Blockchain in insurance services: A bold disruption or an incremental evolution?
25 Jan 2017
Information has been the lifeblood of businesses during this century, and corporates have evolved over the last two decades accessing, processing and monetising exponentially growing volumes of data. It has also exposed new risks around trust, security, transparency (or lack thereof), privacy and related trade-secrets. The global economic slowdown following the 2008 mortgage crises in the United States highlighted the risks of information asymmetry prevalent in financial services leading to abuse of unilateral trust that had been placed with certain fixed income securities market makers. The post 2008 world has seen a great deal of regulatory clamp-down and oversight in terms of compliance and reporting overheads. It also led to the creation of alternate systems of information management that natively manifest multilateral trust and transparency, called blockchains.
What is Blockchain?
While the origins of the technology behind blockchains date all the way back to research in distributed systems and cryptography in the 1970s, the first commercial grade blockchain platform was delivered by Bitcoin – an alternative to sovereign monetary systems that digitally gamifies money circulation through a large network of independent witnesses economically incentivised to honour bearers and keep up liquidity. While Bitcoin is going through its own lifecycle, there has been heightened interest in applications of its underlying blockchain technology in a wide variety of financial services use-cases across markets, including banking, credit and insurance services.
At its core, a blockchain is a decentralised system of record or a distributed ledger, which can efficiently enforce multilateral consensus on every transaction recorded. Core systems in today’s financial institutions use relational databases with unilateral consensus across a given institution, and deploy reconciliation, settlement and audit services to build consensus across institutions. Blockchains break down these large batch services by systemically incorporating them in a digital protocol based consensus that includes all counterparties and stakeholders of the transaction. Blockchain protocols also build redundancy to tolerate malicious counterparties within pre-designed threshold limits.
As a system of record, a blockchain exhibits a strong set of unique properties that are consequential to the business, legal and regulatory aspects of financial transactions:
Immutability: Blockchains enforce multilateral consensus on every mutation of the system of records and use the properties of the protocol to reject any unilateral mutations, rendering the records immutable outside of the consensus protocol given that the number of malicious counterparties are within the tolerance limits. This property greatly reduces the need for intermediaries like clearing depository and custodian services for counterparties to enter into financial transactions. However, the intermediaries also fulfil regulatory and legal requirements, which need to evolve to accommodate digital blockchain platforms. This would lead to increased liquidity and bring down the transaction processing costs.
Transparency with privacy designs: Blockchains’ multilateral consensus creates a digital footprint of transactions’ provenance, which can be used to verify transaction-chains against fraudulent counterfeits and double-consumption (like an asset fraudulently hypothecated twice). It leverages modern cryptography to provide privacy and protect against trade-secret leaks by using one-way digital watermarks to represent entities on the shared system of record.
Composability: Blockchain consensus networks are composable to allow transactions to flow across multiple layers of counterparties. For instance, transactions could flow across policyholders, brokers, cedants and reinsurers through multiple consensus networks designed for every layer of transaction.
What are Smart Contracts?
Changes in the system of records in a blockchain brought about by multilateral consensus need to adhere to pre-agreed terms between the counterparties involved in the transaction. The consensus validates the identities of the counterparties involved and that the changes in the distributed ledger adhere to the terms of agreement. These terms need to be digitally stored as a secure programme accessible to a network of computer nodes participating in the consensus. This computer programme would be a digital representation of a legal contract between the counterparties, and is called a smart contract. The validity of execution and the uniqueness of the inputs to a smart contract are electronically notarised by the blockchain’s network of nodes participating in the consensus protocol. Hence smart contracts are integral to the functioning of a blockchain; and bring legal validity, allow for flexibility in terms between the counterparties and guide the consensus protocol to validate changes made to the distributed ledger.
