Always Remember that You Might be Wrong…

In a world in which everyone wishes to believe that they are “above average”, we have long argued that a little epistemic and intellectual humility is essential in trying to minimize error and avoid ruin.

While, in order to be effective decision-makers and risk managers, we have to have the courage of our own convictions, we should always consider that we might, actually, be wrong.

The aphorism about the benefit of having “strong convictions, loosely held” comes to mind.

If there is anything that experience has taught us, it is that being dogmatic and refusing to address contra-evidence, or a change in circumstances, is a sure way-point on the road to mediocrity at best, and self-destruction at worst.

Expertise and specific, relevant knowledge are, of course, hugely valuable in any professional undertaking such as underwriting complex credit, economic and financial risks. One really does have to have some idea of what one is doing; what is realistic; and how an environment can change with blinding speed if one is not to be seen and taken advantage of as the “dumb money”.

A related issue is that, in thinking about issues or factors following what one might term “well-worn, synaptic grooves”, one runs the risk of becoming mentally trapped in a form of linear, deterministic thinking, which can lead to ignoring signals that would cause a change of direction. Couple that with wishful thinking and one has the recipe for potentially very poor outcomes, or degraded and lazy thinking.

Sometimes “ ‘Twas ever thus” makes sense; but not always.

Consider the now seemingly endless economic “party game” of forecasting the next US recession…

Supposedly, it has been going to arrive within the next quarter for at least a year, if not longer. Yet, so far, it has not. Economists, “pundits” and other soothsayers fixate on such matters. If one of their forecasts proves prescient, are they smart, or just lucky?

After all, economies are complex systems. Yes, there can be feedback loops, and cause and effect; but to engage obsessively in a predictive game of false precision is self-defeating.

Far better, as an underwriter, to think about a range of possible timings and outcomes, and assess how they may have an impact upon the existing or potential exposures one may have or select. After all, in this business cycle, the key thing to consider is the consequence of a rapid doubling of the cash cost of interest payments on floating-rate debt, and the availability and replacement costs of all debt when re-financing. After all, funding costs have risen materially. Trying to predict the timing and extent of any central bank decision to start reducing rates is all very well for those who make a living from trading on such factors; but, for corporate treasurers, ensuring that their business has sufficient available cash and access to liquidity to meet all obligations as they fall due is rather more pressing.

When many in the market have never had to operate in world in which a 10% cost of debt is a reality, accepting that that world has changed can be paralyzing, unless one has experience of prior examples and their consequences.

However, perhaps paradoxically, the COVID pandemic has taught us that company managements can be remarkably adaptable in facing unexpected risks. All this means that one must try to avoid viewing the world in ways in which one assigns probabilities to the more extreme outcomes that are not warranted by realities- neither following the naïve path of Voltaire’s Candide, nor the existential gloom of his interlocutor, Martin- “What a pessimist you are!” exclaimed Candide.
“That is because I know what life is,” said Martin.”

The Awbury Team

What now…?

At the start of a new year, it is worth pausing and thinking about what may come next- for good or ill.

Obviously, as underwriters and managers of complex, multi-year risks, the Awbury Team has something of an obsession with trying to parse how the forces acting upon the present will impact the future, and so the risks which we have selected.

As should be obvious by now, in many sectors, supposed “experts” have no more ability to predict outcomes than the proverbial dart-throwing monkey. Our world is complex; and, even if trends or patterns appear to be discernible, they can change rapidly, or turn out to be a mirage, even a fata morgana.

So, is all this a counsel of despair?

Absolutely not!

One simply needs to recognize that the art of underwriting is exactly that, an art, with an overlay of achievable scientific rigour, or at least parametric constraints, in certain areas.

For example, the next US recession has been predicted for at least a year, and has yet to show up. Do recessions matter. Yes, they do, but their consequences depend upon scale, length and scope- i.e., many variables. Rather than try to be unduly specific, far better to look at the nature and outcomes of past recessions and see the extent of their actual impact. In so doing, one will get a more informed idea of potential outcomes, which one can then overlay upon one’s portfolio and risk selection. Of course, there are always outliers- examples being the Great Depression, the GFC and the Pandemic, yet even these add to the understanding of potential outcomes given different causes and responses.

