Insurance-linked securities and cyber risk - a risky mixture?
20 November 2017
Insurance-linked securities (ILS) are a way to access additional financial protection outside the traditional insurance and reinsurance providers, typically through capital markets. ILS are most commonly associated with catastrophe bonds providing reinsurance cover in the event of significant natural catastrophes.
Cyber risk is one of the most discussed new areas of risk for the insurance industry to address. As a relatively new exposure, the development of cyber insurance solutions presents a range of challenges, including specific challenges for those seeking to offer ILS solutions.
Catastrophe risks and ILS
ILS have made considerable progress within the catastrophe reinsurance market, in part because there is a degree of consensus on the way in which the risks can be modelled. This level of consensus has arisen as data relating to past catastrophes has been analysed and knowledge shared across the market. Therefore, investors in ILS can have some comfort in the pricing of ILS and the assessment of potential risks and returns.
While the chance of a natural catastrophe is uncertain, it is possible to analyse the available data on past claims and events to develop an informed estimate of that likelihood. The risk of an earthquake or flood is likely to be highly correlated with past experience for a specific geographic area.
The nature of losses is also likely to be consistent, with property damage a prime issue. The risk of such losses will be closely linked to known perils such as floods or windstorms.
Of course, factors such as global warming, or the decision to build on flood-prone areas can influence potential outcomes. However, such issues are regularly discussed and broadly understood, and investors appear to have become comfortable with backing ILS structures based on existing models.
Challenges for cyber risk
In contrast, cyber risk poses a number of challenges in developing an agreed approach to assessing the risk.
Firstly, cyber risk is not a clearly defined term. It is in fact a term covering a number of related risks including; third party liability for loss or exposure of data, notification costs (to let those affected know of a data breach), impact on call centres, data loss and restoration etc. This list is not exhaustive, and different insurers may cover different mixtures of risks, requiring a variety of concurrent modelling approaches.
Secondly, the trigger for cyber claims is very different. The existence of a natural catastrophe is likely to gather much publicity, so the existence and scope of the event is public knowledge. Cyber risks are often related to malicious or criminal intent to steal data. Such events may become public, but it is widely believed that many organisations prefer not to go public (and make others aware of their vulnerability) when confronting cyber incidents.
The risk of an incident is part of an ongoing struggle between those seeking access to systems with criminal intent and the effectiveness of systems and staff to manage these risks. Such claims can become more frequent if new means of hacking become available or less frequent if system protections are readily updated.
Thirdly, insurers need to assess to what extent companies and individuals should be protected if they have neglected basic precautions such as (regularly updated) anti-virus software. Underwriters currently seek such information on particular policies, but it is difficult to develop an ILS product which responds at an aggregate level to risks which may be strongly dependent on the actions and cultures of different organisations.
Will the ILS industry rise to the challenge
As noted above there are significant challenges in developing standard products suitable for an ILS approach. However, much effort is likely to go into trying to develop solutions including ILS because the potential market is very large. Virtually all organisations have some exposure to cyber risk and the costs of claims could be extensive. If most organisations can be convinced that appropriate insurance cover should be part of the process for managing this risk, the potential premium could be significant.
Education, education, education
A key initial task will be to educate the various parties involved in ILS structures of the nature of cyber risk and the potential benefits of offering a product.
The potentially large premiums remain likely to compel interest. One estimate of the market was that pure cyber risk premiums amounted to $2.5 billion in 2016 (an increase of 35% on the prior year). Some elements of cyber risk are also likely to be covered in other policy classes.
Nevertheless, key market participants may be less than enthusiastic to share details of their experience which they may view as commercially sensitive. The absence of publicly available data and the non-standard nature of cyber insurance products mean the growth of an ILS market will remain challenging.
Public claims may drive change
While details of some claims remain confidential there are other data breaches that inevitably become well known due to their scale. As such incidents are published the appetite for insurance to cover the risk may increase.
If large claims emerge then insurers will need to seek reinsurance support. This is likely to drive exchanges of information as reinsurers try to assess their potential exposures. It is at this stage that opportunities for ILS structures may be more likely to emerge.
Even if risks remain to some extent non-standard, it may be possible to analyse risks by exposure to particular hardware or software. The status of third party providers may also have an impact, as their own security and risk management practices may have downstream implications.
Informally or formally underwriters may start to agree on key issues that will contribute to the assessment of risk to specific organisations.
The new EU legislation on data protection (GDPR) is already having a profound impact on organisations as they seek to ensure compliance. This will drive an awareness of the risks inherent in holding personal data and consideration of means to manage those risks, including insurance.
The level of risks will also increase as the costs in potential fines and compensation have to be factored into business decisions.
At this stage it remains challenging to develop ILS solutions as the cyber risk market remains relatively new. Underwriters are likely to have differing views on the potential for claims and there are no widely agreed ways to quantify the risks involved. Furthermore, the nature of cyber risk remains diverse and will need more rigorous definition.
However, I am optimistic that these issues can be addressed over time. The ILS industry has shown its willingness to innovate outside natural catastrophe risk, including insuring large lottery pay-outs.
As with natural catastrophes, the costs involved in major data breaches can be high and legislation means that the risks are increasing. Therefore, insurers and reinsurers will need access to capital to back these risks. I would anticipate that solutions will gradually emerge and that ILS will play a role in supporting these solutions.
An original version of this article was first published by PropertyCasualty360, September 2017.
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