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Cyber Risk

Cyber Risks and ILS

The race is on to develop a CAT bond-like vehicle that could build an extra layer of protection against cyber threats.
By: | October 15, 2016 • 8 min read

As losses with cyber risks pile up, the insurance industry is looking for alternatives to offer capacity to buyers. Could capital markets hold the key to provide broader coverages and higher limits?

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The answer may well be yes.

The race is on among underwriters and their advisers to develop CAT bond-like vehicles that could enable them to build extra layers of protection against cyber threats and to expand insurance and reinsurance capacity.

With pension funds and other institutional investors showing ever more appetite for insurance-linked securities (ILS), conditions appear to be set for a new market to flourish that could also extend in the future to corporations and government entities with a high exposure to cyber events.

Bill Dubinsky, head of insurance-linked securities, Willis Capital Markets & Advisory

Bill Dubinsky, head of insurance-linked securities, Willis Capital Markets & Advisory

“Many investors are looking for ways to take more risks,” said Bill Dubinsky, head of insurance-linked securities at Willis Capital Markets & Advisory. “Cyber risk is something that could work for them because a lot of it is catastrophic and it is generating real growth in insurance and reinsurance needs.”

The drivers behind the growth of ILS markets are the same that are pumping record levels of capital in the reinsurance industry.

As they look for alternatives to low-risk fixed income securities, institutional investors have taken a favorable view of CAT bonds and other ILS products, which offer solid rates of return and low probabilities of losses (although they tend to be huge when they take place).

But the development of a bond market to transfer cyber risks stumbles on difficulties that also affect the insurance industry in its dealings with a fast changing, hard to predict threat.

Cyber risks have fundamental differences with the catastrophes that constitute the traditional focus of ILS securities, which means that a lot of work still needs to be done before the new asset class takes flight.

“I do not think it is something that will happen quickly, but it is a natural evolution for the market,” said Ben Brookes, vice president of capital markets at RMS, the risk modeling firm.

Cyber Risks Are Unpredictable

One of the main challenges is that cyber risks are unpredictable and evolve all the time, and the same goes for the losses that they can generate.

“The scope of the coverages has continued to expand. Insurance contracts today have a much broader coverage than five years ago,” said Michael Carr, technology practice leader at Argo Group.

“For example, the privacy coverage has gone from just security-type triggers, such as hacking or malware, to any sort of privacy violation. In the area of business interruption, policies now also cover losses caused by failures of third-party software or even by failures of the insured’s own IT department.”

Companies use insurance coverages to protect their networks, physical structures and supply chains against cyber attacks, but they are also exposed to third-party liabilities, which should soon become the most important source of losses caused by cyber events.

The unpredictability of the peril frightens off investors who look at ILS investments as a source of portfolio stability in volatile times. Liability risks with a long tail are very likely to be the toughest one for asset managers to swallow.

So the first challenge that cedants and their advisers need to tackle before a cyber ILS market comes into shape is to develop reliable ways to measure, aggregate and model cyber risks, so that investors will feel more comfortable taking them in.

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A very solid understanding of how the risk evolves is important as — different from hurricanes and floods — hackers learn from past experience, and they adapt their attacks accordingly.

“There is no standard way to quantify cyber exposures at the moment,” said Thomas Harvey, the product manager of emerging risks at RMS. “The human factor and the various motivations behind attacks add a huge element of complexity to the modeling of cyber risks. Also, the balance between attack and defense is shifting all the time.”

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But he sees progress in this issue, as access to data on cyber attacks — for a long time a scarce commodity — is gradually becoming more available to the parties involved. Reporting rules in the U.S. are playing a large part in promoting the sharing of information, and the E.U. will make reporting on cyber attacks mandatory by 2018, Harvey said.

Big Data Models Cyber Risks

Some kinds of losses, such as extortion, which companies do not like to make public, present particular challenges, but modeling firms are negotiating with insurers and reinsurers to have access to all kinds of data about cyber events. Participants in the market have realized that sharing knowledge is good for everybody, Harvey said.

For example, the Association of British Insurers, ABI, made an appeal in May for the creation of a database with mandatory information about cyber incidents.

