The Fat Tail and Feedback Loop at the End of the World…

In these somewhat strange times, we have been musing about how individuals and enterprises still have a habit of trying to avoid contemplating “the end of the world” (as opposed to coping with the “news”), even if the (re)insurance industry exists at least in part to mitigate extreme risks for it clients.

Nassim Nicholas Taleb has made a career out of pointing out the risks of “fat tails” and unexpected events, with a series of books which remain essential reading, even if one does not agree with all of his views or conclusions. In addition, Mr. Taleb has run investment vehicles intended to protect against scenarios in which systemic fragility overwhelms the financial markets.

And now, in a more easily accessible form, Algebris Investments (a UK-based investment manager) has announced the launch of its own “end of the world fund”, officially a “Tail Risk Fund”.

The firm points out, quite reasonably, that after a decade of a generally benign overall investment climate in which those adding risk have been rewarded, a number of large investors have begun to seek mechanisms to limit potential portfolio losses. As Hyman Minsky wrote: “Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.”

Given all the noise around the likes of Argentina, Turkey and Italy; Middle East conflicts; the recently failed G7 summit; US/PRC trade tensions (we could go on!), one might well ask: “But how can you say the markets are stable?”

This is a fair question. However, it remains the fact that there have been no real market breaks, nor stampedes for the exit as yet, minimal “tantrums” (outside country-specific ones), and the appetite for risk shows little sign of abating, which begs the question of what happens when sentiment changes (as it surely will at some point.) At that point, George Soros’ Theory of Reflexivity is likely to get another workout, as the thinking (panic) of market participants feeds on itself, creating negative feedback loops and further increasing instability, uncertainty and volatility.

The Great Financial Crisis is beginning to recede into memory, and one is led to believe that regulatory and macro-economic steps taken since then have significantly reduced the probability of a recurrence. While it may be reasonable to assume that the causes of the next GFC will be different from those of the last, to assume that there will not be another extreme financial crisis (whether or not correlated with a political one) is the height of foolishness.

At Awbury, of course, our business is based around our E-CAT franchise (providing protection against high severity/low frequency credit, economic and financial risks). So, we are always scanning the horizon for the first signs of factors that could generate the next GFC, as well as idiosyncratic and seemingly isolated events that can cascade into something systemic. It is why our clients and Insureds seek out our bespoke coverages, backed by our diverse panel of (re)insurers, whose ability to withstand systemic shocks has been amply demonstrated over many decades, and why the Awbury team also works hard to build structural and economic mitigants into those coverages in order to continue to deliver a highly attractive risk/reward ratio to its reinsurance partners.

The Awbury Team

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