Pratap Tambe explains how blockchain and distributed ledger technologies may be useful in the reinsurance value chain, using nuclear risk as an example
Insurers take on credit risk when they enter reinsurance contracts. To make matters more complex, the reinsurer may then enter retrocession contracts (possibly with further retrocession of their own), and/or insurance-linked securities contracts with capital market participants.
When this happens, the reinsurer takes on credit risk of its own; from the insurer’s perspective, its credit risk becomes diversified and reduces. At the same time, multiple layers of retrocession also make it possible for reinsurers to enter ‘loops’ in which they end up reinsuring their own risks, which can exacerbate credit risk for other parties in the chain.
With current market technology and solutions, it is very difficult for insurers to monitor the credit risk in a transparent manner and avoid such loops. Blockchain can help, although the exact shape and nature of this solution still needs to be debated in the industry.
Use case: nuclear pools
Nuclear risks are notoriously large, and no single player has adequate capital to cover the magnitude of the risk. To overcome this, ‘nuclear pools’ provide a mechanism through which multiple insurers, usually within the same country, can jointly underwrite a risk. These nuclear pools exist in many major insurance markets.
Inter-pool risk transfers are one option in the risk management toolkit for nuclear pools. However, the transferring country’s nuclear pool retains a high degree of credit risk unless the receiving country’s nuclear pool allocates capital to the transferred risk, or transfers the risk it cannot allocate capital for to yet another pool. At each step in the chain, the pool allocates capital to the part of the original insurance risk it retains and to its credit risk. Such onward inter-pool transfers thus increase the total capital allocated to the risk and reduce the credit risk for the original cedent.
Insurers maintain uncollectible reinsurance recovery reserves for the counterparty credit risk they face from their local nuclear pool reinsurer. Blockchain or distributed ledger technology (DLT) solutions can enable such insurers to receive instantaneous information about the credit quality of the onward reinsurance chain; with such information, if the inter-pool risk transfers have any value, they should reduce such reserves.
A resilient and sustainable solution
Are blockchain or DLT solutions overkill for the seemingly simple task of passing information along the reinsurance chain? I don’t think so.
These solutions are uniquely resilient to climate challenges when it comes to delivering contract certainty. They automatically maintain multiple copies of the contract data and its full audit trail on the contract parties’ nodes, as well as other observer or regulator-type nodes; this decreases the risk of data loss in natural disasters. This might sound trivial, but it is not. As floods, hurricanes and extreme weather become more intense and frequent, ensuring a responsive and resilient risk transfer infrastructure for our biggest risks will be important. Centralised systems are much less resilient in this respect.
Proof-of-work algorithms, a class of algorithms associated with blockchains, have sparked some environmental concerns. However, most market solutions for reinsurance contract certainty use permissioned blockchains networks. In essence, permissioned blockchains are more efficient and cost-effective, and maintain the advantages of decentralised storage. The price of the efficiency is trust – and these networks are run with an understanding of collaboration, reflecting existing trust relationships within the (re)insurance industry.
The UK government recently announced that it will set up eight more nuclear plants. Nuclear energy is a critical part of a sustainable future, as a shock absorber for volatility in wind and solar energy supply. I have no doubt that, as climate events become more intense and frequent, other countries will also launch more nuclear plants. As the scale of nuclear risk increases in the world, the importance of contract certainty for nuclear risk transfers will increase further. The same thing applies to all pools, such as terrorism, natural catastrophe, pandemic, agriculture and energy. As risk rises globally, instantaneous contract certainty and low credit risk for risk transfer contracts across value chains is critical.
Pratap Tambe is head of banking, financial services and insurance cyber and blockchain consulting at Tata Consultancy Services
Image credit | Getty
