Storm Warning: The Perils of Reinsurance
Plus Q2 2017 Market Report

Insurers are on the hook when a hurricane slams into the coast of Florida, a tsunami hits Japan, a drought-stoked fire consumes large swaths of Northern California, or a Malaysian airline goes missing. Backing the insurers is a nearly $600 billion reinsurance juggernaut that’s also on the hook. As new investment money pours into this sector, some industry analysts worry that a storm is brewing with potentially devastating consequences. Could this be the next banking meltdown? After a review of Q2 2017 market data, we take a closer look at the reinsurance market.

World Asset Classes

Looking at broad market indices, non-US developed markets (5.78%) and emerging markets (6.27%) recorded similar positive returns, outperforming the US (3.09%) during the quarter. The value effect was negative in the US, non-US, and emerging markets. Small caps outperformed large caps in non-US developed markets but underperformed in the US and emerging markets.   

US Stocks

The broad US equity market posted positive returns for the quarter but underperformed both non-US developed and emerging markets. Value underperformed growth indices in the US across all size ranges. Small caps in the US underperformed large caps.

International Developed Stocks

In US dollar terms, developed markets outperformed the US equity market and had similar performance to emerging markets indices during the quarter. Looking at broad market indices, the value effect was negative across all size ranges in non-US developed markets. Small caps outperformed large caps in non-US developed markets.

Emerging Markets Stocks

In US dollar terms, emerging markets indices outperformed the US and recorded similar performance to developed markets outside the US. Looking at broad market indices, the value effect was negative across all size ranges in emerging markets. Small caps underperformed large caps in emerging markets.

Select Country Performance

In US dollar terms, Austria (18.39%) and Denmark (15.14%) recorded the highest country performance in developed markets, while Australia (-1.43%) and Canada (0.48%) posted the lowest returns for the quarter. In emerging markets, Greece (34.11%), Hungary (18.88%), and Turkey (18.88%) posted the highest country returns, while Qatar (-11.23%) and Russia (-9.87%) had the lowest performance. 

Select Currency Performance vs. US Dollar

Most non-US developed currencies appreciated against the US dollar during the quarter, with the Danish krone and the euro experiencing the biggest gains. Emerging markets currencies were mixed vs. the US dollar. The Czech koruna appreciated by more than 10%, while the Russian ruble, Brazilian real, and Columbian peso depreciated by more than 4%.

Real Estate Investment Trusts (REITs)

Non-US real estate investment trusts outperformed US REITs.

Commodities

The Bloomberg Commodity Index Total Return declined -3.00% during the second quarter. The livestock and grains complexes led quarterly performance, with lean hogs returning 14.44%, live cattle 8.59%, wheat (Chicago) 15.95%, and wheat (Kansas) 17.82%. Softs was the worst-performing complex, with sugar and coffee declining -18.76% and -12.79%, respectively. Cotton also experienced a decline, losing -9.44%. 

 Fixed Income

Interest rates were mixed across the US fixed income market during the second quarter. The yield on the 5-year Treasury note decreased 4 basis points (bps) to 1.89%. The yield on the 10-year Treasury note decreased 9 bps to 2.31%. The 30-year Treasury bond yield decreased 18 bps to finish at 2.84%. The yield on the 1-year Treasury bill rose 21 bps to 1.24%, and the 2-year Treasury note yield rose 11 bps to 1.38%. The yield on the 3-month Treasury bill climbed 27 bps to 1.03%, while the 6-month Treasury bill yield increased 23 bps to 1.14%. In terms of total returns, short-term corporate bonds gained 0.59% and intermediate corporates gained 1.49%. Short-term municipal bonds gained 0.56%, while intermediate muni bonds returned 1.97%. Revenue bonds gained 2.19%, outperforming general obligation bonds by 39 bps.

Feature Article
Are CATs A Catastrophe in the Making?

If there’s one thing the financial industry excels at, it’s packaging and marketing new products with the lure of higher returns. That’s been especially true following the great financial crisis, when low yields increasingly turned advisors and their clients toward riskier corporate bonds and higher dividend-paying stocks. Enter the reinsurance industry, a once-staid business that’s a new darling of financial advisors.

Reinsurers do what the name implies: they insure big insurance companies against mega-losses caused by natural and man-made disasters including earthquakes, hurricanes, floods, aviation and shipping accidents, mortgage defaults, interest rate risk on annuities, cyber-crime related losses and more. 

The inflection point came in 1992, a brutally expensive year for reinsurers as Hurricane Andrew pummeled South Florida and Louisiana, leaving 65 fatalities and $65 billion in losses in its wake, resulting in a shortfall of reinsurance capital. This is when pension funds and hedge funds entered the picture, giving birth to the market for Insurance Linked Securities (ILS).

Equity Capital 

Insurance Linked Securities (ILS), are essentially financial instruments whose value is affected by an insured loss event. These instruments are sold to investors as so-called “sophisticated” portfolio diversifiers with returns “theoretically” uncorrelated to other asset classes. The market for these securities now stands at close to $80 billion. And the returns look attractive if you go back five or ten years. Diversification and high yields, what’s not to like? We’ll answer that in a moment. 

The best-known reinsurance products are catastrophe (CAT) bonds, in which an investor’s principal and pre-determined interest are returned at the end of a specified period (barring a disaster, in which all can be lost). CATS are just one variety of Alternative Risk Transfer (ART) products sold by market-makers who are carving up and packaging catastrophe risks in the same way subprime mortgages were carved up, packaged and sold by big banks. Meanwhile the market has expanded from pension and hedge funds to investment advisors and their clients. As you’d expect, much money exchanges hands along the way; liquid alternative risk funds are not inexpensive. 

