Cat bonds have been called the perfect alternative investment. Their historically consistent, attractive risk-adjusted returns provide unique diversification potential, with almost no exposure to the credit cycle, equity market or indeed any other mainstream market risk. John Seo is one of the asset class’s pioneers: the former academic founded Fermat Capital Management with his brother Nelson soon after the birth of the cat bond market in the mid-1990s. Today, the firm, which runs the GAM FCM Cat Bond Strategy, dominates what is now a fast-growing and increasingly popular asset class.
Seo first became involved in catastrophe bondsin the late 1990s. Following a remarkable academic career which saw him take a Harvard PhD in record time, he was working in esoteric financial derivatives at that university’s endowment fund when, in 1998, Lehman Brothers hired him to be the lynchpin of a brand new division. Inspired by the profits Warren Buffett had been making in the insurance sector, Lehman had decided to turn its considerable resources to making insurance into an investable asset class. The investment bank hired the best insurance industry experts money could buy and tasked them with teaching Seo the business so that he could make investment decisions. Without knowing it, Lehman was laying the foundations of what would become Fermat Capital. For his part, Seo duly confirmed what Lehman had suspected: that the major re-evaluation of disaster insurance sweeping the industry had created an opportunity for capital markets investors to buy catastrophe risk at an extremely attractive price. Lehman had also been right about something else: correctly evaluating catastrophe risk would require a new, much more mathematical approach – one for which there were few people better-suited than Seo.
The origins of the market
The birth of cat bonds as an asset class can be traced back to 1992 and Hurricane Andrew. The devastation that this single storm caused in Florida and the East Coast of America led to insurance claims that bankrupted a dozen insurers, and paralysed 30 more. It had become clear that the insurance industry was underestimating the chances of major natural disasters hitting areas of dense, high-value real estate. Insurers’ prediction models were also out of sync with the potential damage serious catastrophes could cause. In short, the potential cost of disaster had outgrown the capacity of the insurance industry to protect against it.
The irony was that at the time Hurricane Andrew struck, risk models capable of accurately predicting storm and earthquake loss probabilities had already been developed. It took a huge storm, but once the penny dropped for the industry, rating agencies and insurance regulators began using these new models to stress-test the largest insurance companies’ risk portfolios. The losses that came out of these tests, says Seo, were in the multi-billions. The regulators’ solution was to insist that insurers protect themselves from potential shocks by setting aside expensive equity capital on a one-to-one basis against extreme events. The large insurance institutions had enough capital to pay for this, but there was no question that the process had effectively increased the cost of disaster risk. ‘It’s paradoxical,’ says Seo. ‘The more remote the event, the more severe it is. The more severe it is, the more deeply it penetrates the balance sheet in these stress tests and the more deeply it penetrates the balance sheet, the more equity capital has to be set aside for the event, and the higher the cost of capital.’ At this new price, insurers could no longer afford to keep the same quantities of disaster liability on their balance sheets. If it was to continue to protect its policyholders, the industry as a whole would need to transfer billions of dollars of disaster risk to an entity large enough to cope with it. The only entity that was both large enough and willing to take on the risk was capital markets, and the best way to transfer the risk proved to be through a new type of instrument called a catastrophe bond.
How cat bonds work
Simple in form, cat bonds are high-yield debt instruments, with usually a three or sometimes five-year maturity. They carry a quarterly coupon with a floating rate, usually set at Libor plus a fixed spread. The typical cat bond is rated BB, making them a non-investment grade instrument. The difference between a cat bond and a corporate bond is that instead of the money raised at issuance going onto a corporation’s balance sheet, with a cat bond, it is held in AAA securities such as US Treasuries. Each bond’s prospectus details the terms according to which a default-triggering catastrophe event is deemed to have occurred, be it a Miami hurricane or a Japanese earthquake. If these criteria are met, then the bond defaults and some or all of the cash held in AAA instruments is passed on to the insurer, helping it to pay out its liabilities.
