Unforeseen

For mitigating risk for companies and individuals, the insurance industry tends to be handsomely rewarded. In fact, one of Warren Buffett's most successful bets was on the insurance company GEICO. And judging by Berkshire Hathaway's ($BRK.B) recent disclosure of its stake in Chubb ($CB), selling insurance still looks to be very attractive for the investment legend. Meanwhile, the S&P Insurance Select Industry Index (tracked by $KIE) has outperformed the S&P 500 (+13.22% to +11.52% this year to date as of 21 May 2024. 

Investors appreciate that insurance premiums are generally overpriced, in that the average policyholder will pay more in fees than they’re likely to get out of insurance claims. This is indeed paramount for the whole industry to function, especially if it is to provide insurance for 'sure events' such as life insurance. 

It's also important for claims to be staggered, otherwise insurance companies might face liquidity issues and not be able to honour all of them at once. That's why few policies cover catastrophes like cyclones, earthquakes or pandemics. 

A study by insurance broker Aon revealed that only one third of the US$380b in catastrophe losses in 2023 were insured. It's a major concern that looms right now for hundreds of thousands of Brazilians assessing the damage to their homes and businesses after the devastating floods across the state of Rio Grande do Sul.

However, when there’s enough demand for a product, there’s a seller willing to supply it. Some hedge funds are making a killing by providing a more complicated and riskier kind of insurance: catastrophe bonds.

Through elaborate financial engineering, including weather derivatives and statistical modelling, hedge funds price and sell bonds that pay out should a certain catastrophe strike. The primary customers are local governments, as well as insurance and reinsurance companies. 

As climate change introduces new risks for economies worldwide, demand for these instruments has been soaring. Buyers are willing to pay a hefty premium to cover losses associated with these events. Trading catastrophe bonds was a top strategy for hedge funds in 2023, as this segment returned nearly 20% – well above the overall average of 8% across all hedge fund strategies.

Volatility-linked products have also been utilised in the insurance sector, with indexes like the CBOE VIX being viewed as proxies for risk. When the VIX shoots up, risk is generally perceived as high, and vice versa, with buying VIX products being synthetically similar to acquiring risk insurance. As volatility has declined since the 2022 interest rate-hiking cycle,  ETFs with performances linked to this trend like $SVIX and $SVXY have risen +25.10% and +16.90% year to date (21 May 2024).

But the strategy of selling VIX products carries higher risk. Unsurprisingly, volatility can spike quite quickly; the February 2018 volmageddon resulted in $SVXY dropping a whopping -89% in a single month. Without knowing the tricks of the trade, investors aiming to become insurance sellers could be making the riskiest of moves.

*This article was written for informative and educational purposes only and should not be considered as financial advice or a recommendation to invest. Inverse and leveraged ETFs are complicated instruments generally suited for professional investors and traders, who monitor their trading regularly and understand the underlying risks of these investments.