The growth in the supply of reinsurance capital from non-traditional sources of coverage has some industry experts worried, including the authors (Jarzabkowski, Bednarek and Spee) of a three-year academic study on the global reinsurance industry published in Making a Market for Acts of God. They see parallels in the marketization of Insurance Linked Securities to the way collateralized debt obligations (CDOs) were linked to the subprime mortgages crisis that took down Lehman Brothers in 2008, causing rippling defaults. “As other financial industries have collapsed, in part through their reliance on inaccurate models, so, too, reinsurance places itself at risk of collapse,” they warn.

One reason is that insurance companies are now giant global firms that need reinsurance cover for only the most extreme tail of their catastrophic exposure. They are only too happy to hand off this risk to less savvy parts of the market, and it’s a safe bet that many cannot adequately assess the risk of their reinsurance investments. And now smaller investors are jumping on the bandwagon.

What could make this house of cards collapse? Perhaps a Magnitude 7 earthquake in pricey San Francisco. If the reinsurance market defaulted and collapsed after such an event, it would leave investors, banks, pension funds, hedge funds and a host of other players holding the bag. Insurance companies could be in danger of collapse without reinsurance funds, and in a worst-case scenario disaster victim expecting payouts would be left high and dry.

The Big Bezzle

In a 2016 Financial Times article, Satyajit Das outlined many ways in which the financial industry has lured investors with higher-risk products during the low-yield cycle that began in 2009. He cites John Kenneth Galbraith in The Great Crash, 1929, who coined the expression “bezzled” to mean “an often lengthy time period between the crime and its discovery. The person robbed continues to feel richer as he does not know of his loss, at least yet. In favorable markets, bezzle increases, only being exposed [when conditions change].” 

This describes how reinsurance investors are likely to feel when a huge disaster strikes. Greed and the desire to outperform the market drive big money managers and certain financial advisors, along with client capital they attract, to embrace questionable schemes. The promise of high-priced advice is always similar: “We’re smart, we’re ahead of the game, there’s limited availability, this is a proven strategy, all the big money is in and you should be too.” Let the bezzle begin. 

Now let’s dissect a few of the marketing claims around CAT funds. 

CATs are an excellent diversifier. 

Are CATs a truly independent source of return? It’s theoretical. Earthquakes and hurricanes are independent of normally occurring economic cycles and financial crises. But once the risk of natural disaster is transferred into a tradeable deal, its value may become tied to financial markets in unexpected ways.

In the market meltdown of 2007, CAT bonds were not immune to the financial crisis. While they didn’t suffer losses as great as other investments, their returns correlated with financial markets in part because assets used as collateral in these trust accounts proved to be of lesser than expected quality. Furthermore, counterparties in swap agreements (put in place in an effort to immunize collateral asset returns from market fluctuations) were exposed to considerable credit risk or even defaulted during the crisis. 

Post 2009, new collateral structures have increasingly disconnected CATs from their underlying assets, masking risks due to poor modeling and misassumptions. Again, the capital providers behind these securities are not insurance or reinsurance experts, and the products being created are complex. Who can decipher the real risk of these collateralized products, or their relationship to the market they represent? 

CAT yields are attractive. 

If one goes back to 2002 CAT yields exceeding 8% or higher could be had, but with money pouring in today, yields have plunged to under 4%. The trailing 3-year return net of fees for the Swiss Re Global CAT Bond Index is barely different than the return on 5-year Treasuries. That makes recent CAT bond returns no better than government securities but with far greater risk. 

Our Advice: Steer Clear of CATs and other Reinsurance products

Many of the biggest players in the asset management industry who were active in the market for Insurance Linked Securities have either exited the business or stepped away from underwriting new commitments in recent years. These names include AQR Capital, Warren Buffett, John Paulson, and George Soros. That tells you something (they’re not making enough money). 

Also bear in mind that we’ve entered an era of global warming where the risk of catastrophic natural events, earthquakes, tsunamis and avalanches is higher than ever before. Rising temperatures are likely to lead to more severe floods, hurricanes, tornadoes, long-term droughts and wildfires. To invest in CATs is to invest in models that are still being developed. According to a Swiss RE catastrophe database, 2016 witnessed 191 natural events, a record number with cumulative insured losses totaling over $80 billion USD. 

But there’s a bigger issue here. Is it really necessary for investment advisors to expose your wealth to “nature’s casino,” as Michael Lewis called the risk-investment playground in a 2007 New York Times article? “Catastrophe risk is fundamentally different from normal risk, he writes. “It deals with events so rare that experience doesn’t help you much to predict them….You don’t know what you don’t know. The further out into the tail you go—the less probable the event—the greater the uncertainty.”

That doesn’t stop liquid alternative asset managers like Stone Ridge from writing this in an investor newsletter: “Radically diversifying risk holding may represent the single biggest, one-way force for good that finance will deliver for the world in our lifetime.” The letter goes on to claim a cultural mantle of “work hard, work deep…” including deep due diligence practices in risk assessment.

I’m sorry, but no matter what your vision, no matter how hard or deep you work, you still don’t know what you don’t know. And it’s the “unknown unknowns” that can kill you.

For most investors, it’s hard enough to focus on what we do know, sticking to a long-term plan with discipline and fortitude through good times and bad. My advice: continue to invest in a proven strategy, stay diversified, and if you’re interested in CATs, talk with me first. 

Do you have questions or comments? Contact me. I am here to help.