“We are confident it is possible to develop a mechanism to model cyber risks,” Harvey said. “Demand for it is strong, as there is a huge amount of risks that the insurance and reinsurance markets want to take on.”

But the uncertain nature of cyber risks also raises the question of what losses would trigger a contract. They could be either single, large events, or an aggregation of claims, according to Brent Poliquin, assistant vice president for insurance-linked securities at AIR Worldwide, the catastrophe modeling firm.

There are many ways that originators of insurance contracts can lose money because of cyber risks, some of them still unknown by the market, which make it much harder to pick a trigger than property destruction resulting from earthquakes or floods.

Separating cyber events from terrorism could be a difficult thing to do on some occasions. Hackers form a heterogeneous group, ranging from religious fundamentalists to corporate spies, government agents and activists, and as a result they can have many different targets and kinds of attacks in mind.

To make matters more complex, the main source of cyber events is usually found within the company, as employees are often at their origin, either maliciously or by accident.

The trigger issue should be an especially difficult one for reinsurance companies, which make use of ILS contracts to spread their own risks and reduce their regulatory capital reserves. If investors have doubts over the trigger events, or fear that contracts could end up in the courts, they will show little interest for them.

In Dubinsky’s view, one of the keys to tackle this issue will be to focus on proportional agreements, instead of the excess of loss deals that prevail today in the ILS market. By doing so, investors can share on the expertise of underwriters to deal with a complex and evolving risk.

Appetite for Cyber Risk

Even after the technical challenges are overcome, however, the appetite for cyber risk bonds may not be as strong as it has been for other ILS securities.

For instance, some investors consider that, differently from natural catastrophes, cyber risks may have a high level of correlation with other securities such as equities and bonds.

The reasoning is that, in the case of a large cyber attack against vital infrastructures, the economic effects could make the stock and bond markets stumble at the same time.

“Asset managers who focus on ILS portfolios should find cyber risks products appealing due to the very low correlation with natural catastrophe risks that they have in their portfolios,” Poliquin said.

“But there may be a challenge related to the root sources of capital that flow to these asset managers, such as pension funds. From their standpoint, they may potentially discourage an allocation of capital to cyber risks bonds because they could have a higher correlation with other investments that they are making.”

Paul Traynor, managing director, BNY Mellon

Paul Traynor, managing director, BNY Mellon

But demand for ILS products has been so strong that, in Dubinsky’s view, investors could be interested despite the correlation issue.

And, when a cyber ILS market becomes a reality, even individual companies with large exposures to the risk might be able to tap capital markets for further protection, in a similar fashion that corporations do today with CAT bonds.

In fact, Paul Traynor, a managing director at BNY Mellon, highlighted that an example of how the market could work was provided by Crédit Suisse, which issued in May a $222 million CAT bond to boost its coverage against operational risks like fraud and cyber crime.

“Take the case of a large financial corporation that has invested very heavily to protect itself against cyber risks, but for regulatory reasons, still has to put operational capital aside to cover that risk,” Traynor said.

If investors believe a cyber risk instrument is a sound investment, the corporation may get capital support from such a transaction.

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This is a solution that could gain steam not only among banks, but also in other highly regulated industries such as telecommunications and health insurance, he said.

Traynor also thinks that the development of a cyber risks ILS market could go a long way toward helping underwriters make available more capacity for a segment where demand is booming, even if evaluating exposures remains a challenge.

“For regulatory reasons, it is very difficult for insurers to offer sizable cyber covers if they cannot model them,” he said. “What they can do is to structure a special purpose vehicle to keep some of their cyber risk exposure and move most of it to capital markets, where entities that are not as regulated as insurers are can take it in.”  &

Rodrigo Amaral is a freelance writer specializing in Latin American and European risk management and insurance markets. He can be reached at [email protected]

More from Risk & Insurance

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Risk Management

The Profession

The risk manager for Boyd Gaming Corp. says curiosity keeps him engaged, and continual education will be the key to managing emerging risks.
By: | May 1, 2018 • 4 min read

R&I: What was your first job?

