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Externalities: Bean-counters’ myopia!

Feb 16, 2020

Externalities are fascinating. Perhaps a bit too daunting for the imagination of bean counters. It is not just the accountants that I am alluding to but the actuaries, rank & file and the risk managers. Economists included. The provocation for the latter comes from Inside Out Economics: Are Externalities the Main Event? (by Duncan Austin) and so does much of the (‘beyond)meat’ to reinforce my conviction.

If risk-management is indeed meant to make governance robust – the function ought to shed its myopia. ‘Tell us more’ said the chairman of a risk committee in response to my choice of the phrase. So, I alluded to Nassim Taleb’s ‘hindsight bias’ followed by a case for liberal arts education as an antidote to myopia. Coz bean counters, I said to him, left to themselves are a risk to the risk function!

How do we de-risk our businesses to ensure their sustainability as well as our planet’s? In response to US treasury secretary Steven Mnuchin’s suggestion that the champion of Climate Change – Greta Thunberg –  must study economics, the author Duncan Austin has something specific to say. “Yet possibly what Greta has noticed is that many of society’s influential decision-makers are either formally trained or well-practiced in economic thinking and still struggling to find convincing remedies to our sustainability crisis. Perhaps the way we have been teaching economics is part of the problem?”.

While the author does not undermine the role of economics as a valuable body of knowledge – he bemoans “downplaying the significance of one of its own discoveries made exactly a century ago” which “has potentially calamitous real-world consequences”. To get under the skin of this hard hitting truth – everyone word in the following quoted text must be read.

Pigou’s inconvenient truth

In 1920, Arthur Pigou, a Cambridge economist, conceived the idea of externalities to describe how market transactions may create unintended harms or benefits for which no monetary compensation or reward occurs.

For example, one study estimated the monetary value of the ‘services’ provided free by the Earth’s ecosystem at $125 trillion in 2011, nearly twice the value of global GDP (gross domestic product). That is just an estimate of certain ecological values ignored by the market. Important social values are missed as well. In the UK, unpaid housework in 2016 was estimated at about 65 percent of GDP – another huge block of nonmarket value. These two studies alone indicate that measured GDP captures about a third of some larger conception of value.

Such estimates suggest that it is not that the market doesn’t capture all things of value, it doesn’t even capture most things of value. Far from externalities being peripheral, they may be the main event!

We have a sustainability challenge because the entire financial system repeats the problem of the discredited EBITDA metric at the level of the whole economy. This is the invisible conceptual cage we have wrapped around our decision-making and from within which the ESG movement is frantically trying to make a difference. Alas, given the incompleteness of our markets, the ESG movement increasingly resembles a hopeful grafting of good intentions onto an unchallenged accounting reality that remains the largely intact source of our problems.

So, every single financial metric on the Bloomberg screen is a BESDA (‘before ecological and social depreciation and amortization’ basis) metric – profits-BESDA, earnings per share-BESDA, return on capital-BESDA, return on equity-BESDA, etc. The millions of financial numbers processed daily by our increasingly automated markets – which, in turn, steer our economy and drag our culture along behind, ripping up nature in its wake – are all BESDA numbers.  It might not only be EBITDA with which we’re conning ourselves, but every financial number in the book. They all represent different degrees of disembedded value, some of which we have unmasked, some of which we have not.”

How does all this tie in with insurance economics?

Let us leave aside the logic or illogic of pricing models, the adequacy or inadequacy of the time frames in which they are expected to operate and the obsession with predictability. Asbestosis by hindsight looks very probable (as Mr Taleb would put it) but the shortsightedness which brought upon all the attendant woes – meant you were collecting too little a premium and something unforeseeable was beyond your imagination. It would be interesting to dig into actuarial signoffs. A formal risk management function was absent, but someone was responsible for something akin. Underwriting profitability – then as it is now – takes a back seat. Lloyd’s almost went broke. Pricing continues to be a mockery, thanks to the seemingly endless supply of ‘alternate capital’.

Climate Change is not a peril priced for. Together with Cyber and aspects of D&I, these three externalities – constitute biggest of the risks. Too far and out of their boxes. Valuation of insurance entities is an addiction that generally induces the insurance industry to gloss over a sustainable price. Many covers like motor third party (GHG / health consequences), pollution and contamination would not pass the sustainability test for not only these run counter to the risk carriers’ sustainability but more importantly our Planet’s too. When car sales fall (including diesel fuelled) insurers panic as their auto portfolio shrinks – not for a moment is there a sense of rejoice that there could be resultant reduction in emissions meaning less impact on the health of those who end up inhaling it.

Is there some unintended good? From outside the blinkers of all concerned arrived – what I like to call Post Millennials – they are not meek, and sshall inherit the earth. It is very much in our interest that they join the shareholder activism – cut through the bureaucratic barricades, recharge the imaginations of all those in serious need of getting externalities inside the pricing models! An art of liberating all forms of bean counting…

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