Hedge Fund Fermat Has Best Year Ever as ‘Cat Bond’ Bets Soar

(Bloomberg) — Fermat Capital Management just had the best year in its more than two-decade history, after outsize bets on catastrophe bonds delivered record results.

The hedge fund’s returns were “in line” with the 20% gain in the Swiss Re Global Cat Bond Performance Index, according to Brett Houghton, a managing director at Fermat, which looks after about $10.8 billion of assets.

For cat bond investors, 2023 “was a unicorn year where you have great returns and equilibrium in the market,” Houghton said in an interview. There was “strong investor interest and the need for the insurance market to issue more and more cat bonds,” he said.

Fermat is the world’s biggest investor in so-called cat bonds, with stakes in 80% of the roughly 280 securities outstanding in the market. The bonds, which typically have maturities of three to five years, are increasingly popular with issuers looking for ways to cover uninsurable risks. Investors stand to get market-beating returns, in exchange for taking on the risk of losing some or all of their capital if catastrophe hits.

“The size of the market has increased, but it hasn’t increased enough to fill the need for potential events,” Houghton said.

Climate change has been driving growth in the cat bond market, as insurers start to retreat from loss probabilities too great to bear in the face of increasingly extreme weather patterns. And Houghton notes that inflation has added about 25% to the cost of rebuilding after a disaster, which also is leading to greater issuance of cat bonds to fill the gap.

Last year alone, natural disasters led to $250 billion of global losses, of which only $95 billion were insured, according to Munich Re.

Aside from large-scale hurricanes and other remote disasters, there’s growing industry interest in cat bonds that seek to capture the risk-reward calculus of so-called secondary perils — hailstorms, tornadoes and floods — which are generating an ever-higher level of losses for insurers. But many investors remain wary because the data and models underpinning such risks aren’t yet robust enough.

“We find some secondary perils to be attractive and some not,” said Houghton. “They can help diversify your portfolio but they also come with uncertainty. There’s less R&D that goes into those models.”

Other high-risk scenarios that cat bonds are being used to address include cyberattacks. Fermat has already started investing in such securities, and expects to increase its exposure, he said.

“The exposure of cyber losses is potentially in the same magnitude range as a Category 4 or 5 hurricane hitting Miami,” he said. “We’ve identified that part of the market as a major area of growth over the next five to 10 years.”

Investor interest in the securities is growing, and asset managers in cat bonds now include Schroders Plc, Leadenhall Capital Partners, Neuberger Berman and Blackstone Inc., which invested in the high-yield instruments to shield property assets from natural-disaster losses.

Fermat was founded in 2001 by John Seo, a physicist by training, and his brother Nelson. Right from the start, the firm focused entirely on catastrophe bonds, then a niche and poorly-understood form of alternative fixed-income investing. A key observation by Seo was that as more people moved to Florida, California and other places prone to natural catastrophes, the insurance industry would want to pass on a chunk of its growing risk to Wall Street.

Harnessing his background in physics, Seo then developed a more precise model than had previously existed to efficiently price the risk associated with extremely rare events, such as a devastating hurricane. Houghton, who says he’s known Seo for about 25 years, describes him as someone who possesses the requisite “enthusiasm” to enable him to “understand everything” there is to know about risk.

Last year’s gains in the cat bond market were buoyed by the fact that the hurricane season was milder than in 2022, meaning bondholders had to cover fewer losses.

The final quarter of 2023 saw $5.6 billion in new cat bond issuance, including private deals, taking full-year deal volumes to an all-time high of $16.4 billion, according to Artemis, a firm that tracks the cat bond and insurance-linked securities market. Those deals brought the total outstanding market to a record $45 billion, it estimates.

“And 2024 promises to be another interesting year for investors in terms of attractive returns,” Houghton said.

–With assistance from Nishant Kumar.

(Adds context around Fermat’s origins in fifth- and fourth-last paragraphs.)

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