The increased use of new forms of risk transfer in the cyber reinsurance market to have renewed discussions about the potential role Insurance-Linked Securities (ILS).
The ILS market originally formed as a way to bring fresh capital to the property-catastrophe when demand was acute and capital was in short supply.
According to Property Claim Services Research, around the world, there are more than 40 ILS fund managers, and their aggregate assets under management exceed US$107 million. The majority of that is with the 25 ILS funds that have at least US$1 billion in AuM.
Originally developed to meet the demand for capital in the property-catastrophe market, the Insurance-Linked Securities community has participated in other segments of re/insurance risk, such as specialty classes like marine and energy, political violence, property per risk, and aviation. Some have also engaged in casualty lines of business.
Some have engaged in cyber ILS activity as well, as the findings below illustrate, although the ILS market is still split on whether cyber will be a significant driver of growth.
ILS Fund Managers by Location
Cyber has generally been difficult to place in the ILS market, although it has been done before. Popular perceptions have focused on the reported small size and infrequency of the transactions completed, as well as the fact that so few have made it into the public domain. As a result, misconceptions about the ILS market and its appetite for cyber re/insurance risk appear prevalent.
To address this development, PCS engaged with 24 ILS funds (78% of the ILS market by AuM), reflecting approximately US$84 billion in AuM. That includes most of the ten largest in the world, as well as five with AuM of under US$1 billion.
PCS contacted 27 ILS fund managers to conduct confidential interviews consisting of the six questions below. 24 ILS fund managers responded and participated in interviews.
The names and companies of the participants cannot be revealed, and the presentation of aggregate statistics is done in a manner that protects the confidentiality of the participants and seeks to minimize the risk that any identities could be deduced. The interviews themselves were designed to increase response rate overall and also to increase the flow of information with respondents once engaged. Participants were encouraged to communicate comfortably and freely when responding to each question.
Each participant was asked the same 6 questions followed by open discussion to maximize the opportunity to gather practical insights as yet unknown to the broader cyber re/insurance market.
Of the 24 interviews, eight were conducted in person, three via video call, one via audio call, and 12 by email.
Email interviews were not necessarily limited to one exchange. Where necessary to clarify responses or elicit further information, follow-up correspondence was used. However, specific answers that did not call for further exploration were respected. In-person interviews and those conducted live by audio or video call were scheduled for 30 minutes.
In some cases, the interviews were much shorter, particularly for participants with no plans to enter the cyber ILS market. Calls were not recorded in order to provide further comfort of anonymity. Instead, notes were taken and are held privately.
PCS employed a certain amount of flexibility during the interview process given the unique nature of this opportunity. The ILS market has been known for opacity, as noted by Carter, Paine, and Enoizi above. As a result, some rigor was intentionally sacrificed for the benefit of maximizing actionable information for the global cyber insurance market.
1. Do you have a mandate preventing you from trading cyber?
To address the persistent belief in the global cyber re/insurance market that ILS fund mandates do not allow for trading in cyber and other man-made risks, PCS first asked participants if this is true.
The sentiment arose during research conducted by PCS in 2021 on ILS fund appetite for political violence risk, and the parallels to cyber were evident. The notion that ILS funds are prohibited from trading cyber re/insurance by mandate is generally not true, although there was some nuance among responses. PCS found that 95% of respondents by AuM (22 of 24 respondents) have no such prohibition by mandate, although 28% do have partial prohibitions (5 respondents).
One of the two respondents that reported a prohibition on cyber insurance risk trading by mandate indicated having no interest or appetite for that class of business. The other indicated a willingness to explore cyber re/insurance risk, which would also require revisiting the issue with their investors. This respondent suggested that favorable market conditions would be sufficient to discuss with investors the possibility of revising those mandates. Additionally, some ILS fund managers indicated that they are not interested in cyber re/insurance risk, regardless of mandate. Thus, while there is some credence to the notion that many ILS funds are averse to cyber risk, it is not necessarily because of a specific prohibition in their mandates.
