Investment strategiesUnderstanding reinsurance and its use in your portfolio

Investors seeking broader diversification in their portfolios may want to consider the potential benefits of reinsurance. From an investment perspective, reinsurance serves primarily as an income-producing asset. Investors pool money in a reinsurance fund that, in turn, provides coverage to back the risk carried by other insurers. Those insurers pay premiums for the coverage, generating an income stream for investors.

The current environment, marked by notable catastrophic events (such as hurricanes and wildfires) that result in insurable losses, can actually work to an investor’s advantage. Reinsurance pools are able to apply higher premiums to the companies they insure in return for taking on the added risk that exists today. This can result in highly competitive income streams for investors.

Reinsurance also plays a role as a non-correlated asset in a diversified portfolio. “Unlike other fixed income assets, economic growth, interest rates, and investor sentiment aren’t primary drivers of reinsurance fund performance,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management.

What are the opportunities created by reinsurance as an asset class and how can it potentially play a role in your own portfolio?

What is reinsurance?

The concept of reinsurance is simple – it’s insurance for insurance companies.

Insurance companies that provide coverage such as property insurance often seek to transfer some of their financial risk to a reinsurance company to protect against large losses in the event of a major natural disaster that results in insurable claims. The insurance companies, in turn, are charged premiums as a tradeoff for the risk assumed by the reinsurer and investors. These premiums generate income that is ultimately directed to investors.

“Insurable losses are unpredictable from year-to-year, but we know the economics of reinsurance premiums are compelling.”

- Bill Merz, head of capital markets research at U.S. Bank Wealth Management

“Essentially, investors are rewarded for a willingness to take on event-based risks that may, in some instances, require payouts to the insurance companies to cover losses,” says Natalie Burke, senior research analyst at U.S. Bank Wealth Management. “The key is that premiums are priced with the goal of providing investors with a competitive return, even in the event the reinsurer needs to pay claims to cover insured losses.”

Income paid to investors is generated by the reinsurance premiums plus interest income generated by those premiums when invested in high-quality instruments like U.S. Treasury securities.

If, over the term of the security, no trigger event occurs (such as a major hurricane that creates significant insured losses), all principal is returned to investors. However, if a trigger event results in insurable losses, the investor’s principal return will be reduced or even eliminated. It does not affect income payments, since they are primarily generated from premiums charged.

Overall, positive returns are expected when premiums received are in excess of total claims paid out.

Insurance-linked securities and reinsurance

Reinsurance is often funded by investors who purchase insurance-linked securities (ILS). ILS is an umbrella term for financial instruments designed to transfer insurance risks to the financial market, including reinsurance. Unlike traditional investments, ILS essentially put investors in the insurance business. “Your total returns are based on premiums you receive that are intended to cover insured losses while still generating a competitive income stream,” says Merz.

There are various types of insurance-linked securities. Among the most prominent are catastrophe bonds (also known as cat bonds), designed to cover losses from specific, low-frequency, high-severity events such as hurricanes and other natural disasters. Some ILS are considered private, non-tradeable instruments such as quota shares, in which investors purchase a share of an insurance company’s book of business. Different forms of ILS offer different risk exposures and degrees of liquidity.

Burke notes that reinsurance has been a profitable sector over time despite years when significant insurable losses occurred. “Premium pricing adjusts to compensate for new risks or changes in market dynamics,” says Burke. “Experienced catastrophe modeling firms have built models based on hundreds of years of data analytics, and those models are used by reinsurers and funds to determine premium pricing. This enables more effective underwriting of current and evolving risks.”

Although some investors may be concerned that natural disasters such as hurricanes and wildfires are more commonplace, such trends are factored into reinsurance premiums. “Premiums in the catastrophe bond market (as of late summer 2023) pay investors income in the range of 15%,” says Merz. “While reinsurers have more commonly been required to cover losses in recent years, the income stream remains compelling even if we assume average or above-average insurable losses.” This reflects the ability of reinsurers to adjust premiums in response to changing conditions. “Insurable losses are unpredictable from year-to-year, but we know the economics of reinsurance premiums are compelling,” says Merz.

