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June 26, 2017

The Dawn of Digital Reinsurance

Summary:

A new reinsurance facility powered by transparent distributed ledger technology is diffusing the impact of adverse events.

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The physical science of matter and motion provides valuable insight for the effective digital management of risk.

In this first installment of the DelphX Innovation Series, we describe how a new reinsurance facility powered by transparent distributed ledger technology is employing digital parallels to physical science to diffuse the impact of adverse events.

Background

The physics of diffusion enables the force of a speeding bullet to be absorbed and rendered nearly harmless by the energy-distributing property of graphene lattice incorporated within a bulletproof vest. That diffusion results from the efficient random-walk distribution of the bullet’s force among the graphene fibers – conveying its energy down a gradient from cells of greater concentration to those of lesser concentration.

That property of absorption also causes fluid collected in a sponge to be efficiently distributed among its cavities in proportion to the relative size and fluid concentration of each cavity. Correspondingly, fluid contained in a saturated sponge placed in a vacuum will be released from each cavity in proportion to its relative size and concentration – with those containing higher concentrations sourcing respectively higher amounts of the outflowing fluid.

Science of Digital Reinsurance

A digital corollary to that balanced distribution process has been integrated into the patent-pending technology of a new risk-pooling reinsurance facility, styled “Quantem” to reflect its risk/collateral-minimizing utility. The facility will be operated by a major global reinsurer to optimally diffuse the impact of loss among risk holders – rendering even a material event nearly harmless to any individual holder.

Ceded risks will be distributed within a transparent digital ledger that allocates each risk among all cedents in proportion to the net current size and concentration of risk ceded by each. While all cedents will have full viewing access to all elements of the ledger, their identity will never be disclosed.

Operation of the Quantem ledger will be perpetual and open-ended, with the level of concentration of each new risk being determined at origination by the anonymous interaction of competing participants in the SEC-regulated DelphX Alternative Trading System (ATS) market. Demand in that market will be sourced from participants seeking to cost-effectively transfer (or speculate on) risk, and its supply will be sourced from participants seeking to assume referenced risks in return for their continuing receipt of a negotiated annual premium/spread.

The aggregate size of the ledger will dynamically increase as new risks are added and decrease as existing risks expire due to their maturity or settlement. As each new risk is added, its size and premium/spread (risk concentration) will determine its positioning along the ledger’s concentration gradient – incrementally adjusting the proportionate quota-share exposure of each other risk.

See also: The Need to Automate Reinsurance Programs  

Credit Market Solution

The Quantem facility will be initially deployed in the global credit market to provide participants a low-cost and more efficient alternative to single-name credit-default-swap contracts. Quantem will diffuse the impact of adverse credit events and provide a regulated security-based solution to the dwindling derivative-based CDS market.

To accommodate that efficient transfer of credit risks and the supporting cash flows among investors, Quantem will commoditize those risks/flows within a new form of digital default compensation receipt (DCR) securities that provide:

  • Fixed negotiated spreads and maturities;
  • MTM-collateralization by cash-equivalent assets held in trust by a highly rated custodian bank;
  • Lump-sum compensation payments to holders upon occurrence of a qualifying credit event involving the referenced corporate, municipal, sovereign, structured or other security; and
  • Anonymous negotiation, origination and trading within the transparent DelphX ATS market.

To source the collateral required and minimize the cost of DCRs, Quantem will also commoditize and reinsure the related DCR risks through the sale of digital collateralized reference obligation (CRO) securities that provide:

  • Fixed negotiated coupons and maturities;
  • Full collateralization by cash-equivalent assets held in trust by a highly rated custodian bank;
  • Deeply discounted purchase prices reflecting the lower risks resulting from Quantem’s reinsurance facility; and
  • Anonymous negotiation, origination and trading within the transparent DelphX ATS market.

Note: All CRO sale proceeds are available to Quantem solely for use in funding the collateral requirements and compensation of DCR holders.

The risk-mitigating utility of Quantem results in DCR spreads well below the cost of comparable CDS protection and low purchase prices for CROs. The enduring benefit of that lower cost of purchase is economically evidenced in the considerable post-claim yields payable to CRO investors. For example, an assumed annual loss ratio of 4.0% (which is more than twice the aggregate mean default rate of all U.S. corporate bonds since 1981), would produce the following post-claim CRO yields:

Market-Based Underwriting

The fixed risk concentration of each new DCR added to the ledger is determined at origination by the clearing premium/spread resulting from the competitive interaction of participants in the transparent DelphX market. That risk-concentration thus reflects the market’s then-current equilibrium of supply and demand for protection relating to the risk of the subject CUSIP/ID.

That transparent interaction among symmetrically informed market participants facilitates the efficient market-based underwriting and selection of new risks – avoiding adverse selection and subjective/uninformed assessments of risk concentration. While the current DCR pricing for each referenced CUSIP/ID will increase and decrease on the DelphX market, the ledger’s design facilitates the aggregate behavior of pooled DCRs to gradually converge onto a normal (Gaussian) distribution.

As the market’s current risk assessment of each CUSIP/ID increases and decreases, the MTM collateral requirements of holders of the related DCRs will correspondingly increase and decrease in response to those changing market prices. Consistent with the law of large numbers, however, as risks of some DCRs are increasing others will be decreasing – resulting in an increasingly predictable mean exposure within the ledger.

As exhibited by the historical behavior of participants in the single-name CDS market, demand for DCR protection (and speculation) for a given CUSIP/ID is expected to increase in proportion to the collective assessment of participants of the likelihood of a loss involving that security. If the risk assessment increases, the pricing and volume of DCR purchases for the subject issue will correspondingly increase.

As those new, freshly priced DCRs are ceded, their higher price/risk concentration will cause the aggregate concentration of risk for the subject CUSIP/ID in the ledger to correspondingly increase. Thus the collateral sourced by those higher risks will proportionately increase the ledger’s aggregate collateral available for MTM adjustments and minimize the impact of a related loss on all other DCR risks.

See also: Transparent Reinsurance for Health  

Market-Based Adjudication

Quantem will also employ its diffusion protocol to distribute the cost of claims among risk holders based on the net size and concentration of each holder’s ceded risk at the time of adjudication of each claim. That adjudication process is transparently accomplished through anonymous single-price auctions conducted within DelphX.

Upon the reporting of a credit event meeting the definition and conditions specified in the DCR documentation, a single-price auction is scheduled within DelphX to facilitate the sale of the collective offerings of the referenced CUSIP/ID by its holders. The clearing price of that auction is then subtracted from the par value of the referenced security, with the remainder determining the compensation payable to holders of DCR(s) referencing the sold issue.

Next Series Installment – Digital Risk Speculation

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About the Author

Larry Fondren is a veteran of the insurance and securities industries, where he has worked to develop and promote fair and electronic markets. He has served in capacities ranging from agent to senior officer and shareholder of domestic and international insurance and reinsurance companies.

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