Model Simple and Think Complex…

Earlier this year a man died who had been a low-key, relatively unknown (to the wider world) RAND researcher (where one of his peers was Daniel Ellsberg) and the US Department of Defense (DoD) official leading a highly-secretive unit called the Office of Net Assessment (ONA). The man was Andrew Marshall, who established the ONA in 1973 and officially retired 42 years later at the age of 93.

Of what possible interest could this man’s work be to the world of business, including (re)insurance? After all, he was not involved in game theory, strategic planning, or systems analysis, and was focused on advising the senior echelons of the DoD on a highly-classified basis. He did not even make recommendations upon courses of action.

Consider the fact that, as the economist Herbert Simon said: “Short term thinking drives out long term strategy, every time”.

In other words, individuals, organizations and bureaucracies (such as the DoD, or large multinational corporations) become so caught up in the perceived need to make countless short term decisions, many of which seem incremental or insignificant in isolation, that they utterly fail to think deeply about anything. Cursed by “departmentalization” and the rivalry it engenders, they ignore creating a comprehensive, integrated assessment of the net position in which they are likely to find themselves over the longer term. In decomposing large, complex problems into manageable, smaller ones, they are rarely equipped to re-assemble them back into a coherent whole that can drive key decisions. In theory, the CEO or Board should perform the integrative function, as the Secretary of Defense would do in the US DoD. However, if reliance is placed upon an assessment (in terms of asking the right questions and thinking deeply about them) which is itself flawed, the decisions are also likely to be flawed.

What Marshall and his small team did was to create a process in which they asked unusual questions (often before anyone else had even thought there was one to ask), and harnessed inter-disciplinary skills and knowledge to provide an essential perspective for policy makers and those tasked with making strategic decisions, both in terms of threats and opportunities. One could almost argue they were the intellectual equivalent of Lockheed Martin’s Advanced Development Programme- the legendary Skunk Works. It should also be noted that the goal was to produce a net assessment- i.e., a comparison of two or more sides in interaction with each other dynamically, rather than a one-way assessment at a static “point in time”.

If one reviews the processes which businesses use as the basis for strategic decisions, these often involve the creation of complex mathematical models, based upon certain assumptions, which are then overlaid by a further qualitative process. In theory, this is reasonable. However, in practice, such an approach tends to cause framing issues, because the model becomes the basis for the decision- yet models are often notoriously flawed or misleading (with the benefit of hindsight.) In net assessment, the models are simple, and the thinking complex- and that is the point. There is no pre-ordained outcome, but rather a comprehensive and reasoned assessment of factors such as the economic, technological, political, societal and cultural that have and will continue to have a bearing upon the issue being analyzed.

At Awbury, we certainly do not have the resources of the DoD to hand. However, we are constantly seeking to expand the approaches and lenses through which we can undertake not only short term, pragmatic assessments of our environment, but also those which we believe will continue to give us an edge far into the future. Using just “standard” or “accepted” methodologies alone is, in our view, not sufficient in any complex and variable environment over an extended period of time.

Therefore, using Marshall’s framework of a net assessment provides another tool for strategic planning.

The Awbury Team

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This is getting really weird, or when did interest-bearing debt become an oxymoron…?

In the “olden days”, when money was borrowed (and ignoring the impact of usury laws and religious prohibitions), it was customary for the debtor to pay the creditor a rate of interest based, inter alia, on the perceived risk to the lender of making the loan, or the lender’s perception of how desperate the borrower was. To say that this was axiomatic would be understating the point.

Those of us who are old enough can, of course, also remember when even the US Treasury had to pay double-digit interest rates, even if, in real terms, the rate was much less.

Yet, now we seem to have stepped Through The Looking Glass and fallen down a Rabbit Hole into some form of parallel universe, in which one begins to wonder what “interest rate” means any more.