2. Are you interested in trading cyber?
The ILS sector struggles with the misperception that it is generally not interested in consuming cyber re/insurance risk. PCS found the contrary to be true. ILS fund managers, in fact, showed a general openness to the cyber class of business, with 13 respondents (71% by AuM) indicating interest, although prospective timeframes varied. The “not yet” response offered by one fund manager was shared in other forms by others who want to enter the cyber re/insurance market when they are ready. Readiness ranged from pricing and terms being adequate for their portfolios to the manifestation of pressure to engage because their peers have.
To be reviewed more thoroughly in Question 4 below, five respondents have engaged in cyber re/insurance transactions already (as well as two more who did not participate in the research but separately confirmed their cyber re/insurance activity). They generally suggest that they will remain committed to cyber ILS and might have further appetite, although that would depend on deal flow.
For those who have not yet traded cyber but are interested in doing so, some impediments remain, including the risk that cyber is correlated with financial markets, pricing and structure, and whether a separate portfolio specifically for cyber risk would be necessary.
One large ILS fund (in the top five by AuM) responded that it was not “desperate” to get into cyber re/insurance but remained interested in seeing opportunities and would enter when a transaction met their standards. Another got quite close, but specific terms prevented the transaction from being completed. Many cited deal structure and pricing as particularly problematic; they were not being offered potential transactions that either paid enough or made sense structurally.
Many respondents specifically cited the lack of a mechanism for efficient capital release, the long-tail nature of the risk, and the lack of liquidity they expected from such instruments.
Additionally, many ILS fund managers stated that (related to pricing), the independent vendor models are not as reliable in cyber as they are for property-catastrophe transactions. However, a subset of those respondents did suggest that they would look past structural or modeling issues if the deal economics were favorable.
Respondents not interested in consuming cyber re/insurance risk echoed the skepticism of their interested peers but saw such issues – e.g., modeling, pricing, and deal structure – as greater barriers to engaging with cyber re/insurance risk.
Most of the respondents who do not want to trade cyber did suggest that the market may carry them along. The implication of such momentum, though, is that the underlying concerns they addressed would likely be addressed at least to some degree.
3. Have you analyzed/reviewed the cyber market?
The overwhelming majority of respondents to the PCS survey have analyzed or reviewed the cyber re/insurance market. With 18 respondents representing 85 percent of the response base by AuM having engaged in such activity, it is clear that a decision to enter the sector would not have been made lightly.
The response rate speaks to the broad understanding that cyber re/insurance has the potential to become a large segment of the market, which could bring significant opportunity along the entire risk and capital supply chain.
Further, respondents tended to express a sense of inevitability, given the amount of original cyber exposure that exists, resulting in demand for insurance that would require further reinsurance and retrocession support.
3 of the 5 companies that respondent that they have not reviewed the cyber re/insurance market have less than US$1 billion in AuM and further said they have no interest in cyber re/insurance at all.
However, that position could change in the future based on substantial changes in market conditions, evolution of strategy, and other large trends and factors, even given a “never cyber” posture at present.
At the other end of the spectrum, a larger respondent explained that the size of the investment necessary to explore a segment in which they are not interested was too large to be worth it. Even that perspective, though, suggests a sense of the cyber re/insurance market that can only have been informed by a preliminary inquiry.
4. Have you traded cyber?
The ILS market is no stranger to cyber re/insurance, although the underlying experience has been uneven. Five ILS fund managers indicated that they have engaged in cyber ILS transactions, representing US$21 billion in AuM. That is 25% of participants in this study (by AuM) and almost 20% of the ILS market as a whole.
ILS participation in cyber re/insurance remains smaller than other specialty lines (e.g., marine and energy, terror, and aviation), but engagement is much larger than the broader re/insurance market appears to have realized.
