When Fermat Capital Management’s John Seo was 12 years old, he got into an argument with his father that lasted well into the night. It was about a math problem.

Seo’s father, a professor at Southern Methodist University in Dallas, was working on something called the investor’s choice problem, where an investor must choose between two investments. The investments have the same expected return and the same expected volatility of return, but the return distributions are visually different — for example, one might look like a bell curve, while the other might look like the top half of a Batman logo, Seo explains. The person solving the problem must choose which investment is better. In the elder Seo’s view, the answer was simply a matter of personal preference.



“It’s kind of like you’re looking at two pictures and you’re saying, ‘Which one’s more beautiful,’” John Seo, 51, explains from a conference room at Fermat’s Westport, Connecticut headquarters on a snowy afternoon in early March. Inscrutable mathematical calculations cover a white board on one wall of the room. “I don’t know why, but it really upset me. I couldn’t believe he was being so defeatist about it.”



Finally, Seo’s mother — who also holds a doctorate in mathematics — had enough and came downstairs to break up the argument.



For the record, academics still consider the problem to be unsolvable. But Seo’s introduction to the problem as a preteen foreshadowed what he would end up doing with the rest of his life. Fermat, a $5.8 billion investment firm that Seo co-founded with his brother Nelson and named after French lawyer and mathematician Pierre de Fermat, has spent much of his career seeking out problems for which no solution currently exists. This is what drew him to the nascent market for catastrophe bonds — securities that ostensibly transfer the risk of damages from catastrophic events, such as hurricanes and earthquakes, from insurers to sophisticated institutional investors — back in the late 1990s.



Since then the market for so-called insurance-linked securities — of which catastrophe bonds are now but one type — has grown to $89 billion, comprising a substantial proportion of the $605 billion global reinsurance industry, according to Aon Securities. Cat bonds, as they are commonly known, now account for some $27 billion of the total ILS market; last year cat bond issuance hit a record $11.1 billion, according to specialist ILS and insurance magazine Trading Risk (like Institutional Investor, Trading Risk is owned by Euromoney Institutional Investor.) At the start of this year, the top ten ILS managers controlled a combined $62 billion, the publication found.



The ILS market got its start when a pair of catastrophes — Hurricane Andrew in Florida in 1992 and the Northridge earthquake in California in 1994 — revealed that the global reinsurance industry, which backstops traditional insurers, was severely undercapitalized to deal with events of that magnitude. But the industry really took off after 2008, when ILS managers proved to be among the only firms in the capital markets that ended the year with gains. As ILS managers explain, it was an eye-opener for many hedge fund investors, who suffered huge losses in 2008 as the industry’s alternative strategies turned out to be more correlated to equities than they thought.



“People started to realize that there was a tail to those strategies as well. The structured credit guy and the long-short guy could lose 30 percent,” says Tony Rettino, a founding principal and senior portfolio manager at Chicago-based ILS investment firm Elementum Advisors, which manages $3.7 billion.



Barney Schauble, a managing partner at Nephila Advisors, the oldest and biggest of the insurance-linked managers, says this caused a huge uptick in interest in insurance-linked strategies, as well as a shift in the investor base. What was once the provenance of wealthy individuals, family offices, and funds-of-funds suddenly attracted investment from pension funds, endowments, and sovereign wealth funds.



Like other ILS managers who performed well in 2008, Nephila had to pay out redemptions that year because clients needed liquidity. Still, when the dust settled, the firm ultimately grew, with assets climbing to $9 billion from $3 billion over the course of just a few years — they now stand at $11 billion — thanks to the influx of institutional money. In 2013, KKR & Co. purchased a 24.9 percent stake in parent company Nephila Capital to become a minority shareholder alongside Man Group.



Other ILS managers popped up and also grew their assets at a rapid clip. Today institutional investors including Dutch pension giant PGGM and the Massachusetts Pension Reserves Investment Management Board either allocate or plan to allocate to the strategy, and ILS managers say many more pensions are evaluating it, at the behest of consultants.



But ILS funds faced a major test last year. After 12 years in which no major Atlantic hurricanes made landfall in the U.S. — the catastrophe, or peril in industry parlance, that accounts for a significant proportion of cat bond coverage — a trio of hurricanes, as well as California wildfires and an earthquake in Mexico, racked up an estimated $130 billion to $135 billion of losses, including $80 billion to $90 billion in losses from hurricanes Harvey, Irma, and Maria, according to Trading Risk. (Some ILS managers, including Seo, think the total from the three hurricanes will come in closer to $60 billion.)



