After an extensive review, my firm, Buckingham Strategic Wealth, recently approved a new alternative investment, one that until recently was only available through hedge funds (along with their typical 2-and-20 fee structure), the Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX). We have begun the process of integrating the fund into client portfolios (both institutional and individual).
I’ll begin with an explanation of the intuition behind the recommendation – explaining the logic behind investing in insurance in general and reinsurance specifically, the rationale for expecting a premium return above the risk-free rate and the diversification benefits provided. I’ll then discuss the specific vehicle we have chosen to use to implement the strategy of investing in reinsurance.
Why insurance as an investment?
While nobody likes to buy insurance, every year consumers spend trillions of dollars on insurance policies. We do not, however, buy insurance to protect ourselves against regular, predictable events. Rather, we budget for such expenses. On the other hand, when dealing with the possibility of rare, unpredictable downside events – such as premature death, disability or destruction of property from a fire, earthquake or hurricane – we do buy insurance to protect ourselves against an outcome too risky to bear on our own. In 2015, the worldwide insurance industry collected more than $4.5 trillion in premiums. Those premiums transfer risk, with the buyer paying to eliminate the possibility of an extreme negative event.
The price that 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).
Reinsurance
Reinsurers are an important part of the overall insurance industry. But, while most people are familiar with at least a few of the largest insurance companies, reinsurers generally aren’t household names because they don’t deal directly with consumers.
Reinsurance is insurance that is purchased by an insurance company as a means of risk management, both allowing them to service their clients (selling more insurance than they have capital to otherwise support) and to diversify risks. The reinsurer is paid a reinsurance premium by the “ceding company,” which issues insurance policies to its own policyholders.
Some traditional reinsurers have legacies reaching back to the mid-1800s. Typically highly diversified, reinsurers offer protection on a broad spectrum of client risks. That broad diversification across uncorrelated risks is what allows reinsurers to be “structurally levered.” Regulators allow reinsurers to hold substantially less capital than their total exposure because it’s highly unlikely that losses will occur simultaneously across uncorrelated and geographically dispersed risks. As an example, a reinsurance company whose risks are highly diversified might be required to hold $2 of capital for each $5 of reinsurance risk.
Collectively, the reinsurance industry now has about $600 billion of capital. And since the 1990s, insurance-linked securities (ILSs) have allowed investors to participate directly in reinsurance risks.
Investment opportunity
Investing in the reinsurance industry presents an opportunity to add an asset with equity-like returns that are uncorrelated with the risks and returns of other assets in their 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 in stocks or bonds. The combination of the lack of correlation and equity-like returns results in a more efficient portfolio, specifically one with a higher Sharpe ratio (a higher return for each unit of risk).
Historically, the capital base of insurers and reinsurers consisted of traditional debt and equity. However, since Hurricane Andrew in 1992, and especially since the tumultuous hurricane season of 2005, the industry has increasingly turned to third-party capital. The interaction between the reinsurance markets and the capital markets is known as “convergence.” Through convergence, investors are able to participate directly in catastrophe risk space, rather than being forced to buy the debt or equity of insurance and reinsurance companies. Today, about 12% of the capital committed to reinsurance comes from third-party investors, not reinsurers themselves.
By Larry Swedroe, read the full article here.