Homage to Catalonia…

George Orwell (who was badly wounded in the Spanish Civil War fighting against the fascist insurrection led by Franco) must be spinning in his grave in light of the Catalan regional parliament’s declaration of independence for Catalonia (or rather Catalunya- one of 17 Spanish regional governments) as an “independent republic” (no more Spanish monarchy for Catalans!)

Not surprisingly, the Spanish government has subsequently exercised its own “nuclear option”; and invoked direct rule over what it sees as a recalcitrant province, led by fantasists bent on destroying the Spanish state (for if Catalonia goes, one can be fairly certain that the Basques at the least will aim to follow.) For avoidance of doubt, the action of the Catalan government is considered a criminal act by Spanish loyalists, as the constitution provides no mechanism for secession. The difference from the UK is that the Scottish referendum on independence was a negotiated process, not unilateral.

One only has to look at the recent history of Europe to be concerned about the potential consequences of the Catalans’ actions; especially since, even within Catalonia, it is considered arguable that there was no true majority in favour of independence and that what was characterized as a referendum was a “democratic coup”. Not surprisingly, no other sovereign state has recognized the “Catalan Republic” as a lawful sovereign entity.

It should be said that Awbury’s interest in these events is “academic”, in the sense that we have no direct or even indirect exposure. However, as we have written before, we are always looking for second or third order effects beyond the obvious.

Of course, it is far too early to predict how the relationship between Catalonia and Spain will evolve, but the legal consequences are already becoming evident, as large corporations move their legal domicile outside the “republic”.

One can also imagine that a frisson of concern is moving across the investor, trade credit and political risk markets. What happens if Catalans resist the central government, such that the rule of law breaks down, taxes go unpaid and uncollected, or an economic blockade is imposed? What if a local Buyer wishes to pay, but cannot because the local banking system is not functioning for “external” payments?

Taking the scenario further, what if Spain as entity begins to unravel, as the former Yugoslavia did some 25 years ago (without the bloodshed one sincerely hopes!)?

Under the conventions of international law, sovereign debt passes to successor states. Spain currently has approaching EUR 1TN of obligations. Apportioning that across a fragmented range of successor states would be a nightmare. It is somewhat ironic, that less than 5 years ago there were legitimate concerns about the ability of Spain to meet its obligations, as it suffered a wrenching recession, from which it has begun to recover; and now, when that concern should have been obviated, it may begin to return because of the political acts of a recalcitrant minority. Compounding the issue is that much of Spain’s sovereign debt is held by offshore investors, including the European Central Bank (ECB). While the risk of dissolution and default is still remote, the fact that the possibility now exists is telling, because a year ago it would have been considered laughable.

And bear in mind that Spain is not the only major European state with a separatist movement (leaving aside the UK). Italy has long had a north-south rift politically; and one can imagine that the Lega Nord is watching events in Catalonia and Spain with some interest.

The overarching point here is that risk can appear out of a “clear blue sky”, and that one has constantly to update one’s knowledge and understanding of the risk terrain and the possible ambush sites. The risk of Catalan secession was not an “unknown unknown”, but we are quite sure that it feels like an ambush to many.

The Awbury Team

Nudge, nudge…

As the recent award of the Nobel Memorial Prize in Economics to Professor Richard Thaler demonstrates, ideas that seem absurdly simple can cause a significant change in behaviour and, thus, outcomes.

For someone of whom his thesis adviser said: “We didn’t expect much of him”, Professor Thaler has had quite an impact by incorporating better understanding of how human beings (rather than the idealized homo economicus beloved by most of his peers) actually make decisions, and applying that to improving public policy. As he himself said after the award was announced” “In order to do good economics, you have to keep in mind that people are human”. How shocking!

All of this matters because, rather than just showing that people are irrational (obvious, but not exactly helpful), he was able to demonstrate that they tend to be irrational in consistent ways, so that reality can be modelled and channeled. Perhaps the most famous, and potentially far-reaching example is in the design of enrolment systems, such as for pension schemes, changing them from “opt-in” to “opt-out”, and thus significantly increasing the level of involvement.

Of course, the world being what it is, such actions are dubbed “libertarian paternalism”, with the emphasis on “paternalism”, which must be a bad thing because it deprives us of our “free will” and the right to make a mess of our lives and futures. And the world also being what is, such an approach can and is used to manipulate people into continuing to pay for services that they do not want- the “Free 30-day trial, auto-renewal” approach. As always, the use to which an idea or technique is put can often be ethical or unethical.

Professor Thaler also demonstrated that we humans are prone to the endowment effect. We are reluctant to part with something we already have unless we receive more for it than we would have to expend to acquire the same item if we did not already possess it. What we have is considered more valuable.

Perhaps less well known is Professor Thaler’s suggestion that (following the work of psychologist Gary Klein, and Thaler’s fellow Nobel Laureate, Daniel Kahneman) “premortems” (yes, you read that correctly) be used more widely in the context of particularly important decisions as a means to counteract the dangers of “groupthink” and overconfidence. In essence, people are required actively to contemplate the consequences of failure before it can happen. Such an approach is not intended to lead to decision-making paralysis, but may help avoid overreach and the fact that, by the time of the postmortem, it is a little too late! At Awbury, we are always trying to ensure that we avoid the dangers that stem from the “usual approaches” to decision-making, because we would rather not be the subject of a postmortem!

And one finding of Professor Thaler which is particularly dear to the Awbury Team is that people place a high value on fairness. They will penalize behaviour that they consider unfair, even if doing so is to their own detriment. As we have written before, a fundamental tenet of Awbury’s business model is that interests must be properly aligned and the economic outcomes and benefits of any transaction or structure be allocated fairly to create an actual “win-win” outcome. This is not always easy, but it is not altruism (we are a business after all!), but simple common sense. No-one likes to think that they have been “ripped-off” or taken advantage of, and it is detrimental to building a sustainable franchise.

