David's Blog

The business we are in at Lloyd's

24th March, 2016

The business we are in at Lloyd's is all about measuring risk. This manifests itself in a number of ways:

What is the risk being undertaken? Is it daily exposure such as home or contents or motor or personal risk?

Or is the risk of a long-term nature such as professional indemnity or employers' liability?

Or is catastrophic such as hurricane or earthquake reinsurance?

Is the syndicate being paid appropriately to underwrite the exposure? What does the underwriter need to measure? Frequency of loss? Size of loss?

It's not an easy analysis. The underwriter may calculate that the right price to charge to insure that fleet of low grade vessels is X. He expects my operating costs to be Y and investment income to be Z.

At X-Y+Z, he may calculate that in a reasonable year he will have a margin of Q; Q+25% in a year of below average loss experience and above average investment income.

Or Q-25% when claims are above a norm and investment income down. So what can be expected if X reduces by 20% in year 1, and a further 20% in year 2 and rises by 10% in year 3 = 80, then 64, then 70.4. Doesn't seem that appealing even if 100 provided exceptional margin. Well, you all know this!

And, at the same time, investment income is less than half of the average earned over the previous 10 years?

The clever and careful and patient underwriter will trim his book and discard the worst performing 10% of his business. He does his utmost to control his expenses but even so the equation of expenses minus investment income is deteriorating.

If he is still making a profit, he has to consider himself extremely lucky. And to depend on luck is an imprudent way to run a business. The risk/reward is clearly unfavourable. Sooner or later he (and therefore we) must pay the price.

In the musical ‘Chicago’, Mistress Mama Morton, the keeper of the keys, the countess of the clink, sings "What's the one conclusion to bring this number to? When you're good to Mama, Mama's good to you."

So, charge the right price, manage your expenses, choose your risks carefully and insurance will be good to you.

But where are we today? Look at it through the parable of the gambler as told by David Dreman in his book 'Contrarian Investments Strategies in the Next Generation': The sure thing nobody wants.

The author paints a scenario where you enter into a casino with two gambling wings, one red, the other green.

You enter the green room. The atmosphere is unhurried, the tables are sparsely attended, and every player sits behind a pile of green and black chips. You see ordinary people playing ordinary games. You wonder how they made such big piles of money. Then you realise, they're all winning. There's hardly a losing player.

You know, of course, that the average house take on table games is 5%, but as you count winning and losing hands, you realise these players are getting a better break. They seem to be winning at a rate of 60% to 40%. A pit boss appears at your shoulder. "Excuse me," you say, "but can this be right? The odds favour the players?"

"Yes, indeed," he replies. "The odds in the green room usually run 60:40 in favour of the players. It's been that way since we opened."

"But most of the players must go away winners," you say. "Sure do," He says. "We calculate that 9,999 out of every 10,000 players make money. It's a good thing we get so few, or they'd break the house."

Somewhat amazed, you wander across into the red wing. The action level is much, much higher. The room is crowded and fairly roars with excitement. Curious, you go in.

Players bet multiple table positions, wave frantically for change, entreat the gods for luck. You see few winning players. The piles of chips in front of them are dwindling with each hand. In fact, the odds are worse than normal. Again, you start to count. This time, the odds appear to be 60:40 in favour of the house. You walk over to a pit boss, who confirms that, indeed, those are the odds. This is obviously not the place you want to be.

So you go home, get your stash and return to the casino. But then a strange thing happens. You walk into the red wing and start to play.

Which Dreman maintains is what most people do when it comes to investing. "Some investments steadily make money," he says, "while others lose consistently. And while most people want investments that have a good chance of beating the market, they gravitate toward investments where swarms of enthusiastic players are endangering their savings at odds similar to those in the red room."

We’d like to think that most of the underwriters whom we support can be found in the green room and even those who are in the red room have generally been winning. But (as Warren Buffett puts it) when the tide goes out, as it is right now, while those underwriters in the green room may continue to win albeit that their gains are reduced, those in the red room will finally be ‘exposed’.

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