Coining it…or just Untethered?

The Awbury Team’s members have been around long enough to have observed, lived through and survived multiple financial bubbles, crazes and crashes. However, we have looked on at the current frenzy surrounding the rise in the value of bitcoin (lower case, as opposed to the upper case Bitcoin payment system) with bemusement, which we shall use as a proxy for analogous “crypto-currencies”.

While the company behind the South Sea Bubble was a fraud, one could at least plant tulip bulbs and console one’s self with the beauty of the flower after that mania ended (Fun fact: in 1637, the Dutch East India Company was worth USD 7.9TN in today’s terms). In the case of bitcoin, it seems that what was once considered a curiosity and subsidiary component on a blockchain-based system has become the focus of the most extreme rise in “value” in recorded history. Having started life with what, in hindsight, is probably the most expensive pizza purchase in history in May 2010, and reaching a price of USD 1 in April 2011, bitcoin was supposedly quoted at a price of over USD 19,000- in early December. To say that the price is volatile is a serious understatement, as it becomes increasingly difficult to discern what, if anything, is “real” about it.

This begs the questions of what exactly bitcoin is; what purpose it serves; and what impact it is having or will have on the financial system, including (re)insurance. Classically, a currency is a medium of exchange, (one hopes!) a store of value and a unit of account. How does bitcoin measure up?

Frankly, as bitcoins are simply entries in a Bitcoin blockchain ledger and there is no-one who guarantees that a bitcoin has any particular value, such value depends entirely on supply and demand. Given that bitcoin is designed in such a way that there are only ever supposed to be 21 million of them in existence, and that creating new ones (up to the limit) costs increasing amounts of both computing power and (literally) energy, one can see how, as the desire to own a seemingly scarce item increase, demand can lead to the sort of frenzy seen in the past few weeks.

In theory, one can transact using bitcoin, assuming that the other party has both the desire and ability to accept them. However, the frictional cost of doing so keeps rising, and the time required to complete and validate a transaction also continues to increase, leading to the risk of “double-spending” of the same bitcoin. So, as a medium of exchange, bitcoin is far from optimal; and, of course, the volatility in its price also militates against that use. While, theoretically, bitcoin could be used as a unit of account for book-keeping purposes (and after all, Bitcoin is supposed to be a distributed ledger), that purpose seems to have become obscured by the frenzy surrounding whether or not bitcoin can be considered a store of value.

Of course, the “bitcoin billionaires” (yes, they now exist) would argue that it most certainly does. However, in reality, one can only realize that value in the real world by converting it into a more conventional and widely accepted currency, such as the US Dollar. Couple this with the thinness of the market; the fact that it would appear that holdings are quite concentrated; and the continuing reluctance of major banks to become involved in trading and clearing bitcoin transactions (in particular the newly-minted CME and CBOE futures markets), and one begins to wonder when and how bitcoin will become anything more than a speculators’ plaything and one more opportunity for the less salubrious fringes of illegal businesses to try to shield their profits from discovery and confiscation.

So, why, one might ask, should (re)insurers care about all this?

Well, consider the current obsession for growing revenues from cyber-risk coverages. Crypto-currencies are supposed to be free from the risk of “hacking” or misappropriation because of the underlying technology. Yet there are already numerous reported instances (and probably many more unreported) of bitcoins and their analogues “disappearing”, being misappropriated or simply stolen. If a (re)insurer had written a cyber-risk or even a standard theft and fraud coverage for a client who owned bitcoin, quantifying and pricing that risk might prove rather challenging, as might defining exactly what had been lost. Or consider covering risks relating to the default of a clearing broker or exchange involved with bitcoins. In theory, initial and variation margins should cover all but the most extreme loss scenarios; but, given the lack of reliable data and the brief history of the “asset”, what exactly is an “extreme loss scenario”.

At Awbury, we aim to maintain an understanding of complex risks and the opportunities they may bring, so we shall, of course, continue to monitor the evolution of the blockchain and crypto-currencies, while remaining a healthy skepticism about whether there is, as yet, sufficient data and market understanding to qualify and quantify the true nature and level of the underlying risks.

However, if you have a blockchain or crypto-currency risk that needs a solution, give us a call

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When is an “unknown unknown” really unknown? And have all the Black Swans gone Grey?

Donald Rumsfeld was once much mocked for his parsing of risks into categories such as “known knowns”; “known unknowns” and “unknown unknowns”. Yet he had a point. There is really no excuse for allowing known risks to overwhelm one’s capital or business model; while accepting risks one can identify, but which are difficult to assess or quantify, is somewhat inadvisable, as many financial institutions have found out the hard way through misaligned incentives and imperfect models.

