Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Natural disasters another demographic problem
(Pictured: John Seo)
John Seo likes his job because he feels like he is doing something worthwhile. He’s the world’s largest investor in catastrophe bonds.
In the funds management industry we tend to focus on the demographic problem of ageing with respect to government funding and deficits into the future. Our old-age pension system and subsidized health care do not augur well for government finances as the baby-boomer blimp moves through retirement towards a drawn-out and costly death.
But there are other big long-term fiscal issues facing governments around the world. One is the inadequacy of the private insurance system, along with governments, to cover for natural disasters. Because the whole world has migrated to the coast as it got richer over the past decades, the cost of damage due to certain weather events, particularly cyclones, has soared.
Seo, the founder of Connecticut-based Fermat Capital Management, says that most of the big global insurance companies are now issuing catastrophe bonds because they can’t cover the losses through traditional policies. Nine out of the top 10 insurance companies and five out of the top 10 re-insurers are issuers of the bonds.
The catastrophe (cat) bond market started to be developed in the mid-1990s, with Swiss Re leading the way. Today, insurance companies are warehousing more risk than the re-insurers can handle so they are trying to offload this onto the cat bond market.
Seo says that the insurance and re-insurance markets are based on “casino logic” which was born in the 17th century. It was observed that the way to control risk was to spread it around with a lot of independent risks of a uniform size. This is why casinos have table limits.
“It’s served the industry well for 300 years but society’s not a casino,” Seo says. “Wealth creation is lumpy.” What this means is that some less-expensive regions, such as the south island of New Zealand, are over-insured and wealthier areas, such as Florida, are under-insured. Governments are starting to intervene by issuing their own cat bonds. California has an earthquake bond and Florida has a bond for cyclones. Turkey, also, has issued a bond off an insurance pool.
Seo says the lack of coverage reflects a “market failure”. The state of Florida has a potential exposure to hurricane and flood risk of about $200 billion but re-insurers are carrying only $20 billion of this. “The system is naked,” Seo says. The Kobe earthquake, in 1995, had an economic cost of $100 billion but the city had insurance coverage of only $1 billion.
Earthquakes, hurricanes and the related floods represent the greatest natural risks, since the impact of major fires in cities has largely been controlled with modern building materials. It was the Great Fire of Hamburg, in 1842, which caused the collapse of the Hamburg Fire Fund, an insurance company which had been started in 1676, which prompted the start of the re-insurance market.
With respect to the current issue, and debate, around climate change, Seo says that it does have an impact, it’s just that we don’t know what the impact is.
Fermat employs scientists but they do not try to predict disasters, as governments have been trying to do for centuries. “You don’t need to know the future,” Seo says, “You only need to know what has just happened… You typically have four-six weeks before the extent of the damage is known, not seconds.”
From an investor’s point of view, cat bonds offer some interesting characteristics, particularly lowly-correlated returns of about 6-7 per cent over extended periods. Seo says that some investors are starting to talk about insurance-linked securities as a separate asset class.
Fermat has raised about A$450 million from Australian investors and has an Australian-domiciled fund, formed with its third-party marketing company, Brookvine, which will accept amounts as low as $250,000 from sophisticated investors. Globally it has more than US$4.5 billion under management, eclipsing PIMCO, which was previously the world’s largest manager of cat bonds.