Trading Risk says many of last year’s losses were retained by primary insurers, rather than being transferred to the reinsurance markets. Still, the ILS market could be on the hook for as much as $15 billion of the hurricane claims, wiping out a substantial chunk of its estimated capital base, the publication found. The Eurekahedge ILS Advisers Index, which began tracking the performance of insurance-linked funds in January 2006, posted its worst-ever loss last year, with the average ILS manager losing more than 5 percent.



But ILS managers say their clients aren’t running for the exits — indeed, several ILS managers are launching new funds right now — in large part because they are sophisticated enough to understand what they are getting into. “They’re called catastrophe bonds. That’s the strongest disclosure you can have,” says Seo. “It means after a loss, you can’t have some board member saying, ‘Wait, wait, wait. I knew that this was insurance linked, but not this!’”



Niklaus Hilti, head of insurance-linked strategies at Credit Suisse Group’s asset management unit, which manages $9 billion in the asset class, says many investors have become sophisticated enough around ILS market dynamics to actually want to increase their allocation to the strategy after a catastrophe-prone year.



“They have become smarter about moving in and out of these markets after a big event,” he says. “They understand after a big event there will be premium increases.”



This increasingly sophisticated investor base has a higher tolerance for losses from the strategy than earlier ILS investors, which also helps. As Elementum co-founder and senior portfolio manager John DeCaro explains, big institutional investors typically allocate just 1 to 2 percent of their assets to ILS strategies — so even an extreme, 1- in-10,000-year event could only result in an overall portfolio loss of 50 to 150 basis points, or 0.50 to 1.50 percent, depending on their risk tolerance in the ILS allocation.



Adds Ben Brookes, London-based head of the capital markets team for catastrophe risk modeling firm RMS, “That is a level of volatility that the pensions are very comfortable with. You see it on a daily basis on Wall Street.”



And with ILS managers so far absorbing last year’s hurricane damages without really blinking, insurance companies — which had once feared that ILS managers were backed by hot money that would split at the first sign of trouble — are now buying into the ILS story too.



“2008 convinced the investors that the non-correlation story is valid. 2017 is convincing insurance companies that insurance-linked securities investors know how to take a loss,” says Seo. “They realized that what they were told about investors being very fragile around losses, or being untested around losses, was not true.”



It also has the endorsement of the Federal Emergency Management Agency. “We need novel solutions to close the insurance gap. And insurance-linked securities, which can transfer financial risk from the public sector to the capital markets, are novel indeed,” Daniel Kaniewski, the second-highest-ranking official at FEMA, tweeted in March.



Now that the strategy has proved its worth, and has the backing of institutional investors and regulators, ILS managers say it has plenty of room to grow. That’s in part because a massive protection gap still exists — that is, the difference between insured losses and uninsured losses. As wealth in the U.S. has increased exponentially over the past few decades, the density of real estate along the coast has skyrocketed, as have the property values of all those beachfront properties.



To explain what that means to the ILS market, Seo relays another story from his childhood. His family used to travel to the Gulf of Mexico, along the Texas coastline, for family vacations twice a year, where his father liked to fish. Seo asked his father why there were so few houses along the coastline. The elder Seo explained that a hurricane hit Galveston on September 8, 1900; with death-toll estimates ranging from 6,000 to 12,000, it remains the deadliest in U.S. history. “It’s just too risky,” he explained to his son.

But today that coastline, like other coastal regions in the U.S., is highly developed. The hurricane of 1900 is a distant memory, even if the risk persists. “People want to look out their window and see water,” John Seo says. “It makes them happy.”



How do you securitize a hurricane? It’s a question very few people thought to ask before August 1992. That’s when Hurricane Andrew, a Category 5 storm, ravaged the Florida coast, killing dozens of people and causing a staggering $26.5 billion of losses, according to the National Hurricane Center. The damage toll was far greater than what insurance risk managers had expected in a worst-case scenario; several insurance companies ultimately went bust as a result, and the World Meteorological Organization officially retired the name Andrew. It was a wake-up call for the insurance industry, which had failed to take into account rapidly increasing population density and property valuations in disaster-prone areas.

