If I were you, I wouldn’t start from here…

The punchline to the famous Irish joke about an Englishman lost in the in the backroads of Ireland and seeking direction from a local, brings to mind the persistent struggle which now faces many longstanding businesses, with the (re)insurance industry being no exception.

Burdened by legacy processes and systems, many fail to cope (in terms of creating value) in a world which is changing around them in ways that make a mockery of the argument that incremental and gradual change is still a feasible strategic approach towards long-term viability.

While “move fast and break things” is probably not the best alternative, it does contain the kernel of truth. There needs to be not only a comprehensive plan, but swift and effective execution.

In January, Oliver Wyman published a paper entitled “The Mindset Collision”, in which it contrasted the “Vision” and the “Value” mindsets- the former being focused on building the business of the future, foreseeing and adapting to new technologies and disruptors; while the latter focuses on delivering financial returns within a fairly short timeframe. In reality, of course, any business which hopes to have a viable and sustainable future needs to blend both approaches. It is all very well having grand visions, but without clear expectations of what return an investment should bring, there is a serious risk of wasting both time and resources- something that will not be lost on those who observe the travails of Softbank’s “Vision Fund”.

If one considers the (re)insurance industry, it tends over time, in the aggregate and in developed markets, to grow at roughly the rate of overall economic growth. This means that, unless one can either find a more efficient way of delivering the product, one has either to seek new markets, or create products that meet unfulfilled needs that command “value added” rather than “cost plus” pricing. Even regulators have realized that the industry needs to be encouraged to take more risks in terms of development by introducing the concept of the regulatory “sandbox”. Without at least some “vision”, the industry’s incumbents (other than those which have scale and network advantages) run the risk of “death by a thousand cuts”, as new competitors, unburdened by the above-mentioned legacy issues, peel away revenues from the most profitable business areas, or provide better-tailored products. Otherwise, as Oliver Wyman puts it, the risk is becoming the financial equivalent of a “dumb utility”, providing capacity priced at the margin, if one is lucky. Not exactly an enticing prospect.

The irony is that in a world full of complex and developing risks, the industry has the opportunity to grow and prosper if it can decide what it wants to be and how to achieve that. Maintaining the status quo, and repeating the usual hopeful mantras about improving underwriting quality, or re-deploying capital and capacity away from “unprofitable lines” is simply evidence of a state of denial. It singularly fails the “vision” test, as well as the “value” one, because it changes nothing.

If you do not understand that past is no longer prologue, and that nimbleness and adaptability, coupled with a clear purpose, are (frankly, as they always were) essential traits, businesses risk becoming, not just a “dumb utility”, but a “financial zombie”, unaware of its own reality, and doomed to stumbling and flailing about until someone “disaggregates” it.

The Awbury Team

Risk is what you don’t see…

The always thoughtful Morgan Housel (of the Collaborative Fund) recently wrote an article with the above title. Adding “or won’t” is equally instructive.

The point is, as most fundamental ones are, so simple and elegant; yet much of the (re)insurance industry (amongst all the rest) spends much of its time obsessing over the things it hopes it can measure and believes it can foresee. Obviously, in many product lines that is the rational and sensible approach, as many risks are, in the real world, bounded and constrained.

However, it is “in the misunderstood tail” that true risk lies. This being the first few months of a new decade (and we are not going to argue that point!), the media and what passes as thoughtful discourse (you know who you are, WEF Davos…) are full of “predictions”, risk surveys, incomprehensible network diagrammes and the like. This is presumably in the hope that the “naming of the risk”, or being part of a “knowledgeable consensus” will somehow make the risk less terrifying (as in “a trouble shared…”), because if it can be named or agreed upon we at least know what we are dealing with (or think we do).

So, as Housel points out: ”The same risks, repeated over and over, [occur in narrative] sometimes several years in a row”- elections, trade wars, climate change, nuclear war. Of course, there are existential risks. We have identified collectively a whole range of them. If they occur, it may well be “game over” for Humanity and “civilization”. Harsh as it may seem, and in no way diminishing the need to take them seriously, it is the ones that are unforeseen or not taken sufficiently seriously that tend to cause the most harm. They are “surprises”, by definition- even if, with hindsight, perhaps they should not have been (e.g., the Japanese attack on Pearl Harbor).