Little information is available on the number and size of transactions completed so far (which was outside the scope of this survey). There are few instances of ILS funds taking several deals per year, particularly over multiple years, according to further client conversations outside this research, and when that has happened, the trades have tended to be smaller. However, there have been instances of private transactions that have not been discussed in broader circles, as well as larger transactions that have been completed.
Outside this survey, PCS has learned of transactions of at least US$20 million having been completed, and using both survey responses and separate client conversations, PCS estimates that the amount of cyber ILS completed over the past five years may approach US$500 million.
Additionally, outside our respondents, PCS understands (through conversations with several sources) that two more ILS funds that have engaged in ILS transactions. They are not included in the totals above, given that the information came from outside our respondents and when included bring the total of ILS funds engaging in the cyber re/insurance market to seven, and total AuM will not be revealed out of respect for a non-participating companies privacy.
5. Have you been shown cyber trades?
Respondents advised that reinsurance brokers turned to the ILS market for support much less than PCS expected, given the shortage of capacity that characterized the global cyber reinsurance market at the January 1, 2022 reinsurance renewal.
The fact that 12 ILS funds were shown cyber reinsurance deals by reinsurance brokers is less interesting than the fact that some funds have been reviewing such opportunities for several years and still have no plans to enter the sector.
The fact that they have reported monitoring with no plans to act suggests the sense of inevitability mentioned above in the discussion of question 3. The ILS fund manager community seems to think that cyber re/insurance may ultimately become unavoidable.
Several ILS funds surveyed have reviewed ILW trades over the past 12 months, particularly given that bid/ask spreads are narrowing to levels close enough that an ILW trade could clear. The introduction of ILWs with more realistic pricing and terms appears to have directly resulted in more engagement between reinsurance brokers and ILS funds on cyber, with several deals reportedly being actively discussed as of this writing.
In the broader reinsurance market, brokers have had to contend with an acute shortage of cyber reinsurance capacity relative to cedent demand. To support their clients, particularly at the January 1, 2022, reinsurance renewal, a number often sent cyber reinsurance submissions to reinsurers that had previously indicated they were not interested in that class of business, behavior that seemed less present in the ILS market. ILS fund managers who reported having no interest in cyber re/insurance transactions reported that they were left alone (nine respondents representing 24 percent of the respondent base by AuM). PCS asked the question above with the broader reinsurance market in mind – to see if brokers were expanding their efforts to the ILS market in order to source the capacity their clients needed.
6. Do you plan to trade cyber this year?
The eight respondents who answered this question favorably heavily caveated their interest, as would be appropriate. Answers include “soft yes,” “only if it makes sense,” and even initially targeting 2023 but would trade in 2022 if the right deal came along.
One respondent answered “maybe,” which has been included here with the “yes” answers. First, this was done to protect the confidentiality of the respondent, as a single “yes” with the attendant AuM could have made it possible to determine which respondent answered in that manner. Further, the “maybe” response does not differ in substance from the “soft yes” and other heavily qualified affirmative responses that PCS received.
Of course, underlying all responses was the reported need for deal flow with appropriate price and structural characteristics. Not all five ILS fund managers who have traded cyber ILS in the past are among the eight planning to do so in 2022, although there is significant overlap. One who responded with a lack of interest in trading cyber this year indicated a willingness to reconsider based on end-investor appetite. Several new entrants seem particularly eager to join the market, as evidenced by the fact that they have reached out to reinsurance brokers specifically to engage in their first cyber ILS transactions.
The format in which a cyber transaction is offered may make a difference in appetite – both in general and over the coming year.
Several ILS funds indicated a preference for cyber risk in catastrophe bond form, citing the benefits of liquidity, the additional rigor in structuring and documentation, and the likely benefit of many market participants on the same transaction. While the speed and flexibility of collateralized reinsurance and ILWs might seem easier to manage intuitively, the infrastructure surrounding catastrophe bonds may provide a layer of comfort, in addition to structural discipline.
