Swedroe: Managing Risk With Reinsurance

May 30, 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 (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 (a higher return for each unit of risk).

Today I’ll discuss one of the more common concerns I am asked to address about reinsurance: the correlation of insurance risks to the investor’s location.

I’ll begin by observing that a well-run reinsurance fund should be diversified across event types with uncorrelated losses. For example, a well-diversified reinsurance fund might write policies covering losses from fire, tornados, earthquakes, hurricanes, political risks, as well as fine art losses while goods are in transport (marine and on land). Each of these risks should be uncorrelated—there is no reason to believe that losses from earthquakes correlate with losses from hurricanes.

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.

Importance Of Global Diversification

Reinsurers also should diversify their event risks globally, because, for example, the risk of earthquakes in the United States is uncorrelated to the risk of earthquakes elsewhere. While it’s possible multiple major earthquakes can occur in the same year, it’s not that likely.

In addition, because other types of risk that reinsurance covers are uncorrelated to earthquakes, the risk of a catastrophic portfolio loss is greatly reduced. In technical terms, the negative skewness of a diversified reinsurance program is much less than it is for any one type of insurance risk.

With a better understanding of these basic points, let’s turn to one of the most common concerns about which I’m asked. It goes something like this: I live in California (Florida) and a big risk for me is loss from an earthquake (hurricane). Why would I want to invest in an asset that takes on more of the same risk?

To answer that question, let’s consider the following hypothetical case.

John and Susan are retired, living in an earthquake-prone area of California. They have a portfolio with a 50% stock/50% bond asset allocation. Their financial advisor pointed out that, because equities are so much riskier than bonds (a globally diversified equity portfolio is about four times as volatile as an intermediate-term high-quality U.S. bond fund), more than 80% of the risk of their 50/50 portfolio was in stocks. Thus, their financial advisor recommended moving toward more of a risk-parity-type portfolio (as described in my new book, the 2018 edition of “Reducing the Risk of Black Swans,” co-authored with Kevin Grogan).

Specifically, to reduce the portfolio’s exposure to equity risk, John and Susan’s financial advisor suggested that, among other steps, they consider replacing some of their stock allocation with an investment in the Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX).* The goal was to maintain that part of the portfolio’s equitylike forward-looking return expectations while diversifying across a unique and uncorrelated source of risk.** (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge funds in constructing client portfolios.)

The couple, however, raised an objection to investing in a reinsurance fund. They stated: “Living near the San Andreas fault line, why would we want more earthquake risk?” It’s a very logical question. And there’s a logical answer. While investing in reinsurance, and specifically taking on more earthquake risk, may seem risky when viewed in isolation, when we consider their entire financial situation, a different picture emerges.

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