Notably, given that natural disasters seem to be increasing, Merz says it actually creates more attractive opportunities. “Some investors feel the urge to shy away from this segment of the market after large catastrophic events, but insurance premiums (which translate to higher income received by investors) often rise soon after those large events to help insurers recoup losses, which can make the asset class even more compelling.”

Burke adds, “From a social perspective, investors in reinsurance help communities rebuild, typically with more resilient structures after a natural disaster, which has a positive impact.”

Insurance-linked securities diversification benefits

For investors with a long time horizon, a key attraction of ILS is that their performance is not highly correlated with that of other investable assets. Stocks and bonds often respond to economic developments and corporate earnings growth, along with investor sentiment. ILS performance depends on insurance premiums (driven by quantitative and statistical models deployed by insurance companies) minus insured losses (typically driven by the occurrence and severity of natural disasters). Significant differences in return drivers compared to stocks and bonds creates return streams that move differently over time, thus presenting the opportunity for more consistent portfolio performance on a year-to-year basis.

Correlation measures the extent to which asset prices move in the same direction. For example, two “perfectly” correlated asset classes, which experience the same performance, would have a correlation of 100%. Asset classes that perform in perfect contrast to each other would theoretically have a correlation of -100%, and investments with no consistent relationship have a correlation of 0%.

Investors seeking to benefit from diversification search for asset classes with low correlations with one another (along with strong return potential). Lower correlation indicates greater diversification value. As the table below demonstrates, the historical monthly correlation between catastrophe bonds and other major asset classes is low.

Source: Bloomberg Data, July 31, 2008 to July 31, 2023.

While investors in reinsurance products must accept a risk of insured losses in return for the premiums collected, Merz says “we believe this asset class offers attractive risk-adjusted returns and can be an effective complement to a long-term investor’s portfolio.”

Over the long-term, volatility of catastrophe bonds is similar to those of investment grade bonds (represented below by the Bloomberg U.S. Aggregate Bond Index). While volatility can be greater over shorter periods of time, over longer time horizons, catastrophe bonds measure up favorably to other prominent asset classes.

Source: Morningstar, August 1, 2008 to July 31, 2023.

While annual results may vary from the data shown here, over time, reinsurance products have demonstrated an ability to generate competitive returns while providing a valuable level of portfolio diversification.

Consider reinsurance in the context of your broader plan

It’s important to recognize that ILS such as reinsurance are suited for long-term investors seeking the potential for attractive returns in a vehicle that offers important diversification benefits to help meet well defined investment objectives.

Additionally, they’ve historically been unavailable to most individual investors and are not readily accessible through most investment platforms. Experienced investment consultants can help you determine if reinsurance is a good fit for your portfolio. If it’s decided that reinsurance is an appropriate investment option, it should only represent a small portion of your portfolio mix (in the range of 5%) within your fixed income allocation.

Learn how Ascent works with clients with complicated investment scenarios.

The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index and is representative of the U.S. small capitalization securities market. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe and is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. The Bloomberg U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. The Bloomberg U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds. The ICE BofAML U.S. High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. The Swiss Re Global Cat Bond Total Return Index tracks the aggregate performance of all U.S. dollar-denominated, euros and Japanese yen-denominated catastrophe bonds, capturing all ratings, perils and triggers.

Reinsurance allocations made to Insurance-linked securities (ILS) are financial instruments whose performance is determined by insurance loss events primarily driven by weather-related and other natural catastrophes (such as hurricanes and earthquakes). These events are typically low-frequency but high-severity occurrences. In exchange for higher potential yields, investors assume the risk of a disaster during the life of their bonds, with their principal used to cover damage caused if the catastrophe is severe enough.