Swedroe: Global Warming & Reinsurance

September 21, 2018

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 Bias

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.

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