13 Ways of Looking at (Re)Insurance…

The title is a tongue-in-cheek homage to Jane Smiley’s excellent book analyzing the origins, history, structure and impact of the novel, “Thirteen Ways of Looking at the Novel”- a literary form which is now so embedded in our culture that very few give much thought to anything other the content of the particular book they are reading.

In a similar way, the business of re(insurance), because it is simply “there” and generally works very well in meeting its primary goal of honouring valid claims, tends to be seen as rather mundane.

So, we thought we would enliven matters a little by using Smiley’s clock analogy (see p 179 of her book) to view (re)insurance through different lenses by employing some of her categories, and adding some of our own:

  • History: Insurance as a construct, even if it was not called that, has a history going back thousands of years, to the Babylonian era pre 2000BC; while the first recorded stand-alone insurance contract was written in Genoa in 1347
  • Tale: Think of the classic film noirDouble Indemnity”, based upon James Cain’s 1943 novel of the same name. It was all about the insurance
  • Joke/Humour: We’re not sure that (re)insurance has a humorous side. It is a very serious business. However… How many actuaries does it take to change a lightbulb? Well, how many did it take last year?
  • Gossip: In its original form, Lloyd’s Coffee House would have been rife with gossip. One might almost say that the London Market was founded upon it; but, of course, rapidly evolved to insist upon “utmost good faith” and ”my word is my bond”
  • Diary/Letter: The bane of any compliance department is the manuscripted policy, whose creator has failed to enter its full terms into the system
  • Confession: Do depositions count?
  • Travel: Just think of the opportunity to be an underwriter in Bermuda
  • Polemic: We all know that those 1/1 renewals can become a little fraught
  • Essay: For those studying for a degree in insurance and risk management, a form of mental cruelty, but “character-building”
  • Epic: Just think of Jarndyce vs. Jarndyce in Charles Dicken’s novel “Bleak House”. Someone should have bought a litigation cover
  • Dynamic: The industry  prospers on being able to respond to fresh challenges and adapting to provide new products and seek new forms of capital. Those systems which do not adapt, cease to have a purpose
  • Balanced: That Combined Ratio could go either side of 100%. Almost a random walk
  • Composition: The industry is going the way of so many others- scale versus specialization. The formerly great middle continues to be hollowed out.

We trust that our readers will forgive us for being a little “unserious”!

And may we take this opportunity to wish all our partners, advisers, and clients good fortune in 2020.

The Awbury Team


The world is going backwards- discuss…

Recent reports that the Central Committee of the Chinese Communist Party has ordered the removal of all western-sourced computer hardware and software from government and public institutions by the end of 2022 (to be replaced by locally-sourced equivalents and potentially affecting up to 30 million pieces of hardware) not only is the latest evidence that the era of “globalization” is probably ending and a long-term trend of rising global trade reversing, but also of why economics really should still be called “political economy”: one cannot properly separate the components.

This act is a response to the uncertainties caused by the continuing US/PRC “trade war” (which may now have reached the “phoney war” stage) , but it raises questions in terms of its likely consequences. While the PRC may have capacity in terms of hardware (through, for example, Lenovo, which is said to derive a third of its sales in the US and only 20% from the PRC), it does not yet have equivalent capacity in high-quality operating software. Ironically, the PRC is already showing increasing interest in developing systems using so-called “open” software.

The key risk in all this lies in the fact that after decades of growth in cross-border trade, and thus in the scale and complexity of supply chains, any government needs to be able to understand and parse each link within such chains, otherwise it may find itself embarrassed by the imposition of “counter-measures” by those impacted by its own high-level policy decision. In the case of the PRC, while Huawei, for example, has seemingly weathered the sanctions placed or threatened upon it by the US better than many had expected (or hoped), it is unlikely that the PRC’s domestic manufacturers can yet replicate every aspect of the technology component list and be able to provide hardware and systems with equivalent functionality to existing ones. Of course, no-one should under-estimate the PRC government’s determination and ability to achieve its goals, but one may wonder whether the announced intention to replace western technology is symbolic for now.

