Bleeding Edge or Leading Edge…battling entropy…

In this world of constant competition and disruption, everyone needs an “edge” to survive and prosper. This is the received wisdom.

There are too many mediocre businesses that somehow survive, limping along, waiting to be put out of their misery- either by their lenders and capital providers, or through the cleansing effect of bankruptcy. As a result, capital and resources, real and intellectual, are misallocated, with a cost to the economy and society.

Of course, it is easy to say that one needs and has an “edge”- both individuals and organizations like to believe that they are above average and more effective than their peers or competitors. However, that is not only mathematically impossible, but patently untrue. Just look around at any industry.

The Second Law of Thermodynamics states: “as one goes forward in time, the net entropy (degree of disorder) of any isolated or closed system will always increase (or at least stay the same)”. In other words, lives, businesses, our planet and the universe all tend towards disorder.

As the Shane Parrish of the excellent Farnam Street blog (www.fs.blog) said in a recent post (entitled “Battling Entropy: Making Order of the Chaos in Our Lives”) “Uncontrolled disorder increases over time”, as systems, societies and businesses have a tendency to dissolve into chaos.

So, in order to move forward and maintain or increase one’s “edge” over one’s competition, one has to make inputs that, when combined, increase control, combat disorder, and provide a net positive value to one’s clients and partners. Most new businesses fail over a relatively short period of time after they are established- even in the S&P 500, comprised of the US’s largest companies, the rate of disappearance has increased over time.

The following quotation (from Roger Zelazny, in Doorways in the Sand) sums up this reality very well: “…there is a law of evolution for organizations as stringent as anything in life. The longer one exists, the more it grinds out restrictions that slow its own functions. It reaches entropy in a state of total narcissism. Only people sufficiently far out in the field get anything done, and every time they do they are breaking half a dozen rules in the process.”

Consider the above in the context of any large, bureaucratic organization. In theory, the order created by systems, procedures, committees and oversight is beneficial and essential for the organization to survive. However, over time, in the absence of constant and diligent re-assessment and intelligent adaptation, organizations’ abilities to get things done and add value decay; and, when the inputs in terms of capital and labour exceed the value (profit exceeding cost of capital) generated, an organization is on borrowed time in terms of its ability to survive for any length of time.

Order is essential, but it must be balanced by creativity; and there is a constant dynamic interplay between these two forces: an organization left to its own devices trends towards entropy, so it needs organizing structure and systems. However, too many structures and systems lead to stagnation and ossification and eventually kill the organization, so it is actually important to maintain a degree of chaos and disorder, and focus on staying far out in the field in terms of innovation to battle complacency. The leading edge is never far from the bleeding edge, and maintaining a balance is hard.

At Awbury, even after 7 value-creating years, we are well aware that we cannot afford to be complacent; nor can we become consumed by the “beauty” of bureaucratic and systemic order. If we do not constantly renew and adapt our capabilities, balancing control with creativity (intellectual property creation) we will run the risk, like every other entity, of succumbing to entropy and decay.

We have no intention of doing so.

The Awbury Team

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Earth Wind and Fire,

Readers of a certain age will recognize the title as a reference to a legendary, genre-spanning music group created in 1969. One could alternatively go back a few thousand years to the Ancient Greeks, who believed that the world was made up of 4 elements, Water, Air, Fire and Earth.

(Re)insurers have long taken earth(quake), wind(storm) and (flood)water seriously in their CAT models, but have tended regard fire as a less likely catastrophic risk, with lower PMLs. This is slightly ironic in the context of the fact that most of the original insurance companies, in the UK and the US, were established to cover fire risks, including Benjamin Franklin’s The Philadelphia Contributionship for the Insurance of Houses from Loss by Fire, founded in 1752.

All that will (or should) now have changed, as estimates for losses from the current spate of wildfires in California run to USD 19BN and are still rising- not, in itself, a threatening amount for (re)insurers’ capital, but nevertheless approaching the levels seen in the other categories. Equally disturbingly, frequency has increased as well as severity.

We are sure, therefore, that firms such a RMS, AIR and Eqecat are rushing to review and update their models, as are the modelling teams in all the major CAT (re)insurers and brokers. It will be interesting to see whether and how events affect pricing and capacity during the forthcoming 1/1 renewal period. Not only that, but it will surely cause corporate risk managers, particularly for power utilities, to re-assess the size of limits they need. After all, one only has to look at the impact of the California wildfires on PG&E’s share price and credit spreads.

So, what lessons and observations can be taken away from such events?

Firstly, that “old” risks, such as fire, that were, no doubt, thought be well understood, can still mutate and cause surprises.

Secondly, if a combination of forest management practices, changing weather patterns and human encroachment can cause such devastating outcomes as in California, which other concentrations of economic value could be vulnerable now and in the future?

Thirdly, tensions between regulators, insureds and (re)insurers are likely to increase. To cover potential losses, rates should increase, but (like flood insurance) homeowners, at least in the US, believe they have a right to build even in areas known to be vulnerable.

Fourthly, the lack of long-term data points is going to make building effective models more difficult, because no-one really knows what reasonable parameters should now be.

Fifthly, new technologies and management practices are likely to evolve to address both the risk and the opportunity.

The overarching point is that even experts can become complacent that the boundaries of certain risks are well understood and so vigilance perhaps wanes. People obsess over “emerging” risks, while overlooking the fact that long-standing assumptions are just that- and need the same periodic re-assessment as any other CAT or (re)insurance risk. Catastrophic fire risk should be a white swan amongst the grey and the black, not a surprise.

As we have said before, to survive, prosper and avoid ruin, one has constantly to re-examine, re-assess and test one’s models and assumptions. Being paranoid helps!

The Awbury Team

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