Is your model an ideology?

In finance, economics and (re)insurance (as elsewhere), it is accepted as a statement of the obvious that one’s model is only as good as the assumptions used to construct it. This depends upon our understanding of what the model’s purpose is; what we consider important; and what we omit.

Yet, as Karl Mannheim (a sociologist of the first half of the 20th Century, and yet another refugee from Nazism) pointed out: thinking (as in the construction of one’s model) is an activity that must be related to other social activity within a structural framework- i.e., in any complex environment, it never exists in isolation. It is, in fact, the product of a particular worldview and context, and so an ideology. Ironically (and echoing Marxism), this meant that any critique of an ideology was also ideological!

Having rescued ourselves from disappearing down that rabbit hole of Marxist dialectic, and barely avoided veering off into Platonic Ideals, the point to be made is that one must always test the assumptions used to build any model not only for their validity and relevance, but also for their origins. Are they the product of some currently dominant belief system, which may have introduced unconscious bias, or caused certain crucial factors to be ignored or overlooked? For, example, a Marxist, Keynesian, or Neo-liberal economist would approach the same issue, or particular fact set from very different starting points, and using very different mental “toolboxes”. As result, the outputs of their models, and so their consequences, would be likely to be very different.

Friedrich Hayek, the Austrian economist, was in no sense a member of the so-called “mathematical wing” of Economics, but rather set out models based upon his philosophical beliefs about the dangers of introducing any element of state influence into an economy. To claim that his most famous work, “The Road to Serfdom” (written in the depths of WWII), was “influential” is to understate the case. However, in reality, he had propounded an ideology, rather than created economic models, in the same way that Milton Friedman did a generation later. We live with the results still.

One might think that the world of (re)insurance must be above such influences, being devoted to the rational evaluation, pricing and management of risks across a broad spectrum of products. One might be wrong!

To give a couple of hypothetical examples: what if a Political Risk underwriter allowed his or her personal and subjective political beliefs to influence a decision, but in ways that were not visible in the underwriting file; or a D&O underwriter deliberately downplayed, or over-emphasized, certain risks to which a business was subject because of his or her own subjective beliefs about the particular industry in which it operated? Of course, any human being is subject to the consequences of his or her biases, preferences and beliefs, and “objective truth” can be a very elusive concept in many areas. However, the failure to consider relevant factors, or basing a decision upon a particular personal belief system, is, in reality, the product of ideology; which, quite interestingly, has an archaic usage referring to the science of ideas- i.e., the study of their origins and nature.

The team at Awbury is most definitely human, and a group with varied backgrounds and personal beliefs. However, we strive always to ensure that any models we build are fact-based and as free from any inherent bias as is possible, testing them to destruction to ensure their robustness.

The Awbury Team

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P&C Cost Containment and Efficiencies- It ain’t working…

Note content with pointing out (“How to win in insurance: Climbing the power curve”) that most of the economic benefits in (re)insurance accrue to a relatively small percentage of the industry, McKinsey has now published a follow-up article, which provides evidence to support the anecdotal view that the industry’s efforts on managing and reducing its often bloated and inefficient cost structures are so far not working in many cases.

In fact, the industry continues to face a structural problem in addressing its operating costs; with McKinsey estimating that, for the top 10 largest composite groups, efficiency has actually deteriorated by some 40% since 2009 in terms of “SG&A” as a percentage of revenues. Of course, this has not been helped by stagnant or declining premiums in many key, but commoditized product lines.

This is not to say that there have not been improvements in certain components such as labour productivity. However, these have been offset by increases in areas such as IT and the increasing burden of regulation. In fact, the gap between the top and bottom quartiles has widened over the past 5 years, such that the operating costs of the former (at 15.3% of GPW) are 44% better than those of the latter (at 22.1%). In an era of lower investment returns, this simply exacerbates the problems facing P&C businesses in terms of earning their cost of capital.

Interestingly, while one would have thought that scale would be beneficial in terms of the ability to drive down costs, the reality is more nuanced, with McKinsey pointing out that “the higher cost players tend to be multiline incumbents with a complex portfolio” that find themselves subject to continuous cost creep. Trying to manage multiple legal entities, brands, legacy systems, product lines, regulatory and capital regimes in the face of static or falling premiums, and the increasing commoditization of hitherto core businesses represents a significant challenge, and one which it seems overtaxes many industry participants, as evidenced by the lack of meaningful cost reductions, as well as existential angst expressed by entities such as Lloyd’s, which recognize that their cost structures are unsustainable.

Naturally, there is no panacea that can magically reduce costs. In reality, success results from something that in many ways represents the Japanese concept of kaizen, continuous improvement, made famous by Toyota. McKinsey suggests a combination of “functional excellence” (e.g., optimizing processes of specific functions); “structural simplification” (self -evident); “business transformation” (such as radical steps to amend operating models, or business portfolio composition); and “enterprise agility” (e.g., ensuring the availability of the requisite talent, communication channels, management focus.) Of course, a business consultancy would make such points. However, they are an amplification of the kaizen approach.

One thing is clear: any (re)insurance executive serious about the long term viability of his or her business model, needs to examine all of its components, rank order them in terms of their impact on its cost base vs. their contribution to generating sustainable revenues, and be prepared to contemplate and then execute upon steps which may appear threatening to vested interests, but which are essential to the business having any chance of becoming part of the top quartile or better in terms of costs, which provides some hope of better returns on capital. The lower and more flexible one’s cost base is, the greater one’s resilience in the face of a competitive market in which the “winners” increasingly dominate.