Smart contracts make blockchains even more interesting, and bring more legal, business and regulatory consequences along with them:
Autonomy: Blockchain consensus networks provide for unilateral execution of smart contracts without requiring a third-party executor, provided malicious actors are within tolerance limits and the contract does not involve any external adjudication or other judicial system service. This provides contracts autonomy in most of the day-to-day execution and operations. Thus, counterparties can enter into transactions with deeply customised terms, but yet have efficiencies of execution seen only in exchange regulated markets. There are still hurdles in digitising alternate dispute resolution and adjudications involving changes in contract laws and judicial processes, but these do not impede the efficiency gains applicable to the vast majority of normal contract executions.
Digital notary and witness: The blockchain also embeds digital witnesses and notarises the validity of the counterparties through electronic signatures stored in the distributed ledgers. These can be openly audited through the blockchain’s transparency properties. These enable the automation of compliance, reporting and other regulatory requirements, which have specially risen to significant overhead costs in the post 2008 world.
Why do Smart Contracts and Blockchains matter to the Insurance Industry?
The unique properties of blockchains and smart contracts discussed above are of great relevance to foundational tenets of insurance within risk management (including receding risks), claim processing and underwriting processes.
I. Risk Management
Shared Indemnity: Complex pools of risks in P&C and industrial verticals are usually shared by multiple parties involving insurers and reinsurers, who would jointly indemnify the insured of losses to the extent of the insured’s interest. However, the risk is distributed across complex layers of paper contracts with very little transparency and information sharing. Blockchain’s properties of transparency with privacy designs can make information sharing feasible and seamless. Its properties of composability can help policy-granular recession of risk with co-insurers and reinsurers. Smart contracts can accelerate efforts around standardisation of shared indemnity contracts by enabling standardised execution of contracts while accommodating non-standard policy-specific terms. The automation of compliance reporting through smart contracts’ digital witnesses will make shared risks across legal jurisdictions much more efficient.
Contribution: Modelling the obligations of the insurance service parties involved in the shared indemnity to the insured is usually very complex involving a network of analysts, lawyers and underwriters. The challenges emanate from the innate lack of transparency, need for trade-secret protection (around underwriting and pricing) and non-standard legal covenants. Blockchain’s properties of immutability and transparency can significantly enhance trust and collaboration between shared indemnity holders. The composability properties protect them against fraudulent actions of the insured that lead to loss allocation of obligations above the share of indemnity. Smart contracts can autonomously model obligations by chaining the distribution of risk together across the insured, brokers, insurers and reinsurers.
II. Claims Processing
Process and Payment Efficiency: Claims processing and disbursements of payments are riddled with complex workflows between brokers, insurers and reinsurers involving layers of verifications. The payment itself is a complex chain of transactions involving banks across borders with high fees. Smart contracts can be very effective in establishing workflows across institutions without needing external oversight by leveraging digital witnesses. Payment processing can be embedded within the smart contract with efficient inter-institutional settlement to significantly lower the transaction fees. Pegged crypto-currency tokens can be used for remittances across borders to reduce the cost of fund transfer.
Ascertaining Definite Loss: Ascertaining the timeline of incidents leading up to a claim of loss can be very challenging, especially for the institutions that share indemnity downstream away from the insured. Blockchain’s immutability and transparency properties can bring significant efficiencies in enabling all stakeholders of the claims process to arrive at a consensus on the timeline of incidents, and verify adherence to the share of obligations. Smart contracts can add further efficiencies by digitally executing legal covenants on the shared view of the timeline, and can be offered as templates for specific arrangements like quota-sharing (QS) or excess-of-loss (XL). This can significantly reduce the legal overheads in claims processing.
Limiting Risk Exposure: Underwriting commercial risks involve mitigating exposure to the insurer to the extent affordable premiums can be offered to the insured. Limiting exposure involves finding other more efficient risk pools to recede risks at a lower price. The options available for recession are limited by the insurer's ability to share information about the insured as well as rigid standards of risk recession. Blockchains hold the promise of extending the insurer’s ability to guarantee properties of risk specific to the insured as well as execute terms of recession more customised to the policyholder. These will go a long way in bringing efficiencies in the insurer’s underwriting process and ability to underwrite more diverse kinds of risks. New categories of liabilities such as cyber-security are inherently digital in nature, and align very well with smart contract driven sharing of indemnity and processing claims.
