examples of value-destruction (leaving aside the truism that the majority of mergers or acquisitions fail to deliver on their supposed benefits)- AOL/Time Warner and Rio Tinto/Alcan come to mind. Both were considered “good ideas” in their time, but turned out to be spectacularly bad in terms of value. And consider that Shell has just accepted the fact that its purchase of US “tight oil” assets near the height of the last oil-price peak was a very poor decision, and is seeking to unload them in some way that at least saves face.

So, why do such events occur with monotonous regularity, when patience and discipline would be more likely to preserve and create value?

There can be no single answer to this, but it seems reasonable to assume that senior executives and Boards are susceptible to the blandishments of bankers and other “advisers” who have an interest (and need) to generate business in order to earn fees (and keep their jobs.) Of course, this is something of a caricature. However, we suspect that there are few investment bankers who have the ability to resist providing a “valuation letter” that does not magically demonstrate that the price for “Xco” is fair and reasonable, and thus risk their fees because a deal then fails.

In reality, the success of a transaction depends upon many factors, both tangible and intangible. And some demonstrably work (witness Ace and Chubb), while others do not (Travelers and Citibank).

We suspect that one of the issues that leads to failure and value destruction is “groupthink”; as, once an “idea” gains traction, more and more of those involved are sucked into the belief (because that is what it is) that “buying Xco” is a very good idea, and that the naysayers are the ones who are irrational. All complex organizations develop a culture over time, which is a major indicator of their long-term viability and success, because, unless it is fit for purpose, open and adaptable, it is likely to lead to poor decision-making and an unwillingness to change a decision in the light of further information. In such circumstances, those who challenge the orthodoxy are likely to find themselves ignored, or worse.

For Awbury, our approach has been, and will continue be, to grow organically, avoiding delusions of grandeur, and to provide carefully constructed, bespoke, confidential and value-added products and solutions to our range of clients. Our ideas (and we have many) should not merely “appear” to be good ones; they must demonstrably be valuable, with the actual outcomes being the objective evidence.

The Awbury Team

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All clear…

In the world of finance, the headlines are usually generated by grandstanding politicians, or by the perceived ethical failings of a large bank, while less attention is paid to the “plumbing”, because that is seen as matter-of-fact, and eveb (perish the thought) “boring”.

Well, we have news for you, dear Reader. The “plumbing” is becoming more, not less important; and you ignore its risk of failure at your peril.

In the wake of the Great Financial Crisis, the Dodd-Frank Act, inter alia, required a far greater proportion of hitherto unregulated and opaque derivatives transactions to be cleared through a regulated clearinghouse; and similar outcomes were mandated in Europe. This is all very well as long as the relevant clearinghouse is robustly capitalized, well-managed and has an effective regulator. However, the clearing business has become ever more concentrated, as owners seek economies of scale and pricing power, with LCH.Clearnet now estimated to clear over 90% of interest rate swaps, while the Intercontinental Exchange (ICE) controls most of the credit default swap (CDS) clearing market.

Such concentrations, given that the clearinghouse stands behind each side of a transaction, in itself poses increased risks of a catastrophic failure and significant market disruption. In theory, regulators can designate a US-based clearinghouse as systemically important, and potentially give it access to the Fed’s discount window for emergency funding, but the current Administration’s at best ambiguous attitude to enforcement of much of the Dodd-Frank Act makes reliance on such regulatory action perhaps unwise, especially if the confusion engendered by most financial crises is compounded by political paralysis.

It is also argued that Title II of the Dodd-Frank Act enables regulators to have the Orderly Liquidation Authority (OLA) take over a failing clearinghouse. Unfortunately, this interpretation is uncertain; and, perhaps fortunately, has yet to be tested, while it also now suffers from regulatory ambiguity.

Of course, a US clearinghouse would be subject to federal bankruptcy laws; but, in a quirk of history, as a clearinghouse would probably be designated as a “commodities broker” for such purposes, it would require immediate application under Chapter 7’s liquidation provisions- an outcome that would be likely to exacerbate rather than dampen market disruption.

Given all this uncertainty, clearinghouses have worked assiduously to create a sequential waterfall of backstops through contractual arrangements between themselves and their members and owners (who are often many of the same entities.) While there are variations (including whether or not a clearinghouse’s legal structure is compartmentalized by type of transaction), in general, the waterfalls are intended to minimize the risk that a clearinghouse will have to exhaust its own capital and thus become insolvent, while the risk management models are designed to ensure that a clearinghouse can withstand the failure of its largest or two largest counterparts.

The structures and models are quite elegant, but depend upon the membership standing fast and complying with all the various contractual requirements of the waterfall, rather than “heading for the exits” at the first sign of trouble; and on the assumptions about the scale of member failure being conservative. While, the clearinghouse system withstood, for example, the failure of Lehmans, and the financial system is more heavily capitalized by now, none of this has been tested in a world of increased concentration.

At Awbury, we have studied this issue in depth, and created a number of mechanisms that we believe would help address the uncertainties described above as part of our programme of financial research and development, so that we are able to assist our clients with their seemingly most complex and intractable problems in the credit, financial and economic realms.

We always welcome calls from those in need of solutions.

The Awbury Team

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