Conversely, with real cash interest rates effectively doubling over the past 18 months or so, it is not hard to understand how this will impact future cashflows of leveraged balance sheets- reducing the margin for error in corporate performance; forcing managements to re-consider the availability of discretionary cashflows; increasing vulnerability to re-financing risks and “market seizures” and closings; and re-emphasizing that “lack of cash kills companies”.

Given that, in underwriting credit and related risks, one is always focused on the “downside”- how might 2024 and beyond turn out?

The honest response is that no-one can properly know the answer to that question; while those who have certainty are deluding themselves and others.

That said a few points are worth making:

• Geopolitics (or, as Adam Tooze terms it, Geo-economics) are ever more complicated. This generates a higher probability of sharp changes in the risks attaching to certain industries- such as hydrocarbons, shipping, semiconductors, and certain metals and minerals. We may live in an increasingly digitized world, but it is one that still depends on the availability and free movement of resources; the stability of supply chains; and the ability to produce and transport finished products
• Spending on defence by the US and its global allies is going to have to increase significantly if certain desired outcomes are to be achieved, or negative ones prevented- especially for materiel such as munitions, rockets/missiles and drone technologies
• A likely hyper-focus on the US election cycle may well provide distracting theatre, and potentially detract from attention being paid where it should
• Central bank monetary policy will continue to create market volatility when decisions do not conform to expectations
• There will be “pain” for banks in certain segments of their loan books; while, at the same time, they are trying to work out how to address the rise of Private Credit

All of these factors are likely to lead to period dislocations, which tend to increase the demand for the bespoke solutions which Awbury can and does provide.

As always, we shall continue to combine our extensive and demonstrable expertise with intellectual humility and institutional paranoia…

The Awbury Team

The uncanny valley… A future too perfect…?

There is a term used in robotics and now in Artificial Intelligence (AI): the uncanny valley.

The phrase was created in 1970 by a Japanese engineering professor, Masahiro Mori, to suggest that a person’s response to robots would shift from affinity and feeling comfortable to one of revulsion as robots became increasingly lifelike, passing through the “uncanny valley” whose far side leads to a “normal” human being.

Now, of course, increases in computing power and regular advances in AI, are creating a situation in which the digital equivalent is becoming real- whether written, verbal or visual. The Turing Test would certainly seemed to have been superseded and passed when it comes to written interactions online; while the ability to manipulate images, both static and moving, coupled with the synthesization of voice capabilities and “normal” speech, can make it very difficult to distinguish whether a “person” is real (“authentic”), or a realistic digital human avatar.

If you could present yourself as an image of your “perfect self”, with the semblance of reality far outstripping “Photoshop”, what would you decide?

Avatars that are clearly caricatures, or represent specific tropes, are not seen as threatening; but what of a perfectly-sculpted face that might or might not be “real”, such that one is not sure who or what one is interacting with?

As much business in now conducted remotely and digitally (including via the infamous Zoom/Teams/Webex meeting), especially in the worlds of finance and (re)insurance, how can one be sure whether that broker or underwriter one is dealing with is truly human, or just plausibly so? What or who is controlling and directing the process?

Ironically, of course, it is the real humans who are imperfect, in appearance, computation, communication, and speech.

Until fairly recently, all of this need for assessing “realty” would have been seen as implausible or unlikely- a science fiction fantasy.

However, over the past year or so, we have moved on from some (re)insurers touting their “algorithmic capabilities”, to one in which generative AI systems can execute very sophisticated processes- especially so-called “multi-modal” ones (that can process and communicate by, say, both text and images); and which increasingly have also been given the ability to use tools (such as a version of ChatGPT-4, with access to a Wolfram Alpha plug-in, which can perform complex mathematical calculations).

And given that all such models rely upon vast amounts of data, as well as access to significant processing capacity (all of which is expensive, even as efficiencies improve), one can see the potential for a “winnowing”, in which only the largest and/or the most specialized businesses will be able to survive and thrive, including in (re)insurance- yet another example of the hollowing out of the “great middle”. One can already see that the more and the more complex your data archives are, the more valuable they are.

While it is far too early to make any definitive predictions as to how the impact of generative AI will pan out within the industry, trying to pretend that it does not matter, or is irrelevant, would simply be foolish.

The whole point of the industry is to assess and understand new risks or other factors as they arise. Whether that will include self-analysis of whether existing business models remain viable remains to be seen.

In the meantime, you may care to ask yourself whether that underwriter with whom you have been communicating is actually human, or merely plausibly so…

The Awbury Team