OBLIGATIONS CATASTROPHES : LA DIVERSIFICATION QUAND ON EN A BESOIN

The full video transcript of the Q&A session can be read below:

About Fermat

Overview of Fermat and the investment team
Fermat Capital was founded in 2001 by my brother and myself in Westport, Connecticut. We are now a team of 35 people, with specialists from every discipline within the marketplace necessary to support a catastrophe bond investment. So everything, of course, from the scientists and the catastrophe modellers, but even the structures and the legal experts for our asset class. We're known as a leading manager of insurance-linked securities, in particular catastrophe bonds, which of course are tradeable insurance-linked securities almost by definition.

Cat Bonds

Can you briefly outline how cat bonds work?
Well, from an investor point of view, it's pretty simple. And in fact, in the old days, some people didn't quite realise that they were investing in a catastrophe bond. They saw it as a simple, short-dated corporate bond with a floating rate coupon. They are a monthly floating rate coupon, but with a very high coupon spread, and in the old days we would actually get them all rated so they'd be rated something like double B. So you would see a double B short-dated floating rate bond paying a coupon, say, of Treasuries, plus 8%. So they say it's double B default risk, is rated by, say, S&P, paying me double the yield of a normal double B bond. Do some investigation and find out it's not credit risk, it's event risk, for example a great Miami hurricane, and that the risk itself is, in a sense, scientifically determined in terms of frequency and severity of hurricanes, understand the fundamental diversification of it, and they just invest in it. You know, they trade and settle through Euroclear. No fuss, no problem. Very, very simple to invest in. But as I touched on, it's not credit risk. It's actually event risk. So some investors do go direct, and they're satisfied with that. But most institutional investors prefer a specialist because they want somebody handling this that has deeper knowledge about the risk.

How can cat bonds protect against rising interest rates and inflation?
The first and key feature is that cat bonds have always been and continue to be floating rate bonds. So you have a monthly reset. The predominant currency in the market is US dollars, so it's really a one month T-bill, plus a rate. So as that short-term rate moves up, obviously due to inflation, every basis point of that flows immediately into your portfolio, and you don't have a lot of the negative consequences that you have in fixed income instruments. So that's the very first protection. Another, I would say is, this is that cat bond spreads themselves effectively are indexing to inflation itself. A lot of the high spreads that we're seeing right now are actually due to inflation. In particular, insurance companies measure their risk on an inflation-adjusted basis, particularly if a building were to burn to the ground they are always calculating how much would it cost to reconstruct the building? So they know the cost of labour and materials in real time always for replacing building stock. So that number has actually gone up by 30% over the last year, and it flows directly into their risk control systems and has created 30% more demand for reinsurance and cat bonds in this year. So that demand imbalance versus supply of risk capital is actually what puts the yields up. So by this market dynamic cat bonds themselves, not only through their floating rate nature, index to interest rates that they're indirectly indexing to inflationary conditions as well.

What are the ESG attributes of cat bonds and your strategy?
So ESG is a very broad world. It has many aspects to it. The history in the cat bond market is actually very long. So I was approached by large institutional investor, he was a client of ours, in 2011, and he introduced me to the concept of responsible investing, sustainable investing. And he pointed out that he thought that cat bonds themselves were naturally aligned with those principles. So we became a UNPRI signatory in 2011 and after much research and thinking I became comfortable with ESG rating every catastrophe bond that came to market since June 2014. And it's a really very simple view. First, that insurance itself is actually a naturally sustainable form of finance in the sense that it creates resiliency against catastrophes. So if you look at the UNSDGs it's filled with language about any form of finance that helps resiliency against catastrophes. It actually uses the word catastrophes, is seen as positively aligned with UNSDGs, so on the social side in general insurance is seen as aligned with responsible investing. On the environmental side I hope it's obvious we're the only market in the world that I'm aware of that gives you a direct price signal on the environmental impact of things like earthquakes, hurricanes and wildfires. Furthermore, by pricing those risks we allow the market to function in such a way that it can price the value of mitigation against those risks. So the E alignment, the environmental alignment is very strong. Finally, on the governance side, through the cat bond market society and the financial system is actually enjoying unprecedented transparency on the exposures that society has to catastrophes. So we will rate a catastrophe bond on how much it contributes to that transparency effort that's ongoing, so that we have a separate E, S, G score about alignment along these factors. And that's what we did since 2014. Now, when ESG became more of a focus broadly in markets I had no idea how institutions would react to our approach and our view on ESG. And I didn't know if they would buy it in a sense. It was just our view. And as you know, ESG is largely about saying what you do and doing what you say and documenting everything in the process. Then the investors themselves can decide whether they think this is a true ESG investment as far as their mandates are concerned. And I won't say to my surprise, but, you know, to our delight, we found that institutional investors around the world have accepted our rating scheme for catastrophe bonds.

