Power Laws and Probabilistic Strategy…

It is well understood that some relationships in terms of how one factor affects another are linear, while others are non-linear (so-called power laws). As Albert Bartlett said:

“The greatest shortcoming of the human race is our inability to understand the exponential function”.

In business, many managerial approaches are based on an incremental, essentially linear approach, aiming for a gradual increase in revenues accompanied by a similar growth in profits. This is a symptom of strategic inertia; of accepting mediocrity. In some areas, such an approach may enable a business to survive for a long time, although its end may come swiftly if its environment changes.

McKinsey recently published an article (How to win in insurance: Climbing the power curve) which should give the incrementalists serious pause for thought. In studying the economic profit (total profit less cost of capital) of 209 insurers (being all insurers with revenues above USD 1BN in 2017) from 2013 to 2017 McKinsey identified what amounts to a “power curve”:

– The top 20% generated an annual average economic profit of USD 764MM equivalent
– The middle 60% produced an average economic profit of USD 26MM (i.e., they just about broke even in nominal terms)
– The bottom 20% suffered an economic loss of USD 976MM per year (i.e., they rapidly destroyed value)

Visually, the data looks much like a two-ended Allen Key held horizontally- essentially showing that most of the wealth creation and destruction are in the tails.

Of course, when challenged about under-performance (re)insurance company managers (like those in any other industry) will state that they are undertaking a “strategic review” which will transform the fortunes of an underperforming business. Unfortunately, as McKinsey points out, not much changes in reality: the odds of a bottom quintile company moving to the top quintile between 2003 and 2017 were 17%; and those from the middle 3 quintiles into the top no more than 10%, which in some ways reinforces the dangers of complacency exhibited by the “great middle”.

As with many things in life, outcomes are usually probabilistic, not deterministic; and so it is with strategy. There are no certainties of success. However, McKinsey’s research highlighted 5 areas which were the most likely to enhance a company’s positive trajectory and move it up the power curve:

– Dynamically shifting resources between business units
– Reinvesting material amounts of capital in organic growth opportunities
– Pursuing thematic and programmatic M&A
– Enhancing underwriting margins
– Making “game-changing” improvements in productivity.

It would be easy to say that these are “obvious”. Yet, if they are, why do so few (re)insurers seem to make a serious effort to implement one or more of them? As McKinsey points out, what differentiates outcomes is the magnitude and intensity applied to escape from the “usual” approach to change. Materiality matters at least as much as direction.

To comment on an area near and dear to the hearts of the Awbury Team, if the key goal of any (re)insurer is to generate a high risk-adjusted return on capital (and to stop seeking the “safety in numbers” of a Combined Ratio of a little below 100%), enhancing underwriting margins should be an obsession, with an equal focus on more efficient processes, higher margin and non-commoditized product lines, and lower loss ratios. Unfortunately, for many, this often requires going outside their “comfort zone”. Yet the behaviour described is not reckless, but rather involves analyzing where the most value is likely to be created, and refusing to be distracted by the siren call of simply a larger premium flow.

To sum up, management teams need to be bold, focused, and know how to apply “leverage” within their business model in the ways that will truly make a difference. Being “comfortable” is not really a valid option.

The Awbury Team

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Come the Revolution…

In 1972, Larry Greiner (Professor Emeritus of Management and Organization at USC) wrote a seminal article which was published in the HBR and entitled “Evolution and Revolution as Organizations Grow”. In it he posited a model (now called the Greiner Growth Model, or the Greiner Curve) describing how organizations grow and prosper (or fail) over time through a cycle of evolution and revolution (or crisis).

In essence, Greiner stated that the idea that any organization could, after being founded, continue to grow and be managed in some stable, essentially linear fashion was deluded; and that, while the precise order, length and nature of each phase might vary depending upon the nature of the business and how prescient and adaptable its management was, each organization would go through periods of “crisis”.

One only has to observe the effects of the passage of time across multiple industries to recognize that the underlying premise is valid. Business model, structure and management style either proactively adapt, or changes are enforced by multiple factors. Trying to “stay the same” leads to ossification, irrelevance and potentially extinction.

In his model, Greiner suggested that there are up to 6 stages or phases in the process, with an attendant “crisis”, or catalyst for change between each:

Phase 1: Creative growth from founding, leading to a crisis of leadership as the business scales and becomes more complex structurally

Phase 2: Growth based upon an adapted leadership style (perhaps with new leadership) emphasizing more formal processes and direction, leading a crisis of autonomy as employees chafe against what is seen as over-centralization

Phase 3: Growth under a delegated structure, in which the autonomy of employees and teams is recognized, and they have broader decision-making authority. This leads to a crisis of control, as senior management and directors begin to sense that they are losing control of the business

Phase 4: Growth continues via greater use of co-ordination in which the business puts in place structures through which senior managers take more direct responsibility for business units, while creating a “staff structure” to maintain consistency across the entire organization. Eventually, this can lead to friction between “line” and “staff” functions, in the guise of a “red tape” crisis

Phase 5: To counteract “red tape”, senior management emphasizes a more collaborative approach, in which problem-solving through team action or through collaboration across teams is used to manage what by now is likely to be a large and complex business. The potential major issue becomes one of growth itself, as employees become overwhelmed because of the demands made on their time, and the pressure to grow

Phase 6 : In this phase, concerns about the ability to continue to grow, lead to an attempt to create broader alliances, M&A, networks, or the use of outsourcing.

Whether and how quickly each stage or phase occurs depends upon a combination of industry dynamics, growth rate and management quality. Viewing the model as deterministic is, in our opinion, misguided. However, it does provide a useful framework for thinking about how to manage organizational structures as a business grows, and to ensure awareness that over time these have to adapt to stand any chance of surviving long term. Of course, not all businesses make it through the phases described above, victims of “creative destruction” or an inability to adapt. If one looks at the (re)insurance industry, one can see that it contains members which exhibit the characteristics of the various phases, from start-ups to global businesses, as well as those which have somehow become “stuck”, which brings into question whether the might succumb to the next “revolution”.

At Awbury, we have deliberately grown carefully and incrementally since being established some 7 ½ years ago, while adapting our business model to changes in markets and opportunities; and we are very well aware that we will have to continue to adapt and evolve over time to meet the challenges and disruptions that face all businesses in a complex industry such a (re) insurance. We have no intention of being overrun by any revolution!

The Awbury Team

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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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