Just two years later, on January 17, 1994, an earthquake with a magnitude of 6.7 hit suburban Los Angeles, killing more than 60 people, injuring more than 9,000, and leading to the wholesale collapse of buildings and freeways, according to a report by The Atlantic.



“Those two things really caused a massive recalibration of the amount of risk that was out there,” says Nephila’s Schauble, who chairs the firm’s climate group. “There was just this wholesale recalculation around, ‘Maybe there’s just more risk here than the insurance industry can digest.’”

This led to a fundamental shift in the industry. In addition to the revelation of the massive protection gap in both Florida and California, insurers and reinsurers were unwilling, or unable, to provide the same level of coverage as before the disaster. Enter the capital markets.



“Twenty-five years ago, all the cat risk in the world was funded off insurance and reinsurance company balance sheets,” explains Elementum’s Rettino. In other words, if there was suddenly more demand for reinsurance, then more reinsurers would pop up to meet it. “It was really a closed system with very limited access to external capital,” he says. “When you had an event that would occur in one part of the market, it would create a big supply-and-demand imbalance. And supply-and-demand imbalance was historically met by formation of new companies.”



In a way, ILS managers point out, the market’s evolution is similar to that of mortgage-backed securities. Before securitization hit the mortgage market, those loans simply sat on banks’ balance sheets; if a bank could not take on additional credit risk, it just didn’t write more loans. But the demand for mortgage loans far outstripped banks’ ability to write them, until the advent of securitization, when other capital market participants stepped up to take the risk.



“Until cat bonds came along, insurance risk was not truly securitized and tradable,” says Seo.

That all changed in 1996 with the issuance of George Town Re, the first-ever catastrophe bond. The deal was underwritten by Goldman Sachs Group; Schauble, who worked for the bank at the time, helped put together the deal, which was designed to cover risks globally.

Schauble has spent his entire career focused on the idea of catastrophe risk; he wrote his senior thesis on the topic at Harvard University. Today he heads up Nephila’s office in Larkspur, California, a scenic 30-minute ferry ride from San Francisco.

Schauble converted a 1994 internship at Marsh & McLennan Cos. in New York into a full-time gig at Guy Carpenter, the company’s reinsurance arm, where he had worked on his thesis. During his stint at Goldman selling the industry’s first cat bonds, he got to know Frank Majors and Greg Hagood, who had been working for insurance broker Willis Group in London. They started Nephila — named for a type of spider in Bermuda that, according to folklore, can predict bad weather — with $12 million in 1997.

“We were the first people selling these products and they were among the first people set up to buy these products, so we got to know them early on,” Schauble says during a conversation in Nephila’s loft-like and spacious Larkspur office, a recently renovated, barn-like building adjacent to an upscale Marin County shopping center.

That’s around the same time that Elementum’s DeCaro and Rettino began working at insurance and reinsurance broker Aon’s capital markets group, which Rettino helped launch in 1997. The two had worked together in Aon’s investment department since 1995 and ultimately worked on creating many of the first cat bonds and catastrophe risk structures, with DeCaro serving as Aon’s dedicated cat bond trader and market maker. The two eventually split from the firm and began managing their first third-party fund at Cochran, Caronia & Co. and later an ILS portfolio for the now-defunct multistrategy hedge fund business at Stark Investments, before spinning out and launching Elementum in 2009.

Meanwhile, Seo was working at Lehman Brothers Holdings, having ditched his dream of working in academia after learning, upon accepting a postdoctoral position at Brandeis University, that its health plan would not cover his wife’s pregnancy, which it had deemed a pre-existing condition. “I was earning $8,900 a year at that time,” he says. “The hospital told me they needed a $5,000 cashier’s check right there and then just to even let me in the hospital.”

He flew to Chicago in 1991 to interview at O’Connor & Associates. Knowing little about the markets, he bought a copy of Gary Gastineau’s The Options Manual at the airport and read it on the plane. Despite startling his interviewers by admitting right off the bat that he had no interest in money — just the health insurance — he landed his first finance gig. He eventually wound up at investment bank Donaldson, Lufkin & Jenrette, working on the mortgage-backed securities team for Donald Peskin, one of the pioneers of the marketplace, before moving on to Harvard Management Co. and then Lehman Brothers. But eventually he grew bored of the work, feeling the early mathematical yearning to solve problems for which no answer existed yet.

“They finally called me up and said, ‘I’ve got something that doesn’t exist: catastrophe bonds,’” says Seo. “What they were really talking about was the birth of a new asset class.”

