Which Fund to Choose for Exposure to the Reinsurance Risk Premium
As is the case with stock and bond funds, not all reinsurance funds are created equal. They can have different expense ratios, levels of diversification and levels of risk – writing policies with higher deductibles (more “out of the money”) and thus smaller premiums, or lower deductibles (less “out of the money”) and thus higher premiums. I will analyze the pros and cons of three funds to access the reinsurance market. Before doing so, I begin with a brief discussion on why investors should consider including reinsurance as part of their diversification strategy.
For investors seeking to diversify the risks of traditional stock and bond portfolios, a logical candidate is reinsurance. Reinsurance investments have a risk premium that has been both persistent (the reinsurance industry has more than 150 years of profitable investing) and pervasive around the globe, survives transactions costs, and has a logical risk-based explanation for why the premium should be expected to persist in the future. And importantly, the risks of reinsurance have been uncorrelated to the economic cycle risks of stocks and inflation, and the credit risks of bonds. Stock market crashes don’t cause earthquakes, hurricanes or other natural disasters. The reverse is also generally true – natural disasters do not cause bear markets in either stocks or bonds. The combination of the lack of correlation and potential for equity-like returns results in a more efficient portfolio, specifically one with a higher Sharpe ratio (a higher return for each unit of risk).
Of course, the expected (not guaranteed) reinsurance risk premium is compensation for accepting the risk that reinsurance will experience extended periods of poor performance – as was the case from 2017 to 2019 for reinsurance funds that invested in quota shares (pro-rata co-investments of the books of business of reinsurers), though not for catastrophe- (“cat-”) bond funds. However, this is no different for any risk assets. For example, the S&P 500 has experienced three periods of at least 13 years when it underperformed riskless one-month Treasury bills. And value stocks experienced their largest drawdown in history from 2016-2020. As another example, gold (which is supposed to be a hedge against inflation) lost almost 90% of its real value over the period January 1980-March 2002. Growth stocks, large stocks, small stocks, international stocks, emerging markets, safe Treasury bonds and real estate have all experienced long periods of underperformance. That’s why investors demand a risk premium! In other words, long periods of underperformance are not a reason to avoid an asset class but a reason investors should construct highly diversified portfolios – reducing the risk that all or most of their “eggs” are in the wrong basket at the wrong time. Most investors are unaware that a traditional 60% stock/40% bond portfolio has about 90% of its risk in market equities, not 60%. The reason is that stocks are much riskier than bonds. That is why institutional investors create much more diversified portfolios. For example, endowments with more than $1 billion had 48% of their holdings in alternatives.