Over the past several years deploying capital in the insurance capital markets, I’ve found that most coverage rarely goes beyond surface-level headlines, outcomes, and broad narratives. 

This newsletter takes a different approach - a perspective from inside the market - the pricing cycles, the capital flows, what’s moving markets, and what’s behind the headlines.

I recently re-read Nassim Taleb's Skin in the Game.

Taleb is not universally loved. The Economist described his writing as "rather like being trapped in a cab with a cantankerous and over-opinionated driver."¹ The Guardian went with "the festival messiah you'd follow into a river until the drugs wore off."²

He's worth reading anyway. Underneath the various feuds he prosecutes, his books keep returning to one idea that any practitioner will recognise: nobody should be able to keep the upside of a risk while handing someone else the downside.

His name for this misalignment is the Bob Rubin trade, after the Citigroup director who collected more than $120 million in compensation in the decade before the 2008 crash. When the taxpayer rescued the bank, rather than writing a cheque, he invoked uncertainty - "Heads he wins, tails he shouts 'Black Swan.'"³

More precisely: “a payoff in a skewed domain where the benefits are visible (and rewarded with some compensation) and the detriment is rare (and unpunished owing to absence of skin in the game)".³

This time round, the words jumped off the page - this message matters most in the market this newsletter tries to demystify - I’d argue that when you allocate to insurance, the manager's skin in the game matters more than it does anywhere else in your portfolio.

Insurance trades have the same basic shape: collect a small, certain premium against a large, uncertain loss. Priced well, it's good business - in 2023, catastrophe bond spreads paid an average of 4.5 times the modelled expected loss.⁴

The trouble is what that shape does to a track record. Take two funds. Fund A holds remote risk: a 1% chance of loss each year, paying a 5% spread - five times its expected loss. Fund B holds riskier layers: a 4% chance of loss, paying 8% - twice its expected loss. Per unit of risk, Fund B is paid less than half as much. But most years contain no major catastrophe, and in those years Fund A returns 5% while Fund B returns 8%.

For as long as the sample stays quiet, the league table runs upside down: the manager accepting the worst pricing posts the best numbers. As Issue 6 argued, the information that matters lives in the bad year, and the sample either contains the bad year or it doesn't.

A bad year in insurance is not a single event that immediately settles the question. Collateral sits locked while natural catastrophe losses are re-estimated. Casualty reserves booked in the soft years of the mid-2010s were still being strengthened ten years later. Buffett put it bluntly in his 2024 letter: a P&C insurer can report "large but fictitious profits" for years - "even decades" - before the truth catches up.⁶

Fees do not wait for this. They’re charged annually, on results as reported. The losses that decide whether those results were real can take a decade to become facts.

Issue 6 used a toy trade: you're paid 7% a year to take a risk that, on average, wipes out half your capital once every fifteen years. This time, hand that trade to a manager. Say the fund is $100 million, on standard terms: a 2% management fee, plus 20% of profits, paid every year.

In a normal year the fund makes 7%, and the manager earns about $3.4 million - $2 million of management fee, $1.4 million of performance fee. In the loss year, investors lose half their money; the manager earns no performance fee, but the $2 million management fee still arrives. Averaged over the whole cycle, the manager makes about $3.3 million a year.

Now suppose the risk was mispriced, and the wipeout comes one year in eight instead of one in fifteen. For investors, the trade now loses money over time. For the manager, the average take falls from $3.3 million to $3.2 million.

The investor's outcome hangs on the true odds of the bad year. The manager's pay barely notices them.

This is not a cynical reading of one contract; it is a theorem. In 2010, two economists proved that a manager with no skill can manufacture any star track record by quietly selling far-out-of-the-money risk, and that "there exists no compensation mechanism that separates skilled from unskilled managers solely on the basis of their returns histories."⁷

Deferred bonuses don't fix it. High-water marks don't fix it. In their worked example, the honest manager and the mimic earn the same fees, in expectation, for years.

So if the track record can't referee…and the fee contract can't either…what's left?

Insurance is the business of managing other people's moral hazard, and it’s never relied on results to do it. In 1766, ruling on an insurance dispute, Lord Mansfield set down the founding doctrine: "Good faith forbids either party by concealing what he privately knows, to draw the other into a bargain from his ignorance of that fact."⁸ Everything since has been engineering on that theme. The deductible keeps the insured exposed to the first loss. The average clause converts under-declared value into retained risk, automatically.