Dealing with such actions, ambiguities and uncertainties is all part of the job description for any seasoned trade credit or political risk underwriter; but it does introduce a question about the need to adjust the weightings applied to the probability that a particular entity will act, or be forced to act, in a way that is not rationally in its economic interests. We are sure that those who write, say, Contract Frustration will be paying close attention.

It is also important to put such announced actions into the wider context, and examine their knock-on effects. It is one thing to wonder where the current weaknesses or vulnerabilities may be in a particular supply chain, but very much another to try to predict where the next “adverse” action will occur and its nature. The growth in international trade is a key reason why the PRC, for example, has been able to grow its economy at the rate at which it has for the past 40 years. Returning to autarky in no longer a viable option for any society which wishes to continue to prosper, particularly one that clearly wishes to become (the PRC) or remain (the US) the regional and global hegemon.

The spectre of the 1930s should give any rational government pause for thought because of the damage which supposedly “protective” actions wrought not only globally, but domestically.

At Awbury, as avid students of history, we try always to understand motivations and reasons for government-level actions, in order to minimize the risk of being “surprised” by how events may impact our business and portfolio; though, as we frequently state, dislocations bring opportunities as well as threats.

The Awbury Team


Is the paradigm changing…?

In many, if not most areas of life and business (including (re)insurance) there are certain constructs or approaches that are considered axiomatic or fundamental. They can appear in many guises- the inevitability of business cycles, the superiority of democracy or capitalism, and the need to manage aggregates.

However, sometimes it pays to re-examine and re-assess what amounts to a paradigm, in case something has changed.

For example, those familiar with Marx and Das Kapital (published in 1867), will recognize the paradigm of the 3 factors of production- land, labour and capital, with much of the resulting argument being not about the components, but about their relative importance, and which one should or must dominate.

However, as Louis-Vincent Gave (of Gavekal Research) recently posited (in an excellent note entitled The Knowledge Revolution and its Consequences), a fourth factor must now be added- knowledge. One could argue that knowledge has always been important, even if not specifically delineated as a factor. However, as Gave emphasizes, real power now belongs to those who can best organize knowledge: the accumulation of capital thus being a derivative. “Knowledge is Power” (attributed both to Sir Francis Bacon and to Imam Ali) encapsulates the point.

Historically, the possession of knowledge was tightly and deliberately controlled- confined to those (almost invariably males) who were literate and had received a formal education- a prior form of extreme inequality. Power depended upon controlling the levers of taxation and coercion through violence or the threat of it.

Now, of course, mass education and the fruits of information technology have expanded access to knowledge to levels where the paradigm has seemingly shifted to a model based on essentially universal access in most of the world.

Yet, diffusion of knowledge is not the same as diffusion of the understanding of it; nor of how and by whom it should and can best be used. “Should” may be contentious, but (as Alexander Pope said) “a little learning is a dangerous thing”.

What if, as a result, the diffusion of knowledge has caused the economic paradigm to shift, but the political superstructures have yet adapted? Possession of or access to knowledge changes the expectations of those who were hitherto less able to make comparisons or exert influence; and one only has to look around the world to see the increasing tensions between citizens and governments.

For a risk manager, all this begs the question of whether it remains reasonable to assume the medium- to long-term continuation of the nation state in something resembling its current form as the basic unit of government, ruled in a hierarchical manner (whether autocratically or democratically). Given the increasing fiscal and budgetary strains that result from demographics, longevity and at least a perception of an increase in inequality even in the face of the above-mentioned rise in expectations, it is a question worth considering.

Logically, something has to give. Will it be the economic or the political side of the equation, or both? Smoothly and predictably, or violently? Just because relative peace has been maintained, in most developed countries at least, since the end of World War II, that does not mean it is rational to project such an underlying premise far into the future.

