A peek into the future of insurance
First a quick recap on decentralised finance
I previously drew an analogy between the growth of decentralised finance (DeFi) and the early stages of the modern financial system in which Maker, DeFi’s most popular project, assumes the role of a fledgling central bank. Maker is slowly feeling its way towards an understanding of what central banking means in a digital realm…that’s not obvious at all since manipulation of the money supply is counter to the fundamental ethos of DeFi.
As our gangly teenager Maker fills out its frame and starts flexing its muscles, and DeFi as a whole matures (and next gen communities like Tezos and Cardano eventually build their own DeFi ecosystems), how will it solve this apparent contradiction? Will it follow the same path as the original bankers, those 17th century goldsmiths, who built the first Central Bank and became the bedrock of the modern financial system? Or will it simply become a digital extension of the global financial system?
I expect that the answer will arise over the next couple of years and you, fellow crypto zombie, have a front row seat to the future of finance.
Lets explore one area I think is going to experience an explosion of creativity in a decentralised financial system: insurance.
The natural form of insurance
To understand decentralised insurance, it is helpful to understand how insurance came about — to get a feel for its most natural form.
The birth of insurance came swiftly after those enterprising 17th century Goldsmiths started issuing notes to merchants who deposited their gold for safe keeping. Remember, this was the catalyst for the modern financial system and these notes eventually led to the formation of banking and the pivotal concept of fractional reserving (read this for more background). Banking became the bedrock of the financial system and the formalisation of insurance soon followed.
British merchants became wealthy by trading across the Atlantic with the British colonies in North America and the Caribbean. They imported sugar, cotton and coffee from the West Indies and tobacco, rice and indigo from North America. Losing a ship during the crossing could be financially devastating. In those days the merchants would congregate at a coffee house called Lloyds, where they began to form groups to share the burden of this risk. They agreed that if one in the group lost a ship, the rest would share the expense, meaning that no one had to face financial ruin resulting from the precipitous loss of a ship. This, my friend, is insurance in its simplest form: an agreement between a few people to share their losses.
As people in the UK became wealthier more ships sailed across the Atlantic and more merchants sought the peace of mind which came from sharing their risk. Luckily it turns out that the more people who share a risk, the better the outcome for all involved as the risk eventually becomes more predictable. However you can imagine the complexity involved with forming your own group of merchants to share these risks: you would need to establish whether you can trust the merchant, what a fair arrangement looks like, what contracts to put in place, how to deal with conflict and so on. That complexity would compound as more and more merchants formed groups to share their risk.
Here was a problem for enterprising third parties who could step in and form the right groups under the right terms.
Lloyds the coffee house, where individuals would strike deals, evolved to Lloyds the global syndicate, where members (or brokers) can insure pools of risk at scale. In todays’ financial system we also have enormous insurance companies, which pool all sorts of risk from death to motor accidents to your poodle breaking its leg.
And so the concept of sharing risk went from a few colleagues agreeing to spread their risk of losing a ship, to the massive industry of insurance companies that gather all kinds of risk under one roof. On the whole this is a much superior way of managing risk…except for two fundamental drawbacks:
1. The trust problem: there is always the chance that the insurer makes poor decisions and goes bust, or simply refuses to honour its obligations. This was less of an issue when it was just a few merchants who knew and trusted one another, but it naturally arose from the nudging of the invisible hand towards the efficiencies of scale.
2. The agency problem: the insurer exists to pay its customer’s claims and at the same time to make money for its shareholders. The less it pays out in claims, the more money shareholders make. There is a natural tension between shareholder and customer interests. Again, a tension which never existed before but a natural tension in a centralized economic structure.
Only 1 in 4 consumers say they trust insurers, which is probably wise given this skewed shareholder vs customer dynamic and how the sector has behaved in the past. Let me repeat that: only 1 in 4 people say they trust the insurance industry! A sorry state of affairs and about time something came along to fix that.
Is Decentralised Insurance the answer?
The insurance realm has seen some exciting innovation over the last ten years as the ubiquity of smartphones combined with digital technology has brought us closer to automating the function of an insurer. For example,
- Digital marketing and rich media can explain a product to customers in wonderfully detailed ways.
- An application can onboard new customers (digital KYC) by allowing them to upload their ID docs and take a selfie — no need for a human.
- AI technology is a game changer in understanding your unique risk profile in place of a human underwriter. Examples abound but one which I really like is called Naked Insurance from South Africa where all you need to do when taking out car insurance is take a photo of your car.
- Increasingly claims can be underwritten and paid automatically. Again, Naked Insurance is a great example of this in the motor insurance space. To a less disruptive extent, parametric insurance lends itself to this too (my favourite example is Pula).
Now with blockchain technology we have the tool to completely automate insurance and put it back in the hands of individuals. This is because blockchain builds trust into the system. Consumers can trust that the technology has been woven together, and makes insurance decisions, fairly and consistently (with complete transparency).
For the first time in human history, we now have the technology to take all that was good from the beginnings of insurance (when trust and the agency problem were non-issues) and still achieve the efficiencies of scale sans the trade-offs.
For now these pieces of insuretech exist in silos within different insurers. Eventually, however, this technology will find its way into the open source realm, as the industry continues to flourish and become the norm. Think of how freely available natural language processors are compared to just five years ago (some free and open source, others of exceptionally high quality available from vendors such as Amazon for a fee). At some point it will only take one smart developer and one smart actuary to stitch them all together into cleverly designed smart contracts which can be released into the world as a free, automated insurer.
This would be an insurer without that pesky shareholder/customer friction and without any human error attached. It would also be an insurer without any fees besides the blockchain transaction costs and the estimated cost of your risk of claims (i.e. no brokerage fees; no shareholder profit margins; no insurer expense margins).
Hopefully it would be an insurance option that more than 1 in 4 people actually trust.
DeFi insurance projects
The good news is that it’s still early days for decentralised insurance, so you’re still in time to grab a front row seat. Currently the focus of DeFi is in the lending space as the various projects look to build bridges from the fiat currency system. The ideal I wrote about above has not yet been achieved in a practical sense, but start-ups are knocking on the door.
- The biggest DeFi insurance project is Nexus Mutual which allows members to form mutual pools of insurance. Currently its main product is an insurance product for smart contracts i.e. it insures against the exploitation of flaws in other DeFi projects’ smart contracts. Opyn does a similar thing.
- Etherisc is a platform which allows people to collectively build decentralised insurance products. They have already launched a flight delay product (automatic, instant payouts if your flight is delayed) with hurricane protection on the way. Those two product choices tell you something about the state of decentralised insurance in that they are easy to automate and confirm a claim. There are information feeds which can trigger a contract if a flight is delayed or if a hurricane event is declared by a meteorological agency. See them as low hanging fruits on the decentralised insurance stage. As AI tools make automatic claims underwriting simpler (remember my Naked Insurance example above) the scope for decentralised, automated insurance will expand over time and start taking on established insurers more directly.
- Teambrella sidesteps the need for an automated or trusted source of truth for a claim event by leaving it up to your fellow policyholders to decide. It’s a neat system that furthermore avoids much of formal insurance law since it can be argued in some jurisdictions that it falls more closely under cooperative (friendly society) legislation which is typically more flexible. This project really hearkens back to those merchants at Lloyds.