Blockchain-driven disruptions to incumbent industry economics
Blockchains create a live network that gives all stakeholders access to a firehose of transactions within the framework of its consensus and privacy properties. Such a live digital access across the value chain of insurance services would be unprecedented in the industry. As blockchain adoption across financial services increases, this could lead to tectonic shifts in the economics of insurance incumbents in the future. We have seen such disruptions in the past in industries like retail, banking and telecommunications, led by widespread adoption of smartphones that enable live non-stop engagement with consumers.
I. Data-driven Continuous Risk Operations
Insurance services will get even more data-driven leading to real-time risk assessment, risk management (continuous optimisation of risk distribution) and more intelligent fraud detection. Incumbents will need new skills in data infrastructure (“big data”), artificial intelligence and data sciences to monetise access to new data effectively. It can also lead new competitors to the industry, who have deeper operational experience in data-driven decision making, access to live operational data and domain expertise; for instance, Amazon.com offers its own insurance services for certain product categories distributed through its online retail operations. With the advent of autonomous transportation, disruptors like Uber, Tesla and Google could dent the auto insurance industry further.
II. Open Market Risk Securitisation
Smart contracts have the promise of digitising insurance services to an extent of de-coupling underwriting, investment management and claims processing. This leads to the possibility of Peer to Peer (P2P) insurance models, where a subject-matter expert earns a spread for underwriting risks from the insured into a securitised risk pool of cash flows distributed to borrowers to generate the requisite risk-return to cover obligations. Such P2P models have already been proposed through different open community blockchain projects. Such models of risk securitisation could deeply disrupt the insurance industry, as it will transform it into a low margin software-as-a-service (SaaS) business. However, the regulatory frameworks across jurisdictions need to evolve to accommodate such disruptive risk coverage models, thus slowing it down. In the medium-term future, the data-driven continuous risk operations from new entrants portend more disruptions than the disintermediated insurance models of the far future.
Business case for adoption of blockchain technology by incumbents
As described in the previous section, blockchains’ unique properties are very aligned with challenges in insurance services. There is a strong business case that can be made for the adoption of this technology for operational transformation. This would also make the incumbents more familiar with the benefits and risks of blockchain technology, and help prepare for embracing longer term disruptions in the not-so-near future. The specifics of the business case will vary across industry verticals and geographies, but will have the following three essential components:
Efficient payments: Smart contracts and blockchains can disintermediate banks and other financial institutions, and reduce the cost of payment processing. As regulators begin supporting pegged crypto-currencies, this can also eliminate the need for intermediaries for distributing payments from multiple parties that share obligations to pay the insured.
Automation: As discussed in earlier sections, smart contracts can drive significant automation in underwriting, claim processing and risk assessment. This will reduce the operational costs and lead times of processes.
Efficient risk distribution: Smart contracts can efficiently accommodate customised policy-level terms in a standardised execution framework and enforce them at scale. This will significantly enhance the efficiencies of risk recession and hence distribution of risk into appropriate risk pools.
The Tipping Scale
The insurance industry has withstood several economic cycles and technology disruptions in the past centuries. The well-organised community of brokers, carriers, reinsurers and regulators have been able understand the nuances of each disruption and adapt to changing realities as a group. Adoption of blockchain will also involve such concerted community efforts to bring standardisation across nomenclature, data-sharing, contract term expressions, privacy expectations and collaboration. Regulators must ensure industry best practices are followed across user-privacy, cyber-security, and digital validations and contracting, while adopting blockchain-driven digitisation. The network effect of such community-wide efforts will keep the incumbents differentiated in the industry and enhance their ability to provide a premium quality of service to customers. This will go a long way in tiding through the longer-term disruptions discussed earlier.
Blockchain technologies are headed towards becoming the standard for digital transaction processing of the future. This will have widespread impact across all forms of financial services. Insurance is a key component of financial services, and essential to interpret new forms of liability in a fast-changing global digital economy. Adoption of blockchain technologies in insurance could be key for dealing efficiently with new liabilities as well as processing transactions globally.