Of course, it is easy to dismiss such thinking as absurd. Yet, no economic or political system is immutable; and we are really only starting to grapple with the consequences of the diffusion of and access to knowledge.

At Awbury, this is just one factor in the scenarios that we ponder when trying to understand the macro and idiosyncratic risks posed by any of the large, complex transactions on which our franchise is built. We believe in taking the long view!

The Awbury Team


Oily tails…

Like forecasting the timing of recessions, it is a truism that predicting the price of oil over anything beyond the short term is usually delusional, because of all the economic and geopolitical factors which have an impact.

How far will US tight oil production surge? Will OPEC decide to curb production with a view to maintaining prices at levels that support members’ already strained budgets? What will be the outcome of the US/PRC “trade war”? How accurate are forecasts of the demand side of the equation?

Amongst all this, there is that perennial favourite, Middle Eastern geopolitics. Venezuela’s production travails are seemingly yesterday’s news!

It can make one’s head spin to try to assess the various scenarios for mayhem that could unfold- especially in a “post-Abqaiq” world in which a few missiles and drones can take out more than 5% of global supply in an instant. In that case, while there was a temporary movement up in price, there was no sustained uptick, which perhaps begs the question of how bad things would have to be before there was a material sustained change in expectations and so prices.

While the world remains beset by far too many bilateral tensions (India/Pakistan being a good example of nuclear war as a tail risk), it is the Middle East which is the source of most state and state-supported conflicts; many of which, because of their seemingly interminable and intractable nature, lead to a jaded and potentially dangerous “so what?” response. What is interesting is that actions which would once have been considered a casus belli are now seemingly regarded as “background noise”. Israel attacks Iranian positions in Syria; or Turkey invades northern Syria, while Saudi Arabia is “certain” that Iran was behind the attack on its Abqaiq facility.

So one has to wonder what it would take for a real “shooting war” to break out that would actually get the oil market’s attention. After all, the conflict in Yemen seems only to elicit ennui.

Iran and Iraq are both much less stable than they may appear (which is saying something!) The governing elites in each, if they felt sufficiently threatened, could easily decide that a “patriotic” war (ruinous as it might be) was “necessary” to maintain power and disguise that increasing fragility. After all, there is a precedent from the war of 1980-88. Of course, this is just one scenario. Israel or Iran could each be seen by the other to have “gone too far” with a particular action, with either side goaded into a war of choice, simply because a failure to respond could be seen as an existential weakness.

These are the topics which “think tanks” and “pundits” enjoy speculating about- but without “skin in the game” it is mere idle chatter.

At Awbury, such things matter. The price of oil has both a macro and an idiosyncratic impact on portfolio risks, so, while we would not claim that we somehow have a special “edge” in forecasting, we most certainly do avoid “wishful thinking” and constantly update our knowledge and understanding of the key factors which do or could have an impact on the supply and price of oil. Regarding it as “background noise” would be foolish.

The Awbury Team


Dead before you know it…

Readers will be familiar with the concept of the post mortem, in both the literal bodily and the figurative business sense.

They may also be familiar with the somewhat modish “pre mortem”, now often used in a wide range of contexts to try to identify potentially unforeseen risks and flaws in a plan before a major, and potentially irreversible decision is made. The foundational text (building upon earlier research on the concept of “prospective hindsight” and his book The Power of Intuition) which brought the technique a wider business audience was published in 2007 in the HBR by Gary Klein.

Some 12 years later, Mr. Klein (together with two co-authors from Columbia University, Paul Sonkin and Paul Johnson) has published a draft paper (Rendering a Powerful Tool Flaccid: The Misuse of Premortems on Wall Street), in which an example of how not to conduct one is described, followed by a “how to” guide covering the right way to do so.

As with many concepts which become a ‘term of art’, intellectual sloppiness and shallow thinking can corrupt what should be a useful tool, rendering it dangerous in the hands of those who have not properly studied and assimilated the proper approach and the reasons for its effectiveness.

