Swedroe: High But Uncorrelated Risk

June 01, 2018

Earlier this week, I addressed the question of whether where you live should impact your decision to invest in reinsurance, and specifically in the fund I recommend investors consider (SRRIX).* Today I’ll address a second common concern about the asset class: the risk of large losses (fat tail risk) inherent in reinsurance contracts. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge funds in constructing client portfolios.)

Potential For Large Losses

Reinsurance exhibits negative skewness and excess kurtosis (fat tails), as it has the potential for large losses, while gains tend to be more moderate. Investors have a strong tendency to prefer assets with positive skewness, meaning the distribution of returns is like a lottery ticket, where most returns are to the left of (less than) the mean, but returns to the right of (greater than) the mean are much further from it (in other words, there is the potential for large gains).

By the same token, they dislike assets with negative skewness and excess kurtosis because of the potential for large losses, as returns to the left of (less than) the mean, though fewer than returns to the right of (greater than) the mean, tend to be further from it.

For example, if our forward-looking return expectation on reinsurance is, say, 7%, then a good year, with few losses, might provide a return of 12%. On the other hand, a really bad year might see losses of 20% or more. Because investors are risk averse, assets with negative skewness (such as equities) tend to have large risk premiums—investors require a large risk premium to accept potentially large losses.

Alternatively, investments with positive skewness tend to have low returns, as investors’ preference for such investments results in their having high valuations. (This is much like the “return” to lottery tickets, where the “risk premium” is, in fact, quite negative. Buying lottery tickets is not a reliable way to build wealth.)

The bottom line is that the potential for large losses (buyers of insurance are paying to transfer the risk of large losses) is precisely what makes investing in reinsurance an attractive investment. Remember that the price the insurance company charges to bear the risk of extreme events, which can lead to large losses, decomposes into two parts: an expected payout and a risk premium to compensate the seller for the uncertain nature of any payout, which may be sudden and dramatic.

In other words, when individuals buy insurance, they hope, and expect, to incur a loss (they anticipate that, on average, the insurance company will generate a profit at their expense). While we buy insurance to protect against risks we cannot afford to bear, wouldn’t you also prefer to be on the other side of that “trade” and earn the premium, one uncorrelated with the other assets in your portfolio?

High Risk, Low Correlation

As I discussed in my prior article, while reinsurance entails the risk of large losses, thinking about any investment in isolation is the wrong way to view things. The only right way to view an investment is to consider how the addition of that asset impacts the risk and expected return of the entire portfolio. The reason is that the addition to the portfolio of assets with high risk but low correlation can actually reduce the risk of the overall portfolio, dampening its volatility.

Compare the risks of diversifying by including exposure to reinsurance to the risks of just holding a diversified portfolio of stocks. Using monthly data, the S&P 500 Index, for instance, lost 80% peak-to-trough in the 1930s and 46% during the 2008-2009 global financial crisis, which was just 10 years ago.

In a truly terrible market for equities, individual stocks tend to become highly correlated. You lose the diversification benefit of holding multiple equities, and it’s like you are only holding one—and that one is doing dreadfully. In contrast, a truly terrible “market” for one type of reinsurance (like Florida hurricanes) has no relationship to other reinsurance markets (like Japanese earthquakes).

Furthermore, there is no logical reason to expect that losses from reinsurance should correlate with losses in either equities or bonds. As evidence of this, using data from Stone Ridge to examine SRRIX’s performance since its inception in December 2013 through March 2018, we see that during each of the 13 months in which the S&P 500 had a negative return, SRRIX had a positive return. While past performance is no guarantee of future results, this is evidence of the tail-risk-reduction benefits provided by the fund.

However, it’s important to note that I expect there will be periods in the future when SRRIX will experience losses at the same time equity markets do. It’s just that bear markets in stocks don’t cause catastrophe losses and, in general, catastrophe losses don’t cause bear markets. Thus, the returns to SRRIX and equities should be uncorrelated. In other words, I anticipate SRRIX should provide diversification benefits against most bear markets, but not all of them.

 

* Discussion of SRRIX is provided for informational purposes only and is not intended to serve as specific investment or financial advice. This discussion does not constitute a recommendation to purchase a single specific security and it should not be assumed that the securities referenced herein were or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives and evaluate all offering materials and other documents associated with the investment. It is important to understand that forward-looking return expectations/expected returns are the mean of a very wide potential distribution of possible returns. Thus, they are not a guarantee of future results. Expected returns are forward-looking forecasts and are subject to numerous assumptions, risks and uncertainties, which change over time, and actual results may differ materially from those anticipated in an expected return forecast. Expected return forecasts are hypothetical in nature and should not be interpreted as a demonstration of actual performance results or be interpreted as a target return.

 

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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