So, how can we help you?

The Awbury Team

Quantum Mechanical CDS…

Credit Default Swaps (or CDS) have been around for over 20 years by now; and their use has waxed and waned over time. One of the arguments that has been used to assert their superiority over other credit risk mitigation or management techniques has been that the nature of their triggers and documentation (under various ISDA protocols) provides “certainty” of payment as long as the fee for protection has been paid.

The title of this blog is homage to an excellent post on the Dealbreaker website entitled “Schrödinger’s CDS”, which alluded to Heisenberg’s Uncertainty Principle and the famous thought experiment about whether, in the weird world of quantum mechanics, a cat could be both alive and dead at the same time; making the point that, in the world of CDS obligors there are supposed to be only 2 possible states- either “normal” or “defaulted”- i.e., no payment due, or payment due.

However, a recent controversy involving the ailing Noble Group has called into question the validity of this binary assertion about state. To sum up, when Noble Group extended loan payment terms on some of its debt parties who had bought protection on the company’s debt asserted that the action triggered payment on their CDS contracts. Given that there are apparently some USD 1.2BN of CDS contracts written on Noble Group’s debt, involving many different parties, the potential claims could be significant (with the FT quoting a figure of “up to USD 157MM”).

The question of whether a trigger had occurred was meant to be determined by the Industry Determinations Committee (IDC) mechanism managed by ISDA, in which 15 members (10 sell-side and 5 buy-side) vote on whether or not a “credit event” has occurred and, thus, payments triggered.

In the case of Noble Group, for reasons which have still not been properly explained (hence Dealbreaker’s mocking post) other than a statement that there was “insufficient information”, the relevant IDC was unable to make any determination at all. Naturally, this resulted in confusion, and no little amount of disbelief and frustration all round, as a mechanism that was supposed to end the practice of bilateral “flurries” of notices of claim and create certainty singularly failed to do so. ISDA has been at some pains to distance itself from the shambles, claiming that it is only the secretary and administers the process: “…we don’t have a vote and we don’t make decisions”.

The IDC then re-considered 2 formal questions posed to it by counterparts involved in the saga; and gave a narrow ruling that any attempts to trigger a payment had to be accompanied by “publicly available information” confirming the existence of particular language. It is unlikely that the CDS market’s major participants will be satisfied; and it has not gone unnoticed that the composition of the IDC creates inherent conflicts, rather than alignment of interests.

And in a further blow, the ICE (owner of the NYSE and LIFFE) has now stated that it will no longer oversee the administration of the DCs, because it cannot agree indemnification from the member banks and investment groups in the event of litigation, which puts ISDA itself as the Secretary of the IDC structure in the position of needing another third party to replace ICE.

At Awbury, our goal is to create and issue contracts which provide carefully-crafted, clear and unambiguous protection against a particular risk or risks, in ways which not only properly align interests, but provide certainty; because creating the potential for an ambiguous and disputed outcome such as occurred in the case of Noble Group’s CDS contracts helps no-one.

The Awbury Team

That’s the good news?! How about the bad?

So, major hurricanes are like buses- you wait for ages for just one, then 3 or more of them come along at once.

Of course, the human and economic cost of Hurricanes such as Harvey, Irma and Maria (or of the Mexican earthquakes) has been devastating; and those affected deserve all the support available.

However, while the (re)insurance industry thought it had had a narrow escape when Irma’s path managed to miss Miami, Maria’s impact brought home with a vengeance how Nature often manages, once again, to prove that CAT models are simply that- models, making a mockery of stated Risk Appetites or Tolerances. The growing catalogue of profit warnings and earnings revisions demonstrates that point very clearly, with rumours that some retro markets may see loss ratios that will make their managements wonder why they ever thought writing such business was a good idea.

The first half of 2017 has already been a relatively weak one in terms of industry profitability and underwriting results; and, while the range of loss estimates for Q3 CAT is still broad, if claims payments reach the USD 150BN level, that will be roughly the equivalent of 1 year’s gross premia for the global reinsurance industry, as a senior Scor executive recently pointed out- and multiples of annual net underwriting income.

So, what is the good news? That the industry has ample capital of some USD 600BN (although that is distorted to some extent by the size of Berkshire Hathaway’s capital base), even if certain markets (such as Lloyd’s) are likely to be disproportionately affected.

And the bad? That, contrary to hope and expectations, the combined costs of Q3’s CAT events may still not be enough to reverse trends and materially harden the market beyond an initial period, unless the sources of alternative capital (currently making up some 14% of the USD 600BN) take fright; decide that the “non-correlated-returns” thesis is no longer valid, and so pull back from replenishing their investments. This will mean a continuation of the uncertainty of trying to generate premium flow that has margins about technical levels.

However, if past behaviour is predictive, there are likely to be at least some new “Class of 2017” entities created to take advantage of potential changes, and, if rates do rise for any period of time, it seems highly likely that fresh alternative capital will be provided- yet its arrival may well cause a further softening.

As a result, all eyes will be on the January 1st renewals, and whether the industry’s underwriters will be sufficiently disciplined to impose rate increases that reflect the impact of 2017’s losses on profitability and capital- although that will only affect one business line, not all the other, commoditized ones where pricing is still deteriorating, or at best stabilizing at marginal levels.

Although Awbury does not write any NatCAT business, we shall be carefully looking for second and third order effects (such as whether there are still-hidden pockets of overly-concentrated retentions within the industry). Importantly, recent events should continue to reinforce the point that our core E-CAT (economic, financial and credit catastrophe) franchise remains the source of highly-attractive, truly non-correlated, risk-adjusted returns for our reinsurance partners.

The Awbury Team