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Saturday, November 3rd, 2012
a little insurance

With the arrival of Hurricane Sandy, the debate about climate change is on again.  That’s an immediate reminder that we tend to see risk and return in the context of recent experience, a foundational principle of behavioral finance.

My views on the topic were expressed in one of the first postings I ever did, in 2008, about warming up the models.  It’s not a black-and-white issue, as believers on both ends of the spectrum want you to think.  It’s an expected value problem.  (I used the then-very-popular TV show Deal or No Deal to illustrate the approach.)

Rather than dwell on the public policy issues, where even a simple expected value problem gets mangled by political calculus, you are seeing more and more examples of what I talked about in my posting:  Capitalist decision makers changing their behavior.  That’s true with some of the insurers and it’s true elsewhere as well.

From an investment process standpoint, the question remains the same as in 2008:  What are the probabilities and consequences of the outcomes regarding climate change and do you include them in your analysis?  That’s going to be the question confronting you for years.

The chart above shows yearly numbers for North American property and casualty companies.  The top panel clearly demonstrates the decline in investment income over time.  The bottom panel illustrates the combined ratio (expressed as a percentage), which is a measure of underwriting success.  A higher number is bad.

So, the pincer movement is not a good one.  After underperforming for a number of years, the P&C stocks had a strong run from mid-summer to the arrival of Sandy.  They have done worse than the market since then.

But, stepping back, is it time to take out a little insurance in how we consider climate change in financial models?  Yes, just as it was in 2008.  (Chart:  Bloomberg terminal.)