Property Catastrophes and Equity Markets Andrew J. Sterge, Ph.D. April 2014 AQR Reinsurance Reinsurance has become increasingly popular with investors for its equity-like risk premium and low correlation to equity and other capital market returns. It pays to further investigate the low-correlation evidence, however, because while dislocations in the global equity markets have no known bearing on the likelihood or severity of major natural or man-made catastrophes, the converse of zero causality between these events and equity markets is not so clear. This is the topic we address in this paper, and the evidence is nuanced. In the U.S., for example, equity market reactions to large-scale insurance catastrophes have been transient and relatively small in scale, ostensibly because the U.S. economy is big and robust enough to handle such losses in stride. In smaller economies, however, where catastrophes can cause losses that are meaningful percentages of GDP, equity market reactions to such catastrophes can be meaningful as well. The author wishes to thank John Lummis for suggesting this study; Kathleen Rode, AQR Capital Management, LLC David Bookstaber and Bernard van der Stichele for their valuable research Two Greenwich Plaza assistance; Mark Stein for his helpful comments; Jennifer Buck for her layout and Greenwich, CT 06830 design; and Peter Nakada from RMS for data and his insightful comments. p: +1.203.742.3600 f: +1.203.742.3100 w: aqr.com Property Catastrophes and Equity Markets 1 Introduction year period are too small relative to the economy to have an impact on broad-based U.S. stock Reinsurance has become increasingly popular indices. However, the situation is different in with investors for its equity-like risk premium and smaller economies such as Japan’s and low correlation to equity and other capital market Thailand’s, where major natural disasters can returns. It pays to further investigate the low- cause (and have caused) losses that are correlation evidence, however, because while meaningful percentages of GDP. In such dislocations in the global equity markets have no instances, large property loss events can foment known bearing on the likelihood or severity of relatively long-term equity market losses. major natural or man-made catastrophes, the converse of zero causality between these events We have not experienced disasters like this in the and equity market performance is not so clear. U.S., but that does not mean one could not occur. Indeed, as insurance losses caused by Using third-party modeled simulations of natural catastrophes have become increasingly large over catastrophes, we investigate the likelihood of the past 50 years (see Exhibit 1), it might be that there being events in the U.S. of similar relative these losses have grown large enough to shake magnitude as those that negatively affected the investor confidence and drive down stock prices stock markets of smaller economies. We do the while also inflicting losses on reinsurance same for Europe. Our conclusion is that any investments. natural catastrophe in the U.S. or Europe that could cause anything greater than a transient This is the topic we address in this paper, and the negative reaction in equity markets would be well evidence is nuanced. For example, the U.S. beyond a 1-in-100-year occurrence. economy — and by extension the U.S. stock market — has been big and robust enough to The Evidence handle $100 billion insurance catastrophes in stride (such as the September 11 terror attacks in Consider Exhibit 2, which compares U.S. equity 2001 and Hurricane Katrina in 2005)1. Further, returns 100 trading days before and after the five there appears sufficient evidence that the kinds of most expensive U.S. natural catastrophe disasters insurance losses one would expect in any 100- since 1980. Hurricane Katrina (2005), the most Exhibit 1: U.S. Aggregate Property Catastrophe Insured Losses (in 2012 dollars) 90 80 70 60 50 40 US$ billion 30 20 10 0 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 1950 Source: Property Claims Services, The Bureau of Economic Analysis (BEA). 1 The $100 billion we refer to are estimated economic losses in current (i.e., 2012) dollars. 