Cult-ivation…

Over time, most corporate (and other) entities develop their own culture- ways of doing things or behaviours that in some way differentiate an entity from its competitors and peers. These can be both external and internal, with the former the “face” it shows to those outside it, and the latter the norms to which its managers and employees are expected to adhere or subscribe.

This is not to say that corporations somehow resemble the Borg Collective into which minds are absorbed and assimilated, but there are certainly what one might term “expected levels of adherence” which vary across organizations.

A corporate culture that grows and adapts is heathy as long as it does not begin to impinge upon the lives of its members to an extent that degrades their quality of life and personal autonomy.

It is perfectly reasonable for individuals to be told the company has established that, for its business model, a certain way of doing things has been found to be the most efficient and effective, and that, therefore, they are expected to follow such an approach themselves. However, sometimes such expected behaviours can veer off into what becomes something akin to a cult.

The standard definitions of a cult tend to involve “excessive devotion” to a particular person, object or belief; with the underlying implication that such “devotion” is misguided, unwarranted or potentially harmful.

In the business realm, there are some entities where it is arguable that the term “cult” should be applied- Apple (under the late Steve Jobs) and Tesla being examples where suspension of rational thought has been visible at times.

So, what characteristics should one look for in determining whether or not a corporation might also be a cult?

Terminology matters. Particular words or phrases take on a meaning that, elsewhere, might induce the “cringe factor” in an observer. Are Disney employees really “cast members”?

Similarly, the creation of company-specific rituals to which all employees are expected to subscribe is another characteristic. The Friday afternoon beer wagon is all very well, if it is simply an opportunity to unwind and socialize; but if attendance is, or is felt to be mandatory, it becomes a method of coercing behaviour.

An obsession with “fit”, or a certain set of personal characteristics, whether physical or intellectual, can be another clue. It is perfectly reasonable for a company that needs certain attributes in its employees (as long as they are not discriminatory) to emphasize those in its hiring processes. However, if everyone is a “clone” from whom identical behaviour is expected, one should begin to question what is going on. Discussion, differences of opinion and even open dissent (as long as reasoned and respectful) are essential characteristics of an adaptable organization. Cults depend upon stifling such behaviour.

So, one should always ask one’s self in a corporate (or, frankly, any other group environment), whether reasonable expectations have somehow crossed the line into coercion.

In the realm of (re)insurance, while there are certainly a number of towering and influential individuals, and entities that are widely admired for their single-minded focus, we would argue that there are no true cults. The Sage of Omaha certainly has cult-like status amongst the shareholders of Berkshire Hathaway, but a true cult requires an element of sanction for “disobedience”. No-one is compelled to own Berkshire Hathaway’s shares, nor transact with National Indemnity; and Mr. Buffett would, we are sure, scoff at the idea that anyone should feel compelled to follow his precepts.

Over the past seven plus years since it was established, those who know Awbury well would probably acknowledge that it has a distinctive corporate culture (as exists amongst our partners), with the points made above demonstrating the importance both of creating a proper balance between that culture and maintaining an openness to diverse opinions and positions. It is the blending of the two elements which is most likely to make and keep an organization successful; and is something that we at Awbury look for when assessing the non-quantitative qualities of our Obligors and Insureds.

The Awbury Team

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The Art of the Deal…

We recently came across a piece which Michael Mauboussin (generally considered one of the more thoughtful and original analysts of financial topics) wrote while at Credit Suisse, entitled “To Buy or Not to Buy”. In it he reviewed the question of whether and how value is created in the course of mergers and acquisitions (M&A); how the “purpose” of an M&A transaction might affect the outcome; and factors to consider in evaluating M&A- all in the context of public markets, where the successor remained publicly-quoted.

What is interesting about the findings is that there are factors or reasons which make a demonstrable and empirical difference between whether a M&A transaction creates or destroys value; succeeds or fails, yet these are often ignored or overlooked.

For example, the management of the acquirer will often state that the transaction will be accretive to earnings per share, which sounds like a good thing. Unfortunately, this appears to have little to no bearing upon whether the transaction proves beneficial. As Mauboussin points out, value creation is based upon cashflows, cost of capital and true profitability, not some accounting construct, yet managements often obsess about EPS.

