An Economical Impact? How Cyber Insurance Shapes Incident Response

According to the recent mixed methods study on how cyber insurance shapes incident response, insurers undoubtedly face incentives to concentrate work among the most efficient firms but may lack the information to do so given insurers do not monitor service quality and must rely on second-hand reports. The study goes on to note that the only thing insurers reliably monitor is cost, which may lead to the commoditization of incident response that rewards cost-cutting above quality.

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Industry Research by Daniel W. Woods and Rainer Böhme

How Cyber Insurance Shapes Incident Response: A Mixed Methods Study

The coverage and cost of cyber insurance is increasingly at the forefront of incident response considerations given the proliferation of cyber attacks targeted at businesses, governments, and consumers. Shared with permission from author Daniel W. Woods, the following paper explores how cyber insurance shapes incident response and examines the economics associated with the transfer of cyber risk to insurers.

Abstract

Cyber insurance policies commonly indemnify the cost of incident response services. This creates a multi-layered economic problem in that the policyholder hiring external firms incurs transaction costs and the insurer paying the bill creates a principal-agent problem. We adopted a multistage research design to understand how insurers address the problem. First, we iteratively derived 12 stylized facts from 29 expert interviews and a sample of 480 partnerships with incident response firms made by 24 insurers. Second, we validated these facts via a workshop attended by 61 unique participants. The results show insurers have created a private ordering by controlling which firms are selected, negotiating prices ahead of time, and punishing low service quality by withholding future work. A minority of firms win the majority of work, thereby building trust through repeated interactions. We discuss how the findings relate to the economics of incident response, cyber insurance as governance, and ransomware.

Introduction

Cyber insurance allows firms to transfer cyber risk to an insurer. This creates a situation—known as a principal-agent problem—in which the agent (the policyholder) can make decisions that negatively impact the principal (the insurer). Early research predicted that insurers would address the problem by offering incentives for ex-ante security investments that reduce the likelihood of a claim. So far, this has been undermined by an over supply of insurance and a lack of knowledge about which investments effectively reduce risk In actuality, the most significant intervention sees insurers indemnify the cost of incident response (IR) services. Doing so opens up a Pandora’s box of economic problems. Why do insurers pay for external services and not offer subsidies for internal response? How do insurers ensure the policyholder selects an effective firm and negotiates a reasonable contract? Who is responsible for monitoring service quality?

These questions are naturally framed within transaction costs economics. Ronald Coase’s theory of the firm speaks to when services are contracted on the market and when they are organized within the firm. Coase argues that firms emerge to avoid transaction costs associated with finding, negotiating, and monitoring service contracts tendered on the market. Coase’s theory suggests firms will hire external services if the associated transaction costs can be managed. Applying the same logic to cyber insurance requires care because the agent who transacts the service has different incentives to the principal who pays the bill. This paper aims to build a concise and correct description of how cyber insurance solves the principal-agent problem.


Complete Paper: How Cyber Insurance Shapes Incident Response: A Mixed Methods Study (PDF) – Mouseover to Scroll

How Cyber Insurance Shapes Incident Response - A Mixed Methods Study

Read the original paper.

Reference: Woods, Daniel, and Rainer Böhme. 2021. How Cyber Insurance Shapes Incident Response: A Mixed Methods Studyhttps://informationsecurity.uibk.ac.at/pdfs/DW2021_HowInsuranceShapes_WEIS.pdf.


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