Insurance-linked Securities and the Opportunity in Cyber Today

The insurance and capital markets have never needed each other as much as they do today.

Insurers and reinsurers need more capacity, just as institutional investors need diversifying assets to de-risk their portfolios.

How to diversify in 2023?

2022 forced both asset owners and asset managers to reconsider their exposure to traditional assets. There are vast and diverse opportunities in alternatives available today, but not all options have been made fully available as present.

Whilst many alternative assets have made rapid progress in establishing their role as diversifying or hedging devices, the insurance-linked securities (ILS) sector has somewhat lagged this trend. However, the ILS asset class in fact displays excellent characteristics on this front and is able to deliver returns with a very low correlation to wider financial markets as shown in the chart below.

Globally, the alternative investment sector has grown dramatically over the past 15 years or so, and is forecast to almost double over the next five years, taking total AUM from just over $13 trillion in 2021 to around $23 trillion by 2026. The ILS asset class has grown alongside other alternative investments and today stands at a total ILS AUM is currently estimated to be around $105 billion, but there is much more potential for growth to be extracted here as more and more lines of insurance risk are now able to be securitized.

Vesttoo’s perspective is that the relative underutilisation of the ILS asset class is likely to change over the next 12-24 months as a series of developments are set to energize the ILS market. Long synonymous in the mind of investors with catastrophe bonds, ILS today offers investors new, varied and highly customizable routes, mainly non-catastrophe, to access returns with very little correlation to movements in the financial markets. 

Is cyber really uninsurable?

The recent debate over the (re)insurance of cyber risk is symptomatic of the dynamism and innovation coming to the ILS market. The sheer scale of the opportunity in cyber insurance is worth underlining. In 2021, the global cyber insurance market was valued at $10.33 billion, and this is projected to grow at a CAGR of 25.7% to reach $63.62 billion by 2029 according to Fortune Business Insights.

Insurance markets use the term emergent risk to characterize a new or unforeseen risk that underwriters are just starting to get to grips with. However, capacity constraints and unanticipatedly large losses from natural catastrophes since 2017 have brought an overly conservative attitude to expanding new lines of coverage.

This increased insurance demand has fed through into comparatively high demand for reinsurance, with insurers currently ceding around 50% to their reinsurance providers according to the Harvard Business Review. This need for more reinsurance capacity is where ILS is poised to help out.

The capacity constraints – which the capital markets are willing and able to fill – have contributed to the so-called hard market we see today, with reinsurance premiums rising well ahead of inflation. 

Importantly, the total size of the reinsurance premium for cyber risk is forecast by Gallagher Re to eventually surpass either Property or Casualty, and therefore represents one of the biggest opportunities of the coming years for investors looking to diversify by gaining exposure to pure insurance risk. Gallagher Re currently forecast the cyber market to double every 3 years, led by the exponential rise in demand for insurance and therefore reinsurance as well.

We expect the absolute growth of this market to be a key factor encouraging more investor participation. The convergence of an emerging risk with innovative financial structures that enable capital markets participants to gain access to the connected premiums is driving renewed interest in the ILS asset class.

By necessity, the fact that the risks are somewhat unknown and still need to be fully quantified with reference to past data, means that the rewards offered to those who take on these risks have to be higher. Accordingly, the steady increases in cyber insurance premiums can be seen in the chart below produced by Fitch Ratings:

Meanwhile, the average loss ratio for the the top 20 US-based cyber insurers provided by NAIC has also risen markedly from 2017 but appears to be stabilizing at levels considered normal for the insurance industry (circa 65%). The combination of rising premiums with these potentially stabilizing loss ratios suggest that the cyber insurance market is rapidly maturing and becoming more predictable today.

The fact that loss ratios have thus far remained within an acceptable range, combined with the fact that risk modeling capabilities in this specialty line are improving all the time, helped to generate the confidence that facilitated the recent landmark achievement whereby risk was transferred from the insurance to the capital markets via a fixed income instrument.