Anecdotally, it seems that many M&A deals do not create the expected positive value. This outcome is all the more likely if a buyer pays a premium for control which is too large, becomes vulnerable to competitors emulating its actions (but without M&A), or sees them taking advantage while it is distracted by integration. Of course, there is a relatively straightforward way of assessing whether or not a transaction should create value for the buyer (as suggested by Mark Sirower of Deloittes):

Net present value of deal to Buyer = present value of synergies – cost of premium

This simple formula highlights the fact that execution is the key to any successful M&A deal. This should be obvious, but management teams, unless they have demonstrable experience and a track record, can get caught up in the moment and excitement of a transaction, and lose sight of the fact that the real work begins once a deal has closed- “transformational” being a favourite term. Mauboussin groups the underlying premise of transactions into 4 categories:

– Opportunistic (e.g., a weaker competitor selling-out)- these have a high success rate
– Operational (bolt-ons, business extensions)- these have a better than even chance
– Transitional (to build market share)- these have mixed outcomes
– Transformational (large leap into new industry)- these tend not to end well

The way in which a transaction is financed also tends to matter. The use of cash and leverage helps focus minds better than the use of equity, as realizing synergies and operational improvements becomes an important factor in reducing the financial risks assumed.

Within the (re)insurance industry, the level of M&A transactions tends to be cyclical, with “soft” markets helping the stronger pick off the weaker, although one should always ask what the real purpose and benefit of any given transaction is. The industry still has great difficulty in using M&A to make significant cost reductions, or to improve operational efficiencies, while there is always the fear of paying up for expertise or client access which then melts away.

At Awbury, with our extensive and diversified panel of multi-line P&C partners, we naturally pay close attention to developments and trends in (re)insurance M&A, as ultimately one always needs to understand not just who can provide capacity, and is likely to continue to do so, but also exactly who we are dealing with. People matter as much as capital, and a badly-executed or misguided M&A transaction is disruptive, or can even materially damage an enterprise’s franchise.

The Awbury Team

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It’s war, Jim, but not as we know it…

War used to be an obvious, physical act, with or without a prior formal declaration, between state-sanctioned and supported actors, whose role was clear, even if they were sometimes mercenaries.

Russia’s annexation of Crimea in 2014 was an inkling that perhaps the usual binary identification (war/not war) no longer held. Ex post facto, it was clearly an aggressive and hostile act committed by one sovereign state against another, but the manner in which it was conducted allowed, for a time at least, the blurring of perceptions to the advantage of the aggressor.

In the realm of cyber insurance coverage, such issues are also becoming increasingly problematic, as cases involving Mondelez and Merck now make evident. In 2017, both companies, amongst many others, fell victim to the so-called NotPetya cyberattack. Ironically, the code used actually incorporated a stolen US National Security Agency (NSA) “cyberweapon”.

Not surprisingly, both companies, having suffered extensive economic damage, running to hundreds of millions of dollars, made claims for reimbursement under insurance policies which they believed would respond to what happened. To their shock, their insurance carriers (Zurich, in the case of Mondelez) rejected their claims, invoking a little-used “war exclusion” clause, which would absolve them from paying a claim which was deemed to have arisen from an act of war. In response, both companies have sued their insurers; and, given the importance of the cases, the resulting litigation is likely to be both closely watched and protracted.

As we have written before, cyber covers are one of the few supposed bright spots for the product lines of traditional CAT (re)insurers, as growth in demand continues- with global premia estimated to almost quadruple from 2017’s USD 4.5BN to USD 17.5BN in 2023. This is a product line in which any major insurer will have an interest, yet the nature of and triggers for coverage remain a work in progress.

The key problem in most such cases is identifying with any appropriate level of proof exactly who, or which entity is responsible for a particular event. In the case of state, or state-affiliated or -directed actors, while that may be known, reasons of state may dictate that proof is not available or made public. The NotPetya event was actually publicly stated by the US government to have been conducted by a state actor- Russia. However, characterization as an “act of war” is problematic, as the impact was widespread and not confined to US entities, even though the Ukraine was considered to be the intended target.

