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Analyst Take: Axa, XL and the leverage of reasonable creatures

One of the lessons of financial markets over the past two decades is that if you pay someone enough, they can provide you with fancy mathematics to justify almost anything.

"So convenient a thing it is to be a reasonable creature," wrote Benjamin Franklin, "since it enables one to find or make a reason for everything one has a mind to do."

From the crisis at Long-Term Capital Management to the 2008 crash, companies used complex statistical models to explain away risk and justify obscene levels of leverage. Yet time and time again, events occurred that had been mathematically shown to be so improbable as to be assumed impossible.

One way to think about this is to critique the limitations of models. There is an inherent sample bias in relying on empirical data drawn from a small window of human history to simulate probabilities for return periods of hundreds or even thousands of years.

And perhaps more importantly, human behaviour is not governed by immutable laws like a hard science. Human beings are sometimes irrational, hard to model and respond to incentives in a way that changes over time.

But more simplistically this is really just a story about human psychology and the business cycle. As risk aversion declines, managers feel more comfortable adding more risk and/or leverage. In balance sheet financial institutions, this essentially comes down to taking more risk with less capital.

The mathematics may be fancier than at traditional companies, and the rationalisations more complex, but it boils down to this one simple truth. And the temptation to do this is even more acute in a low-growth economy.

Which brings me to Axa's proposed $15.3bn takeover of XL. One of the remarkable features of this deal is that the limited identified cost and revenue synergies seem to have been used to fund the take-out premium.

Therefore, the upside to Axa's shareholders seems to be premised largely on capital "synergies", with management estimating it can improve capital efficiency at XL by 30 percent over time.

Now, in many ways, it could be easy to classify this transaction as de-risking by Axa. P&C has less financial risk than life and annuity products and faces fewer substitution threats.

P&C products are also largely a non-discretionary purchase and therefore the business is less economically sensitive. And, unlike many life products, P&C liabilities can't be accelerated by counterparties and create a "run on the bank".

Additionally, XL's sources of income volatility are different and partially non-correlated to Axa's existing businesses. Therefore, in theory the combination of the two earnings streams should be lower risk than each on its own.

However, to borrow a phrase, in theory there is no difference between theory and practice - but in practice there is. The simple truth is that relying on diversified earnings makes sense in a normal environment. But in a crisis, it is capital that matters, not earnings.

It is a well-known fact that every US P&C insurer that got into trouble in the crisis did so from operations outside of P&C business. And though some P&C companies notably contributed billions of dollars to bail out their corporate parents, the result was not a quick fix.

Instead, the stress of the corporate parent simply imported bankruptcy risk to the P&C company and made it more difficult to trade through the crisis and deliver the earnings the diversified model depends on.

Axa's strategy appears to be a response to the rating agency and regulatory models that give credit for diversified earnings. Arguably, the move into mortgage (re)insurance by many global P&C (re)insurers was also due to the limited additional capital required to support this "diversifying" business under these rating agency models.

Now, there are real world limitations to this strategy, particularly in the US where capital cannot be double stacked in local entities. But there are workarounds, particularly for international groups to exploit. And, as the business cycle progresses, I think it is likely we will see more of these "diversifying" transactions.

Notably, these types of risks take a long time to play out. Axa predicts it won't get approval for its XL internal model until 2020 and will likely only decapitalise the company over time. Should this become a broader trend, it might take a decade or more materialise.

Much will depend on real-world events and the source and timing of the next economic and financial stress.

But one of the unintended consequences of the rating agencies and regulators incentivising diversification may not be a net reduction of systemic risk, but simply an import of risk to the P&C sector.

Those interested in the long-term health and reputation of our sector should be paying attention here.

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