So, what about “unknown unknowns”? Objectively, one does not even know that one does not know. Consider “cyber risk”. Fifty years ago, that would have probably counted as an “unknown unknown”, because the products, systems and software that have created the risk did not exist- even if some might have been foreshadowed in the works of various science fiction authors. And what of the still-running asbestos saga? One could lay reasonable odds that none of the original underwriters foresaw what would happen, or that the risk existed.

In a broader context, into which category should the recent actions of the Saudi Crown Prince “MbS” be placed? Expropriation for political or financial gain is nothing new, but the event was considered unforeseen, as could be gauged by the reactions. So, a Grey Swan perhaps, being charitable?

The point of all this sophistry is that the ability to survive and prosper in any business, including (re)insurance is based upon being able to detect, avoid and mitigate risks before they reach unmanageable proportions. However, the quality of risk detection capabilities appears to vary widely: it requires a willingness to be proactive in “thinking the unthinkable”; which, frankly, many find difficult because it can lead to some uncomfortable conclusions and requires being both contrarian and disciplined. FOMO is not a viable approach!

Consider the risk of nuclear confrontation- most likely involving North Korea (altho’ both India and Pakistan are nuclear powers, with muddled military doctrines and a long history of enmity and mistrust). Lobbing the odd low-yielding ICBM across the Pacific Ocean is not likely to be a good survival technique for the Kim dynasty, which leads into a consideration of the potential behaviours of other actors as they try to gauge responses. The risks of miscalculation are probably higher than they have been for more than a decade, made more dangerous by the rapidly-increasing nuclear weapons capabilities of the regime in North Korea, and they are no longer negligible. This then requires thinking about the consequences of a nuclear weapons exchange. MAD (Mutually Assured Destruction) might not apply in this case in the literal sense, although tens of millions of Koreans would rather not see the hypothesis tested, but the increased probability might cause underwriters to take another look at the wording of their Nuclear Exclusion clauses.

Of course, this is a “known known” risk, but it requires mental effort that many may not wish to take, which practically speaking could push it into another category.

Turning back to “unknown unknowns”, worrying about them is counter-productive. They are, by definition, currently “unknowable”. One should instead focus on risks that can be detected and then decide where they sit upon the spectrum of probability and severity; and whether they are sufficiently capable of being measured, and so priced and managed. At Awbury, while we are always surveying our environment for new and unexpected risks, we continue to emphasis our ability to provide our clients with products and techniques for managing their “known knowns” and “known unknowns”.

The Awbury Team

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What if…it had been worse?

Lloyd’s of London recently published a useful paper (https://www.lloyds.com/news-and-insight/risk-insight/library/understanding-risk/reimagining-history) on counterfactual risk analysis- a topic that will appeal to viewers of “The Man in the High Castle”, or readers of the novel Fatherland.

Counterfactuals, or “what ifs?” are interesting, because they require an individual to consider how even a small change can have a significant impact. After all, the “Russian Revolution” succeeded almost in spite of its primary actors; but what if it had not?

Turning to the more prosaic world of (re)insurance, the world of NatCAT is full of “what ifs?”- for example, the track of Hurricane Irma being 20 or so kilometres east, such that it hit Miami directly?

As the Lloyd’s paper quite properly (and importantly) points out, there are both “upward” and “downward” counterfactuals- the former asking what would have happened if things had turned out better; and the latter if they had been worse. One does not really want to operate on the basis of the “upward” approach!

Thinking about and modelling different potential outcomes, while now carried out on an industrial scale, both inside and outside (re)insurers, is still prone to bias and the lure of “commonality”. Paradoxically, if a regulator requires those it supervises to model the outcome of a series of standardized scenarios, it may create for itself a useful comparison of relative vulnerabilities or weaknesses across it charges, yet at the same time run the risk of causing them (and itself) to be constrained in thinking about risks that fall outside the dataset used.

Therefore, it becomes important to think about risk with less constraint, because “out of experience” or “unmodelled” events have the unfortunate habit of occurring rather more often than they “should”. Modelling the probability of defined risks to a 1-100- or 1-in 250-, or even 1-in 10,000-year standard is all very well, but what if it is the “wrong” risk, or the estimate of probability or consequence is seriously flawed? What if it is “not in model”?