From the point of view of a (re) insurer this raises the issues of how to define and limit the extent of the coverage to what the (re)insured intended (and what the Insured expected), as well as determining whether those impacted were the intended target(s), or simply collateral damage. The inter-connectedness of the world makes how far that damage can spread increasingly hard to determine. Given the potential potency of the “act of war” exclusion, one can also foresee the risk of “moral hazard” in terms of who might, and might have the incentive, to state that a particular cyberattack was an act of war, and where the burden of proof should lie.

At Awbury, a key focus of our business model is ensuring that the terms and “triggers” of any coverage we write are unambiguous and clearly defined. We do not wish to find ourselves in the position of having to debate with an Insured whether or not a claim exists. Ambiguity, or the raising of an unforeseen defence, serves no-one’s interests. And, for the record, we do not write cyber covers, although we keep a close eye on cyber risks as the may relate to any of our credit-based coverages.

The Awbury Team

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Risk, what is that?

We have long been admirers of the investment skills and thoughtfulness of Howard Marks, co-founder of Oaktree Capital Management. Like Warren Buffett’s Annual Shareholder Letters for Berkshire Hathaway, Mr. Marks’s periodic Memos, which now date back almost three decades, are always worth reading for their thoroughness, and intellectual diversity and depth.

Anyone who wishes to understand what the nature of risk is would be well advised to read a Memo from 2015- Risk Revisited Again in which Mr. Marks (as one should) updates and describes not only what he considers to be the true nature of risk, but provides a useful starting checklist for those risks which one should consider in an investment and business environment.

So, what exactly is risk? As the Memo points out, it should not be confused with volatility (which is a tendency that is still prevalent.) Academics and model-builders like to use volatility because it is a property that can be recorded and measured- just think of Value at Risk (VaR) and the use of such concepts as standard deviations. However, volatility is a fluctuation and is simply a property of most exposures or investments. Risk is something else. As Mr. Marks points out, what investors and risk managers are really concerned with is the possibility of permanent loss. Of course, volatility can expose one to that risk if one is unable to manage it and absorb it, which is why lack of liquidity is such a killer of companies and of investors’ hopes and expectations.

The problem with this is that (to quote the Memo): “The probability of loss is no more measurable than the probability of rain” (which reminds us of Andre Brink’s novel “Rumours of Rain”). Like volatility, one can model it and estimate it, but it can never be fully known ex ante- nor even ex post. After all, just because there was no permanent loss, does not mean that there was no risk. Too often people confuse dumb luck with skill when it comes to identifying, assessing and managing risk.

The Memo wryly quotes JK Galbraith: “We have two classes of forecasters: Those who know- and those who don’t know they don’t know”. Being in the latter category, is never a good idea. Ignorance is not bliss. In the real world, it is far better to recognize that, because the future is unknowable, one can never be certain of how much risk truly exists in a particular investment or exposure, or as a consequence of one’s decisions. Humility is an essential virtue for any risk manager! Far too many things that should not or “cannot” happen actually do. Therefore, one must focus on trying to ensure that the worst possible outcome (the real risk) is not such as to also cause ruin.

In reality, the future is always a range of possibilities. One can try to identity scenarios and assign probabilities to create a distribution, but in the end only one thing will happen (putting to one side the fascinating topic of quantum mechanics!) The probability of that causing a permanent loss may be remote, but the risk will always be there until such time as an obligation has expired. Of course, the entire concept of an “insurable risk” depends upon there being an expected minimum level of risk and thus of loss.

At Awbury, we aim to be assiduous students of risk both as a concept and as an inevitable factor in all that we do. Our business model and franchise depend upon never being self-satisfied or complacent about its existence, nor believing that we must be right. A healthy skepticism and paranoia are also essential virtues for the Team.

The Awbury Team

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As the world turns…

The phrase “the Pacific Century” is now something of a trope, while the probability of a recurrence of the so-called Thucydides Trap in the context of rivalry between the US and the PRC causes furrowed brows and debate amongst geo-political scholars and military analysts.