Economics has the concept of the Zero Interest Rate Bound (ZIRB), also called the Zero Lower Bound (ZLB), which posits that nominal interest rates (as opposed to real ones) should not become negative. This “certainty” was shattered, first in Japanese money markets some two decades ago and again in the wake of the Great Financial Crisis (GFC), in which yields on a wider range of sovereign bonds, such as Bunds, became negative. As the global economy has gradually recovered and grown since then, one would have thought that “negative yields” would have been consigned to history. However, some USD 12.5TN equivalent of debt now has a negative yield, including (according to Deutsche Bank) some USD 600BN of corporate debt. Not only does one have to process the fact that apparently all the Czech Republic’s Euro-denominated debt now trades at sub-zero yields, but also cope with the reality of even some “high-yield” bonds yielding less than zero. It is almost Orwellian doublethink when “high yield” = <0!

One can, of course, debate whether we are increasingly the victim of that old central bank and governmental favourite called “financial repression” (in a new guise), or of misguided attempts to “keep the economic music playing”. Nevertheless, the reality is that such circumstances can have strange and surreal consequences.

Consider the tale (as related by Charles Gave of Gavekal Economics) of the Dutch pension fund manager who was reminded by his regulator that he needed to reduce his cash holdings (cash being regarded as “risky” for a pension fund) and buy more long-dated bonds. When he remonstrated that, as most high-quality Eurozone bonds had negative yields, he was bound to lose money, the response was the Dutch equivalent of: “Them’s the rules”. Perhaps even more surreal is the idea of Danish mortgage lenders offering borrowers a mortgage that pays the borrower interest.

Look at the world from the point of view of a life insurance company. If it is forced to lock in a negative yield on increasing components of its Invested Assets, what steps can it take to mitigate this embedded risk to its P&L and capital accounts? Raise its premiums, scale back business, or go hunting for assets that do actually demonstrate a reasonable chance of generating a positive interest return? None of this is straightforward.

Such an environment will favour those who are able both to think through the consequences beyond the first order, and can understand and manage the risks and opportunities that it poses and offers; because, where there is risk there is usually opportunity.

The Awbury Team

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Power Laws and Probabilistic Strategy…

It is well understood that some relationships in terms of how one factor affects another are linear, while others are non-linear (so-called power laws). As Albert Bartlett said:

“The greatest shortcoming of the human race is our inability to understand the exponential function”.

In business, many managerial approaches are based on an incremental, essentially linear approach, aiming for a gradual increase in revenues accompanied by a similar growth in profits. This is a symptom of strategic inertia; of accepting mediocrity. In some areas, such an approach may enable a business to survive for a long time, although its end may come swiftly if its environment changes.

McKinsey recently published an article (How to win in insurance: Climbing the power curve) which should give the incrementalists serious pause for thought. In studying the economic profit (total profit less cost of capital) of 209 insurers (being all insurers with revenues above USD 1BN in 2017) from 2013 to 2017 McKinsey identified what amounts to a “power curve”:

– The top 20% generated an annual average economic profit of USD 764MM equivalent
– The middle 60% produced an average economic profit of USD 26MM (i.e., they just about broke even in nominal terms)
– The bottom 20% suffered an economic loss of USD 976MM per year (i.e., they rapidly destroyed value)

Visually, the data looks much like a two-ended Allen Key held horizontally- essentially showing that most of the wealth creation and destruction are in the tails.

Of course, when challenged about under-performance (re)insurance company managers (like those in any other industry) will state that they are undertaking a “strategic review” which will transform the fortunes of an underperforming business. Unfortunately, as McKinsey points out, not much changes in reality: the odds of a bottom quintile company moving to the top quintile between 2003 and 2017 were 17%; and those from the middle 3 quintiles into the top no more than 10%, which in some ways reinforces the dangers of complacency exhibited by the “great middle”.

As with many things in life, outcomes are usually probabilistic, not deterministic; and so it is with strategy. There are no certainties of success. However, McKinsey’s research highlighted 5 areas which were the most likely to enhance a company’s positive trajectory and move it up the power curve:

– Dynamically shifting resources between business units
– Reinvesting material amounts of capital in organic growth opportunities
– Pursuing thematic and programmatic M&A
– Enhancing underwriting margins
– Making “game-changing” improvements in productivity.

It would be easy to say that these are “obvious”. Yet, if they are, why do so few (re)insurers seem to make a serious effort to implement one or more of them? As McKinsey points out, what differentiates outcomes is the magnitude and intensity applied to escape from the “usual” approach to change. Materiality matters at least as much as direction.

