ILS / ILW retro needed for non-affirmative cyber: Johansmeyer, PCS

As re/insurers struggle to find ways to manage their non-affirmative cyber exposures, there’s an opportunity for the insurance-linked securities (ILS) community to support an ILW-based retro market to address the issue, says Tom Johansmeyer, Head of PCS.

Non-affirmative cyber risk losses occur when a policy pays out on a cyber cause despite the policy wording failing to explicitly state cyber.

Highlighted by the NotPetya event, which amounted to almost $3 billion in insured losses, large property programs could be exposed to a sizeable amount of unhedged or even unknown cyber risk.

Johansmeyer of PCS explains that re/insurers have struggled to develop a solution and for the most part, have focused on establishing cleaner and more specific policy language regarding cyber.

While this will undoubtedly remove some of the ambiguity, wordings can’t be altered while a program is in effect, and ultimately, it’s not exactly straightforward getting insureds to accept clearer language. Furthermore, insurers could face reductions in market share by taking a firm stance on language that’s ambiguous on cyber.

Johansmeyer continues to warn that similar challenges exist for reinsurers. As well as being exposed to the risks associated with the underlying policy language, reinsurers face cedants committed to consistency of reinsurance cover with their underlying insurance programs.

“So, what’s the state of play?” questions Johansmeyer. “Well, there could be a lot of unhedged or even unknown cyber exposure in large property programs. And even as the market tries to push some ambiguity out, we can expect a significant dose of it to remain for quite a while.”

According to Johansmeyer, this leaves reinsurers with two choices. First, they can accept the mismatch risk for now and hope that a significant event doesn’t occur before the market corrects itself, or, implement a hedging strategy that addresses unknown risks.

“The exposure that reinsurers face from non-affirmative cyber in the large risk market is real. The scope of the problem is certainly difficult, and the historical record is thin at best. That doesn’t make risk transfer impossible, though. The market has access to the right mechanism to address an emerging problem that’s little known and hard to know,” he says.

The mechanism Johansmeyer is alluding to is the industry loss warranty (ILW), a structure he feels is uniquely suited to address reinsurers’ non-affirmative cyber risk problem.

“The specialty lines segment of the ILW market has had its brief moments over the past few decades, providing tactical risk-transfer alternatives that yielded much-needed temporary relief to cedents. The lack of ongoing need, however, has prevented the permanence and robustness of a reliable market for those in need of capacity.

“Meanwhile, the ILS sector has matured to the point where the ongoing consumption of specialty risks (especially on an ILW basis) has become more realistic. And the specialty sector has become large and robust enough to have a regular need for ILWs (and ILS capital in general) as part of a broader risk-transfer strategy.

“The timing of this convergence suits the needs of reinsurers seeking retro capacity for non-affirmative cyber in their large risk books,” explains Johansmeyer.

Of course, limited historical data points and complexities around modelling mean that when compared with catastrophe ILW analysis and pricing, which focuses on expected losses, the specialty ILW market can’t adopt a similar approach to pricing and trading. But according to Johansmeyer, it doesn’t need to.

“Protection buyers and sellers should have sufficient insight into key programs and market sizing information to help them generate a view of the relevant “risk universe.” The use of historical losses within this context provides a reasonable starting point for determining expected losses, pricing, and terms.

“Relying on a deep knowledge of a fairly small risk universe and working with historical losses and other trends to ascertain an expected loss may not work for large syndicated catastrophe bond transactions, but it should get the job done for bilateral ILW trades and private cat bonds, both of which could provide near-term relief to a market that craves a solution,” says Johansmeyer.

With this in mind, Johansmeyer points to the benefits of the ILS market and specifically its ability to solve capacity problems reinsurers are unable to solve alone. He notes that in today’s affirmative cyber market, there’s an opportunity for ILS funds to support the global risk and capital supply chain by providing retro capacity where a more traditional route could result in concertation risks.

“For non-affirmative cyber in the global large risk loss market, there’s a similar opportunity. We’ve already seen appetite for reinsurers to secure ILW-based retro from ILS funds for traditional large risks, such as fire and explosion. To focus that interest on non-affirmative cyber specifically within the large risk space provides a further opportunity for the ILS market.

“Currently, the need for protection to fill gaps in cover in the reinsurance market appears to be tactical, which supports the use of ILWs—a natural way to engage the ILS community,” he explains.

Concluding, “The fact that non-affirmative cyber can struggle to be known in the large risk loss sector doesn’t mean it can’t be hedged. The tactical use of ILWs can help the industry implement point solutions in the near term as insurers and reinsurers work toward more consistent wordings and terms up and down the risk and supply chain.

“And over the long term, ILWs will grow into the sort of tool they’ve become for other classes, such as property-catastrophe and marine and energy. It all starts with that first effort to cut through the chaos. And the time for that first effort is upon us.”