When the World Becomes Riskier: Investing in Companies That Turn Risk into Return
As the Atlantic hurricane season enters its most active weeks and the news fills with storm systems forming over the Caribbean Sea, there is a category of companies watching the situation with professional attention but without fear. These are the large reinsurance companies, the businesses that in effect organise the distribution of risk for the global insurance sector. For them, an active hurricane season is not a nightmare scenario but the very reason their business model exists.
That sounds paradoxical. How can a company that has to pay out large claims when hurricanes destroy homes make a profit? The answer lies in the difference between understanding risk and fearing it.
What reinsurance actually is
When an insurance company writes a policy for a home or a business, it takes on a risk. If enough damage occurs within a short space of time, think of a major hurricane striking thousands of homes, the total loss can far exceed the financial capacity of a single insurer. To spread that risk, the insurer buys insurance of its own from a reinsurer: a contract under which the reinsurer assumes part of the excess loss in exchange for a share of the premium income.
Reinsurance has existed for centuries. Lloyd's of London, founded in a coffee house in the seventeenth century, was one of the earliest forms of risk-sharing for shipping. The principles have remained the same ever since: whoever takes on risk that they understand and have priced correctly can earn from it structurally. Whoever takes on risk that they do not understand, or have priced wrongly, loses.
The hard market: when prices rise after heavy losses
The reinsurance market moves in cycles. After a period of relatively few catastrophic losses, premiums fall because more capital flows into the market in search of those returns. After a period of heavy losses, such as major hurricanes or wildfires, capital and participants leave the market, premiums rise to compensate for the higher expected damage, and policy terms tighten. Practitioners call this a hard market.
In a hard market, the most disciplined players hold the strongest competitive advantage. They have the models, the experience and the financial strength to continue while others step back. They can deploy capital at premiums that genuinely compensate for the underlying risk. And when the losses eventually arrive, they have the reserves and the structure to pay and carry on, while less solid competitors stumble.
Understanding risk as a source of return
What sets the best reinsurance companies apart is that their competitive advantage does not come from avoiding risk, but from understanding it better than anyone else. Whoever can model a hurricane, an earthquake or an industrial fire more accurately can ask exactly the right price. Priced too high and the client goes to a competitor. Priced too low and money is lost when things go wrong. Priced exactly right, year after year, produces structural profit.
That analytical sharpness has been built up over decades. The storm models the best reinsurers use are the result of decades of data, scientific research, loss analysis following major events, and continuous refinement of the assumptions underlying the pricing. It is not a secret that anyone can copy. It is expertise compounded over a long period, much like a proven track record in any other complex discipline.
What this means for the investor
For the long-term investor, reinsurance companies offer an interesting characteristic: their profits are largely independent of the economic cycle. Whether the economy grows or contracts, people continue to insure their homes, businesses and ships. And those insurers continue to buy reinsurance. The profitability of a good reinsurer depends on the catastrophe year, the quality of its pricing and the performance of its investment portfolio, not on the growth of gross domestic product.
That makes reinsurance a valuable addition to a diversified portfolio. In years when markets are favourable, the reinsurer contributes through investment income and solid underwriting profit. In years with major catastrophes, the reinsurer pays claims but then raises its premiums for the following period, so that profits in the years thereafter turn out structurally higher. That asymmetry, in which poor years are followed by better ones, is an attractive feature for the patient investor.
Anyone who would like to know more about how we select this kind of company, and the role they can play in a diversified investment portfolio for private or institutional clients, is warmly welcome to get in touch with us.
Disclaimer. This article is published by Lunar Asset Management N.V. for general informational and educational purposes only. It reflects the personal views of the author at the time of writing and does not constitute investment advice, a recommendation, an offer, or a solicitation to buy or sell any security or financial instrument. References to specific companies are illustrative and should not be interpreted as buy or sell recommendations. Investing involves risk, including the possible loss of principal. Past performance is not a reliable indicator of future results. Readers should consult a qualified financial advisor before making any investment decision based on their personal circumstances. Lunar Asset Management N.V. is supervised by the Centrale Bank van Curaçao en Sint Maarten (CBCS).
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