The impact of blockchain’s smart contracts on insurance
Last month we delved into the blockchain, the disrupting technology behind cryptocurrency Bitcoin. We then outlined how the technology works and discussed its implications for the banking industry. Today we look at smart contracts that can be created in the blockchain, and how they will affect the insurance industry.
The most widely known blockchain is the ledger of transactions for cryptocurrency bitcoin. A blockchain is a distributed ledger that maintains a continuously growing list of data records on decentralized servers, working as nodes. Every node holds a complete copy of the blockchain, a shared single source of truth. Nodes are incentivized to maintain a copy of the ledger by rewarding them with the cryptocurrency through a process called mining. A transaction would only be added to the ledger when a majority of the nodes agree on the validity of that transaction.
The core advantage of the blockchain as decentralized ledger is that it exists in an endless number of nodes. This ensures transparency, even when nodes are run anonymously, have poor connectivity with one another, and have operators who may be dishonest or malicious. Furthermore, through the elimination of intermediaries, blockchain ensures lower fees, whatever the ledger may hold.
The data in the distributed ledger can hold any amount or information, not just a cryptocurrency like bitcoin. The data is both individually identifiable and programmable. This means that users can assign properties to the data. Users can program the data to represent an amount in a currency, a share in a company, or even diamond certificates. Everledger is a start-up launched in 2015 that collects dozens of cross-referenceable data points on each recorded diamond in a permanent distributed ledger to ensure verification for insurance companies, owners, claimants, and law enforcement.
A concept that lends itself ideally for the blockchain is the smart contract. A smart contract is a contract between two or more parties that is created and stored in the blockchain, it involves more than the mere transfer of an amount and is self-executing upon programmed rules.
The concept is most easily explained with an example. Imagine a life insurance smart contract that pays a benefit to the designated beneficiary upon the death of the policy holder. The contract can perform real time checks on online death registers to determine the moment of payout. Smart contracts are trustless, autonomous, and self-sufficient.
Last September, a team at the London FinTech Week hackathon utilized smart contracts to walk away with the first prize. Given the fact that around 550,000 airline passengers in the UK do not claim on their insurance for delayed flights, the team presented a smart contract system that provides direct compensation for affected passengers. The team was able to do so by connecting tons of online data feeds containing flight information to smart contracts in Ethereum.
The Ethereum platform, by some experts dubbed as ‘Blockchain 2.0’ or ‘Bitcoin 2.0’, is a programming framework to allow a network of peers to create and administer their own smart contracts, without a central authority. It combines a blockchain network with a universal programming language that would allow users to invent whatever smart contract they want. These smart contracts, or apps, run exactly as programmed without any possibility of downtime, censorship, fraud or third party interference. The apps are able to interact with one another and conduct transactions in Ethereum’s own cryptocurrency, called ether. The platform even enables the design and issuance of one’s own cryptocurrency, where you either set the total amount in circulation to a simple fixed amount, or let it fluctuate based on any programmed ruleset.
Although Ethereum was launched in July 2015 and is still in a development phase, the platform has already spawned the creation of a large number of interesting apps and projects. WeiFund, for instance, is a non-profit, decentralized crowdfunding platform built on Ethereum. Because of the blockchain, this ‘Kickstarter in a box’ features lower fees and enhanced security.
Implications for the insurance industry
Lower operating costs are the biggest beneficiary for insurers that utilize smart contracts. Because the contract would be self-sufficient after its creation, no costly human interaction would have to take place afterwards. Furthermore, the self-executing character would greatly increase speed and efficiency in claims processing. Smart contracts are also said to avoid the textual ambiguity of traditional contracts, preventing legal disputes. Because the rules of the smart contract are programmed at creation, the contract would only execute according to said rules.
The programmable character also allows for less insurance fraud. Imagine a car insurance payout that can only be used for repairs at certified parties. Whether someone actually follows the rules is no longer verified in the bureaucratic process afterwards. The payout can even be programmed in such a way that it will automatically return to the insurer if the receiver doesn’t use it within a certain amount of time.
The hackathon example with the flight delay information showed us that the smart contract can also interact with the online world outside the blockchain. By connecting with the Internet of Things, insurers could even take this one step further to tailor their products. Think of travel insurance premiums that are only collected when your phone tells the contract you are abroad or car insurance premiums that are only collected when your car tells the contract you are driving. The possibilities of smart contracts fully depend on the creative minds walking around in the offices of the insurer.
But, what if the ‘traditional’ insurer can be cut out of the policy? Dynamis is creating peer-to-peer insurance on the Ethereum blockchain. Like Friendsurance, policyholders pool together, based on a sharing economy concept, and support each other financially in the event of any claim. But instead of a policy managed by people who process applications for new policies and applicants for new claims, the peer-to-peer insurance in Dynamis would only be managed by smart contract code, significantly reducing costs. You can read an overview of how to use blockchain technology to execute peer-to-peer insurance here.
Whether the current blockchains are the most suitable for smart contracts is still doubtful. Blockchains rely on an underlying cryptocurrency that is highly volatile. Furthermore, the networks are maintained by miners that expect a reward to compensate for the energy consumption this requires. You would expect a consumer of insurance to be able to depend upon a network for more than a decade without having to worry about crypto-economic game theory issues. And are consumers going to rely on networks where jurisdiction and regulation have no reach?
Distributed ledger systems, like Ripple and Hyperledger, are said to overcome these issues. Rather than existing in anonymous nodes, these ‘permissioned’ ledgers use legal entities to validate transactions. Imagine a distributed ledger between an insurer, intermediaries and a network of health providers. These distributed ledgers are applicable to all assets, including fiat money and shares, but can still replicate all applications pioneered by the cryptography community. Furthermore, they are relatively compatible with existing regulations.
Some of these distributed ledgers, like Ripple, still use a cryptocurrency. But, these currencies or tokens are being built without the expectation or intention of making these coins available for purchase to retail customers. These tokens are only used as verifiable cryptographic receipts internally between permissioned parties, as a way to prove that certain events happen at certain times for the parties involved, as well as for outside compliance and auditing agencies. Other distributed ledgers, like Hyperledger, do not even have a built-in cryptocurrency.
The distributed ledger might, for the time being, be more attractive because of the control they afford over the system. They are not subject to price volatility of underlying currencies, offer less regulatory risk and have a more secure authentication process that doesn’t rely on the incentives for miners to authenticate transactions.
Ultimately, it is for the organization to question whether the blockchain or distributed ledgers could provide in its requirements. The possibilities of the smart contract are endless. It is for the insurance sector to experiment with it, before everybody else does.