Of course, some risks are inherently constrained or obviously bounded. For example, if one is an unleveraged equity or debt investor, one can only lose 100% of one’s investment; whereas, the risk of loss from, say, a rapid series of sequential and inter-connected defaults by large, highly-leveraged financial institutions can wreak damage far beyond anyone’s or any then extant model’s expectations.

In the realm of (re)insurance, managements will also argue that they have controls over aggregation of risks; set careful limits based upon rigorous technical underwriting; and, naturally, have a carefully-crafted programme of reinsurance and/or retro in place. However, given that each (re)insurer is an autonomous actor, which tries to protect the proprietary nature of its risk management protocols, what if all the assumptions about network linkages and effects are wrong and the “Big One” (whatever it is) occurs? Having focused on first-order effects, they potentially miss the second- or third-order ones.

Interestingly, the issue with counterfactual analysis is not that something could not have happened, but more often that it was not conceived of as capable of happening; or a necessary connection was not made; or an event forgotten. Intriguingly, the Lloyd’s paper also makes the point that many European languages do not have any expression equivalent to English’s “counterfactual history”. As Wittgenstein said: “The limits of my language mean the limits of my world”, which begs the question of vocabulary as a constraint upon conceptualization.

In the world of NatCAT, post-event analysis often tends to be limited to understanding what happened and why; but gives little, if any consideration, to what might have happened, which is unfortunate because, yet again, it means that thinking and modelling become self-limited. One has to believe that, in an era where the resources available to model and develop scenarios are becoming ever more powerful, it should be possible to generate counterfactual scenarios and outcomes with more frequency than appears currently to be the case.

At Awbury, we do not pretend to be believe we are infallible. However, we do believe that our thinking should be as unconstrained as possible, so that we minimize the risk of downward counterfactuals.

The Awbury Team

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Innovate effectively, or become a Zero…

The news of the creation by Google’s DeepMind unit of an enhanced and self-taught AlphaGo Zero, which trounced its own progenitor AlphaGo, and appears to play not only differently, but at a different level from human experts, set the Awbury Team thinking about the topic of innovation and change.

FinTech and InsureTech are all the rage, with more and more (re)insurers announcing “venture” units that seek access to new ideas and technologies externally; while predictions are made constantly about the industry being yet another one to be “disrupted” (another newly-fashionable term). Executives may wish to ponder the meaning and consequences of the word, and the fact that it implies that they are in danger of losing control over the destiny of their own businesses to others- disrupt, or be disrupted, because business as usual is not an option for most.

Whether rightly or wrongly, there is also a perception that the (re)insurance industry itself is “out of ideas”; and at the mercy of the latest “fad”, as it seeks desperately to find revenues that will augment its current “zero-sum”, commoditized business lines, and tries to justify losing tens of billions of dollars as a result of the recent spate of NatCATs, wiping out years of profit accumulation.

One can see similar patterns in other industries, where the incumbents, having become complacent, find that they are no longer able to generate significant ideas themselves, and have to rely on third parties to do the basic research that they themselves used to do- “Big Pharma” now being a classic example. The glory days of Bell Labs and Xerox PARC are long gone, while many governments seem to regard funding basic research (other than for “defence” and “national security”) with disdain, because it does not serve the particular vested interests to which they are in thrall. Clearly, there are pockets of excellence such as DeepMind and various university research departments, but too much of what passes for innovation is merely disruption and a “re-hash” rather than original- such as Uber, or WeWork. The so-called “gig economy” is hardly a step forward in human progress.

This matters; because, while the “D” in “R&D” is also essential, without the basic research on which it builds, there can be no progress. Incrementalism is all very well, but Humanity’s welfare has historically improved because of step-changes resulting from different modes of thinking.

So, the (re)insurance industry needs to focus on how it can generate truly fresh ideas itself, that will enhance its offering and margins. If it does not, others will consume its premia, and it will become increasingly obsolescent, as investors lose patience with moribund returns that do not even meet the cost of capital. There is absolutely no reason why a Google, Amazon, or Apple cannot create (re)insurance businesses built upon new business models, and almost certainly using artificial intelligence (AI).

The ability to generate executable and scalable new intellectual property is a fundamental requirement for any business that wishes to survive and prosper. Note the use of the word “executable”. Paradoxically, while basic research and new ideas underpin progress, if one cannot then execute on them, the enterprise is pointless. One’s lunch will still be eaten!

At Awbury, while we regard ourselves as an integral part of the industry, our franchise depends upon both innovation and execution; and we have absolutely no intention of becoming “zeros” as we build for the long term.

