A trailblazer to creating ‘needed’ cyber ILS market

In January,  Hannover Re, the third-largest reinsurer in the world, partnered with asset manager Stone Ridge to deliver the “first” proportional reinsurance structure designed to transfer cyber risk to capital markets investors.

Although technically not a true insurance-linked security (ILS), it did represent a massive breakthrough in moving risks of this type into the capital markets. Stone Ridge provided $100 million in capital to support an innovative retrocession tool that “for the first time” enabled the capital markets to participate directly in coverage of its cyber risks through a quota share cession.

The transaction covers cyber risks in Hannover Re’s worldwide portfolio and has a long-term orientation. The reinsurer noted in a statement at the time of the deal that it enabled it to reconcile the complexity of a proportional cyber risk cession with the needs of a capital markets investor.

But, as helpful as the deal undoubtedly is to Hannover Re’s own risk transfer needs, executives see the deal as far more than a one-off; instead, they believe it could represent a trailblazer, creating a landscape in which other, similar, risk transfer mechanisms can be created.

In fact, in the context of rapidly growing demand for cyber coverage, such mechanisms could become central to the industry’s ability to keep pace with such demand.

“Demand for cyber coverage is forecast to triple in the next few years. The need is there,” says Ludolphs, managing director, retrocession and capital markets, Hannover Re, in a video interview with Intelligent Insurer.

“There is a need for insurance, but insurers cannot cope, just as they cannot cope with peak cat risks. That’s why reinsurance comes into play, but it will also get too much for reinsurers. Then the capital markets come into play. All these pieces in the chain will grow. I’m reasonably confident that in a couple of years we’ll see far more risk spread across all these levels,” he says.

He adds that the growth of the market will be augmented by the fact that investors broadly see cyber risks as diversifying to natural catastrophe risks, which will likely have been the entry point for most into this market.

“Nat cat and cyber are diversifying as investors look at it. There is also the issue of cycle management and timing. Over the last couple of years, premiums in cyber went up a lot, which is good timing,” he explains, but suggests that cyber rates and nat cat will not necessarily move in sync going forward.

Getting comfortable

Ludolphs acknowledges that education was essential for getting the deal done. The idea of moving cyber risks into the capital markets has been discussed for at least a decade. This deal specifically took around a year from start to completion.

“We had to get investors comfortable with the underlying cyber risks. Given the limited historical data, and the fast-changing environment, we had to educate them,” he says.

“Hannover Re has 30-plus years of experience underwriting cyber. But beyond the underlying risk, there were other things investors needed to be familiar with. They need finality, they needed to understand the collateral.

“In that sense, this was no different from other ILS transactions, but these questions did have to be addressed specifically to cyber requirements,” he says.

The key to the firm’s getting such a deal over the line was listening to its partners, “to understand their requirements and find solutions. You have to try and find bridges. I think a lot of it is having a trusted partnership”.

Ludolphs is confident more deals will emerge as a result of this one coming to market. “I’m convinced there will be more transactions, from us, but also from other issuers. I think we will see deals in many ways: as bonds, as proportional deals, as parametric deals. I’m convinced we may see more even this year.

“We want to expand on what we have done. We are thinking of other structures, and non-proportional structures. These recent transactions will help investors deal with any concerns. It may reduce the hurdles to look at these cyber risks. And, remember, not every investor has to take a $50 million share. They can easily start small and then grow participation over time,” he explains.

Ludolphs believes that the models developed to help better understand cyber will become more sophisticated, in the same way as they have for natural perils. “I’m sure these models will develop further as they have for natural catastrophe risk.

“Some 30 years ago, the first models for hurricanes in Florida were simple. Now, we are 100 times more sophisticated. I’m sure a similar development will occur on the cyber side,” he concludes.