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Typically, we view insurance not as an investment, but as tool to protect assets or replace income. However, investing in one type of insurance, called reinsurance, is becoming increasingly popular. It even might be considered an asset class all of its own.
Catastrophe reinsurance is purchased by insurance companies to help cover the cost of payouts due to natural disasters like storms, floods, earthquakes, and wildfires. Reinsurance investors absorb an insurance company’s losses when those losses exceed a certain cap. This helps the company manage its exposure to catastrophic risks while being able to write more business.
For investors, catastrophe reinsurance profits are not tied to the economy, interest rates, business cycles, or politics. They are tied only to natural disasters. This lack of correlation to normal financial market influences is what makes it an attractive asset class.
Investors in catastrophe reinsurance make money in two ways. The first is by making short-term deals to protect an insurance company through aptly named catastrophe bonds (cat bonds). Unlike corporate bonds, the money must sit in T-bills in a trust (rather than being used by the insurer) and the principal does not have to be repaid if the company’s natural disaster losses exceed certain thresholds. For this risk, the bond holder receives an interest rate that can be three or four times the market rate of corporate bonds. Successful cat bond investors make money on the yields being higher than the long-term loss rate and relying on diversification and an index-like approach to manage unnecessary losses. Since 2002, the cat bond market has had no down years and an average return of 6.2%.
The second way investors make money is by sharing a slice of the reinsurer’s risk quota share contract. Investors may take 10% of the risk of a natural disaster and in turn receive 10% of the premium from a pool of reinsurance contracts. The investor and reinsurer make money by investing the premiums and on successful underwriting (premiums greater than claims). Since 1993, quota shares have shown five years of losses and 22 years of gains, with an average return of 11.2%.
The reinsurance business has a reputation as boring and sleepy. It makes money only on good underwriting and yields on investments. This asset class is not suited for hedge funds or private equity looking for “fast money.”
You might wonder why, in this time of climate change, anyone would want to insure property against natural disasters. All politics aside, those in the industry tell me that the anticipated increases in frequency of hurricanes from climate change simply have not developed. Greg Richardson of TransRe, speaking at a recent conference on reinsurance hosted by Stone Ridge, told us that the past 150 years shows no increase in hurricane frequency and climate change isn’t even in the top five hurricane risk factors.
It is true that the financial damage caused by hurricanes and wildfires is steadily increasing. This is mostly because of higher values and increased building nearer the sea, rivers, and forests. Industry insiders say the “media hype” on climate change is helping to drive up the rates on property reinsurance, which actually bolsters profits.
The potential benefits of investing in reinsurance are:
- Stocks, bonds, real estate, commodities, and politics don’t cause natural disasters.
- Premiums increase and underwriting tightens to adapt to risks.
- Reinsurers must make money, or the coverage simply won’t exist for insurers to expand or share their risk.
There’s one final “feel-good” benefit to investing in reinsurance as part of a diversified portfolio. It’s the only asset class where your investment losses go to help people rebuild after natural disasters.