Reinsurance risk is clearly diversifying against pension funds’ core financial market risks. But Martin Steward writes on the importance of defining objectives beyond simple diversification when investing in this asset class.
You may have heard that Warren Buffett has bought a big chunk of Heinz. Berkshire Hathaway’s stake consisted of about $4bn in ordinary shares yielding 2.8% and $8bn in preference shares yielding an astonishing 9%. Even without dividend growth, that amounts to 7% yield – almost 100 basis points in excess of the average US high yield bond.
Much discussion has focused on whether Buffett had finally been caught overpaying for something. Less discussed was the cost of Berkshire Hathaway’s own financing. Even if that were the US Treasury Bill rate of 0.4%, we would still be looking at a 660 basis point spread. But we aren’t. An important source of leverage for Berkshire, as described in a recent paper by AQR Capital Management’s Andrea Frazzini, David Kabiller and Lasse Pedersen, comes from the loanlike practice of collecting insurance premiums up front and paying claims later. Since 1976, the authors estimate the cost of that loan and other financing has been, on average, just 2.2%. But since 2006, that cost has actually been negative – on average, -4%. That makes the Heinz deal’s spread over Treasuries, high yield or the equity risk premium look even more impressive.
This is interesting for pension funds that are also taking, or considering, reinsurance risk. The case usually revolves around the obvious diversification benefits – but that clearly has nothing to do with why Warren Buffett assumes this kind of risk. Should investors look beyond simple diversification and consider the other characteristics that reinsurance risk brings to their portfolios?
While pension funds do not need the cheap leverage, they certainly are searching for yield in our low-rate world – and reinsurance risk lends itself well to being structured as an income-generating, yield investment.
Reinsurers’ premiums can be received up-front (as they are by Berkshire Hathaway), quarterly or semi-annually. Direct, bespoke reinsurance contracts, which last one year, can be structured for income, but investors can also buy catastrophe bonds, which typically last for 3-5 years and pay a quarterly Libor-plus floating rate. The premium divided by the total notional at risk is called ‘Rate on Line’ (ROL) if you are in reinsurance but you can think of it as ‘yield’ if you are more into bonds.
“It’s a very fixed income-like asset class,” says Pete Drewienkiewicz, head of manager research at Redington. “You get paid a regular income for as long as something doesn’t go wrong, and when it does, you take a loss – it has the same asymmetric risk profile as credit.”
Ryan Bisch, alternatives boutique leader in Mercer’s Toronto office, agrees, and points out that, as investors increasingly blur the lines between fixed income and growth assets in more complex credit portfolios, more and more investments are being drawn out of the generic ‘alternatives’ bucket and into the relevant part of the broader portfolio.