by ~ Kristin Suga Heres (Email) (Web Site)
Entrepreneur Dr. John Seo of Fermat Capital Management, LLC kicked off the Seventh Annual MReBA Symposium with a keynote address that enlightened and inspired an audience eager to learn about the burgeoning market for Insurance Linked Securities (ILS), including CAT bonds. Skillfully navigating complex subject matter with ease and humor, Dr. Seo made ILS accessible to a diverse crowd of insurance professionals, and at the same time, challenged them to engage in the outside-the-box thinking that has been the driving force behind his own success.
Dr. Seo’s comments reflected and adapted several concepts from the world of technology. One theme that permeated Dr. Seo’s presentation was “Moore’s Law”: with the related notion that computing capability increases as we pack more and more transistors into microchips. By “densifying” or cramming resources into less and less space, we actually increase output. Dr. Seo observed that manifestations of this principle are all around us. For instance, cities are densified areas of population and resources which generate increased productivity as compared with less densely populated areas. According to Dr. Seo, one-half the world’s GDP is produced on 1.5% of the land surface. This is no coincidence. It is a form of Moore’s Law in action. The same principle can be observed in financial markets. By densifying productive assets, Dr. Seo posited, we increase wealth.
Indeed, Dr. Seo’s own personal story is akin to a Silicon Valley success story. Dr. Seo was in the right place at the right time as the CAT bond market emerged in the late 1990s. While working at Harvard Management Company, Dr. Seo received a call from Lehman Brothers. Warren Buffet had been trading in earthquake risks, and it was paying off (and handsomely so). Dr. Seo went to work for Lehman Brothers and risked up to $1B on insurance, including political risk, aviation, life/casualty, and “prop CAT” risks. At the time, Dr. Seo thought the CAT bonds were the most interesting of the group. In retrospect, however, Dr. Seo noted his surprise that CAT bonds ever survived the start-up stage, given the challenges for the formation of any new asset class. Dr. Seo decided to start his own firm to go after the CAT bond market. At the time, the consensus was that the market for CAT bonds was a $2-4B market at most. Dr. Seo ignored the naysayers and put everything he had into the market. Remarkably, he and his co-founder brother raised $1B before hiring a single employee.
Reflecting a real estate version of Moore’s Law, Dr. Seo noted, catastrophe risk doubles every ten years. In 1998, “the big one” in Florida was assumed to be $50B insurance industry loss. Today, in part because of increasing standards for capital adequacy, it is $180B. However, the traditional reinsurance market is not set up to deal with this scale of loss. Dr. Seo recognized that this pent-up need for coverage was could not be satisfied by traditional reinsurance markets in the long run. According to Dr. Seo, it is this force that is reshaping the industry, and CAT bonds are accelerating and catalyzing these changes.
Dr. Seo observed that CAT bonds currently available in the market vary in structure, particularly when it comes to the method by which the principal impairment is triggered. For instance, some CAT bonds – much like traditional insurance/reinsurance – have an “indemnity” trigger and respond when actual losses are sustained. Other CAT bonds are triggered when the insurance industry’s losses arising out of a particular event or catastrophe reaches a predetermined threshold. This is known as an “index” trigger. The CAT bonds that differ most dramatically from traditional insurance/reinsurance in terms of their trigger are “parametric” loss contracts, which are not tied to direct physical loss or damage to insured property. Instead, parametric bonds pay out upon the occurrence of certain benchmark conditions (e.g., the wind speed reaches x miles per hour in sixty ZIP codes or the tidal surge reaches x feet above sea level at a handful of specified coastal locations). As opposed to the traditional property reinsurance model (damage --> payment), some CAT bonds operate more like life insurance (need --> occurrence of condition --> payment). There was a very lively discussion regarding the various trigger mechanisms available, and the audience expressed particular curiosity with respect to the “parametric” trigger.
Dr. Seo opined that disasters like Superstorm Sandy have revealed that traditional insurance/reinsurance sometimes fall short of providing full indemnification for actual losses, particularly business interruption losses, sustained in connection with major catastrophes. In response, many businesses are diversifying their risk protection by going to the CAT bond market. While CAT bonds will likely never wholly replace traditional reinsurance, CAT bonds and ILS more generally are here to stay.
Ms. Heres is counsel in the Boston office of Zelle LLP. She can be reached at firstname.lastname@example.org.
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