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Lloyd’s of London, a 300-year-old insurance body, collects more than 33 billion pounds in gross premium every year. Its history goes back to the 17th century.
In 1906, when a major earthquake destroyed more than 80 percent of the Californian city of San Francisco, Lloyd paid out all the policyholder claims, irrespective of the terms of their policies. That cemented Lloyd’s reputation in the American market.
However, in the 1990s, this insurance behemoth was brought to its knees by a risk that had gone unnoticed for decades. After California earthquake episode, Lloyd started underwriting wide-ranging general liability cover to US businesses, including asbestos manufacturers.
Thousands of employees who had worked in asbestos plants were diagnosed with asbestosis, a deadly lung disease, twenty years later. These workers claimed the compensation from their former employer in 1990s. The employer, in turn, claimed it to the insurance companies like Lloyd who wrote the policy in the 1960s. Lloyd had failed to understand the nature of future risk and thus faced near bankruptcy.
Asbestosis is a classic example of a “long-tail” risk – one that can result in insurance payouts years after an original policy was first underwritten. Many of Lloyd’s policies were open peril policies, i.e., they covered any claim not excluded. That was a huge blunder.
In the field of software security, a network firewall is a way to thwart hackers and malicious programs from entering your system. One way a network firewall works is to rely on a whitelist instead of a blacklist.
In other words, access by default is blocked for everybody except those who are present in the whitelist. If you take the blacklist approach, you’re blocking people on the blacklist but those who are not in that list have access – similar to Lloyd’s open peril policies.
So that was Lloyd’s first mistake, i.e., to assume cover for a risk which they didn’t understand. And the second mistake was to not account for an unknown risk.
In insurance jargon, the cost arising out of such long-tail risks are called IBNR – incurred but not reported.
The triumph of Warren Buffett’s annual letters is in delivering a remarkably useful explanation of how the world of business and investing works. With his inexhaustible font of wit and wisdom, this is how Warren Buffett explained the idea of long-tail hidden costs in his 1985 annual letter –
A man was traveling abroad when he received a call from his sister informing him that their father had died unexpectedly. It was physically impossible for the brother to get back home for the funeral, but he told his sister to take care of the funeral arrangements and to send the bill to him. After returning home he received a bill for several thousand dollars, which he promptly paid. The following month another bill came along for $ 15, and he paid that too. Another month followed, with a similar bill. When, in the next month, a third bill for $15 was presented, he called his sister to ask what was going on. “Oh”, she said. “I forgot to tell you. We buried Dad in a rented suit.
Reading Buffett’s letter is an experience akin to having the top of one’s head removed for repairs. Buffett wrote the above anecdote in the context of the insurance industry. And although I have no economic studies I can cite to back this but I sense that the idea of “Rented Suit Liabilities” can be extended to other businesses and even our lives.
Martin Fowler is a British programmer and a world known authority on software architecture. Reflecting over Fowler’s acute observations about how software should be built has completely rearranged the interior decoration of my mind. Many times. He says –
If you can get today’s work done today, but you do it in such a way that you can’t possibly get tomorrow’s work done tomorrow, then you lose.
One of the most important principles of software engineering is to write code which is easily maintainable and extendable. But that requires deep thinking and a lot of mental effort. Since most software is built in the face of aggressive deadlines, software developers find it convenient to gloss over the design principles and slap together a hacky code which somehow works.
Imagine building a car with lego and instead of connecting two blocks with an appropriate connector, you glue them together with fevicol. It will work, but tomorrow if someone wants to replace a block, it becomes hard. In software, this is called ‘creating a technical debt.’ Sounds similar to rented suit liabilities, doesn’t it?
The first no-brainer which creates long-tail hidden risks is lack of integrity. And it applies to both – personal as well as corporate conduct. Every time a company’s management tries to get away with minor corporate governance issues, they might think they’re sweeping things under the carpet but they are actually laying the foundation of a graveyard which will soon be housing corpses buried in rented body bags.
In fact, any activity which focuses on short-term results at the expense of long-term benefits sows the seeds of rented suit liabilities. The hidden nature of rented suit liability comes from our unwillingness to think deeply about our decisions beforehand.
Another source of these hidden risks is when the incentives of decision makers are at odds with those who have to live with the long-term consequences of those decisions. For example, a CEO can slash the R&D and marketing expenses and boost the earnings of a company for a few quarters. That earns him a fat bonus and by the time the long-term effects of those expense-cuts start rearing their head, the CEO usually makes an unceremonious exit with a big severance package, and the shareholders are left washing their hands in the air.
Not just in business and investing, rented suit liabilities plague most of us in our non-investing endeavors too. Cut corners on exercising or eating healthy today, and it’s an invitation to rented suit liabilities.
Spending all the income today and postponing the savings? Well, isn’t it akin to accumulating the rented suit liabilities?
Nick Maggiulli, in his fantastic post on Hidden Costs, explores a very interesting question – If you’re offered $100 million on the condition that you have to accept this money publicly during a widely televised event, would you take the offer?
Had you posed this question to me a few years back, I would have said yes with gleeful confidence. However, now I am not so sure. In fact, I explored this subject sometime back in my post Inverting the Money Problem.
Here’s what Nick writes –
Time and time again I have seen how our society idealizes things that are littered with hidden costs. We want the great body, but without the reps. We want the returns, but without the risks. We want the lake house, but without the frozen pipes bursting because we forgot to put in antifreeze. We can idolize wealth, status, fame, and beauty all we want, but we don’t think about what happens if we ever actually get them…
We can never avoid all the hidden costs for the only way to do that is not to take any decisions. And if we tried to do that, it would leave us paralyzed.
So, what’s my point? Instead of throwing caution to the wind and jumping on decisions, we should think hard about what rented suit liabilities may emerge from our actions. And one of the mental tricks that helps is an idea called premortem.
Anne Duke, in her wonderful book Thinking in Bets, writes –
A premortem is an investigation into something awful, but before it happens. We all like to bask in an optimistic view of the future. A premortem is where we check our positive attitude at the door and imagine not achieving our goals. Imagining a headline that reads “We Failed to Reach Our Goal” challenges us to think about ways in which things could go wrong that we otherwise wouldn’t if left to our own devices.
Objectively, rented suit liabilities and hidden costs are simply the consequences of our decisions. Nothing more nothing less. With the benefit of hindsight, we call them liabilities because they turn out to be undesirable.
What if those decisions resulted into something which creates value? Rented suit asset, if your will. Or maybe hidden assets. After all, the rented suit was an asset for the guy who gave it on rent. That’s an interesting line of thought, isn’t it?
Have you seen any businesses which have long-tail hidden liabilities? How about any specific decisions in life which can create rented suit liabilities?
Please share your thoughts in the comments section.