Catastrophe Bonds: Diversification when you need it

"A market crash cannot cause a hurricane or earthquake to occur.”

~ John Seo, co-founder and managing director, Fermat Capital

The catastrophe (cat) bond space is seeing unprecedented demand for capital. The abundance of quality issuance since Hurricane Ian in what can often be a restricted asset class is opening up an unexpected opportunity and therefore portfolio diversification potential.
In a world of high inflation and volatile financial markets, investors are increasingly seeking ways to protect returns and diversify their portfolios. Cat bonds are ideally placed to provide just this. At GAM Investments, we partner with recognised insurance-risk industry leader and highly experienced manager Fermat Capital to offer these distinctive and specialist cat bond strategies to our clients.

Catastrophe bonds and insurance-linked securities, by their very nature and construct, are adjustable rate instruments that index well with interest rate rises and inflation.
John Seo, Co-founder and Managing Director, Fermat Capital Management

What are Cat Bonds?

Cat bonds, a type of insurance-linked security (ILS) are fixed income instruments issued by insurers and reinsurers to transfer to investors exposures from potentially large insured losses associated with natural catastrophes, as well as other ‘perils’ such as terrorism and cyber risk.  These bonds provide a form of reinsurance so that the insurer’s liabilities are covered, and they can afford to settle in full and aid recovery. In return - investors in Cat Bonds get paid a fixed rate of interest – just like a regular bond.  The skill is to calculate each Cat Bond’s true risk and identify the opportunities with the most attractive yields. 

 

 

Why invest in cat bonds now?

  • Diverse return drivers
  • Uncorrelated with broader financial markets
  • Enhanced liquidity
  • Strong ESG credentials
  • Attractive entry levels relative to history

Key Characteristics

Adaptive to rising rates and inflation.

Cat bonds by their very nature and construct are adjustable-rate instruments that are indexed to inflation. The coupons on cat bonds are all floating rate; every basis point rise in interest rates on the short end of the curve flows directly into the coupon.

With regard to inflation, insurance companies themselves meticulously reset their premiums on an annual basis with every policyholder according to prior and expected inflation. This means that the very nature of the business itself is indexed to inflation.

Fear, uncertainty and doubt drives insurance and reinsurance buying.

Fear, uncertainty and doubt tends to affect the psychology of insurance buyers, compelling them to buy more insurance at a premium.

But crucially investors in the cat bond market do not necessarily pay for the benefit with a higher risk because a market crash, or even an event like the war in Ukraine, cannot cause a hurricane or earthquake to occur.

Alignment with ESG principles.

Cat bonds are well aligned with environmental, social and governance principles.

E: They are at the forefront of monitoring changes in weather extremes and their impact on economies.  

S: Insurance in general is a social form of finance, applied to neutralise risk across a broader pool to reduce its impact and severity on society.  

G: The cat bond market brings an unprecedented level of market transparency around pay outs for catastrophes. This allows governments to plan and budget for their response to such catastrophes. 

The World Bank has estimated that having funding in response to a catastrophe from ILS has a multiplier effect of at least one hundred times. This means that every USD 1 of response to a catastrophe coming from ILS is worth at least USD 100 of aid that comes through the traditional response system.”

Cat Bonds during crisis years

In a world of specialist asset classes whose alternative status has been undermined by correlations with other risk assets, cat bonds offer diversification on a fundamental level. Because their pricing is not driven by economic or corporate events, returns from cat bonds are largely independent of mainstream markets and fundamentally non-correlated with traditional asset classes.

John Seo: Cat bonds pioneer

In the 1990s the insurance markets in both Florida and California were collapsing due to earthquake risk. At that time John Seo, co-founder and managing director of Fermat Capital, was invited to set up a proprietary trading group at an investment bank focusing on a new type of product – catastrophe bonds – in response to this opportunity.  
What I loved about the asset class is it’s mainly driven by risks from earthquakes and hurricanes. That fundamental isolation from market risks was immediately appealing to me. My father, a mathematician, gave me a tail risk pricing problem when I was about 12 years old and it has been something that has fascinated me intellectually ever since."

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GAM’s partnership with Fermat

GAM partners with Fermat, who is a recognised insurance-risk industry leader and highly experienced cat bond manager, based in the US. The portfolio managers, Dr John Seo, Nelson Seo and Brett Houghton, manage assets of approximately USD 8.1 billion and have over 50 years' combined experience in ILS and cat bonds, dating back to the inception of the market in the late 1990s.

The level of experience and in-depth market knowledge is critical to Fermat's ability to identify the true risk of each bond, as well as granting them ready access to new issuances.

Over time, the team have demonstrated their expertise by actively trading billions of dollars in catastrophe bonds through a series of large insurance industry events and natural catastrophes, while providing stable returns for clients and maintaining high levels of liquidity.

Dr John Seo
Co-founder and Managing Director of Fermat Capital
Nelson Seo
Co-founder and managing director of Fermat Capital
Brett Houghton
Managing Director, Fermat Capital

Introduction to Cat Bonds

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Disclaimer: Past performance is not an indicator of future performance and current or future trends. The indications could be based on figures denominated in a currency that may be different from the currency of your residence country and therefore the return may increase or decrease as a result of currency fluctuations. Capital at risk: all financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Any reference to a security is not a recommendation to buy or sell that security.