How Blockchain Could Really Change the Insurance Industry

Is blockchain a solution in search of a problem? For the insurance industry, there’s been plenty of chatter about distributed ledger technology and smart contracts, but take-up has been thin.

The recent catastrophe swap that Allianz Risk Transfer (ART) completed marks an important development in the adoption of blockchain, and it could pave the way for much more activity. The first transaction is always the hardest. And there’s one significant barrier to making blockchain an industry standard: the nature of insurance protection itself.

It comes as little surprise that industry loss warranties (ILWs) have taken centre stage in the global insurance industry’s blockchain discussion. To unlock all the benefits of this technology, the insurance protection involved needs an independent source of data to determine when a claim payment should be made—just think of how the PCS® Catastrophe Loss Index is used. In blockchain parlance, this is the ‘oracle’. ILWs and other index-triggered covers (such as parametrics) work well in the blockchain environment because they rely on independent third-party reports to determine when a triggering event has occurred.

Most insurance policies, however, don’t work that way. The original insured has a loss, the insurance company reviews the event, and then an appropriate claim payment is made. The payment is reflective of the underlying loss (within the context of the policy). For blockchain smart contracts, the basic insurance policy doesn’t fit for several reasons:

• The workflow would simply mimic what exists now, offering no efficiency gain.
• The losses are self-reported (essentially), which provides no opportunity for the blockchain solution to mitigate bias or fraud risk.
• Any reduction of costs would likely be too small to justify the technology investment.

The nature of the original insurance policy winds up perpetuating the use of structures that don’t work well on the blockchain. Insurers, seeking to reduce basis risk, generally prefer to transfer risk on an indemnity basis, with the same holding true for reinsurers buying retrocessional transaction. In cases where an ILW makes more sense, we see the first real opportunity for the blockchain to be effective.

But what if the original insured bought protection differently? Doesn’t this seem a bit like the tail wagging the dog? Why would insurers change how their policies are written simply to be able to take advantage of smart contracts? Well, of course, they probably wouldn’t. However, there are some scenarios in which blockchain-friendly triggers may make sense in the primary insurance market. And this is where parametrics come into play.

The global insurance and reinsurance industry is no stranger to parametric covers, an approach that has been featured in both catastrophe bonds and ILWs for a while. And more recently, there have been developments involving the use of parametrics in primary market covers for hurricane and earthquake. Although it’s a start, penetration may not be sufficient to justify the implementation of a blockchain smart contract solution.

Taking the long view, it’s fairly easy to conceive of end-to-end insurance and reinsurance solutions that provide efficient protection (including fast claim payments) while also making sense for the blockchain. One that’s been discussed frequently this year is parametric terror cover.

The nature of the global terror threat has shifted from large attacks on ‘trophy’ targets to smaller active assailant scenarios focussed on loss of life rather than physical damage. The result has been a protection gap for commercial insureds, which are forced to bear the losses on their balance sheets. Some companies have begun to introduce broader covers for terror, but the gap is still significant. A parametric solution could fill the void rather quickly, providing protection for original insureds while creating an environment for effective risk transfer through reinsurance and retro. And it could all be done on the blockchain.

With Verisk Maplecroft as the oracle, consider a parametric trigger for terror using fatalities, incident type, date, event duration, and perpetrator group (necessary for hours clauses to link together separate incidents that are part of a larger coordinated event). Call it an aggregate annual triggering on 5,000 fatalities with an event ‘franchise’ of 500 fatalities in Europe (excluding Turkey). The smart contract listens for reports in the Verisk Maplecroft system that meet the criteria of the contract, aggregating relevant events. When the threshold is reached, the cover is triggered, and the insured receives payment.

Now, the insurer will need protection and could enter into a reinsurance agreement reflective of the underlying protection—essentially a parametric terror ILW that triggers on fatalities reported by Verisk Maplecroft. Of course, it’s effectively an indemnity cover, because the parametric trigger in the ILW reflects the underlying primary cover. Again, it could be implemented on the blockchain, removing frictional costs and administrative overheads from management of the transaction. And the same could be done for the reinsurer’s retrocessional protection.

In the end, you have a single oracle for every link in the risk and capital supply chain with the elimination of basis risk, increases in efficiency for every participant, and an independent third party responsible for reporting the loss event. This same approach could be used for an end-to-end solution involving any parametric-triggered cover, including East Coast tropical storm and California earthquake, to name a couple. And it would benefit from the speed, efficiency, and reliability of the blockchain infrastructure.

Blockchain technology and smart insurance contracts don’t have to be a solution awaiting a corresponding problem. Rather, they address the very real challenge that the industry is only starting to recognise. There are more ways to cover risk than the standard approach that’s been taken for decades—or longer, really. Using parametric triggers for threats such as terror, where more insurance protection could be provided, opens the opportunity to do so.

The industry has the chance to take a significant leap forward, combining a new market, a new form of cover, and a new way to manage the overheads.

Several trends are converging right now. It’s up to the insurance industry to seize the moment.

This article was contributed by Tom Johansmeyer.

Tom Johansmeyer is Assistant Vice President – PCS Strategy and Development at ISO Claims Analytics, a division of Verisk Insurance Solutions. He leads all client- and market-facing activities at PCS, including new market entry, new solution development, and reinsurance/ILS activity. Currently, Tom is spearheading initiatives in global terror, global energy and marine, and regional property-catastrophe loss aggregation. Previously, Tom held insurance industry roles at Guy Carpenter (where he launched the first corporate blog in the reinsurance sector) and Deloitte. He’s a veteran of the US Army, where he proudly pushed paper in a personnel position in the late 1990s.