Examining The Performance Of Stone Ridge’s Reinsurance Premium Interval Fund

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Traditionally, portfolios have been dominated by public equities and bonds. The risks associated with the equity portion of those portfolios are typically dominated by exposure to market beta. And because equities are riskier than bonds, beta’s share of the risk in a traditional 60% equity/40% bond portfolio is much greater than 60%. In fact, it can be 85% or more (the shorter the bond duration, the greater the risk share of market beta).

To provide a vehicle that provided further diversification benefits, in December 2013 Stone Ridge launched its High Yield Reinsurance Risk Premium Fund (SRRIX), one of the first 1940 Act funds to invest primarily in quota share agreements with leading reinsurance companies. Reinsurers are paid a premium in exchange for providing the valuable service of protecting insurers against rare but catastrophic events that might create enough claims to bankrupt them. The fund’s target allocation is 80%-90% to quota shares (risk-sharing contracts with reinsurers) and 10%-20% to liquid catastrophe bonds. The fund has a total expense ratio of 2.42%.

The following table shows SRRIX’s risk allocation and diversification by geographical region and peril as of December 31, 2023.

I will start by reviewing the fund’s performance in isolation.

Performance

The quarterly performance of the fund over the last 10 years is shown here:

Over the first three years, the fund provided returns within expectations. However, in four of the next five years, the fund not only underperformed expectations, but it produced losses. Unfortunately, that led many investors subject to recency bias to flee, and assets under management fell from about $5 billion to about $1 billion. In the section below, I’ll discuss why this failure to maintain discipline was caused by a failure to understand that risk assets have what I call a “self-healing” mechanism.    

The table below shows the annualized return, volatility (standard deviation), and Sharpe ratio (risk-adjusted return) for SRRIX as well as those of Vanguard’s Total Stock Market ETF (VTI), Vanguard’s Total International Stock ETF (VXUS), and Vanguard’s Total Bond ETF (BND). Data is updated through December 2023.

Portfolio

Annualized Return (%)

Annual Standard Deviation (%)

Sharpe Ratio

Maximum Drawdown (%)

VTI

11.4

15.6

0.69

-24.8

VXUS

4.1

15.3

0.26

-27.8

BND

1.8

4.9

0.13

-17.3

SRRIX

4.4

8.6

0.41

-24.7

Source: Morningstar, Bloomberg. Standard Deviation and Sharpe ratio are annualized based on monthly returns from January 2014 through December 2023.

When considering volatility, it is important to recognize that because of the seasonal nature of the risks, reinsurance returns within a year are unique. Within any given year, two averages compete in the volatility calculation when using monthly data – an average return during hurricane season and a different average return outside of hurricane season. When annual returns are used instead of annualized monthly returns (the common practice), there isn’t that same noise. Based on 10 calendar years of returns, SRRIX now appears to have higher volatility and lower Sharpe ratio. Because of the difference, also shown are the returns using annual figures.

Portfolio

Annualized Return (%)

Annual Standard Deviation (%)

Sharpe ratio

Maximum Drawdown (%)

VTI

11.4

16.1

0.71

-24.8

VXUS

4.1

14.7

0.26

-27.8

BND

1.8

6.3

0.11

-17.3

SRRIX

4.4

15.7

0.28

-24.7

Source: Morningstar, Bloomberg. Standard Deviation and Sharpe ratio are based on annual returns from 2014 through 2023.

While I reviewed the fund’s performance in isolation, sophisticated investors know that the right way to view performance is by how the addition of investment impacts the risk and return of the entire portfolio. A fund can add value beyond its individual return contribution by providing unique risk exposures with low correlations to the other portfolio assets. The table below shows the correlation of annual returns for the four funds listed above. Although there are only 10 calendar years of returns and thus only 10 data points for the correlation, the correlation numbers are similar if we calculate them using monthly or quarterly returns. Note the close-to-zero correlations of SRRIX to the stock and bond indices.

 

VTI

VXUS

BND

SRRIX

VTI

1.00

0.88

0.79

0.11

VXUS

0.88

1.00

0.65

0.00

BND

0.79

0.65

1.00

0.17

SRRIX

0.11

0.00

0.17

1.00

Source: Morningstar, Bloomberg. Correlation based on annual returns from 2014 through 2023.

Every investor should be interested in including in their portfolio a fund with a Sharpe ratio of either 0.28 or 0.41 with a very low correlation to both traditional stocks and bonds.

SRRIX exhibited a very low correlation to each of the three core funds – providing evidence of the diversification potential benefit of adding SRRIX to a balanced portfolio of stocks and bonds. I cannot provide examples to help with that; the SEC marketing rules have very strict requirements for the presentation of backtested hypothetical portfolios because they can be abused by cherry-picking data by funds and advisors who are marketing versus providing educational information.

Reinsurance has a self-healing mechanism 

A self-healing mechanism occurs after periods of losses, not just with insurance but with all strategies that involve risky assets. When losses occurred due to the historic fires in California, not only did premiums rise dramatically, but underwriting standards tightened (such that you could not buy insurance if you had trees within 30 feet of your home, and all brush had to be cleared for another 30 feet) and deductibles increased significantly (reducing the risk of losses). Destruction from hurricanes in Florida caused the same combination of events to occur (rising premiums and deductibles, and tougher underwriting standards). 

This effect can be seen by reviewing SRRIX’s performance. After three strong returns in its first three years (2014-16) came a string of losses. SRRIX lost -11.4% in 2017, -6.1% in 2018 and -4.5% in 2019 due to more hurricanes, wildfires and typhoons than expected. At its inception, the net of expenses “no loss return” (a yield equivalent of the fund if there were no natural catastrophes in a year, which is unrealistic) was about 13%. A more realistic modeled (50th percentile) return to investors was about 7%. Due to the losses, the resulting fleeing of capital, the rise in premiums and an increase in deductibles, the no-loss and the modeled returns have been persistently rising. By 2023 the no-loss return for SRRIX was over 30%, and the 50th percentile modeled return was over 20%.

The increase in premiums and deductibles along with tightened underwriting standards meant that not only was the expected return now higher, but the risk of losses was reduced. Of course, just as low equity valuations don’t eliminate the risk of losses, the worst one-in-25-year model estimated a loss of about -20%, and worse losses are possible. In other words, there is no risk premium without risk. Those events are what led to the spectacular returns to reinsurance investments in 2023, with SRRIX returning 44.6%. Unfortunately, many investors had fled and did not earn those high returns. Those investors may have failed to understand that because premiums adjust on an annual basis, they need to have a long horizon to realize the true economics of the asset class.

The trend toward rising premiums and tightened underwriting standards has continued into 2024, with the expected return (the mean of a wide potential dispersion of outcomes) once again in the low 20s.

Investor takeaways

Investors willing to accept the tracking variance risk (the risk of underperforming traditional assets) of investing in nontraditional assets that have historically documented risk premiums that have been persistent, pervasive, robust, and survive implementation costs, and have logical explanations for why the premium should persist, can improve the efficiency of their portfolio.


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Disclosure: For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based on third party data and ...

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Dick Kaplan 8 months ago Member's comment

Excelllent read, thank you.