In the world of (re)insurance, as in many other industries, we suspect the use of the technique is fairly prevalent, particularly when it comes to reviews of potential M&A transactions.

So, it may be helpful (as set out in the recent paper) to re-visit the factors that make a pre mortem a valuable tool, as opposed to the potential precursor to a damaging mistake.

Firstly, problems and issues are reframed, because the purpose is to explain ex ante why the plan failed, forcing the participants in the process to identify the causes.

Secondly, one cannot have a pre mortem team of one! One needs to assemble as diverse a team as possible, not just in terms of background, but also in terms of experience and expertise. Youth and inexperience may well not be a hindrance in this case, as questions should be raised which others may have dismissed as irrelevant based upon their greater “experience”. Cognitive diversity is essential.

Thirdly, because every team member is supposed to participate (no exceptions!), it is absolutely critical that each member feels safe doing so, without being overwhelmed by fear of mockery or retribution because those perceived to be in a position of power may not like what they hear. Therefore, the usual approach to mitigating this is for the leader or most senior member of the group (perhaps the CEO) to go first- in effect explaining why what may well be his or her “pet” project has failed. It should be a salutary lesson in intellectual humility.

Fourthly, each member of the team has to be treated equally, without incorporating bias or hierarchy in terms of their opportunity to express the concerns they have. Applying a weighting ab initio negates the purpose of the exercise.

And, finally, a pre mortem is not intended to be a leisurely exercise or symposium. There has to be urgency and pace, to avoid the danger of “over-thinking” or “discussion unto death”.

If done properly, the pre mortem is valuable. However, the title of the paper hints at and mocks the fact that overuse and abuse of the technique have led to it becoming more part of a box-ticking exercise, rather than an attempt to produce an effective, executable decision, or even demonstrate the folly of proceeding with a particular course of action. One wonders if those underwriting the IPO of WeWork, made use of pre mortems. After all, what could possibly go wrong…?

As readers of this blog will know, at Awbury we are constantly exploring a diverse range of decision-making and risk-assessment tools. The pre mortem is part of our armoury- one approach to avoiding over-reach, ruin, or the destruction of value.

The Awbury Team


Loss Creep or Mission Creep…?

Until recently, the term “loss creep” was not one much heard publicly in (re)insurance circles. Reserve releases were generally the order of the day, and useful for primping Combined Ratios for public consumption.

Now, however, the phrase has become almost a trope, as increasing estimates for the overall claims cost of a greater number of major CATs (think of 2018’s Typhoon Jebi as the current “poster child”) mean that (re)insurers not only have to worry about increasing their reserves, but also about the risk of blowing through their retro covers. And just think what specialized writers of retro CAT must be feeling!

Such events are a further sign that, in the commoditized world of CAT, the “old certainties” need re-thinking. Hitherto “conservative” assumptions are now revealed as no longer fit for purpose. All this means that rather than being as equally wrong as everyone else, underwriters (and their CAT-modelling colleagues) are going to need to re-think their assumptions about what a “1-in-x” year event might look like, both in terms of frequency and then scale. Relying upon prior “industry standard” models, or estimates could become rather damaging to (re)insurers’ crucial reserve management methodologies, and ultimately to solvency levels.

Of course, this is likely to lead to executive managements wondering where they can look to assuage the pain of regularly missed “target” or “normalized” Combined Ratios. And what exactly is an appropriate “attritional” CAT Loss ratio or “budget” anymore?

Another phrase that is also becoming more prevalent is “closing the gap” when speaking about the availability of insurance coverage for natural disasters, particularly in so-called emerging markets. Given the demonstrated difference between economic and insured losses depending upon jurisdiction, and the continuing shift in the rate of economic growth away from developed markets, it is not surprising that a CEO looking for premium flow would be attracted to the idea of expanding into new geographic markets and helping to close the gap in coverage. However, one wonders whether a sufficient level of skepticism and true conservatism will be employed in the process of deciding to expand coverage into new jurisdictions. One can imagine the temptation to argue by analogy with existing developed markets that the same assumptions and criteria can be used. Yet if, in developed markets, the existing models are being demonstrated to be no longer fit for purpose, what can make a (re)insurer’s Board comfortable that somehow the process will be easier or more accurate in a new market?

