This is the third in a series of posts that breaks down our article, “Smart After All: Blockchain, Smart Contracts, Parametric Insurance, and Smart Energy Grids,” recently published in the Georgetown Law Technology Review. We previously discussed the enforceability of blockchain-based smart contracts under ESIGN and UETA and the application of blockchain-based smart contracts for simple insurance contracts. We will now examine the use of blockchain-based smart contracts for parametric insurance. You can read the full article here.

As discussed in our last post, life insurance and final expense insurance are good examples of simple “if-then” arrangements that can be digitized into blockchain-based smart contracts in relatively straightforward ways. But could other types of insurance that are currently reliant on more subjective factors be restructured into products with more firmly defined parameters, enabling their digitization and administration through blockchain’s transparent processes? Parametric insurance policies offer such potential. By pairing parametric insurance with blockchain-based smart contracts, insurers can reinvent the manner in which classes of insurance are offered.

Parametric insurance is a form of insurance where the payouts are determined not through a claims adjuster surveying the damage, but based on objective measures, such as the magnitude of a weather event. It is most often used for insurance for natural catastrophes, such as tornadoes or hurricanes, where individualized policies based on specific damage would be difficult and costly to administer but a standardized payout based on proxies, such as the severity of the storm, would suffice. Parametric insurance is preferable to other forms of insurance when a quick payout is necessary, such as when a country suffers a hurricane and needs to quickly obtain money to begin rebuilding and pay emergency workers. Parametric insurance can lower the time of payment from months to two weeks, which can help jumpstart the rebuilding process.

The key to parametric insurance is finding objective indicators that can serve as an effective proxy for the type of loss being covered. The benefit to doing so is that once effective proxies are identified, policies that would need to be adjusted qualitatively could instead be reduced to simpler “if-then” statements. For example, by relying upon objective markers, such as storm intensity, wind speed, or amount of rain, there is no need for individualized adjustment of claims. After a hurricane damages an area, an oracle can pull data from a third-party site, such as the National Weather Service, to determine objective measures, such as the strength of the storm, and then make a payment based on that data. While individual losses may be greater or less than the specified payment amount, the insurer gains certainty in loss forecasting and the policyholder gains speed in payment. Both parties benefit from the automation of the process and the reduction in frictional costs.

Parameterizing current forms of insurance based on proxies for loss and coding these policies onto blockchain-based smart contracts can fundamentally alter insurance offerings by (1) lowering transactional costs of simple policies to allow for lower-premium policies to be profitably administered and (2) opening new markets for insurance products since locally-based claims adjustors or other local trusted agents would no longer be necessary to effectively administer the policy. Although some costs are difficult to manage, studies have found that for property and casualty insurance, management and contract administration is the largest driver of cost variance. Indeed, a study by Mckinsey & Company concluded that for property and casualty insurance over eighty percent of the cost variance was attributed to management factors, not to the underlying product. It is estimated that improving IT efforts alone could reduce costs by twenty to forty percent, with business complexity and performance management being other large drivers of cost variance.

Moving to parametric blockchain-based smart contracts has the benefit of addressing IT improvement, business complexity, and performance management, while gaining transparency and trust. Blockchain technology can be implemented without having to discard current IT systems, as a blockchain-based platform can be added on top of an existing IT system. Commercial blockchain platforms are already available through several cloud services providers (e.g., Microsoft Azure). Parameterizing current policy structures drastically reduces business complexity, and its standardization of payouts and parameters allows for much more bounded modeling of potential loss events and amounts. Finally, blockchain-based smart contracts can be administered through oracles and monitored in real-time through analytic software examining the permanent blockchain record of transactions and loss occurrences. Fewer local agents would be necessary, and the use of oracles could replace the need to rely on the reports of adjusters on the ground.

As a result of the reduction in frictional costs, policies that were previously unprofitable because of low margins—due to the low premiums or high administration costs—could become profitable areas for new products. For example, companies could profitably insure extremely low premium and low payout events through no-fault parametric policies, where the payouts are determined based on readings from sensors installed in the cars to monitor damage, pattern of driving before the incident, violation of local traffic laws, or other factors. Homeowners could have parametric insurance for incidents such as fires in their homes where a smart fire alarm and smart home sensors could identify the source of a fire, the resulting damage, and potentially its cause.

Moreover, the agricultural industry lends itself to the use of parametric, blockchain-based smart contract insurance. Touting the numerous potential benefits of parametric insurance to improve the welfare of smallholder farmers, increase resilience, and eliminate the need to verify losses, numerous organizations have piloted index insurance programs all over the world, particularly in developing countries. However, the ability to reach smallholder farmers to make sure they can access and understand the insurance contracts currently limits scalability. Rural areas with poor infrastructure may be hard to reach with traditional methods.

The ability to market and administer blockchain-based smart contract-enabled parametric insurance policies solely through internet-connected smartphones can aid in reaching underserved populations. For example, a smartphone-based system, potentially modeled after Kenya’s M-Pesa, could be a good solution. M-Pesa is a mobile payment system that allows people to send and receive money using their cellphone. Since 2007, the technology has taken off with at least one individual in ninety-six percent of Kenyan households using it. Indeed, seventy-five percent of the unbanked population in Kenya uses M-Pesa. Elsewhere in Africa, BitPesa is using the Bitcoin blockchain to bring the M-Pesa model to other African countries and to cross-border transactions.

In sum, parametric, blockchain-based smart contracts represent not only an opportunity to digitize existing insurance products to realize efficiencies, but also open potentially untapped markets for insurance products using the benefits of newly-developed technology.