2 Property Catastrophes and Equity Markets Exhibit 2: Major U.S. Property Cat Losses vs. U.S. Equity Performance Change in the S&P500 index 100 trading days before and after the five most expensive U.S. natural disasters since 1980 20% 10% 0% -10% -20% -30% -40% -50% -100 -80 -60 -40 -20 0 20 40 60 80 100 Northridge Andrew Sandy Katrina Ike Source: Bloomberg L.P. expensive at an estimated $125 billion of tremendous loss for those in its path, and it had economic losses in 2005 dollars, caused no the potential to be even more disruptive had it noticeable effect on equities. This stands to damaged offshore oil infrastructure, it is doubtful reason because these losses were less than 1% of that a loss of this magnitude (0.25% of GDP) did the $13.1 trillion U.S. GDP in 20052. The same was anything to exacerbate an established bear true for Superstorm Sandy (2012); the Northridge, market that eventually erased approximately $8 California, earthquake (1994); and Hurricane trillion in the market value of U.S. stocks4. This Andrew (1992), which are estimated to have illustrates an important principle: random events caused $65 billion, $44 billion and $27 billion of that are independent can still happen in the same economic losses in original dollars, respectively3. year, thereby creating the appearance of As terrible as these were in terms of lives lost and correlation when none exists. All in all, we find property damaged, they were not big enough no connection between the biggest historical U.S. relative to the overall economy to affect U.S. property catastrophes and U.S. equity market stocks on whole. performance; presumably, the events have all been too small relative to GDP to matter. Hurricane Ike (2008), which caused an estimated $38 billion in economic losses at the time, appears All of the top 10 U.S. property catastrophes are to be an exception. While this event was a listed in Exhibit 3. With the exception of Exhibit 3: Top 10 U.S. Natural Catastrophes (1980–2012) Losses from even the costliest disasters have been relatively small compared with the overall U.S. economy Economic Losses Insured Losses Economic Losses Insured Losses U.S. GDP Name Year (2012 $B) (2012 $B) (Original $B) (Original $B) $B Hurricane Katrina 2005 155 77 125 62 13,095 Northridge, CA earthquake 1994 98 34 44 15 7,309 Hurricane Sandy 2012 65 30 65 30 16,245 Hurricane Andrew 1992 64 42 26 17 6,593 Hurricane Ike 2008 42 20 38 19 14,720 Hurricane Ivan 2004 30 18 23 14 12,277 Hurricane Wilma 2005 27 16 22 13 13,095 Hurricane Charley 2004 24 11 18 8 12,277 Hurricane Rita 2005 20 15 16 12 13,095 Hurricane Frances 2004 16 7 12 6 12,277 Source: Munich Re NatCatService, BEA 2 Source: data.worldbank.org/indicator. 3 Munich Re NatCatService. 4 Wilshire Total Market Index, Bloomberg L.P. Property Catastrophes and Equity Markets 3 Exhibit 4: Major Terror Losses vs. Equity Performance Change in benchmark equity-market indices 100 days before and after major terror attacks 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -100 -80 -60 -40 -20 0 20 40 60 80 100 9/11 WWII Sarin Madrid Source: Bloomberg L.P. Hurricane Ike, the graphs of equity index after the sarin attack and Madrid bombing, performance surrounding the event are all although both reverse in short order. As horrible similarly flat (i.e., including those not shown). as these events were, they were not big enough to affect earnings expectations or risk aversion in Terror — An Exception? any meaningful or long-term way. The September While the equity-market impact of large-scale 11 attacks, after which a short-term market sell- property loss from natural catastrophes is the off also followed, destroyed more property and focus of this discussion, terror events can also was a more transformative event than the sarin cause large-scale destruction of wealth and attack or Madrid bombing, but the negative property, so it is worthwhile to examine the effect market reaction was still short-lived. Indeed, after of these events as well. Data from developed 9/11 the U.S. equity markets were closed until markets are thankfully sparse; we examine three: September 17; upon reopening, the S&P500 fell 11 the September 11 terror attacks in the U.S. (2001), percent over the ensuing 4 days before fully Tokyo sarin gas poisonings (1995) and the Madrid recovering to its pre-9/11 close exactly one month train bombing (2004)5. We also include the Pearl later, on October 11, 2001. Only after the Pearl Harbor (1941) bombing for context, though from Harbor attack was there an extended sell-off and an insurance standpoint per se, this was not a recovery, with the Dow Jones Industrial Average major event. falling 20% after the event, and then taking almost one year to fully recover, in November Exhibit 4 shows the pre- and post-event analysis 1942. using the major domestic stock market indices relevant for each event (i.e., the Dow Jones From an insurance loss-to-GDP standpoint, none Industrial Average (Pearl Harbor), S&P 500 (9/11), of these events, or others in the historical record Nikkei 225 and IBEX 35 indices).