I was trained as an accountant, worked in public accounting and became a CPA. Being comfortable with numbers is helpful in my current role, and obviously, the language of business is financial statements, so it helps.

R&I: How did you come to work in risk management?

Working in finance in the corporate environment included the review of budgets and the analysis of business expenses. I quickly found the area of benefits and insurance — and how “accepting risk” impacted those expenses — to be fascinating. I asked a lot of questions. Be careful what you ask for — I soon found myself responsible for those insurance areas and haven’t looked back!

R&I: What is the risk management community doing right?

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I have found the risk management community to be a close-knit group, whether that’s industry professionals, risk managers with other companies or support organizations like RIMS and other regional groups. The expertise of the carriers and specialty vendors to develop new products and programs, along with the appropriate education, will continue to be of key importance to companies going forward.

R&I: What’s been the biggest change in the risk management and insurance industry since you’ve been in it?

As I’m sure many in the insurance field would agree, Hurricanes Katrina and Rita in 2005 changed our world and our industry. It was a particularly intense time and certainly a baptism by fire for people like me who were relatively new to the industry. This event clearly accelerated the switch to the acceptance of more risk, which impacted mitigation strategies and programs.

Bob Berglund, vice president, benefits and insurance, Boyd Gaming Corp.

R&I: What emerging commercial risk most concerns you?

The fast-paced threat that cyber security represents today. Our company, like so many companies, is reliant upon computers, software and IT expertise in our everyday existence. This new risk has forged an even stronger relationship between risk management and our IT department as we work together to address this growing threat.

Additionally, the shooting event in Las Vegas in 2017 will have an enduring impact on firms that host large gatherings and arena-style events all over the world, and our company is no exception.

R&I: What insurance carrier do you have the highest opinion of?

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With the various types of insurance programs we employ, I have been fortunate to work with most of the large national and international carriers — all of whom employ talented people with a vast array of resources.

R&I:  How much business do you do direct versus going through a broker?

We use brokers for many of our professional coverages, such as property, casualty, D&O and cyber. We are self-insured under our health plans, with close to 25,000 members. We tend to manage those programs internally and utilize direct relationships with carriers and specialty vendors to tailor a plan that works best for team members.

R&I: Who is your mentor and why?

I have been fortunate to have worked alongside some smart and insightful people during my career. A key piece of advice, said in many different ways, has served me well. Simply stated: “Seek to understand before being understood.”

What this has meant to me is try everything you can to learn about something, new or old. After you have gained this knowledge, you can begin to access and maybe suggest changes or adjustments. Being curious has always been a personal enjoyment for me in business, and I have found people are more than willing to lend a hand, offer information and advice — you just need to ask. Building those alliances and foundations of knowledge on a subject matter makes tackling the future more exciting and fruitful.

R&I: What have you accomplished that you are proudest of?

Our benefit health plan is much more than handing out an insurance card at the beginning of the year. We encourage our team members and their families to learn about their personal health, get engaged in a variety of health and wellness programs and try to live life in the healthiest possible way. The result of that is literally hundreds of testimonials from our members every year on how they have lost weight, changed their lifestyle and gotten off medications. It is extremely rewarding and is a testament to [our] close-knit corporate culture.

R&I: What’s the best restaurant you’ve ever eaten at?

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Some will remember the volcano eruption in Iceland in spring of 2010. I was just finishing a week of meetings in London with Lloyd’s syndicates related to our property insurance placement when the airspace in England and most of northern Europe was shut down — no airplanes in or out! Flights were ultimately canceled for the following five days. Therefore, with a few other stranded visitors like myself, we experimented and tried out new restaurants every day until we could leave. It was a very interesting time!

R&I: What is the riskiest activity you ever engaged in?

I am originally from Canada, and I played ice hockey from the time I was four years old up until quite recently. Too many surgeries sadly forced my recent retirement.

R&I: What do your friends and family think you do?

That’s a funny one … I am a CPA working in the casino industry, doing insurance and risk management, so neighbors and acquaintances think I either do tax returns or they think I’m a blackjack dealer at the casino!




Katie Dwyer is an associate editor at Risk & Insurance®. She can be reached at [email protected]