The Awbury Team

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Homage to Catalonia…

George Orwell (who was badly wounded in the Spanish Civil War fighting against the fascist insurrection led by Franco) must be spinning in his grave in light of the Catalan regional parliament’s declaration of independence for Catalonia (or rather Catalunya- one of 17 Spanish regional governments) as an “independent republic” (no more Spanish monarchy for Catalans!)

Not surprisingly, the Spanish government has subsequently exercised its own “nuclear option”; and invoked direct rule over what it sees as a recalcitrant province, led by fantasists bent on destroying the Spanish state (for if Catalonia goes, one can be fairly certain that the Basques at the least will aim to follow.) For avoidance of doubt, the action of the Catalan government is considered a criminal act by Spanish loyalists, as the constitution provides no mechanism for secession. The difference from the UK is that the Scottish referendum on independence was a negotiated process, not unilateral.

One only has to look at the recent history of Europe to be concerned about the potential consequences of the Catalans’ actions; especially since, even within Catalonia, it is considered arguable that there was no true majority in favour of independence and that what was characterized as a referendum was a “democratic coup”. Not surprisingly, no other sovereign state has recognized the “Catalan Republic” as a lawful sovereign entity.

It should be said that Awbury’s interest in these events is “academic”, in the sense that we have no direct or even indirect exposure. However, as we have written before, we are always looking for second or third order effects beyond the obvious.

Of course, it is far too early to predict how the relationship between Catalonia and Spain will evolve, but the legal consequences are already becoming evident, as large corporations move their legal domicile outside the “republic”.

One can also imagine that a frisson of concern is moving across the investor, trade credit and political risk markets. What happens if Catalans resist the central government, such that the rule of law breaks down, taxes go unpaid and uncollected, or an economic blockade is imposed? What if a local Buyer wishes to pay, but cannot because the local banking system is not functioning for “external” payments?

Taking the scenario further, what if Spain as entity begins to unravel, as the former Yugoslavia did some 25 years ago (without the bloodshed one sincerely hopes!)?

Under the conventions of international law, sovereign debt passes to successor states. Spain currently has approaching EUR 1TN of obligations. Apportioning that across a fragmented range of successor states would be a nightmare. It is somewhat ironic, that less than 5 years ago there were legitimate concerns about the ability of Spain to meet its obligations, as it suffered a wrenching recession, from which it has begun to recover; and now, when that concern should have been obviated, it may begin to return because of the political acts of a recalcitrant minority. Compounding the issue is that much of Spain’s sovereign debt is held by offshore investors, including the European Central Bank (ECB). While the risk of dissolution and default is still remote, the fact that the possibility now exists is telling, because a year ago it would have been considered laughable.

And bear in mind that Spain is not the only major European state with a separatist movement (leaving aside the UK). Italy has long had a north-south rift politically; and one can imagine that the Lega Nord is watching events in Catalonia and Spain with some interest.

The overarching point here is that risk can appear out of a “clear blue sky”, and that one has constantly to update one’s knowledge and understanding of the risk terrain and the possible ambush sites. The risk of Catalan secession was not an “unknown unknown”, but we are quite sure that it feels like an ambush to many.

The Awbury Team

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Nudge, nudge…

As the recent award of the Nobel Memorial Prize in Economics to Professor Richard Thaler demonstrates, ideas that seem absurdly simple can cause a significant change in behaviour and, thus, outcomes.

For someone of whom his thesis adviser said: “We didn’t expect much of him”, Professor Thaler has had quite an impact by incorporating better understanding of how human beings (rather than the idealized homo economicus beloved by most of his peers) actually make decisions, and applying that to improving public policy. As he himself said after the award was announced” “In order to do good economics, you have to keep in mind that people are human”. How shocking!

All of this matters because, rather than just showing that people are irrational (obvious, but not exactly helpful), he was able to demonstrate that they tend to be irrational in consistent ways, so that reality can be modelled and channeled. Perhaps the most famous, and potentially far-reaching example is in the design of enrolment systems, such as for pension schemes, changing them from “opt-in” to “opt-out”, and thus significantly increasing the level of involvement.

Of course, the world being what it is, such actions are dubbed “libertarian paternalism”, with the emphasis on “paternalism”, which must be a bad thing because it deprives us of our “free will” and the right to make a mess of our lives and futures. And the world also being what is, such an approach can and is used to manipulate people into continuing to pay for services that they do not want- the “Free 30-day trial, auto-renewal” approach. As always, the use to which an idea or technique is put can often be ethical or unethical.