Likewise, the growing sophistication of cyber security measures put in place by end users means today the cyber insurance market represents a vastly transformed investment project to what was the case even just a few years ago. These factors have led analysts at Gallagher Re to point to what they term the disconnect between cyber headlines versus the reality of insured cyber losses, with losses often developing well below the levels initially anticipated.

The first cyber bond has arrived

As such, the excitement with which the market created the recent launch of UK specialty insurer Beazley’s ‘cyber bond’ is to be expected.

The $45 million private placement set to mature in Jan, 2024 will pay out to Beazley if an insured client suffers a cyber attack causing more than $300 million in damages.

The bond is indicative of the sort of financial innovations which have been emerging that allow the bridge between the insurance markets to deepen.

With Swiss Re estimating the protection gap in cyber insurance to be around 90%, the need and willingness to pay for reinsurance capacity here can only expand. More innovation is likely to follow as third-party capital providers seek ways to enter this potentially highly profitable risk line. Now that it has been demonstrated that it is possible to transfer this type of risk and that there are willing investors out there ready to allocate capital towards assets generating low beta returns, growth in this space is likely to accelerate.

Vesttoo helps At-Bay transfer cyber risk to capital markets

Another example of an ILS cyber deal connecting the insurance and capital markets is provided by Vesttoo’s At-Bay cyber transaction, which was structured as an Aggregate Stop Loss (ASL) treaty agreement. Brokered by Guy Carpenter, the transaction was fully collateralized and carried out using Vesttoo’s AI-based technology suite to model, price and structure the deal.

The subject business was US-based Cyber and Tech E&O risks, representing At-Bay Captive's participation alongside their reinsurance panel. The time to market from the firm order stage through to placement was just three weeks, further illustrating the appetite and ability of the insurance and capital markets to meet each other’s needs on this issue.

Roman Itskovich, Chief Risk Officer and Co-Founder of At-Bay, commented that: “Cyber risk is quickly growing, and we believe that it will require a broader capital base than traditional reinsurance to support the very real demand for cyber coverage." 

The transaction was a fully collateralized transaction in which the collateral was provided by an NAIC-compliant bank behind a collateralized Bermudian Reinsurer.

ILS is far more than cat bonds

While there are and will remain some interesting possibilities in traditional cat bonds - i.e. those that transfer risk stemming solely from natural catastrophes like hurricanes - we believe a growing share of investors active in ILS today or entering the asset class for the first time are interested in other offerings. The 5 years of poor performance from cat bonds due to elevated losses from natural catastrophes has seen the asset class slide out of favour.

Cyber represents one of the key new lines of insurance that is now able to be securitised. Whilst some aspects of cyber resemble catastrophe risk, there is an increasing opening for high frequency, low severity cyber risk to be modeled and securitised. This opens the door to vastly expanded reinsurance capacity being available, and this in turn encourages insurers to provide the cover their clients need. This positive-sum relationship is further compounded by the potential for investors backing such deals to earn returns ahead of the risk-free rate.

The common misunderstanding that ILS means cat bonds alone has to be corrected. Investors who think ILS is synonymous with catastrophe bonds should take a fresh look at the offerings available today and those coming soon to the market.

Please see the article in Dig-In here.

Sources:

Treasuries:

Bloomberg US Treasury Total Return Unhedged USD 2002-2021, calculated on an annual basis Investment grade: Bloomberg US Corporate Total Return Value Unhedged USD 2002-2021, calculated on an annual basis High yield: IBOXX HY Total Return Index 2002-2021, calculated on an annual basis Equities: SP 500 yearly Return 2002-2021, calculated on an annual basis Vesttoo’s lines of business: S&P Capital IQ NAIC data 2002-2021, calculated on an annual basis, including home/farm-owners multi-peril, private auto, marine lines combined, other liability and commercial auto