We are not saying that entering new markets is misguided; simply that current experience in supposedly well-known and hitherto understood developed markets should give pause for thought before blithely entering new ones, especially if, as is often the case, everyone thinks the same thing at the same time. It may sound absurd, but could “closing the gap” become the classic “crowded trade”, whereas the smart money re-engineers its processes and increases discipline in markets in which it has long experience?

At Awbury, we believe strongly in focusing on the area- credit/economic/financial risks- in which we have a demonstrable and defensible track record. We adapt as markets and risks change, but we know that there are realistic boundaries to the scale and probability of losses that may occur, and that careful structuring can significantly mitigate risk of loss. Contrast that with the CAT environment, in which the probability of full-limit losses is all too real, especially in a world beset by increasing loss creep.

The Awbury Team


The Dangers of Economic Dogma- Models and Financial Mayhem…

We recently came across an interesting paper by George Akerlof, a Nobel Prize winning economist in which he describes the unreality of the basic macro-economic models used by the profession in the half-century ending with the Great Financial Crisis (GFC).

In essence, Akerlof posits that the models used were misleading, because they failed to ascribe sufficient importance to the impact of the financial system on the wider economy. He also makes a point, often overlooked, that the choice of textbook used as the core for teaching a particular topic has far-reaching consequences, because it influences how students are taught and come to understand a subject, and thus how they apply their knowledge.

In the 1960s (before Friedman’s monetarism and economic neoliberalism took over the world), the basic model used (at least in most US universities, including Akerlof’s MIT) was the so-called Keynesian neoclassical synthesis, which was based upon the concept of finding equilibria between the various components of the underlying economic model, principally supply and demand. Unfortunately, in creating the “synthesis”, its acolytes decided that any changes to an equilibrium would be one step at a time and proportional. The models did not really address circumstances in which disorderly changes could occur- i.e., panic or crashes.

Somehow, they had forgotten, or overlooked, Keynes’ own “beauty contest” theory of market behaviour, under which individuals (and so corporations and banks) allocate their wealth and make financial decisions based not upon careful analysis of economic fundamentals, but rather on what they think others will see as the value of an asset- a version of the “greater fool” approach, which only works as long as the greater fool exists and behaves as expected!

As Akerlof explains, because the real world is a very complicated place, even for the DSGE (Dynamic Stochastic General Equilibrium) models now beloved of central banks, relying upon a model that essentially smooths out the impact of financial decisions is a recipe for macroeconomic mayhem, because it fails to account for the fact that systems and economies can appear very stable until, suddenly, they are not. In the case of banks, deregulation in the 1980s and 1990s removed both oversight and constraints, which, when coupled with malign incentives and dogma such as “housing prices cannot decline systemically”, created the conditions for the GFC, whose effects we are still living with today.

Strange as it may seem, the dominant economic models failed to include the impact of the financial system (as a system) on the wider economy. With a few honourable exceptions, the dismal science failed miserably in terms of its forecasting ability. Why? Because a model, which actually ignored a key tenet of its supposed creator (Keynes), became the basis for teaching a generation of economists- and questioning it was risky at the individual level.

One may ask what such a tale has to do with (re)insurance. Simply that there are dominant models and “orthodoxies” in the industry (as in many others) that are used to guide decisions, often without question. In reality, as we aim to do at Awbury, every time one uses a model one should always ask one’s self not only whether it is appropriate for the decision that will be based upon it, but also whether there any characteristics which place a boundary on the circumstances in which it will remain useful. In other words, is it truly fit for purpose?

As we all know, the real damage comes from the extreme left of the distribution (which, ironically, is another convention!); but, first, the distribution has to be grounded in some form of reality!

The Awbury Team