So far, so straightforward. However, for most investors, the idea of taking on the risk of catastrophe loss is not appealing in itself. What makes cat bonds interesting from an investor’s point of view is the fact that, thanks to the huge pressure regulators are putting on insurers to divest catastrophe risk from their balance sheets, supply rather than demand is the primary driver both of the market’s growth, and of bond pricing. This dynamic has been very positive for yields, which are usually between 5% and 15% above Libor, and around twice that of corporate paper with a similar risk rating. Because their pricing is not driven by economic or corporate events, catastrophe bonds also have very low correlation to mainstream markets.
Calm in a storm
The historic problem for cat bonds has not been the numbers, but investor scepticism, which Seo feels is understandable. After all, if something looks too good to be true, there is often a good reason for it. Yet in only its second decade of existence, the cat bond market can already look back on some of the sternest shocks imaginable, trials which it has come through strongly. The financial crisis of 2008 subjected the cat bond market to a severe stress test. Correlations between all asset classes spiked in September and October 2008, when equities, credit and cat bonds all registered falls. However, correlations with US high yield and US equities rose only slightly from their long-term averages and while the cat bond market did register falls, the maximum drawdown was 4% over an 8-week period (as measured by the Swiss Re Cat Bond Index). This compares with a 25% fall in the US high-yield index over 32 weeks and a 52% fall in the S&P 500 index over 44 weeks.
‘We’ve gone through both financial as well as natural disasters,’ says Seo, ‘Japan being the most recent one. And in every single instance, cat bonds have been severely tested and they have been proven to perform as promised.’ He believes this is the reason for investor interest. ‘Back in 1998, you could say all the clever things about the asset class, and they were all true. But in the end nothing speaks like experience and now we have that.’ Seo uses the analogy of a market going from seatbelts to airbags. The new system promises a certain level of safety in a crash. ‘We’ve now had those crashes and the system has worked. That was the missing element.’
A growing market
The broad dynamics that sparked the growth of the cat bonds market, and drive its attractive risk-adjusted yields, are part of a secular process of re-evaluation that is likely to continue for decades to come, Seo believes. ‘In the old days, when I first got involved in this business, capital was regulated to the one in 50-year event – that’s a two percent probability per annum. Then as the cat bonds market got started, they regulated to the one in 100-year level. Now it’s common practice to regulate to the one in 250-year.’ In the longer term, Seo, like many others in the industry, believes the market is inevitably moving towards regulating capital to one in 500- and one in 1,000-year events. ‘Even if the risk doesn’t grow, the simple increase in regulatory pressure only pushes the market further and further towards catastrophe bonds.’
The historical statistics bear that view out. Since the market’s inception, the volume of outstanding cat bonds has grown to more than USD 13.5 billion today, at a compound rate of around 20% per annum. And despite its expansion so far, the broad catastrophe risk security market still covers only 12% of total catastrophe reinsurance. Even conservative predictions put cat bond market growth at around 25% per year over the next three to five years as insurers hedge out more and more risk.
A unique perspective
For Seo and his soon-to-be ex-Lehman colleagues back in the late 1990s, these favourable dynamics made two things apparent. The first was that trying to invest in cat bonds using a traditional reinsurance skill-set would be a fruitless task – the maturity and size of the reinsurance market meant that they would have no real edge. The second was that they didn’t need to. ‘The reason reinsurers are paid what they’re paid is because they’re taking on tremendous risks,’ Seo argues. ‘On the surface, cat bonds may look like securitised reinsurance, with the associated risk transfer, but the underlying industry dynamic means they are quite the opposite.’ Seo realised that if he maintained a disciplined focus on the capital relief aspect of the bonds, he could vastly reduce exposure to risk transfer, and he knew that here, his mathematical derivative investor’s background would constitute a real competitive advantage. With the right strategy and the right tools, he believed that it was possible to protect investors from those risks, while significantly improving potential returns.
The Fermat approach
When Seo founded Fermat Capital Management in 2001 with his brother Nelson (who like him is an MIT graduate turned derivatives trader) the firm’s competition in the cat bonds arena was primarily from managers who held cat bonds as part of a much broader reinsurance portfolio. That remains the case today. This type of manager’s approach is typically simple: to examine a cat bond’s structure, consider its pricing on a historic basis, then, if it seems attractive, buy and hold it. Fermat’s philosophy is, both quantitatively and qualitatively, markedly different. Its strategy uses a series of repeating processes that rely heavily on extensive and highly sophisticated risk modelling.
