According to a new report authored by Tom Johansmeyer, Global Head of Index Classes, at broker Price Forbes Re, addressing the need for liquidity is starting to make an impact towards the various constraints that currently stand that are limiting the rapid adoption of cyber catastrophe bonds.
Johansmeyer notes that the ILS market has long been seen as a potential participant in cyber insurance and risks, highlighting how ILS managers have clamored for access to liquid cyber re/insurance instruments and indicated that liquidity would be crucial to scaling their involvement.
Moreover, he also states that the overall role of liquidity towards the growth of the cyber ILS market has generally not been addressed.
“Liquidity features prominently in the ILS market, as this paper will proceed to discuss, as some ILS managers require at least some amount of the instruments in their portfolio to be liquid. As a result, this article addresses a significant gap in the historical literature with regard to cyber ILS, namely the importance of liquid instruments in cyber risk transfer,” the paper reads.
A study that was conducted by Johansmeyer throughout the report, shows that eight out of twelve participants that were interviewed from within the ILS market, raised the role of liquidity towards attracting investor capital to the cyber ILS market.
It’s important to note that all twelve participants that took part in the study were interviewed either before and during the period during which the first three private cyber catastrophe bonds were issued.
“The fact that the four respondents who did not discuss liquidity have engaged in cyber ILS does stand out. It is evident from their interviews that they are already committed to the sector and thus did not see the lack of liquidity (until the 144A transactions were issued) as an impediment,” the report reads.
“Their participation in the market varied. One respondent had engaged in proofs of concept and another deployed significant amounts of capital to collateralized reinsurance deals, making liquidity irrelevant. The third company (two respondents) is a strategic player in the space with an interest in growing the cyber ILS class of business.”
As per Johansmeyer, a number of themes emerged from the discussions about liquidity.
“The most important, of course, is the role of liquidity in attracting end-investor capital to the ILS sector. Some investors require that ILS managers only invest in liquid instruments, and others may not require liquidity but do prefer it,” Johansmeyer explains.
“There is a salient difference between theoretical and practical liquidity, the respondents noted, and the former should be enough to help attract capital to the cyber ILS market. Liquidity may come from format (e.g., 144A), but it also involves being able to understand and analyze the transaction itself, which is why respondents also indicated the importance of structure in liquidity. Finally, participants in the study discussed the importance of both deal size and frictional costs together in achieving a liquid market for cyber ILS.”
But an important factor that Johansmeyer highlights, is given the size of the ILS market in general, there are questions around the practical liquidity of the ILS market.
However, Johansmeyer affirms that while secondary trades in catastrophe bonds are completed, it is generally accepted that the catastrophe bond market is much less liquid than broader equity and bond markets.
“Nonetheless, the lack of practical liquidity has not been a barrier in attracting end-investor capital requiring funds with liquidity mandates. In fact, this is evident from one response, indicating that the private cyber catastrophe bond issuance activity of 2023 lacks liquidity because of “the fact that it’s a private placement.”
Johansmeyer also goes on to highlight how catastrophe bond tenor has been flagged as a barrier to liquidity.
“One respondent observed that the short tenors in the private transactions represented “a practical constraint on liquidity, in that there isn’t really enough time to trade them.” The ILS manager continued that “if a tradable event were to occur,” such as a cyber catastrophe or even just further issuance activity that causes an ILS manager to rebalance the portfolio, “such short tenors afford little time to do any analysis for a trade,” the report reads.
“If a trade could get done, the buyer of the bond would not have much time left to on the transaction. The respondent explains, “Trading out of a twelve-month transaction with a 15% coupon with only four months left would leave the buyer with only 5% of the principal as income. Five percent of a $10 million trade would be $500,000, which would hardly cover the soft costs of the relevant analysis.”
As well as trigger and contract structure and tenor, the study also emphasizes that size matters in regard to the liquidity of cyber cat bonds.
“There are several reasons why deal size matters. First, there needs to be enough size to enable trading among many potential buyers and sellers, according to an executive from a large ILS manager with experience in the cyber sector. According to the respondent, “I think investors do need liquidity, they do need size … ultimately I think you do need some scale for the market.” Generally, size limits the ability to scale analysis and trading activity, in addition to simply not making enough product available for potential investors to review and trade. However, the availability of bonds is not the only constraint that deal size can have on liquidity,” Johansmeyer explains.
Importantly, Johansmeyer affirms that the cyber cat bond market will begin small and take time to add both sponsors and participating ILS managers. In order to make this possible, he states that it is necessary to recognise today what is the result of a new and emerging market versus the constraints that are genuine impediments to scale, and which require more focused attention and remediation.
As per Johansmeyer, this includes gaining a general understanding of the companies that could sponsor cyber catastrophe bonds and the base of ILS managers that would consume them in the near term, as well as which managers would take longer to engage with cyber ILS activity.
“The population of potential sponsors is somewhat limited. As the ILS managers participating in this study noted, deal size is important to liquidity. A transaction that is too small will struggle with frictional costs. Further, smaller transactions are more difficult to trade because of the scale associated with trading analysis,” Johansmeyer continues.
“A robust cyber ILS market may seem to be in sight, but reaching it will require discipline, planning, and an understanding of the most appropriate uses of this form of capital for a new and emerging class of business. A range of market constraints still stands to limit the rapid adoption of cyber catastrophe bonds by both sponsors and ILS managers,” the report reads.
“However, addressing the need for liquidity has clearly begun to make a difference already. The demand for liquid cyber risk transfer instruments expressed by a dozen ILS managers throughout 2023 was not idle chatter, given that nine such transactions have now come to market, five of them using the 144A format.”
You can read about every cyber cat bond transaction, including the first private cat bond deals and the more recent 144A cyber cat bonds, by filtering our Deal Directory by peril to view only cyber cat bond transactions.