To comment on an area near and dear to the hearts of the Awbury Team, if the key goal of any (re)insurer is to generate a high risk-adjusted return on capital (and to stop seeking the “safety in numbers” of a Combined Ratio of a little below 100%), enhancing underwriting margins should be an obsession, with an equal focus on more efficient processes, higher margin and non-commoditized product lines, and lower loss ratios. Unfortunately, for many, this often requires going outside their “comfort zone”. Yet the behaviour described is not reckless, but rather involves analyzing where the most value is likely to be created, and refusing to be distracted by the siren call of simply a larger premium flow.

To sum up, management teams need to be bold, focused, and know how to apply “leverage” within their business model in the ways that will truly make a difference. Being “comfortable” is not really a valid option.

The Awbury Team

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Come the Revolution…

In 1972, Larry Greiner (Professor Emeritus of Management and Organization at USC) wrote a seminal article which was published in the HBR and entitled “Evolution and Revolution as Organizations Grow”. In it he posited a model (now called the Greiner Growth Model, or the Greiner Curve) describing how organizations grow and prosper (or fail) over time through a cycle of evolution and revolution (or crisis).

In essence, Greiner stated that the idea that any organization could, after being founded, continue to grow and be managed in some stable, essentially linear fashion was deluded; and that, while the precise order, length and nature of each phase might vary depending upon the nature of the business and how prescient and adaptable its management was, each organization would go through periods of “crisis”.

One only has to observe the effects of the passage of time across multiple industries to recognize that the underlying premise is valid. Business model, structure and management style either proactively adapt, or changes are enforced by multiple factors. Trying to “stay the same” leads to ossification, irrelevance and potentially extinction.

In his model, Greiner suggested that there are up to 6 stages or phases in the process, with an attendant “crisis”, or catalyst for change between each:

Phase 1: Creative growth from founding, leading to a crisis of leadership as the business scales and becomes more complex structurally

Phase 2: Growth based upon an adapted leadership style (perhaps with new leadership) emphasizing more formal processes and direction, leading a crisis of autonomy as employees chafe against what is seen as over-centralization

Phase 3: Growth under a delegated structure, in which the autonomy of employees and teams is recognized, and they have broader decision-making authority. This leads to a crisis of control, as senior management and directors begin to sense that they are losing control of the business

Phase 4: Growth continues via greater use of co-ordination in which the business puts in place structures through which senior managers take more direct responsibility for business units, while creating a “staff structure” to maintain consistency across the entire organization. Eventually, this can lead to friction between “line” and “staff” functions, in the guise of a “red tape” crisis

Phase 5: To counteract “red tape”, senior management emphasizes a more collaborative approach, in which problem-solving through team action or through collaboration across teams is used to manage what by now is likely to be a large and complex business. The potential major issue becomes one of growth itself, as employees become overwhelmed because of the demands made on their time, and the pressure to grow

Phase 6 : In this phase, concerns about the ability to continue to grow, lead to an attempt to create broader alliances, M&A, networks, or the use of outsourcing.

Whether and how quickly each stage or phase occurs depends upon a combination of industry dynamics, growth rate and management quality. Viewing the model as deterministic is, in our opinion, misguided. However, it does provide a useful framework for thinking about how to manage organizational structures as a business grows, and to ensure awareness that over time these have to adapt to stand any chance of surviving long term. Of course, not all businesses make it through the phases described above, victims of “creative destruction” or an inability to adapt. If one looks at the (re)insurance industry, one can see that it contains members which exhibit the characteristics of the various phases, from start-ups to global businesses, as well as those which have somehow become “stuck”, which brings into question whether the might succumb to the next “revolution”.

At Awbury, we have deliberately grown carefully and incrementally since being established some 7 ½ years ago, while adapting our business model to changes in markets and opportunities; and we are very well aware that we will have to continue to adapt and evolve over time to meet the challenges and disruptions that face all businesses in a complex industry such a (re) insurance. We have no intention of being overrun by any revolution!

The Awbury Team

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