David's Blog

Black Cygnets

18th June, 2014

Much gloom and doom reverberates around insurers, particularly reinsurers.  This depression follows the climate shift with possibly hot money provided by a whole new stream of investors competing for business.  Well, if not new, certainly many more of the kind who wouldn't have looked at writing insurance risks ten years ago, maybe even five.

Something seems incongruous.  How should we reconcile this behaviour with Mr Buffett's counter-intuitive style: 'I want to be greedy when everyone else is fearful', and so on?  What about the words of that swash-buckling Anglo-French entrepreneur, Jimmy Goldsmith, 'if you can see a bandwagon, it's too late to get on it'?

If you are privileged to umpire this match between sophisticated but uneven adversaries (after all, there may be too much insurance capital available but it's dwarfed to insignificance by the trillions of dollars controlled just by pension funds) you might think it fair to give the insurers a game or two in hand.  Yet I doubt if this is more necessary than arming them with weapons they should already be possessed of: experience, discipline, patience and perhaps most of all relevance.

As an advisor to underwriting members of Lloyd's, recommending caution, I find myself today faced principally by impatience based on the extraordinary profits we've enjoyed subsequent to the World Trade Center disaster in September, 2001.  Perhaps because time is a great healer, most people forget about the panic which then ensued.  Impossible to get cover for a group of Catholic Churches in Montreal; household premiums in deepest Iowa rising disproportionately; and, even, aviation underwriters predicting by mid 2003 that their premiums were unsustainable.

The rules of supply and demand were in good shape.  But not now!  Ten years plus of remarkable returns for insurers versus financial shenanigans, huge losses and above all lower interest rates have shifted perceptions so that today the insurance bandwagon leads the parade.  Let me not be the first person to predict that it won't last!

For traditional insurers it may be sufficient to do what they should be doing anyway.  Regularly pruning their gardens of the weeds which inevitably appear year on year.  And now taking advantage of new capital which is prepared to sell almost the identical product at what will eventually turn out to be a big discount to cost.  I don't regard this as arbitrage.  There is no suggestion that traditional insurers should lower their standards.  It's just prudence at value.

But when will the ART products turn out to be too cheap?  Externally, this capital must always be looking at the historic paradigm.  When the return from underwriting can be predicted to be X while the monetary return is less than half X, the insurance proposition will continue to look attractive.  On the other hand, when the winds of volatility combine with heavy seas and rumbling earth, those returns will not be valued at safe X but rather unsafe X-Y.  Not for this capital is Mr Buffett's preference for a lumpy 15% return rather than a smooth 12% return.

Meanwhile the less-than-half-X yield will have risen to X on cash/bonds...

If WTC in September 2001 was the ultimate black swan, what were the UK storms of October 1987 and January 1990?  No doubt black cygnets, but the appearance of the second so soon after the first caused a black swan response.  There have been so many of these black cygnets appearing in the past three years that it seems incredible that the warning signs are being ignored.  'Just you wait, 'enry 'iggins!'

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