That asset class has become substantially more sophisticated than it was 25 years ago. Catastrophe bonds are by far the simplest insurance-linked security available; these deals function like multiyear insurance contracts and consist of a sponsor (the insurance company) and investors (the capital market participants) whose assets are essentially held in an escrow account that buys AAA-rated securities, such as money-market funds. If the bond is triggered — in other words, if a catastrophe happens — then the insurers collect the money in the escrow account. If no catastrophe occurs, the capital market participants get it back, plus whatever coupon they charged the insurers in exchange for the extra protection.

“Japanese earthquakes, European windstorms — name a catastrophe, we’ve securitized it,” says Judith Klugman, global co-head of ILS distribution at Swiss Re Capital Markets. She explains that cat bonds differ from normal asset-backed securities in one major way, which is that each bond has a third-party risk assessor to provide the bond with an analysis of loss probability — in other words, how much of a loss the ILS manager or pension fund buying a given cat bond can expect to face if that specific catastrophe comes to pass.

By far the biggest component of the reinsurance market consists of collateralized reinsurance — one-off, custom deals between insurers and ILS managers covering a one-year insured period. ILS managers liken cat bonds to publicly traded stocks and collateralized reinsurance to private equity.

Then there are riskier retrocession strategies — reinsurance for reinsurers that Schauble calls “the CDO-squared of the cat bond market” — and industry-loss warranties, which are year-long derivatives contracts that only get triggered if total industry losses exceed a given amount.

ILS managers vary in the type and degree of these instruments they invest in; Nephila invests about 90 percent of its ILS assets in collateralized reinsurance deals and 10 percent in cat bonds; Fermat’s ratio is the opposite, and Elementum falls in the middle, with a roughly 60/40 split between collateralized reinsurance and cat bonds. Other major players include Credit Suisse, the ILS unit of LGT Capital Partners ($7.9 billion in assets), Securis Investment Partners ($6.2 billion), and Stone Ridge Asset Management ($6.1 billion).

ILS managers underwrite several different types of perils — earthquakes in California and Japan, windstorms in Europe, and, by far the biggest, U.S. Atlantic hurricanes, the type of peril that birthed the ILS market.



It’s also the peril that gave the ILS market its first major test. In 2005, Hurricane Katrina caused $41 billion in insured losses alone, according to Property Claim Services, a unit of Verisk Analytics that has been estimating damage tolls from natural disasters since World War II. Another slew of hurricanes — Rita, Wilma, Ophelia, and Dennis — pushed the total insured losses that year to $80 billion, according to Swiss Re. The year brought 28 tropical storms, three of which caused major damage to three entirely different states and cities.

Schauble had only joined Nephila the year before — and barely had time to get used to the job before the stress of 2005 made him briefly question his career choice.

“Every day from June to November there was something in the water, so that wears you down,” he says. “I can remember being at an investor meeting in a room with maybe 14 people there, all of whom were basically just shouting at me, ‘How could this happen?’ and talking about climate change and cities being destroyed and U.S. government policies — a lot of things that I’m not actually personally responsible for.” Schauble — who can now smile as he tells the story — recalls thinking, “‘This isn’t a ton of fun.’”

The world wasn’t exactly catastrophe-free for the next few years — there was the massive 2011 earthquake in Japan that “vaporized” at least one cat bond, as Schauble points out — but there wasn’t another major hurricane-loss year until 2017, which Seo describes as a hurricane drought. The California wildfires that began in October caused $9 billion in losses, the state’s insurance commissioner estimated in December, though those losses are expected to be primarily absorbed by traditional insurers.



One major difference between 2005 and 2017: The cat bond market wasn’t big enough in 2005 for ILS managers to actively trade around the storm. Last year provided managers with the opportunity to stress-test their live storm trading skills.

“In the automobile industry they claim Formula One is really where you test your technology and your skills against others,” says Seo. “When you actually get these live events occurring, like we did have last year, that’s our Formula One of the market. You have to recalculate in real time” what you think the losses will be, he explains, and “you can actually test that and trade on that. That’s not really something that was possible ten years ago.”

On the whole, 2017 turned out to be an intense year, but it wasn’t nearly as bad as it could have been. Because it could have been really, really bad.



“What we saw were three approximately $20 billion insured losses,” as well as California wildfires, which “one could argue occurred in relatively distinct segments of the insurance or reinsurance markets,” says DeCaro. “To a certain extent they were almost independent events. We didn’t see a hurricane strike Miami.”