This is not surprising given the re-emergence of economic power across Asia. The two-century dominance of the European and North American economic and political systems tends to cause many to overlook (assuming they are aware), that such domination is something of an aberration in the period since the fall of the Roman Empire (which, even then, was part of a multi-polar world.) At the end of the Seventeenth Century, Europeans were the ones admiring the influence and cultures of Asian powers (Asia constituting some two thirds of GDP and three-quarters of its population) such as the Middle Kingdom Chinese Empire and the Mughal one of India; and as late as 1820, Asian economies constituted an estimated 60% of global GDP at Purchasing Power Parity (PPP). Jared Diamond’s now iconic book “Guns, Germs and Steel” chronicles what changed the “natural order”.

The United States and the EU may still constitute the world’s largest economic blocs, but their dominance is beginning to fade. They may still be rich and militarily powerful (in the case of the US), yet Asia now has more than half of the world’s population and the majority of its largest conurbations.

Of course, statistics and trends can be manipulated by selective use and interpretation of data, but the rate of economic growth within Asia is such that, in relative terms and at UNCTAD-defined PPP levels, The Financial Times (FT) estimates that the size of Asia’s collective economies will surpass those of the Rest of the World within the next year or so. Even at market value (as the FT also points out) Asian economies account for 38% of global output (up from 26% in the early 2000s). The PRC alone, at PPP, now probably has a larger economy than that of the US.

Such projections can be disrupted or even reversed. However, given the trends, one should not ignore the contingency that eventually Asian economies will again become dominant economically. That does not mean that all of them will, or even wish to project power beyond their borders, with the obvious exception of the PRC. India probably wishes too, but is a good example of scale in terms of economic potential and population failing to equate to global influence.

Naturally, in a world of Make America Great Again and the desire of some within the EU for “Ever Greater Union”, there are those who would deny current reality and future possibility. While such intellectual avoidance may be comforting for those who hold such views, ultimately it is likely to prove counter-productive, because it prevents consideration of how to adapt to, or even challenge, reverse or guide outcomes.

At Awbury, we are both realists and pragmatists. We thrive by thinking strategically, while being tactically flexible, recognizing that denial and wishful thinking are simply foolish. Our world is constantly changing, and is a mixture of volatility, probabilities and certainties.

And we are very certain that the trends and potential changes described above will continue to present opportunities, as those affected try to manage changes in risk.

The Awbury Team

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Jaded, Distracted, or just Overwhelmed…?

In our world of potential “information overload”, in which attention spans are supposedly becoming ever shorter, and the tendency in some quarters to misrepresent, distort or simply repeatedly lie seems ever more prevalent, there is a danger that one’s mind (the System 2 part in Kahneman terms) can suffer what amounts to processing paralysis.

Not only is there too much data masquerading as information, but one has to exercise great vigilance and maintain abundant skepticism in order to be able even to function. One has to practice a form of informational triage, deciding what matters and what does not in terms of the particular decision at hand- and one has to know when to stop. It is always possible to ask another question or examine another factor, but is it relevant or material? Does it supply new information or a different perspective?

Of course, much of the skill behind effective decision-making is a product of both experience and constant practice. Theory is all very well, but it is essential to have seen the outcome of one’s own decisions, as well as observing and learning from those of others.

In the (re)insurance underwriting context (as in others), there is the danger that familiarity can breed contempt, as well as complacency- both of which run the risk of causing decision errors- because, while some factors are largely unchanging (e.g., lack of cash kills companies), others may be new and unexpected. For example, the “Softbank effect”, in which an early stage, or even relatively mature business is essentially “forced” to accept far more money than its principals know what to do with or can deploy effectively may lead to them changing the very behaviours and processes which made the venture promising in the first place. Paradoxically, there can sometimes be something such as having too much cash.

Therefore, any underwriter has to be able to adapt his or her mental models when circumstances and new information dictate, including the heuristics which we all use, often subconsciously (System 1 behaviours in Kahneman terms.)