Professor Thaler also demonstrated that we humans are prone to the endowment effect. We are reluctant to part with something we already have unless we receive more for it than we would have to expend to acquire the same item if we did not already possess it. What we have is considered more valuable.

Perhaps less well known is Professor Thaler’s suggestion that (following the work of psychologist Gary Klein, and Thaler’s fellow Nobel Laureate, Daniel Kahneman) “premortems” (yes, you read that correctly) be used more widely in the context of particularly important decisions as a means to counteract the dangers of “groupthink” and overconfidence. In essence, people are required actively to contemplate the consequences of failure before it can happen. Such an approach is not intended to lead to decision-making paralysis, but may help avoid overreach and the fact that, by the time of the postmortem, it is a little too late! At Awbury, we are always trying to ensure that we avoid the dangers that stem from the “usual approaches” to decision-making, because we would rather not be the subject of a postmortem!

And one finding of Professor Thaler which is particularly dear to the Awbury Team is that people place a high value on fairness. They will penalize behaviour that they consider unfair, even if doing so is to their own detriment. As we have written before, a fundamental tenet of Awbury’s business model is that interests must be properly aligned and the economic outcomes and benefits of any transaction or structure be allocated fairly to create an actual “win-win” outcome. This is not always easy, but it is not altruism (we are a business after all!), but simple common sense. No-one likes to think that they have been “ripped-off” or taken advantage of, and it is detrimental to building a sustainable franchise.

So, how can we help you?

The Awbury Team

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Quantum Mechanical CDS…

Credit Default Swaps (or CDS) have been around for over 20 years by now; and their use has waxed and waned over time. One of the arguments that has been used to assert their superiority over other credit risk mitigation or management techniques has been that the nature of their triggers and documentation (under various ISDA protocols) provides “certainty” of payment as long as the fee for protection has been paid.

The title of this blog is homage to an excellent post on the Dealbreaker website entitled “Schrödinger’s CDS”, which alluded to Heisenberg’s Uncertainty Principle and the famous thought experiment about whether, in the weird world of quantum mechanics, a cat could be both alive and dead at the same time; making the point that, in the world of CDS obligors there are supposed to be only 2 possible states- either “normal” or “defaulted”- i.e., no payment due, or payment due.

However, a recent controversy involving the ailing Noble Group has called into question the validity of this binary assertion about state. To sum up, when Noble Group extended loan payment terms on some of its debt parties who had bought protection on the company’s debt asserted that the action triggered payment on their CDS contracts. Given that there are apparently some USD 1.2BN of CDS contracts written on Noble Group’s debt, involving many different parties, the potential claims could be significant (with the FT quoting a figure of “up to USD 157MM”).

The question of whether a trigger had occurred was meant to be determined by the Industry Determinations Committee (IDC) mechanism managed by ISDA, in which 15 members (10 sell-side and 5 buy-side) vote on whether or not a “credit event” has occurred and, thus, payments triggered.

In the case of Noble Group, for reasons which have still not been properly explained (hence Dealbreaker’s mocking post) other than a statement that there was “insufficient information”, the relevant IDC was unable to make any determination at all. Naturally, this resulted in confusion, and no little amount of disbelief and frustration all round, as a mechanism that was supposed to end the practice of bilateral “flurries” of notices of claim and create certainty singularly failed to do so. ISDA has been at some pains to distance itself from the shambles, claiming that it is only the secretary and administers the process: “…we don’t have a vote and we don’t make decisions”.

The IDC then re-considered 2 formal questions posed to it by counterparts involved in the saga; and gave a narrow ruling that any attempts to trigger a payment had to be accompanied by “publicly available information” confirming the existence of particular language. It is unlikely that the CDS market’s major participants will be satisfied; and it has not gone unnoticed that the composition of the IDC creates inherent conflicts, rather than alignment of interests.

And in a further blow, the ICE (owner of the NYSE and LIFFE) has now stated that it will no longer oversee the administration of the DCs, because it cannot agree indemnification from the member banks and investment groups in the event of litigation, which puts ISDA itself as the Secretary of the IDC structure in the position of needing another third party to replace ICE.

At Awbury, our goal is to create and issue contracts which provide carefully-crafted, clear and unambiguous protection against a particular risk or risks, in ways which not only properly align interests, but provide certainty; because creating the potential for an ambiguous and disputed outcome such as occurred in the case of Noble Group’s CDS contracts helps no-one.

The Awbury Team

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