In this the latest in our series of interviews with figures from the risk transfer and insurance-linked securities markets we spoke with John Seo, co-founder and managing principal at ILS and catastrophe bond investment specialists Fermat Capital Management LLC. Fermat Capital Management is one of the largest ILS investors around the globe with $3 billion in assets under management at 30th June 2012, so we felt it would be interesting for our readers to find out more about the firm and John’s perspective on the ILS market in general.
Tell us about Fermat Capital Management’s interests and activities in the insurance-linked securities market and catastrophe bond market?
We remain primarily a catastrophe bond manager, with minor activity in the over-the-counter ILS market. This includes private cat notes.
You’ve been in the market for quite a while, having founded Fermat Capital Management in 2001. Was your focus always on ILS and cat bonds and what made you choose this sector?
The roots of the firm go back a little further to 1998 and the Lehman Brothers insurance proprietary trading group. That was how many of us here at Fermat Capital got involved in the insurance-linked securities market. We had quite a major effort going on at Lehman Brothers in those days—five managing directors, our own Bermudian reinsurer, Lehman Re, and a global mandate to underwrite risks in life, non-life, and all specialty lines. Lehman publicly disclosed a minimum risk capital commitment of US$500 million via Lehman Re, but we had authority to go much further than that. That was the largest risk-taking ILS group in the late 1990’s that I am aware of.
Before Lehman, I was a mortgage-backed securities portfolio manager at the Harvard University endowment. Lehman called me up one day and basically said “let’s change the world together.” It took me a while to see the light, but I eventually came around and became the senior ILS trader and portfolio manager at Lehman with the understanding that if, by some miracle, the ILS market should actually survive its start-up phase, I’d leave to start my own ILS investment management company.
What’s your opinion on the state of the ILS and catastrophe bond market right now?
ILS and catastrophe bond markets are looking better than ever. They are enjoying a dramatic increase in investor interest at the same time that supply is surging as well. New money coming into the market has been acting responsibly, and protection buyers are taking the market very seriously as well. Transparency and liquidity continue to increase. A greater variety of investors as well as a greater variety of ILS risks are materializing. This all lays the foundation for the next phase of healthy growth. I cannot see how anyone could ask for anything more beautiful than market conditions like these.
How do you view the investor landscape and appetite for ILS and cat bonds at the moment?
The investor base is both widening and growing rapidly now. Ultra-high net worth individuals, family offices, pension funds, private banking, traditional money managers, global asset management platforms, hedge funds, fund of hedge funds, sovereign wealth funds, and of course new ILS funds and offshore ILS platforms—some or all of these investors types from essentially every continent in the world are either considering getting into the ILS market or are already invested in the ILS market, either directly or indirectly through their externally managed portfolios. What is truly interesting to me is the variety of motivations and goals among this widening and growing investor base. Some are merely seeking an offshore, tax-advantaged platform for the investment side of the balance sheet, some are looking for highly niche ILS strategies, while others are choosing to enter the market anywhere from the low risk to the very high risk part of the market. Liquidity preference is quite varied as well, although I believe the overall trend, with notable exceptions, is toward higher liquidity terms.
What issues or problems have you identified in the ILS market currently?
The main issue that I see is just the education barrier. ILS markets have a pretty steep learning curve. Some investors have a knack for it and pick up the concepts and terminology right away, but most investors need to put a lot of time into their due diligence to get over the education barrier. An incomplete education process can potentially lead to suboptimal investment restrictions, which can lead to some pretty bad market behaviours—in particular, capacity hot and cold spots and over-structuring of trades, especially in the over-the-counter-market but the catastrophe bond markets are not immune to this either. We are not seeing much of these ill effects of under-education in the ILS market yet, as the current wave of new investors seem to have things well in control, but I cannot be the only ILS manager wondering what the next wave of new investors or the one after that will bring to the market.
How do you see the ILS and catastrophe bond market developing over the next few years?
Given these favorable market conditions, if history is any guide, we believe there to be the potential for 20-25% annual growth of the ILS and catastrophe bond market over the next few years.
Do you have any thoughts you can share with us on the topic of liquidity in the ILS market?
ILS stakeholders ignore liquidity issues at their own peril. I find it disturbing that some ILS market participants seem to scorn liquidity, implying that investors pay too much for it and are unnecessarily exposed to mark-to-market volatility. If an ILS manager wants to pursue illiquid ILS investments, that is fine with me, but they should make their case based on the merits of those investments alone, not by putting down the benefits of liquidity to the ILS market as a whole.
Do you have any thoughts on how regulation, including Solvency II and Dodd-Frank could impact the ILS market (both for issuers and investors)?
Increasing regulatory capital requirements for financial services companies only fuels long-term ILS market growth. Currently unfolding regulatory initiatives, Solvency II in particular, are intended to deleverage the financial services system by requiring more equity capital next year to support the same business done last year. This, however, is intolerable dilution to equity investors, who are already experiencing a dwindling return on their financial services investments. The only way to resolve these contrary forces is to securitize the most capital intensive parts of the business, which, for the insurance and reinsurance side of the financial services sector, is what ILS are all about. If the ILS market gets this regulator-driven, recapitalization trend right, equity investors in insurance and reinsurance companies will be less diluted than they are now, the insurance and reinsurance market will be better capitalized against severe loss events, and investors as a whole will have a greater opportunity to participate in a greatly expanded ILS market.
Is there anything that Fermat Capital Management does which you feel is a particular value-add for your investors, or unique within the market, that you can mention?
We use a CATastrophe asset pricing Model (CATM) to price and size our portfolio positions dynamically throughout the year. CATM extends traditional CAPM concepts like beta and market-price-of-risk to the ILS market by using non-traditional measures of tail risk, which, obviously, is necessary when dealing with investments like catastrophe bonds. We believe our CATM approach is unique, and we believe our active-trading approach to ILS markets in general is a value-add to our investors, though only they can be the judges of that in the end.
Our thanks go to John for his time and insight into the work of Fermat Capital Management.