One level up - where insurers buy their own protection - the tooling gets properly sophisticated. A quota share treaty pays the ceding insurer a commission that slides with the loss ratio - in a standard structure, every point the book deteriorates costs the cedent a point of commission, inside a collar, with deficits carried forward into next year's calculation.⁹ Loss corridors hand a slice of the losses back to the party doing the claims handling. Reinstatement premiums make sure using the cover isn't free.

The market worked out centuries ago that in this business you price a counterparty's exposure directly - line by line, at every renewal - because waiting for their results to tell you is waiting too long. No one’s looking at the Sharpe…

In most asset classes, an allocator has working defences against a misaligned manager. Prices are set by a market rather than by the manager's own model. Results arrive quickly enough to mean something. A bad year shows up as a bad year, roughly on time. A manager's skin in the game helps, but other checks are doing most of the work.

In insurance, those defences go quiet one by one. The record stays smooth regardless of the underlying risk. Results are estimates for years, and in private structures the estimates often belong to the manager. The one test the industry itself trusts - actual versus expected, in the loss years - takes a full cycle to run. Nearly everything an allocator normally leans on arrives too late to be helpful.

The manager's own money, in the same risks, on the same terms, over the same horizon as the investor's.

It has to be large enough that the bad year is personally expensive, held in the risk itself rather than in the management company. In other markets that arrangement is a comfort. In this one, it is doing the work the track record can't.

Berkshire's National Indemnity provided a good demonstration of what it looks like when the arrangement is real - between 1986 and 1999 they let premium volume fall from $366 million to $55 million rather than match soft-market pricing - and stayed profitable through every one of those years.

Buffett explained the design in one sentence: "we have always promised NICO's workforce that no one will be fired because of declining volume, however severe the contraction."¹⁰ Nobody in that building had a reason to write bad business to protect their own pay cheque, and the capital making the decisions was the capital that would eat the losses.

Is the manager’s capital contribution real ‘hurt money’?

Is it cash, or is it borrowed against the fees themselves?

Who marks the book that the fees are paid on?

Taleb's most quoted line is the right one: "Don't tell me what you 'think,' just tell me what's in your portfolio."³

The standing invitation holds. If you’ve been sitting on a question - about a product, a structure, an idea - send it over.

Until then.

Charlie Evans, CAIA
Chief Investment Officer, Zephyros Investments

¹ The Economist, "Nassim Taleb explains the power of 'skin in the game'" (22 February 2018). https://www.economist.com/books-and-arts/2018/02/22/nassim-taleb-explains-the-power-of-skin-in-the-game

² Zoe Williams, "Skin in the Game by Nassim Nicholas Taleb - review," The Guardian (22 February 2018). https://www.theguardian.com/books/2018/feb/22/skin-in-the-game-nassim-nicholas-taleb-review

³ Nassim Nicholas Taleb, Skin in the Game: Hidden Asymmetries in Daily Life (Random House, 2018) - the Rubin passage and the "portfolio" line are in the Prologue; the Bob Rubin trade definition is in the glossary.

⁴ Artemis - average catastrophe bond spread multiple (spread ÷ expected loss) of 4.54x in 2023, the highest in over 20 years. https://www.artemis.bm/news/cat-bond-investors-secured-higher-risk-adjusted-returns-in-2023-as-multiple-rises/

⁶ Berkshire Hathaway 2024 shareholder letter - "a P/C insurer may report large but fictitious profits to its owners and regulators for many years – even decades." https://www.berkshirehathaway.com/letters/2024ltr.pdf

⁷ Dean Foster and H. Peyton Young, "Gaming Performance Fees by Portfolio Managers," Quarterly Journal of Economics 125(4), 2010. https://deanfoster.net/research/gaming_performance_fees.pdf

⁸ Lord Mansfield, Carter v Boehm (1766) - the founding statement of utmost good faith in insurance law.

⁹ David R. Clark, "Basics of Reinsurance Pricing," CAS study note - sliding-scale ceding commissions, loss corridors and profit commissions, with worked examples. https://www.soa.org/globalassets/assets/files/edu/edu-2014-exam-at-study-note-basics-rein.pdf

¹⁰ Berkshire Hathaway 2004 shareholder letter - the National Indemnity premium-volume table and the no-layoffs policy. https://www.berkshirehathaway.com/letters/2004ltr.pdf