ILS fund respondents varied on trigger type preference when talking about trading appetite for 2022-2023.
Those already engaged in the cyber ILS sector reported using traditional reinsurance structures and could continue to trade on that basis. Most potential new entrants indicated a preference for ILWs or parametric transactions.
The latter were cited as a way to narrow the coverage to specific perils, which many protection sellers see as favorable. However, adoption has been quite limited, given that buyers reported seeking broader coverage to reflect their underlying books of business more accurately. Market conversations suggest further trading in collateralized reinsurance, as well as likely first trades in the cyber ILW market.
PCS learned outside the research project of one more ILS fund that would like to trade cyber this year but was not a respondent to this survey.
Next steps for the development of a cyber ILS market
The fact that traditional re/insurance perspectives about cyber attitudes toward ILS were not correct oddly failed to change underlying market dynamics, largely because of other impediments to the ILS sector’s adoption of ILS.
However, an increase in interest in cyber re/insurance among many ILS funds suggests that better alignment of expectations between cyber re/insurers and the ILS community could be an important first step toward turning the occasional transaction into a repeatable and scalable market that can provide robust and reliable support to the worldwide reinsurance sector.
Most ILS funds surveyed have at least a foundational understanding of the cyber re/insurance market and are open to evaluating cyber ILS deals.
Even those unwilling to consider such transactions have a sense that there will come a day when they are pulled into the cyber ILS market. Ultimately, these sentiments are quite favorable, in that they all end with deeper ILS market engagement for the cyber re/insurance sector, which may translate to increased capital availability, a return to strong growth, and a more mature market that is not constrained by concentration risk at key value chain choke points. A primary challenge at present is to identify the mechanisms by which barriers to adoption can be removed.
Some problems may take a while to solve, but as standalone concerns, they could be managed, in part, through increased trading volume in the near term. The perceived lack of maturity among risk models, for example, is almost universally cited as an impediment to the growth of cyber ILS. That said, five funds have already transacted, and many more reported that they want to. Those that want to engage in cyber ILS, particularly in the next year, may not wait for cyber models to mature, indicating that they see bilateral trades (particularly in ILW form) as manageable through internal actuarial and analytical exercises. Further, several ILS fund managers have indicated a willingness to tolerate “best efforts” in modeling in order to see cyber catastrophe bonds come to market (which itself suggests that private perceptions of model maturity may be more positive than those offered publicly).
Price and structure have historically been problematic for cyber ILS deal completion, with a lack of historical data and uneven market penetration often noted as complicating factors.
It seems that acute demand for capacity has lifted protection buyer expectations on price and increased their flexibility on terms, which means that clearing prices should be easier to attain for structures that buyers have avoided in the past, such as index-triggered transactions including ILWs and parametrics. ILS funds reported seeing potential returns increasing to levels that are worth exploring in detail, which could help repeatable deal structures get completed, an important first step toward the commoditization of the risk. That commoditization should drive scale, which ultimately may support broader cyber re/insurance market growth.
What is most evident from the responses offered by more than 75% of the global ILS community is that cyber ILS is still very much a work in progress. The responses suggest that the sector generally wants to consume cyber re/insurance risk and is looking for ways to do so.
Short-term barriers outside the cyber re/insurance market (such as several years of high property-catastrophe losses) do not appear to be slowing cyber ILS progress as much as they used to, particularly for funds that are willing to take on cyber risk as a diversifier in their portfolios, even if it does potentially introduce some end-investor correlation. From 12 months of this writing, the amount of cyber ILS transactions completed is likely to increase substantially from where it is today, if for no other reason than the combination of acute protection buyer need and the increased interest among ILS funds in providing such cover.
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AUTHORS: Tom Johansmeyer – PCS Verisk (Bermuda), Alex Mican – PCS Verisk (United States) by The Journal of Risk Management and Insurance
