The Culture of Hard Markets

In insurance, a hard market is when carriers can exert extraordinary pricing power. I spend an embarrassing amount of time discussing whether the market is hard or soft or hardening or softening and when the hardening or softening will change, etc.

It’s tiresome and really distracting, in my opinion. The business model that relies on timing the market is necessarily volatile and limited in scope, which are things that public equity markets (ie permanent capital bases) don’t like. They like consistency and reliability. A hard market strategy is anything but.

Anyway, I’ll stop my rant there and focus a bit on what hard markets do to the CULTURE of a business.

You see, if you can properly identify a hard market, you have properly identified a free lunch. In such a case, making lots of money is easy: you just have to show up with a minimum of skill. Put your kids in the chair, says my boss, and in a hard market you still get rich.

What would happen if a hard market was the norm? What would happen to an institution if the degree of difficulty for profit suddenly dropped? [edit: what I’m really asking is what happens when a hard market lasts a long time and then suddenly reverses. Like a bubble, you never know you’re in a hard market until you leave one]

Well, luckily we have a case study.

I’d say that this is what happened in the investment industry in the Great Moderation period, up until the wrenching (ongoing) financial crisis we’re living through right now.

We recently reviewed our pension scheme and we were astonished at the terrible menu of choices presented to us. In a book of 500 different mutual funds, there were very few index funds and even these only got as cheap as 0.72% of assets per year.

Expensive, but we’re a small company so our costs will be higher. Fine.

But how about the rest of the funds, with expense ratios of 1-3% per year? Maybe the managers can justify this when they’re beating the index funds reliably, but we know that’s simply not possible for the VAST MAJORITY of funds to do, right?  And run-of-the-mill mutual fund managers?

Puh-leeze. They’re 30th percentile at best.

Eventually, when the market turns, they get found out. As Tyler Cowen says, we aren’t as wealthy as we thought we were. Well, banks weren’t as smart as they thought they were. And that’s WITH bailouts protecting them from the realization of exactly how stupid their high leverage business models were.

When the music stops and you look back, here’s what I’d bet you realize was happening when you suffered the illusion of a prolonged hard market:

  • Lesser talent being paid like it’s higher talent
  • Aspects of Scott Adams’ confusopoly, where the money is so plentiful everybody starts taking little cuts from all over and it becomes really hard to compare options.
  • The market rewarding ex-ante status, power and wealth (ie status, status and status) as opposed to real value-creating activity.
  • Astonishingly stupid pseudo-science to explain what is going on

So if I may caricature: the median firm/employee becomes richer per point of IQ*, higher status (child of or former celebrity/ politician/professional athlete), employed in obfuscation rather than productive activity and unable to distinguish between luck and skill.

*I don’t like using IQ here because I tend to think its predictive power as an exogenous factor in success is vastly overstated. But it works as a placeholder for ‘units of ability’.

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