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

More from Risk & Insurance

Risk Report: Entertainment

On With the Show

Entertainment companies are attractive and vulnerable targets for cyber criminals.
By: | December 14, 2017 • 7 min read

Recent hacks on the likes of Sony, HBO and Netflix highlight the vulnerability entertainment companies have to cyber attack. The threat can take many forms, from the destruction or early release of stolen content to the sabotage of broadcast, production or streaming feeds.

Brian Taliaferro, entertainment and hospitality specialist, JLT Specialty USA

“Cyber attacks are becoming the biggest emerging threat for entertainment companies, bringing risk to reputations, bottom lines and the product itself,” said Brian Taliaferro, entertainment and hospitality specialist, JLT Specialty USA.

For most entertainment firms, intellectual property (IP) is the crown jewel that must be protected at all costs, though risk profiles vary by sub-sector. Maintaining an uninterrupted service may be the biggest single concern for live broadcasters and online streaming providers, for example.

In the case of Sony, North Korea was allegedly behind the leak of stolen private information in 2014 in response to a film casting leader Kim Jong Un in what it considered an unfavorable light.

This year, Netflix and HBO both faced pre-broadcast leaks of popular TV series, and Netflix last year also had its systems interrupted by a hack.

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Online video game platforms are also ripe for attack, with Steam admitting that 77,000 of its gamer accounts are hacked every month.

The list goes on and will only get more extensive over time.

Regardless of the platform, any cyber attack that prevents companies from producing or distributing content as planned can have huge financial implications, particularly when it comes to major releases and marquee content, which can make or break a financial year.

“People and culture are the biggest challenges but also the keys to success.” — David Legassick, head of life science, technology and cyber, CNA Hardy

The bottom line, said David Legassick, head of life science, technology and cyber, CNA Hardy, is that these firms have a combination of both assets and business models that are inherently open to attack.

“Vulnerabilities exist at every point in the supply chain because it’s all tech-dependent,” he said, adding that projects often run on public schedules, allowing criminals to time their attacks to maximize impact.

“The combination of IP, revenue and reputation risk make entertainment a hot sector for cyber criminals.”

Touch Point Vulnerabilities

Film, TV, literary and music projects invariably involve numerous collaborators and third-party vendors at every stage, from development to distribution. This creates multiple touchpoints through which hackers could gain access to materials or systems.

According to Kyle Bryant, regional cyber manager, Europe, for Chubb, there is nothing unique about the type of attack media companies suffer — usually non-targeted ransomware attacks with a demand built in.

“However, once inside, the hackers often have a goldmine to exploit,” he said.

He added targeted attacks can be more damaging, however. Some sophisticated types of ransomware attack, for example, are tailored to detect certain file types to extract or destroy.

“NotPetya was designed to be non-recoverable. For a media company, it could be critical if intellectual property is destroyed.”

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As entertainment companies have large consumer bases, they are also attractive targets for ideological attackers wishing to spread messages by hijacking websites and other media, he added.

They also have vast quantities of personal information on cast and crew, including celebrities, which may also have monetary value for hackers.

“It is essential to identify the most critical information assets and then put a value on them. After that, it is all about putting protection in place that matches the level of concern,” Bryant advised.

As with any cyber risk, humans are almost always the biggest point of vulnerability, so training staff to identify risks such as suspicious messages and phishing scams, as well as security and crisis response protocols, is essential. Sources also agree it is vital for entertainment companies to give responsibility for cyber security to a C-suite executive.

“People and culture are the biggest challenges but also the keys to success,” said Legassick.

“Managing the cyber threat is not a job that can just be left to the IT team. It must come from the top and pervade every aspect of how a company works.”

David Legassick, head of life science, technology and cyber, CNA Hardy

Joe DePaul, head of cyber, North America, Willis Towers Watson, suggested entertainment companies adopt a “holistic, integrated approach to cyber risk management,” which includes clearly defining processes and conducting background checks on the cyber security of any third party that touches the IP.

This includes establishing that the third parties understand the importance of the media they are handling and have appropriate physical and non-physical security at least equal to the IP owner in place. These requirements should also be written into contracts with vendors, he added.

“The touchpoints in creating content used to be much more open and collaborative, but following the events of the last few years, entertainment firms have rapidly introduced cyber and physical security to create a more secure environment,” said Ryan Griffin, cyber specialist, JLT Specialty USA.

“These companies are dealing with all the issues large data aggregators have dealt with for years. Some use secure third-party vendors, while others build their own infrastructure. Those who do business securely and avoid leaks can gain an advantage over their competitors.”

Quantification Elusive

If IP is leaked or destroyed, there is little that can be done to reverse the damage. Insurance can cushion the financial blow, though full recovery is very difficult to achieve in the entertainment space, as quantifying the financial impact is so speculative.

As Bill Boeck, insurance and claims counsel, Lockton, pointed out, there are only “a handful of underwriters in the world that would even consider writing this risk,” and sources agreed that even entertainment firms themselves struggle to put a monetary value on this type of exposure.

“The actual value of the IP taken isn’t generally going to be covered unless you have negotiated a bespoke policy,” said Boeck.

“If you’re in season five of a series with a track record and associated income stream, that is much easier, but putting a value on a new script, series or novel is difficult.”

Companies for whom live feeds or streaming are the primary source of revenue may find it easier to recoup losses. Determining the cost of a hack of that sort of service is a more easily quantifiable business interruption loss based on minutes, hours, ad dollars and subscription fees.

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Brokers and insurers agree that while the cyber insurance market has not to date developed specific entertainment products, underwriters are open for negotiation when it comes to covering IP. The ball is therefore in the insured’s court to bring the most accurate projections to the table.

“Clients can get out of the insurance market what they bring to the equation. If you identify your concerns and what you want to get from insurance, the market will respond,” said Bryant.And according to Griffin, entertainment companies are working with their brokers to improve forecasts for the impact of interruptions and IP hacks and to proactively agree to terms with underwriters in advance.

However, Legassick noted that many entertainment firms still add cyber extensions to their standard property policies to cover non-physical damage business interruption, and many may not have the extent of coverage they need.

Crisis Response

Having a well-planned and practiced crisis response plan is critical to minimizing financial and reputational costs. This should involve the input of experienced, specialist third parties, as well as numerous internal departments.

Ryan Griffin, cyber specialist, JLT Specialty USA

“The more business operation leaders can get involved the better,” said Griffin.

Given the entertainment industry’s highly public nature, “it is critically important that the victim of a hack brings in a PR firm to communicate statements both outside and within the organization,” said Boeck, while DePaul added that given that most cyber attacks are not detected for 200-plus days, bringing in a forensic investigator to determine what happened is also essential.

Indeed, said Griffin, knowing who perpetrated the attack could help bring the event to a swifter and cheaper conclusion.

“Is it a nation state upset about the way it’s been portrayed or criminals after a quick buck? Understanding your enemy’s motivation is important in mitigating the damage.”

Some hackers, he noted, have in the past lived up to their word and released encryption keys to unlock stolen data if ransoms are paid. Inevitably, entertainment firms won’t always get so lucky.

Given the potentially catastrophic stakes, it is little surprise these firms are now waking up to the need for robust crisis plans and Fort Knox-level security for valuable projects going forward. &

Antony Ireland is a London-based financial journalist. He can be reached at [email protected]