As we saw with the Great Financial Crisis (GFC), when a central tenet of belief (that US housing prices could not in aggregate decline significantly) proved to be unfounded, people were shocked and surprised. They panicked, with consequences that we still have to grapple with even now. With few exceptions (read Michael Lewis’s excellent book The Big Short), people could not contemplate that what happened not only could, but would.

Secondly, once surprised, and compounding the issue, people tend to extrapolate outcomes beyond the logical or probable, becoming (unduly) paranoid and pessimistic about the future, which often creates a worse outcome than if they had behaved rationally. It is useful to remind one’s self of that probability ex ante! Unfortunately, it is also hard to imagine any of today’s political “leaders” being seen as credible when uttering something analogous to Roosevelt’s: “The only thing we have to fear is fear itself”.

One could argue that such risks are “black swans” or “unknown unknowns”, but most are not. Naturally, one cannot plan for what one cannot imagine happening, but convincing one’s self that one has foreseen all the possible risks amounts to hubris.

From Awbury’s point of view, we are institutionally paranoid about risk. We know that we are not infallible or omniscient, and that the whole point of being in the (re)insurance business is to accept risk. However, we also aim to design our products and solutions in ways that not only meet our clients’ needs, but also contain mitigants and margins of error that minimize the likelihood of being surprised in a way or to an extent that causes ruin.

The Awbury Team

The really, really, long view…

Major central banks have the resources to produce papers that may seem arcane, but also provide an interesting perspective. A recent paper Bank of England Working Paper, entitled “Eight centuries of global real interest rates,

R-G, and the ‘suprasecular’ decline, 1311–2018” is no exception:
‘Suprasecular’ Decline

In it, economist Paul Schmelzing constructed a time series for real interest rates going back some 700 years to 1311. One only has to read the paper to understand the scale of the work undertaken, as well as the fact that there really is not much that is truly new under the (financial) sun. Who knew, for example, that in 1262 (sic) the Venetian Grand Council decreed the establishment of a secondary market in the Serenissima’s long term debt?

Fascinating historical facts aside, what is intriguing about Schmelzing’s work is that it leads him to the conclusion that since the late 1400s there has been a steady decline in real interest rates over the intervening centuries that cuts across asset classes, political systems and monetary regimes. He is careful not to be dogmatic about the precise cause (and the time series is volatile year to year). Capital accumulation and the ability to save more (and expect to be able to enjoy the fruits) are probably the most likely (but in no way definitive) reasons. As a result he posits, in essence, that the “lower for longer” mantra may be rather more than a convenient tag for something hitherto considered to be without much historical context or precedent. In more concrete terms, he suggests that the long term real rate for 2018 would be around 1.50%, which, set against indicative targeted inflation rates of 2% for most major central banks, indicates a nominal cap of around 3.5% for whatever is deemed the safest asset provider- which, of course, has shifted materially over the centuries, heading North West across Europe to the UK and then crossing the Atlantic to the US. In fact, Schmelzing suggests that no-one should be surprised at the current fact of negative nominal interest rates given ultra long term trends.

Of course, this is merely one study. Arguments will doubtless be made that, given what has happened since the GFC to inflation rates and the fact of the piercing of the “zero lower bound”, the author is indulging in the abiding sin of financial modelers and using a backtest (albeit a very long one!) to confirm a desired hypothesis.

However, Schmelzing is studiously careful not state that what is observed has a clear cause (because it does not), but simply points out that the data provide evidence of a secular decline in real interest rates, and that it would be foolish to ignore that point simply because it may be an inconvenient truth.

So far as the (re)insurance industry is concerned, in Awbury’s view it re-emphasizes the need to focus both on the quality of underwriting and on ensuring that nominal investment returns are not used as a “crutch” to mask weak Combined Ratios, while at the same time suggesting that focusing mainly on standard fixed income products to generate those investment returns may also be something that bears re-examination.

The Awbury Team