Using crypto tokens in insurance
$4Bn of ICO funding was raised in 2017 (Forbes), of which 10% was in financial services (Coinschedule). This explosion of activity has led to a lot of chatter about tokens in financial services and whether or not they are needed.
Let’s look at tokens in insurance. But first, what is a token?
If you decide to take part in an ICO then you will receive a cryptographic token that needs to be stored in a digital wallet. We have (notionally) been dealing with tokens ever since the first base metal coin was struck. It had a value other than the intrinsic value of its composition and represented a promise to pay the bearer. This is one of the key areas where digital tokens differ. They are not linked to real world assets i.e. no promise to pay or share in the ownership of the creating entity. Tokens are also different to cryptocurrencies and this article by Master the Crypto explains the difference between the two asset classes.
ICOs have allowed startups to crowdfund their projects by issuing tokens in exchange for cryptocurrencies on their blockchain platform. The end user adds value to the platform by trading, spending or using the newly acquired tokens. For these tokens to grow in value, they must be intrinsic to the business model and be easily transferable to a real world asset.
In this article we explore 3 possible uses for token in the insurance sector: -
- Tokens as a medium for premium/claims payment and capital reserving
- Tokens used to transfer value within a multinational market or organisation
- Tokens as an incentive for valued activities on a mutual insurance platform
One of the key areas that we do not cover in this post is regulation, as that deserves a whole paper to itself.
Tokens as a medium for premium/claims payment and capital reserving
Tokens on a blockchain platform reduce the cost of value transfer and provide a trustless trading environment. Can cryptocurrency based tokens be used in insurance to reduce the total transaction costs and speed up the processes?
Insurance contracts provide policyholders with financial security against losses in exchange for a premium payment. Insurance works because insurers pool the capital collected in financial reserves that are sufficient to pay all the claims that occur. One principle used by insurers is asset liability matching to provide certainty around capital adequacy. They should hold assets in the same currency as risk exposure to manage volatility in exchange rates, or they adjust solvency capital to take into account any potential volatility.
Supposing an insurer offers insurance that is based on tokens rather than fiat currency. Both the insurer and the policyholder would be exposed to volatility that is currently far greater than in fiat currency markets. Let’s look at two specific areas: -
- Reserving — Actuaries would have to include token volatility in their pricing and reserving models so they can provide certainty around claim payments. They will need to use a cautious approach and solvency requirements will probably very onerous.
- Investment gains/losses — Consideration also needs to be given to large changes in the value of tokens: -
- How would a policyholder perceive this and how would they view the change in value?
- Would a warning need to be issued with each policy sold to protect them?
- Does this change the nature of the policy from a simple insurance contract to an investment product?
For these reasons, cryptocurrency based tokens may not currently be suitable for this use in insurance. Stability is key before tokens should be considered.
Tokens used to transfer value within a multinational market or organisation
A better use case may perhaps be to issue tokens that are tied to specific fiat currencies. Their use as ‘wooden dollars’ would reduce transaction costs through market-wide net settlement and minimal banking transaction fees. Value can be transferred globally, either across insurance marketplaces (insurance, reinsurance and retrocession) or internally for large corporates. The tokens could be readily exchanged for fiat currencies on demand and there is no speculative component of the token value.
Tokens can transfer very small subunits of value at very low transactional cost. This can be of significant benefit in microinsurance, where the original premium amounts would normally be outweighed by the banking transaction costs. However, it is essential that the end user can easily translate the token to usable currency in their local economy.
Fiat-linked tokens would significantly reduce the market-wide costs of transferring funds, and supports use of a mutual distributed ledger. A viable alternative to tokens would be the use of existing fiat-linked cryptocurrencies such as Tether (USDT) where each USDT unit is backed by a U.S Dollar held in reserve and can be redeemed through the Tether Platform.
Tokens as an incentive for valued activities on a mutual insurance platform
The purpose of mutual insurance is for the members to provide insurance coverage for each other on a pooled basis. Each member has the right to participate in underwriting and claims assessment, but this is not currently feasible because existing technology cannot deliver this at scale. These functions are normally delegated to a management organisation. By contrast, members of a DLT-based mutual platform could participate fully in any of the activities and therefore significantly reduce administration costs.
In such a model, members buy tokens with cryptocurrency to join the mutual insurance platform. Risk, premium and claim values are represented in the platform by the token value, which is set by pre-determined algorithms and expressed in a specified cryptocurrency. Tokens may then be: -
- Burned (to acquire cover or to penalise fraud / collusion)
- Time locked (as a stake for claims assessment, underwriting or to be eligible for surplus distribution)
- Used to pay claims
- Issued as rewards for carrying out specific roles (rating, loss assessment or governance).
The more active a member is on the platform, the more tokens they would accumulate. Success of this business model is conditional on three key factors:
- Continued growth in value of the token against the cryptocurrency
- Stability of the value of tokens against the insured asset amounts
- Existence of a ready market to sell tokens for fiat currency
Given the present extreme volatility of cryptocurrencies, this seems a bold assumption indeed. It is not clear how stable token values or a sufficiently liquid trading market could be established. These two conditions are needed for members to be able to guarantee claims payment or realise the real world value of any distributed surpluses.
Why not use a cryptocurrency instead of a token?
Where tokens are used in a platform to accrue value, they are issued in exchange for a specified cryptocurrency (3 step process).
Potential users of the platform need to translate from fiat currency to tokens via the cryptocurrency in complex and expensive transactions. As there is generally poor liquidity in cryptocurrency exchanges and the bid offer spread is very high, the transaction cost of buying cryptocurrency is high. Using this cryptocurrency to buy tokens may be simple and relatively inexpensive, but the investment is now exposed to the combined volatility of token and the underlying cryptocurrency.
Cashing-in tokens uses the same process in reverse, but may be even more costly where there is little liquidity in the market for the tokens. Equally, over the term of the policy, token and cryptocurrency values may have moved significantly against fiat currency (down as well as up).
In the current climate, an insurer or policyholder will need to reverse the transaction so they can fulfil the claims liability.
Looking at insurance, the resulting wide variation in valuation between the insured asset and the corresponding tokens means that policyholders would be unable to rely on the issued policy to provide sufficient indemnity or insurers will need to hold much larger surpluses than is currently required.
The question that needs to be asked is why do you need to go through a 3 step process for a token?
Let’s consider the second example above — Tokens used to transfer value within a multinational market or organisation. An insurance marketplace is set up:-
- Issues tokens that are pegged to a Fiat currency.
- Builds a platform on blockchain or DLT based technology
- Achieves all the benefits of a blockchain based platform
Therefore, is a 3 step translation process actually needed for tokens to be really useful?
Tokens can bring cost savings in moving value through a marketplace on a DLT platform when they are tied to a fiat currency, or when the underlying cryptocurrency is stable relative to fiat currencies. For example, this could reduce the banking costs of inter-company settlements in a global insurance programme by streamlining the net settlement. It is essential that market participants agree on the translation or pegging mechanisms so that token values are fully representative of the real world assets.
However, tokens based on cryptocurrencies are currently too volatile to be used.
- Insurer capital requirements make the matching of actuarial liabilities with cryptocurrency investments unappealing.
- Customer’s ability to utilise at point of claim is difficult. How will the unbanked and uninsured use these tokens when they really need them?
- Does the translation process add an extra unneeded step?
Where tokens are issued in ICOs, the acid test is whether their value is enhanced by the business model of the platform. If this is not evident, then the ICO has the hallmark of a speculative gamble on a growth in demand for a scarce supply of tokens.