ILS can add loss-absorbing capacity for cyber risks: Swiss Re

The development of innovative insurance-linked securities (ILS) vehicles could enable the capital markets to assume some of the world’s growing cyber exposure, according to the first Sigma report from the Swiss Re Institute.

The Swiss Re Institute officially launched on March 1^st, 2017, with the release of its first Sigma report that explores the complexities of the cyber risk world, discussing what the insurance, reinsurance, and ILS markets can do to improve current coverage shortcomings and develop an effective cyber insurance market.

Perhaps unsurprisingly, owing to its recent growth and ability to develop innovative risk transfer solutions, the ILS sector and its broad investor base is highlighted by the reinsurance giant as a viable way to increase the volume of “loss-absorbing capacity for cyber risks.”

The report states that the development of innovative investment vehicles that facilitate the use of capital markets investor capacity to assume some of the world’s vast cyber exposure, could help to align supply and demand for cyber protection.

“Some commentators believe that further innovations in ILS will ultimately pave the way for more cyber risks to be transferred to capital markets. As well as cyber catastrophe bonds, sidecar structures that pool risks for corporates, funded captive-type vehicles or some form of contingent capital instruments could all yet emerge, allowing capital markets to take on peak cyber exposures,” says Swiss Re.

Being such a huge and complex exposure with both great challenges and opportunities for the risk transfer landscape, Artemis has discussed the role of ILS in the cyber space numerous times. Interestingly, ILS and cyber risk experts recently explored the idea of a cyber catastrophe bond, saying that it’s time to stop talking about it and to start working to make this happen.

Regarding the development of a cyber catastrophe bond, Swiss Re draws on the recent issuance of Operational Re Ltd. in May 2016, a deal that provided Credit Suisse with protection against extreme operational risks, which included cyber-related catastrophe losses.

This innovative transaction, along with the experience of the catastrophe bond space and the variety of trigger structures utilised in the broader ILS sector, as well as the desire amongst the investor base to access diversifying risks outside of the highly competitive property catastrophe space, suggests that ILS can play an important role in the development of an effective cyber insurance market (as former Secretary of the U.S. Department of Homeland Security and now Chairman of Ridge Global, Tom Ridge said).

However, the Swiss Re Institute does highlight some potential hindrances to the expansion of ILS in the cyber risk space, which includes data and risk modelling challenges, and also the ability to show investors that returns on such securities would be uncorrelated with the wider financial markets.

This is an important point, as one of the key attractions to the ILS market for capital market investors is its extremely low correlation with other asset classes, meaning that during times of broad financial market turmoil the ILS space, typically and in the past, has outperformed comparable alternative investments.

As noted by Swiss Re, “a widespread cyber attack could, among others, also hit the value of stock and bond market investments,” suggesting that investors might require evidence of low correlation.

Basis risk, says Swiss Re, could also hinder the ability of ILS to participate in the complex cyber risk space.

“Sponsors of ILS typically want as broad coverage as possible so that they can recover the full range of losses they might incur. However, investors often want securities where the payoff is triggered by well-defined and observable metrics, because this reduces the potential for adverse selection and moral hazard (e.g., less motivation to limit losses), and also lowers their costs in evaluating company-specific underwriting and financial results,” says Swiss Re.

The above, combined with a lack of understanding of the risk, could hinder the establishment of a “deep and liquid market” warns Swiss Re.

“Nevertheless, the experience of the cat bond market suggests that over time, innovation can help align supply and demand for cyber protection through capital market vehicles,” says Swiss Re.

Cyber models continue to be developed all the time, seeking to assist with the pricing and assessment of cyber exposures, which will ultimately enable greater involvement from risk transfer markets around the world, ILS included.

“Transferring cyber-related risks to insurers and capital market investors will increasingly become a viable solution,” says Swiss Re. Adding; “There are nascent initiatives to develop insurance-linked securities that cover operational-type risks like cyber, although significant hurdles need to be overcome before such alternative risk transfer mechanisms become mainstream.”