First comes a due diligence and screening stage, in which an individual catastrophe bond’s risk is modelled. Bond structures are examined from a legal perspective (offering circulars for these instruments can be hundreds of pages long and highly complex). Next comes pricing, which is done using a sophisticated proprietary system. Unlike the rest of the industry, which uses single-point estimates for this, Fermat prices bonds by generating both bond and wider market exceedance probability curves, allowing far more accurate risk calibration. Crucially, and, again, uniquely, the Fermat team also assesses the marginal impact of the bond’s potential losses on both the wider market and the portfolio using a proprietary variation on the capital asset pricing model (CAPM) that Seo calls ‘CATM’. Finally, portfolio composition is evaluated and risks managed on an active basis.
Surprisingly, Seo considers the initial risk modelling the simplest part of the process. ‘The first stage, in which you rate the risk and see how much on average in a year you are going to lose, although very technical, and some people think very fun and very impressive, is actually the easy part from an investment point of view. It’s putting the risk into the portfolio and assessing its marginal impact, and seeing whether you’re being paid for that – that’s where we distinguish ourselves.’
The process of analysing the marginal impact of each bond in the portfolio means knowing the correlation of potential losses for a single bond with every other potential loss in the portfolio. It also means understanding the diversification effect of adding each incremental unit of risk, something Seo believes is impossible with the flawed ‘bucketing’ diversification method widely relied on by competitors. ‘What you won’t see in our charts are nice neat allocations to say Japanese earthquake risk, California earthquake risk and so on,’ he notes. A believer in trigger diversity, Seo considers it beneficial for a portfolio to contain different types of triggers, even to the same event. That does not mean arbitrarily insisting on diversity of event-type or geography, at a potential cost to premium. On that score, says Seo, Fermat is unconstrained. ‘We use a proper portfolio analytic that guarantees by its nature that we won’t ever want to pay someone for the privilege of being exposed to a loss.’
Seo believes the industry as a whole is slowly moving towards his firm’s methodology, but that there are political reasons why making the switch from a bucketed scheme to a non-bucketed scheme can be difficult. This is especially true for large organisations, where it can mean a dramatic change in the pecking order of various different stakeholders. As a result, he does not expect the adoption of these more modern approaches to happen quickly. ‘When that day happens, we may lose a certain amount of our edge, but I don’t expect these large organisations to do that any time soon.’
The current picture
Today, the outlook for the market is brighter than ever. Not only have yields remained at the remarkable levels seen at the birth of the asset class, a broader multi-year trend has seen them widen over time as the market grows. This is the precise opposite of the path seen in other fixed income markets, and stems from the fact that growth is supply-, rather than demand-driven. Meanwhile, a shorter-term phenomenon has been the rise in yields following the recent Japanese earthquake, an event which is also likely to spark increased insurer issuance, at ever more attractive yields. Given cat bonds’ attractive risk/return profile and their status as an uncorrelated source of beta, that dynamic makes it hard to interpret today’s environment as anything other than an unusually compelling opportunity for both existing and prospective cat bond investors.
Dr John Seo is Co-Founder and Managing Principal at Fermat Capital Management, LLC. He has over 20 years’ experience in fixed income trading and has been active in the catastrophe bond market for over 12 years. Prior to forming Fermat, John was senior trader in the Insurance Products Group at Lehman Brothers, an officer of Lehman Re and the sole industry practitioner to hold a State-appointed advisor role with the Florida Hurricane Catastrophe Fund. After Hurricane Katrina, he testified before US Congress in 2007 as an expert on the catastrophe bond market. John holds a PhD in Biophysics from Harvard University and a BS in Physics from MIT. He is based in Connecticut.
Nothing in this article constitutes investment, legal, accounting or tax advice and should not be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. The statements and opinions in this article are those of the author at the time of publication and may not reflect his/her views thereafter.
INTERVIEW WITH DR JOHN SEO, CO-FOUNDER OF FERMAT CAPITAL MANAGEMENT
Originally published in the June 2011 issue