December 09, 2019
Recency Bias Erodes Discipline and Destroys Investor Returns: Reconsidering Reinsurance
Among the errors discussed in my book “Investment Mistakes Even Smart Investors Make and How to Avoid Them” is one called “recency.” Recency bias is the tendency to overweight recent events/trends and ignore long-term evidence. This leads investors to buy after periods of strong performance—when valuations are higher and expected returns are now lower—and sell after periods of poor performance—when prices are lower and expected returns are now higher. Buying high and selling low is not exactly a prescription for successful investing. Yet, it is the way many individuals invest. What disciplined investors do is the opposite—rebalance to maintain their well-thought-out allocation to risk assets.
Sadly, while most investors consider three years a long time to judge performance, and five years a very long time, wise investors know that all risk assets go through much longer periods of underperformance. If you doubt that, just consider that the S&P 500 Index underperformed totally riskless one-month Treasury bills over the 13-year period ending 2012, the 15-year period ending 1943, and the 17-year period ending 1982. Of course, over the succeeding periods, they went on to produce spectacular returns—returns that were only earned if you happened to have stayed the course.
Just as it is important to stay the course when investing in the S&P 500 Index, it’s also important to stay the course to earn the reinsurance risk premium. Reinsurance has been a profitable industry for over a hundred years, has returns which are uncorrelated to traditional assets, and has adapted to increases in risk by increasing premiums. In other words, just as periods of poor stock returns usually result in lower valuations and thus higher expected future returns, losses in reinsurance lead to higher premiums and higher expected future returns.
2017, 2018 and 2019 have been difficult years for the industry. Note that in the three years prior to 2017, the fund returned 11.0 percent, 7.9 percent and 6.4 percent, respectively. It’s also important to note that before 2017 no Category 3 or greater hurricane had made landfall in the United States since 2005. More importantly, there is no evidence of any long-term trend in hurricane landfalls.
Regarding the recent losses, in response, reinsurance premiums have increased dramatically. Abandoning a well-thought-out plan of investing in an asset with a long history of profitability, with the added benefit of returns that are uncorrelated with stock and bond returns, is to allow yourself to be subject to the mistake of recency.
To help you avoid that mistake, I’ll review the case for investing in the asset class. To begin, our investment process starts with identifying a unique/independent (uncorrelated) risk that has demonstrated a persistent premium over a long period of time and has been pervasive around the globe. It must also have an intuitive risk- or behavioral-based explanation for why we should have confidence that the premium is likely to persist in the future. And it must be implementable, surviving transactions costs.
Intuitive, Unique and Pervasive
Globally, reinsurers have been around for more than a hundred years. They have survived through two world wars, recessions, depressions and massive, unexpected natural disasters. Hurricanes and earthquakes, the two main risks of the fund, are intuitively unrelated to stocks and bonds. Finally, if you have a mortgage on your home, you must have homeowner’s insurance—you can’t decide to go uninsured because you don’t like the price.
To access this asset class, my firm, Buckingham Strategic Wealth, recommends the Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX). The type of reinsurance underlying SRRIX has been profitable for 21 of the past 25 years, with a historical average return of 6 to 8 percent over the risk-free rate. Of course, this doesn’t mean that there are no down years or that we cannot experience two or more years in a row of poor returns. For example, while the S&P 500 did not experience two consecutive years of losses over the 25-year period 1975 through 1999, it did go on to have three negative years in a row starting in 2000. Sadly, recency causes investors to question the premium going forward. With reinsurance, we’ve seen this “movie” before: back-to-back loss years that made people question the risk premium. Most people remember Hurricane Katrina in 2005. Far fewer remember that there were two more major hurricanes that year: Rita and Wilma. Fewer still remember that there were four significant hurricanes the year before, in 2004: Charley, Frances, Ivan and Jean. That’s a total of seven significant hurricanes in just two years.
The Wall Street Journal headline from June 6, 2006, read “Are Hurricanes Uninsurable?” There was talk that this was the new norm because climate change was causing more frequent and more extreme hurricanes. This period was followed by a decade-long hurricane drought, the longest in recorded history—along with the most profitable five years for reinsurers in decades.
Premiums Adjust to Loss Events
In response to the losses of the last three years, reinsurers have been able to substantially increase premiums. This demonstrates that climate change does not mean that the size of the risk premium has diminished—insurance products adjust rates to compensate for changes in risk, whether it is auto, life, market, or natural catastrophe insurance. For example, loss-impacted reinsurance for wildfires is priced up to 60 percent higher. And there has been about a 20 percent increase for hurricane-affected Florida contracts, along with 20 percent hikes for Japan typhoon exposures. The bottom line is that the losses over the past few years has resulted in a significant increase in premiums.
Resisting recency bias is the key to earning the premiums available from all risk assets, including reinsurance. Wise investing, as Warren Buffett noted, is simple, but not easy. It’s not easy because of all the behavioral biases investors must overcome, with recency among the most powerful. It’s tempting to sell out of an investment that has suffered losses because it’s easy to think that losses will keep happening. It’s even more tempting when the media keeps telling us that climate change is responsible for the losses (as it did after 2004/2005, which was followed by the most profitable years ever for the industry). But it is not a prudent strategy to decide to get out of reinsurance immediately after losses—you’ve taken the losses but haven’t gotten the benefit of increased premiums. Because premiums adjust on an annual basis, investors need to have a long horizon to realize the true economics of the asset class.
As with any long-term risk premium, the evidence demonstrates that it’s highly unlikely you can time entry and exits because it’s simply not possible to know when losses will occur. Getting out of reinsurance now would be the classic “buy high/sell low” strategy—like exiting equities in March 2009 or exiting value stocks in 1999.
It’s not easy to help investors stay the course, but doing so is a big part of the value that advisors provide.
(Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge in the construction of client portfolios.)
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