Investment Risks

What are the main risks when investing in a cat bond?
The main risk in the market has always been and remains Florida hurricane. That's the big one in our market. And I always advise investors that are looking to get into our asset class they need to be ready to accept that if there's a great Miami hurricane the portfolio could be down 25%. So that's starting with the downside there. The upside now is that you can earn a Treasuries plus 10% return against that risk. But it is not without risk and you have to be able to accept that type of concentration risk to Florida hurricane.

Is climate change likely to lead to more catastrophes and therefore higher losses for insurers?  How does Fermat mitigate these future risks?
So we do follow all the science and all the modelling around that, which improves every year that goes by, not only in terms of performance of these models, these climate models, but also even transparency. And the picture that's emerging is, as you would expect, mixed or nuanced. It's actually becoming clear that certain risks in a warming world won't increase. They might decrease. And of course, others would decrease. But the order of magnitude of the changes that we're seeing by end of century amount to a 50 to 70% increase or even decrease of the risk. That's the order of magnitude. And that picture is becoming very clear. But that's by end of century. So, really, of course, what you have to wonder is, does it come in nice and steady or is it all of a sudden that a risk elevation happens? But really, when it comes to climate change, all of a sudden is something like 10 years, right? Now fortunately, we're able to observe what's going on on an annual basis across the world and look for signs that this rise by end of century is occurring faster or potentially slower than expected, and we re-price it. So the analogy that I use is that climate change for our market looks a lot like inflation. We're pricing the risk, but due to climate change, you could have an adjustment to that risk estimate. It looks a lot like inflation, but because we're able to annually revise our prices versus a multi-decade trend we're able to act like a climate linker. An analogy to inflation linkers. So, really, what many institutional investors have concluded is that, and it's counterintuitive for some people, is that if you want to protect yourself against the adverse effects of climate change, invest in a climate linker and cat bonds are exactly that.

How do your risk models differ from those of your peers?
Our risk models differ in two ways. One we're a so called multi-model shop and essentially most shops actually have to choose one type of model and standardise on that. There's actually technical reasons. To have multiple models it's difficult to combine their output the way that they're constructed, so just from a purely operational point of view, you have to pick your poison, choose the model that you feel is best for your book of business. We have a different approach. We actually licence all the available commercial models and we solve the operational problem of combining them by building our own model that combines all the outputs from these models to create a consensus view that, of course, we hope leverages the strength of each individual model while actually mitigating the blind spots inherent to each model. So that is absolutely what makes us different from other managers in this space and, to my knowledge, makes us different than most reinsurance companies as well.

Investment Portfolio

What perils are you typically exposed to?
So the market is dominated by US perils, so US earthquake and hurricane, wildfire, flood and tornado. So all the things that you might see in the headlines outside the United States; that's what drives our market primarily. Secondarily, we have perils coming from Japan, both earthquake and typhoon, and then next would be Europe, so European windstorm and even a little bit of European earthquake. But the market is absolutely dominated by US risk.

