Cryptocurrencies, specifically stablecoins, are the gateway to building full-scale decentralized financial services. The broad design space enables innovation and accessibility in financial goods and services unbounded by borders and legacy constraints. Nearly any product related to the store or transfer of value and risk can be created using stablecoins. In this article we propose a framework for how insurance financial services can function on the blockchain. Core aspects of an insurance product must be preserved when migrated to a blockchain platform, with additional features to optimize and streamline contracts and execution. The result is a simple, transparent, and scalable solution with higher payouts and improved efficiency.
The State of Insurance
The global insurance business has a high barrier to entry due to capital costs and regulation which has hitherto permitted inefficiency, low levels of customer satisfaction, and lack of investment among large incumbents. High overhead from legacy systems and dawdling digital strategies leaves customers without much value and convenience. Agency risk in assessing and settling claims, and delays or denials that stem from costly processing can leave customers in limbo without funds in times of need.
The result is only 29% of insurance customers are satisfied with their current providers, and over $470 billion of premiums are ‘in play’ due to declining customer loyalty. Since nearly 2/3 of the global insurance market is concentrated in the U.S. and Europe, the rest of the world is mostly uninsured or underserved. Insurance is a sizable market that is ripe for disruption, so let’s begin…
The Future of Insurance
By combining blockchain technology, smart contracts, stablecoins, an exchange, and a decentralized development bounty program, the legacy insurance business can be improved and scaled.
- Blockchain — decentralized, provable, immutable record, global, no intermediaries
- Smart Contracts — safe, transparent custody of funds with automated, instantaneous processing and settlement
- Stablecoin — borderless money that maintains its value
- Exchange — efficient market for pricing, transferring, and pooling risk
- Bounty — reward innovation, integration, and development
A global blockchain insurance solution offers buyers competitive, dynamic pricing, faster claims processing, and higher payouts than traditional insurance. Access can be extended to anyone with an internet connection. Sellers are incentivized to participate and write policies due to higher profit margins than traditional insurance, lower costs, streamlined processing, embedded protections, risk pooling and reinsurance, and new sources of global business. A seller can be anyone with capital and access to the information sets and sophisticated models necessary for pricing risk, including traditional insurance firms, banks, asset managers, and cryptocurrency investors.
One of the most compelling reasons for utilizing a decentralized insurance exchange is its potential to overhaul the cost structure of the legacy insurance market. When you consider that about 50% of an insurer’s cost base is consumed by operations and IT, and an additional 25% is taken up by sales, marketing, and other support functions, overhauling this staid industry by adapting the core business model to operate in a decentralized manner offers tremendous cost reduction and other advantages for more progressive firms.
Bootstrapping the exchange and each new product from a cold start is an important challenge to solve. The mechanics of bootstrapping are not in scope for this writeup, but could involve temporarily guaranteeing excess returns for the approved sellers that offer pre-funding, operational, and marketing support. Ensuring that the opportunity cost of capital for participants in a decentralized insurance exchange remains competitive is another consideration. Aside from the overall cost reduction compared to legacy markets, increasing ROI on the capital pools is also possible if the right custodian or smart contract investment structure is put in place to ensure safety, fairness, transparency, and a market return on committed capital. In addition, proper structuring of the risk and reinsurance pools ensures all ecosystem participants are properly incentivized and that capital is utilized efficiently. This is described in greater detail in the next section.
Mechanics of a Decentralized Insurance Exchange
The proposed design for a decentralized insurance platform allows for efficient competition and risk transfer in a market with adverse selection and asymmetric information.
Market and Risk-Transfer Overview
One of the greatest challenges of designing a decentralized financial product or service on the blockchain is ensuring that pricing, risk-transfer, and settlement can be conducted in a trust-less manner. An insurance governing body in conjunction with external developers incentivized by a bounty program, can create and approve a set of standardized insurance options contracts for listing on a global insurance exchange. Pricing is market-determined using options models and actuarial models, becoming increasingly accurate and sophisticated over time. Buyers and approved sellers agree on a price, then the insurance contract is locked into a smart contract that waits on an oracle to determine the payout. Buyers and sellers are willing to engage anonymously because both parties lock the required amount capital into a smart contract to initiate the insurance contract. The insurance contract must then be placed into the appropriate risk pool within a predefined timeframe.
Buyer funds and seller funds form the risk pool, along with an external reinsurance backstop. Sellers receive a small commission from the buyers, to increase ROI in a competitive market and to incentivize contract locking. Sellers pay an exchange fee to the insurance governing body which provisions a reinsurance pool and funds the external developer bounty. Risk pooling and automated servicing via smart contracts lowers seller costs. The segregated funds from the buyer (premium) and seller (capital) are used to settle an individual contract within the pool, while the shared funds of the buyer and seller are used to settle any contract in the pool that is triggered by the oracle, to cover the shortfall that remains after that individual contract’s segregated funds are used. The reinsurance fund is shared across risk pools, to protect against very low probability events that could drain the funds from a single risk pool. Uncorrelated ‘Act of God’ events, outside the sphere of influence of any individual or entity, are a good first market to simulate. Margin trading on existing highly liquid financial assets is another potential market.
The above example demonstrates how both buyer protection and seller ROI is increased by risk sharing, through premiums and capital as well as reinsurance pools. In order to grow the reinsurance pool more quickly, the exchange can sell reinsurance pool returns as a subsidy to scale. Risk pool collateral return can be increased once the reinsurance pools are large enough to warrant the creation of an investment tranche that can be offered to investors with different risk/return profiles. The insurance exchange governing body can tweak the economics and mechanics of products and contracts to incentivize the full ecosystem. It’s important to note that the above example doesn’t include the additional return generated from investing the committed funds into safe assets that yield market rates of return.
Efficient Market Pricing and Adverse Selection
There exists collusion risk in a trust-less, decentralized market with adverse selection with asymmetric information. Sellers can purposefully under-price policy risk and collude with buyers to unfairly gain access to the shared funds of lower policy risk pools. To eliminate this risk, exchanges should enforce both a private market and public market, identical in terms of contract offerings, so that any profits from mis-pricing policies in the public market are offset by losses on the same mis-priced policy in the private market.
The logic is simple, a set of approved sellers in a private market can be more easily monitored than the broader public market, and thus have incentive to maximize long-run profits rather than collude with each other. This type of decentralized market equilibrium has never been fully explored or proposed before. It is rooted in academic work by Prof. Anastasios Dosis of ESSEC Business School. Note that similar to any market, an additional set of parameters and bounds can be instituted to properly manage liquidity and risk, and to mitigate attack vectors.
- Swiss Re
- Professor Anastasios Dosis, ESSEC Business School