For Awbury, our focus has always been, and will remain on underwriting bespoke credit, economic and financial risks; maintaining a focused “fit for purpose” organizational structure; and making sure that, as our business scales, our costs do not.

The Awbury Team

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Homo Economicus- “rational” self-interest, or risk-pooling…?

Economics is one of those topics that can easily cause eyes to glaze over and attention falter, yet it is an area that it is unwise to ignore because of the often-controversial interplay between economics and public policy. After all the discipline’s original name was Political Economy for a reason.

What politicians understand (or fail to) about economics, and whose advice they listen to (or reject) has a significant impact on the welfare of the citizens of every state.

Like many other disciplines, economics goes through cycles of what is considered “orthodox”, appropriate, or relevant- whether Neo-Keynesian or Neo-Liberal or any other “school”- but each approach is generally based upon certain core assumptions about human behaviour, so that these can be used to construct the models used to drive decision-making and policy.

So, one has the core construct of “homo economicus”- the figurative human being characterized by the ability to make only rational, self-interested decisions, who “attempts to maximize utility as a consumer and economic profit as a producer”. The idea is that this individual will analyze and understand all relevant factors and then assess the “expected utility” of each potential outcome and choose the one most beneficial to his or her welfare.

There is just one slight problem with this: human beings do not make purely rational, self-interested decisions. Not only that, but the real world is so complex that making the best decisions and acting wisely through time is subject to significant uncertainty, feedback loops, questions of agency, random events, incentives…. We could go on!

Not only that but human beings are subject to outbreaks of altruism, in which they most certainly do not seek to maximize “expected utility”, because they realize, to quote John Donne: “No man is an Island, entire of itself; every man is a piece of the Continent, a part of the main.” In other words, life is not just about competing for personal gain or advantage, but often depends on cooperation to generate the better outcome for the majority. One can, of course, see echoes of Benthamite Utilitarianism in this- promoting the greatest happiness of the greatest number.

Naturally, because human beings are emotionally and intellectually “messy”, they are also unpredictable, even if, in the majority of circumstances they are likely to act or decide a certain way. Of course, the more factors one introduces, the more uncertain the actual outcome is likely to be because mental capacity can only cope so much. As such, human beings often need to rely on resources beyond their own.

The concept of (re)insurance is, to state the obvious, based not upon maximum expected utility, but upon risk-pooling, because the world is uncertain. Bad things do happen in spite of the best of intentions or the most rational of decisions, and (re)insurance is there to mitigate the consequences of poor or unpredictable outcomes.

Awbury provides coverages to protect its clients against credit, economic and financial risks, based upon models which factor in human “messiness”, because an effective and pragmatic approach produces much better outcomes than one based upon the supposed mathematical rigour of expected utility and some idealized, but constrained model.

The Awbury Team

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At least the ECB thinks profitability is a good idea…

Strangely enough, in a recent article on its website (“Profitability numbers are looking up, but not enough”), the ECB took the view that profitability, at least for the European banks which it supervises, is a good thing, making the point that, even though bank profitability “improved slightly” in 2018, the ECB remained concerned because “profitability levels are still low”, and that stated numbers in isolation do not provide sufficient evidence of sustainable business models.

In what seems like a direct challenge to views in certain quarters (see our previous post “Profitability? How quaint!), the ECB also stated: “Moreover, profitable banks are more attractive to investors”, also pointing out that the average return on equity, at 6.4% in 2018 (from 2017’s 6.1%) is too low, and in many cases below a banks’ cost of capital.

Of course, as we have repeatedly emphasized, if a business cannot generate sustainable profits that provide a margin that exceeds its cost of capital, and allows for re-investment to promote resilience and growth, absent constant infusions of fresh capital, it will eventually fail.

It may be that “traditional” fractional reserve banking is not seen as sufficiently “sexy”, with no-one likely to brag on the cocktail circuit about their position in “Standard Eurobank” (although Warren Buffett would beg to differ when it comes to US banks). Nevertheless, unlike VC-backed “fintechs”, many, if not most of which, will fail or otherwise disappoint, the EU’s (and other countries’ core banks) remain essential to the functioning of their underlying economies. If their viability is threatened, the consequences are potentially serious- one only has to look at the Great Financial Crisis (GFC) and its aftermath for that.

So, it is worrying that many EU-based banks are still unable to generate adequate levels of profitability, even though the level of impaired assets and, thus, provisioning has declined to very low levels. Not only that but, as the ECB commented “on aggregate, operating costs marginally increased in 2018”. All this begs the question, in an increasingly fraught economic environment, with growth stagnant or declining in core EU jurisdictions such as Germany, of how much ability local banks have to withstand the next downturn. They may be better capitalized, and have lower leverage than before the GFC, but their inability to generate adequate returns rightly troubles the ECB.

This also leads to the paradox that the regulator wants the banks it supervises to make strong profits and an attractive return on capital from sustainable business models, yet, through a combination of tougher capital requirements and a monetary policy that suppresses achievable margins, makes that goal ever more challenging. One should not feel sorry for the bankers, as those who are pro-active, flexible and bold should always be able to prosper, but it does raise the prospect of “zombie banks” remaining a drag on the entire economic system.

Awbury has deep knowledge and experience of helping banks globally manage their capital needs, as well as address their portfolio risks, whether on- or off-balance sheet. We always welcome the opportunity to discuss how the suite of products we have developed may assist managements in achieving their targets.

The Awbury Team

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