At the same time, as stated above, one has to be able to ensure that your System 2 thought processes are able to filter sources in terms of their accuracy, relevance and “weight”. Going back to primary sources is usually essential (i.e., reading the actual accounts; interview transcripts; and regulatory filings) is essential. Just reading pre-digested pablum such as presentations means that one is already dealing with someone else’s filter and motivations. Often those may be harmless, but equally they may deliberately distort or deflect. US GAAP or IFRS may be far from perfect, but “adjusted” numbers almost invariably only go one way in terms of their purpose, which is to make things look favourable- unless a new CEO is using the “kitchen sink” approach to clear the decks for his or her new regime.

The Awbury Team has by now getting on for a couple of centuries of relevant combined experience. However, that does not mean that we have succumbed to the “seen it all” fallacy. We know that there are, and always will be, new factors to take into account in our underwriting of the large, complex risks in which we specialize. Jaded we are not! As for being overwhelmed, our carefully focused approach enables us to filter out the informational dross and distraction that constitute an increasing problem.

The Awbury Team

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Banks fail (or have to be rescued), but P&C (re)insurance companies just soldier on…

In most financial systems (with Bermuda being an interesting exception), banks dominate the financial landscape in terms of their absolute and relative scale and economic importance. We witnessed the potential consequences of that during the Great Financial Crisis, when highly-leveraged, under-capitalized banks had to be bailed-out by public money (i.e., the taxpayers) on a huge scale- something whose effects still linger even now.

Of course, over the past 10 years, regulation and re-capitalization have significantly strengthened many banks’ financial position, even if sustainable business models still elude quite a number of mainly European banks. However, the fact remains that, in the fractional reserve banking system which is still the dominant model, any bank needs to maintain a highly-leveraged business structure in order to generate the returns which shareholders expect and is inherently subject to the risk of a “run” if confidence falls.

There are now increasing signs that regulation fatigue, political amnesia and pandering to vested interests are leading to pro-cyclical, rather than the necessary anti-cyclical behaviour amongst regulators in the world’s largest financial market- the US- at a time when both the credit and businesses cycles are potentially approaching a reversal, even if not another “crash”. In fact, changes in regulation can fuel a boom- consider what happened after the repeal of the Glass-Steagall act.

As we are seeing now, risk also tends to migrate away from the regulated to the unregulated components of the financial system- as the rise of so-called “shadow banking” and “FinTech” demonstrates, further obscuring sources of potential trouble. If regulators do not pay attention and “follow the money”, they are, in essence, condoning a rise in systemic risk.

And while the phrase “This Time is Different” is not yet being uttered as a general mantra, the longer time passes without even a recession, the greater the risk that people, including “experts”, will start to believe that the beast of the Business Cycle has finally been tamed, with excuses being made to justify that belief, even in the face of contra-indicators. One can already observe this is the debate going about the “meaning” of the recent US yield curve inversion.

Compare that scenario with that of the (re)insurance industry. While (re)insurers may carry some leverage (usually at the holding company level, not at regulated subsidiaries), the cost of, or risk of withdrawal of funding is rarely an issue. Similarly, they are not subject to liquidity puts, nor deposit outflows. What happened to AIG in 2008 is the exception that proves the rule, yet its core insurance businesses were able to continue to meet their obligations without stress, in an environment that was potentially chaotic.

In reality, in the absence of fraud or serious mismanagement of pricing, aggregations and reserves, diversified P&C (re)insurers very rarely fail. This is not a reason to be complacent, nor to assert that such a thing cannot happen. However, the evidence built over many decades and business cycles is clear. Companies’ business models may become obsolete, or they may have reserving issues, but even then the consequence is usually an orderly run-off, rather than precipitate failure.

The key distinction between banking and (re)insurance is that duration mismatch is a necessary element of any banking system but not present in the re/insurance industry. While both industries have to pay close attention to their ability to cover realized losses and ensure adequate levels of risk capital (equity or the equivalent), only banks have to deal with the embedded liquidity risk that comes from that duration mismatch.

At Awbury, even though the quality of our partner (re)insurers is very high, and they are all large, diversified P&C businesses, we constantly monitor their financial performance and condition, because we believe that one should never assume that “received wisdom” cannot change; and we would be doing our clients a disservice if we did not maintain vigilance.

The Awbury Team

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