Swedroe: Climate Change & Reinsurance

May 03, 2019

Recency Bias

Before summarizing, we need to cover one more important issue that might prevent you from investing if you are unaware of it.

“Recency bias” 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 his or her portfolio’s targeted asset allocation.

The aforementioned three major U.S. hurricane landings in 2017 resulted in significant losses for the reinsurance industry. SRRIX lost 11.4% in 2017. The fund also lost 6.1% in 2018.

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%, 7.9% and 6.4%, respectively. It’s also important to note that, before 2017, no Category 3 or greater hurricane had landed in the U.S. since 2005. More importantly, there is no evidence of any long-term trend in hurricane landfalls.

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 dataset (HURDAT, maintained by NOAA) on landfalling hurricanes going back to 1851.

Meteorologists and climate scientists have studied this dataset intensively and have found no significant trend in the frequency of landfalling hurricanes over time. Data shows the long-term average is about 1.8 U.S. hurricane landfalls per year and about 0.6 major (Category 3 or greater) hurricane landfalls. The evidence also shows that one year’s losses from hurricanes tell us nothing about the following year’s losses.

Summary

The past two years were the worst two consecutive years in history for insured losses. It has also been an opportunity for the mainstream media to draw connections between climate change, natural disasters and insured losses.

While some investors exit the asset class because of fears of climate change, their doing so creates an opportunity for the evidence-based investor to dive deep into the data and facts to get a clear picture of the actual impact of climate change on the reinsurance asset class. As discussed above, the actual impact of climate change on property reinsurance is less than the popular perception.

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. Also note that the industry historically has had its strongest performance in years immediately after large losses. The reason is simple.

Losses create a need to restore capital, and the industry raises prices to address that need. This year is no different, as premiums for loss-impacted reinsurance contracts have risen between 5% and 35% 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. Of course, that is also when losses are likely to be greatest. (Full disclosure: my firm, Buckingham Strategic Wealth, recommends Stone Ridge funds in constructing client portfolios.)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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