With uninsured losses from Irma expected to be significant, according to RMS, the event underscored how big the protection gap still is. That’s because, as Seo explains, reinsurers have to operate as if the dollar amount of underlying risk in each geographic region they cover is roughly the same — otherwise they could lose their A grade from ratings agencies, which would likely deem the underlying risk too high in particular areas (mainly California for earthquakes and Florida for hurricanes). That would jeopardize their ability to offer more reinsurance policies.



In reality, catastrophe risk is much more concentrated in specific areas — the probability of a hurricane in Florida is much higher than the probability of a windstorm in Europe, for example — and therefore the total amount of dollar losses is potentially much higher. And there are so many areas that aren’t covered by primary insurance that the need for reinsurance is far greater than existing reinsurers can provide.



“If you go down to Florida, there’s no nationally recognized insurance companies doing business down there to any significant degree,” says Seo — think Allstate Insurance Co., State Farm, Geico, and other names you might know. “It’s because they can’t risk their balance sheet. There’s not enough reinsurance to back them if they want to go down there.” The significant lack of national insurers leaves room for “misconduct in claims practices to get out of control” in some areas of Florida, says Seo, which in turn discourages national insurers from entering the state’s market.



Taking on the excess risk from these perils is where alternative capital providers like Fermat come in. Seo likens it to posted table limits at casinos.



“Effectively, what’s going on is that in certain markets, the risk is exceeding the table limit,” he says, pointing out that current estimates for insured losses from a Category 5 hurricane hitting Miami stand at $180 billion, while only $30 billion of that would be covered by traditional reinsurance — a massive gap. Seo argues that the amount of property on U.S. coastlines has gone up by 50 percent per decade since World War I, but the concentration risk has increased by 100 percent per decade over the same period. What’s more, the risk that traditional insurers and reinsurers are willing to absorb has not kept pace.



“We now have $1 trillion concentrations of property. The other table that they have to go to is the ILS market,” Seo says. “We think that meeting this capital need, which is growing rapidly and is structurally unserviceable by traditional insurance and reinsurance mechanisms, is the most interesting dynamic in the marketplace.”

In the meantime, industry watchers are still wondering what would happen if a major hurricane slammed into Miami and then made its way up the East Coast. If the Category 4 hurricane that hit Miami in 1926 were to happen today, it would cause an estimated $125 billion in losses, DeCaro says. He points out that the likelihood of such an event is extremely remote — but not beyond the realm of possibility. Whether a similar event will hit the insurance industry again is the $130 billion question.



“It all comes down to the unexpected,” says Brent Poliquin, assistant vice president in the ILS market segment of AIR, a part of Verisk that has provided catastrophe risk modeling services and software for more than 30 years. “A Category 5 hurricane hitting Miami, the potential impact of that is well understood — and people can plan for it because it’s a known and quantified risk. It’s when something occurs that wasn’t thought of before that could be a market-crippling event.”

While scientists and risk modelers ponder the answer to that question, industry experts are figuring out ways to take on even more risk. Some managers, like Fermat, have already expanded beyond weather, earthquake, and fire-related catastrophes into so-called pandemic risk, or the (admittedly remote) risk that an event like a terrorist attack or global flu pandemic could cause mass casualties. One burgeoning area is cyber risk — for example, what would happen in terms of damages if, say, Amazon’s cloud went down due to a cyber attack — and how to offer protection against it.



Earlier this year, Nephila launched Nephila Climate, a $500 million business based on weather strategies, selling protection to businesses that are adversely affected by everyday weather conditions as opposed to catastrophes — think golf course and theme park operators dealing with heavier-than-usual rainfall during traditionally busy periods. Schauble thinks this strategy could eventually be adapted to offer protection related to power generation or crop yields.



Schauble says the business feels like the catastrophe market did in the early 1990s, with high potential but few buyers. But, as he points out, the ILS market was created as an answer to a problem that, until disaster struck, people didn’t know they had — and the fact that it has taken off the way it has only serves to show how truly necessary it is.

“In the end, there’s a real basis for this asset class. People need noncorrelated investments, and they need protection. We have a business in the middle trying to make that market a reality,” says Schauble. “Not a lot of jobs in financial services are like that, where you can say, ‘Okay, this is good for both people.’”