Upcoming Trades: New Reinsurance Mutual Fund

Next week we are buying a fund called Stone Ridge Reinsurance Risk Premium Interval Fund (SRRIX) in most client portfolios. This fund invests in what are called Insurance Linked Securities (ILS). In this WJNotes, we explain some of the basics of reinsurance, how it fits into your portfolio, and how an interval fund works.

Reinsurers provide the valuable service of protecting homeowners and businesses against event-based risks, such as natural disasters and accidents. Typically, a primary insurance company will insure some peril up to a maximum loss, and the reinsurers will cover losses above that. For example, let’s say AIG insures Miami against storm surge damage, but only wants to be responsible for a maximum loss of $1 billion. AIG would then pay a reinsurance company (SwissRe for example) a premium to cover any losses above that threshold. If there are no losses over $1 billion, the reinsurer collects the full premium. If losses are greater than $1 billion, the reinsurer pays as agreed.

Stone Ridge partners with several different reinsurance companies primarily through private contracts called quota shares. Each quota share specifies the type of peril covered in a particular region, as well as what share of profits and losses each side participates in. One of the attractive qualities of Stone Ridge’s fund is that it invests in a diversified set of perils from all over the world. So even if there are losses from a Miami hurricane, the fund will only be partially exposed, and will continue to collect premiums from other quota shares such as Japanese earthquakes or European windstorms.

ILS funds have historically been attractive investments. The premiums earned by these securities generally compare with stock returns, while the volatility is considerably lower than stocks. Perhaps the most important feature of this fund is its lack of correlation with stocks or bonds. The returns of this fund do not depend on the success of the economy, nor what interest rates are doing. This is especially attractive since most investors’ portfolios are dominated by these two risks. There of course will be bad years when natural disasters are prevalent (think of this past year). In these years the fund will likely experiences losses, but after bad years, reinsurance companies increase premiums resulting in higher returns in following years. Therefore, now is an ideal time to invest in reinsurance.

Finally, this fund is an interval fund. Interval funds are simply mutual funds that limit when investors can buy and sell. SRRIX limits buys and sells to once per quarter. We don’t believe this restriction will impact our ability to manage the portfolio as we intend to hold the position for the long term and the fund will make up only a small portion of investor’s portfolios.

Because of the low volatility nature of the reinsurance type investments we will primarily be funding the purchase from bonds. Next week we will place trades to generate the cash to purchase the fund. In addition, we intend to rebalance portfolio at the beginning of next year to avoid generating any additional capital gains taxes this year.

Finally, you will see some cash build in your portfolio over the next month as mutual funds will be making capital gains distributions. Rather than immediately reinvesting the cash, we will wait until next year to invest to avoid purchasing funds that have not yet made distributions.

If you have any questions regarding the fund SRRIX, insurance linked securities in general, interval funds, or future rebalancing, please call or email.