Swedroe: Managing Risk With Reinsurance

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.

Another Perspective

Here is what their advisor pointed out to them:

• While they did have some earthquake risk because of where they lived, they also had an insurance policy on their home (the asset subject to earthquake risk), which would protect them from catastrophic losses. Their real exposure was the deductible on the policy. Their home was worth about $2 million and their policy’s deductible was 15% (the most common deductible). Thus, their exposure to loss was $300,000. (Note: Regardless of any investment in SRRIX, homeowners who live near fault lines should be adequately insured.)
• The estimated realistic loss to SRRIX from even a massive California earthquake is likely far lower than the 83% loss that equity markets actually suffered in the 1930s. Were a market event similar in magnitude to occur again, which is entirely possible, it would surely devastate the couple’s finances.
• Importantly, only a percentage of the portfolio’s total risk is allocated to the risk of California earthquakes. SRRIX maintains exposure to many other types of perils and is geographically diversified across perils, reducing the risk of a catastrophic loss to the portfolio caused by any single event.
• SRRIX’s risk would provide strong diversification benefits to their portfolio’s stock and bond allocations due to the lack of correlation, and also to other alternatives in which they wanted to invest.

And, with tongue in cheek, their advisor added that an investment in SRRIX would give them a chance to earn back some of the premium they were paying to insure their home! This is particularly true after a large earthquake, when, even though the fund would decline in value, the premiums for reinsurance would be likely to increase.

Their advisor also suggested that, rather than viewing the decision to invest in SRRIX as black and white, they could decide to invest in SRRIX but underweight it relative to other alternatives, because of their California residence and the fact that their $300,000 deductible was not an insignificant figure. If they did so, John and Susan’s exposure to earthquake risk would be even less than in the preceding illustration.

The situation is similar when we look at Florida and hurricane risk. Again, not all of that risk is in the area where the investor lives. And investing in the fund would provide significant diversification benefits for the rest of the investor’s portfolio. Note that in Florida, the deductibles for policies with protection against hurricane risk are much lower than they are with earthquake policies. A typical deductible in Florida is in the 2-5% range.

The bottom line is that it’s important to not view any investment in isolation. Certainly, it’s important to consider the location in which you live, and the risks to which you are exposed, before investing in a fund such as SRRIX. For example, if the investor owned a business that would suffer large losses not covered by insurance, that would be a reason to consider not investing in the fund.

However, it’s also important to make sure you are considering the entire picture. The only correct way to view things is in the whole. Ask yourself: How will the addition of a given investment impact the risk and return of the entire portfolio?

* 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.