Put your trust in the insurers

With the hurricane season drawing to a close, the reinsurance industry is breathing a sigh of relief. Hurricanes that come ashore in the US have historically been the biggest contributor to insurance industry losses from natural catastrophes, but claims in recent years and again in 2016 have been light. Global losses from natural catastrophes in 2015 were $37bn, well below the $62bn average of the previous ten years, estimates insurer Swiss Re. Losses in 2016 are unlikely to be much higher.

For investors, low claims can be a mixed blessing. This year's returns will be great, but there is a threat that insurance rates in the January renewal season will come down, both because investors extrapolate low claims into the future and because this leaves more capital to underwrite next year.

However, Nick Martin, co-manager of the Polar Capital Global Insurance Fund, believes that "after three years of softening markets, catastrophe reinsurance pricing is now bottoming as reinsurers are no longer willing to cut rates". There has also been a "significant drop in demand for specialist catastrophe bonds" (securities issued to help hedge against the risks of natural disasters).

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While insurance premiums, paid in advance, provide visibility of cash income, the incidence and the scale of losses are highly uncertain. When the Costa Concordia sank in 2012, the eventual cost of salvaging and disposing of the wreck was $2bn nearly four times the cost of the ship's construction. Only large companies with strong balance sheets can write such policies, and even they need to limit their losses through reinsurance. The reinsurance companies, in turn, are required by regulators to reinsure via "retrocession" policies to limit their own losses.

In the past, many insurance companies used investment returns to subsidise insurance, but increased regulation has constrained their investments to low-risk, low-return strategies. This has forced the whole industry to be more disciplined about pricing and increased the demand for reinsurance.

The days when unsophisticated but wealthy investors could underwrite through Lloyd's of London are long gone, but there are now some much better alternatives. Catco (LSE: CAT) underwrites retrocession policies, the business on which Warren Buffett built up Berkshire Hathaway.

The fund targets returns of 12% to 15% above market interest rates, of which at least 5% is paid out in dividends. This year, returns are expected to be 3% below target, despite only a moderate level of losses, due to Catco's policy of limiting risk while rates are low. This follows returns of 11.6% in 2015 and 17.1% in 2014. Keep in mind that returns will be erratic, however good management is at reducing risk.

Another alternative is the Polar Capital fund. Its returns have compounded at 9% per annum, over 3% better than equity markets, from investing in non-life insurance companies. The portfolio is diversified, but there is some chunky exposure to the higher-quality names, and nearly 5% in Berkshire Hathaway. The managers believe that valuations remain attractive: the US and Bermuda-based firms (over 75% of the portfolio) trade at a 25% premium to book value, in line with the long-term average.

What makes this sector compelling is that returns are largely uncorrelated to broader markets, demand for insurance in an era of risk aversion is growing steadily, and companies are getting better at pricing and managing the risks they underwrite. Returns in any year may be poor if, for example, a hurricane hits Florida, but will soon bounce as a jump in claims pushes up rates.