Why is your portfolio so heavily concentrated in the US? Could it be more global?
There is a lot of global catastrophe risk, but the way that our market is structured, its function, its reason for existence is that the traditional reinsurers absorb a lot of catastrophe risk in Europe and Japan already. And then they come to the US and they expose themselves to an amount of US risk that until that risk is equal to the risk that they're taking in Europe and in Asia. So you want to have an equal amount of risk in every geographic zone that they have. So once they go through that exercise, everything is neatly taken care of except for in the US. So the US structurally just has the largest concentration of insured catastrophe risk in the world. Now say, for example, if you go to, look at a city like Paris or even London, you have a tremendous amount of insured property there. But it's not an active hurricane or earthquake zone that's besetting those two cities. So I'm not trying to say that we have more insured property than the rest of the world, but we have more insured property that's also exposed to severe catastrophes. So again, that levelling exercise where the reinsurers go globally, cover as much as they can while keeping their risk exposures equal across all zones results in a structural shortfall of reinsurance in the United States, small structural shortfalls in Japan as well as in Europe. So we also take those. So really, that's just the natural risk profile of our market. And if you try to push it away from that then really all you're trying to do is take market share away from established players like Swiss Re and Munich Re. And we think that is not only pointless, but also unwise.

What timeframe should investors consider when investing in cat bonds? More opportunistic or more strategic?
I'd never make recommendations to anybody on that. If they want to come in and come out, they can do so. Cat bonds have the type of liquidity that actually could sustain that, or at least a catastrophe bond fund can withstand that type of action. But really, of course, for a serious investor, we would say that you should think about it for the long term.

Investing Opportunity

Why do you think there is a particular opportunity to invest in cat bonds right now? 
The current market conditions have created a significant imbalance between supply of cat bonds and capital able to absorb it. So effectively coming into 2023 there's the potential to triple the normal issuance volume of cat bonds, demand for risk capital is so high. So that supply/demand imbalance. And, by the way, this is not increasing the risk of cat bonds. If anything, it's actually decreasing it because now issuers are willing to pay more yield at a lower risk for the bonds that they're covering due to the scarcity of capital just to attract the capital into the marketplace. So really, it is, and we've said this without any qualification, that these are the most attractive conditions that we've seen in 25 years. When I ask people that have been around longer than 25 years, they'll say, yeah, you know, I've been around for 32 years, these are the most attractive conditions ever seen. It's not just pricing, It's not just risk, which is actually slightly throttled down here in our marketplace. Terms and conditions are improved as well and even diversification in the market is improved. As I touched on earlier I look at risks outside the United States. How are those moving? How are those affected? We're even seeing cat bonds come from other parts of the world that we haven't seen in 10 years because the market is so stressed for risk capital that even non-traditional areas for catastrophe bond issuance are coming to market. That, of course, only improves our ability to diversify the portfolio.

Are there other major segments of the cat bond market that you think should be of interest to investors (eg cybersecurity or pandemics)?
Pandemic is definitely a possibility. There was actually a bond that covered the pandemic that we just went through; it was issued by the World Bank. It was triggered and it made a full payout. So the mechanisms for doing that are there. It's yet to be seen whether governments will act on that,but the market is ready to take that risk down. I would say that the more promising and interesting risk, emerging risk is cyber risk. So just two weeks ago we had come to market the first cyber catastrophe bond, and it's no secret because I allowed our name to be put in the press release that we were the lead investor for that. It was a small issue, USD 45 million. So this is just the beginning. It's less than half a percent of our portfolios. But if the expected growth trajectory takes place in that market that everyone is expecting, that Florida hurricane will no longer be the largest risk in the catastrophe bond market, It will be cyber risk. Again this is far down the line. It's expected, perhaps, that this USD 45 million of cat bonds turns into, say, USD 500 million three years from now. And I think that's about right. But that USD 500 million, compared to probably a USD 50, 60 billion catastrophe market is still small. But again, the growth trajectory is so strong that it might be that 10 to 20 years from now the largest risk in the catastrophe bond market is cyber and no longer Florida.

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