Larry Swedroe* – ETF.com.
Forests cut warming better than technology
As the director of research for Buckingham Strategic Wealth and The BAM Alliance, I get many questions about whether reinsurance is an appropriate investment. The basic argument in favor of the asset class is that reinsurance has equitylike forward-looking return expectations that are uncorrelated with the risks and returns of other assets typically in investor portfolios (that is, stocks, bonds and other alternative investments).
Stock market crashes don’t cause earthquakes, hurricanes or other natural disasters. The reverse is also generally true—natural disasters tend not to cause bear markets, either in stocks or bonds. The combination of the lack of correlation and potential for equitylike returns results in a more efficient portfolio, specifically one with a higher Sharpe ratio (meaning it achieves a higher return for each unit of risk).
Global Warming’s Effects Examined
Today I’ll discuss one of the more common concerns I am asked to address about investing in reinsurance: the impact that effects from global warming have on reinsurance losses, specifically the risk of hurricanes. This concern was heightened by the three major hurricanes that made landfall in the U.S. last year, which led to large losses for reinsurers.
I’ll begin by noting that the reinsurance risks from global warming mostly relate to wind damage from hurricanes and tornados, and we can include the risk of wildfires as well. Flood damage is generally not covered by reinsurance companies. Instead, it is generally covered by government-run programs.
It’s also important to note that while catastrophe (CAT) bonds provide very concentrated exposure to risks arising from hurricanes and tornados, a well-diversified reinsurance fund might provide coverage on a wide variety of other risks, such as earthquakes, political risks, fine art, and losses while goods are in transport (marine and on land).
What’s more, today we are seeing innovative new insurance products that protect against losses from hacking, business interruption, concert cancellations, and even lack of sufficient snow for ski resorts. Such offerings present further diversification opportunities. Each of these risks should be uncorrelated; there is no reason to believe that losses from earthquakes correlate with losses from hurricanes.
The fund my firm recommends for accessing the asset class of reinsurance is the Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX). Currently, it has about 50% of its estimated risk allocation in risk associated with wind-related and firestorm losses. The other 50% of its exposure is unrelated to global warming issues. Thus, while the fund is exposed to weather-related risks, only half its risk exposure is connected to risks from global warming.
Information Vs. Value-Relevant Information
It’s also important to understand that if anyone is aware of the weather-related financial risks linked to global warming, it would be reinsurance companies. In fact, collectively, they probably employ more weather scientists than anyone else to make sure their pricing adequately compensates them for such risks.
In other words, it’s like anything else in investing. If you are aware of the risks, it’s a virtual certainty that the people who run businesses and fund companies also are aware of them. Therefore, you should assume this information is already embedded in the pricing of such risks. Thus, if the market is pricing for greater-than-historical losses, losses to investors in reinsurance products will only occur if the losses are even greater than already expected.
Recency is the tendency to overweight recent events/trends and ignore long-term evidence. This leads investors to buy after periods of strong performance—when valuations are higher and expected returns are now lower—and sell after periods of poor performance—when valuations are lower and expected returns are now higher. This results in the opposite of what a disciplined investor should be doing: rebalancing to maintain their portfolio’s targeted asset allocation.
The aforementioned three major U.S. hurricane landings last year resulted in significant losses for the reinsurance industry. SRRIX lost 11.4% in 2017. With that in mind, let’s look at the historical evidence, recalling that global warming is a very long-term phenomenon, one that doesn’t occur overnight but rather is felt over many decades. In the three years prior to 2017, the fund returned 11.0%, 7.9% and 6.4%. It’s also important to note that, before 2017, no Class III or greater hurricanes had landed in the U.S. since 2005. More importantly, there is no evidence of any long-term trend.
What The Data Tells Us
When it comes to matters affecting reinsurance, the measure of hurricane risk we should focus on is the frequency of landfalling hurricanes. The good news is that there is a clean data set on landfalling hurricanes going back to 1851 (it’s called HURDAT, and it is maintained by the National Oceanic and Atmospheric Administration).
Meteorologists and climate scientists have studied this data set intensively and have found no significant trend in the frequency of landfalling hurricanes over time. Data show the long-term average is about 1.8 U.S. hurricane landings per year and about 0.6 major hurricane landings (Class III or greater).
While global warming has been scientifically documented, it’s important to understand that weather has no memory—last year’s losses from hurricanes tell us nothing about this year’s losses. Let’s examine the data to test that theory. There are 167 years in the HURDAT data set. Of those 167 years, there were 75 years (45%) in which major hurricanes landed. Of those 75 years, there were 34 years (again 45%) when a major hurricane year was followed by another major hurricane year.
In other words, having just had a major hurricane year didn’t impact the odds of having another major hurricane year at all. Of course, this doesn’t rule out that 2018 will not be another year of significant losses. If history is any example, it’s almost a coin toss. It does demonstrate, however, that, historically, there is no correlation between losses in one year and losses in the next.
In addition, if 2018 were to be another bad year for hurricane losses, while it might be tempting to conclude a trend exists, the more likely explanation would be that it is just normal variability in a system that starts from a clean slate each year.
The bottom line is that the logic of investing in reinsurance as an asset class still holds, whether or not you believe in the effects of global warming. Note, also, that the industry historically has had its strongest performance in years immediately after large losses. The reason is simple. The losses create a need to restore capital and the industry raises prices to account for that. This year is no different, as premiums rose between 5% and 40% depending on location.
On a final note, because losses typically are greatest during hurricane season (June through November), most premiums are allocated to that period, meaning a reinsurance fund tends to produce the highest returns in the second half of the year. (Full disclosure: my firm, Buckingham Strategic Wealth, recommends Stone Ridge funds in constructing client portfolios.) September 21, 2018
*Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.