Distributed ledger technology offers insurers the potential to become more efficient, create new business models and launch innovative products. But can the so-called ‘Internet of finance’ live up to the hype?
Distributed ledger technology (DLT), also known as blockchain, is one of those types of innovation that appear to offer companies huge potential to operate more efficiently and serve customers better, but is not quite developed enough to do so. For that reason, the insurance industry has exercised understandable caution in assessing the technology’s utility. “The problem with that approach,” says Julian Miller, Partner at DAC Beachcroft, “is that companies that wait too long may end up missing the boat.”
Distributed ledgers are shared databases comprising digital lists of transaction records. Their unique characteristic is that identical copies of the ledger are ‘distributed’ among multiple hosts, who validate transactions written as ‘blocks’ through a consensus process. Once validated, blocks are secured by a cryptographic ‘hash’, or fixed-size alphanumeric string, which allows hosts to verify input data but stops anybody from reconstructing data.
Conceptually, cryptographic distributed ledgers are similar to peer-to-peer payment networks or lending platforms, in which the intermediary is redundant and replaced by technology. Transactions can be executed instantaneously and directly between contractors, creating an immutable shared record and theoretically eliminating settlement risk and reconciliation risk from the system. The ledger also minimises fraud by enabling asset provenance and transaction history to be established within a ‘single source of truth’.
As with any apparently disruptive technology, the development of blockchain has been accompanied by a significant amount of hype. Almost every large financial institution has paid lip service to its potential and many have put money to work in innovations labs, start-ups or ‘sandboxes’, in which developers are invited to try out software in a secure environment. Even the Bank of England has one.
Still, behind the hype there has also been some heavyweight support for blockchain. The World Economic Forum, known for the annual meeting in Davos, said in a report last year that blockchain will “live up to the hype” and “form the foundation of next generation financial services infrastructure”.
“It is early days for this technology, and it’s often observed that markets overestimate what can be achieved in a year but underestimate what can be achieved over five to ten years,” says Miller. “Blockchain may be a prime example of this, resulting in substantial changes in the medium term.”
Perhaps the most notable application of distributed ledger technology to date is the payment system Bitcoin, launched in 2009. The Bitcoin blockchain comprises a record of every transaction using the currency, the market capitalisation of which has jumped sharply in recent months to reach almost $35 billion in late May 2017. This appreciation reflects Bitcoin’s rising acceptance as a payment method, but has also sparked talk of a bubble.
From an insurance perspective, on the face of it the technology offers game-changing opportunities, from transforming the industry’s complex web of relationships to automating business processes including customer due diligence, contract placement, claims management, accounting and settlement.
The database itself can be used for identity confirmation, timestamping, transacting and record keeping in the insurance market, while so-called smart contracts sit on top of the database and can be programmed to automatically execute processes and support non-core functions such as customer lifecycle management and compliance.
“The insurance industry is hunting opportunities for growth and dramatic reductions to distribution costs,” says Miller. Distributed ledgers are being taken seriously because they may provide an answer to both challenges.”
Traditional insurance markets are comprised of complex and multi-layered document trails between clients, brokers, underwriters and reinsurers. The system relies on numerous manual processes to make it work, and is susceptible to delays, inaccuracies and mismatches, all of which increase costs. If all members of the industry value chain were joined to a distributed ledger, delays would be limited to the time it takes to write transactions to the ledger (for Bitcoin just a few minutes on average), following which any member of the network would be able to access and verify the same permanent record in real time.
So-called smart contracts (they are rarely contracts in themselves) meanwhile bring the apparent benefit that they can offer self-enforcing mechanisms, increasing efficiency and reducing the risk of fraud or breach. They can also be executed more quickly and offer a lower (some say zero) chance of errors. Because the rules of the contract are preprogrammed, there is almost no possibility of legal disputes over their intention.
In the insurance context, smart contracts have numerous potential uses, from automating payment cycles to validating simple claims based on a predefined set of triggers. An example would be an insurance agreement that pays out when a specified transport service is delayed for more than an agreed amount of time. The contracts can also capture coverage conditions, syndicate insurance agreements and insurer/ reinsurer agreements. They can automate the claims process, enabling digital claim submission (via sensors or internet-connected data sources) and processing (eliminating the need for brokers and loss adjusters) and making payments. Where there is a syndicate, a smart contract can automate the liability calculation for each carrier, or specify reinsurance liabilities.
“Certainly where there are simple claims or the quantum is small there is an argument for the withdrawal of human intervention beyond auditing,” says Miller. “Large complex claims may still require human input.”
Given the potential offered by distributed ledgers, it is not surprising that some companies have launched initiatives to try to capture value or jointly develop programmes. In October 2016, Aegon, Allianz, Munich Re, Swiss Re and Zurich launched the B3i Blockchain Initiative, which invited insurers to join an industry group to explore the potential of distributed ledger technologies. The group agreed to run a pilot, using anonymised transaction information and anonymised quantitative data, aiming to achieve a proof of concept for inter-group retrocessions.
“Another trend we are seeing is more collaboration between major players and tech companies,” says Michael Peeters, Technology Projects Partner at DAC Beachcroft. “Such a shared approach should allow a less revolutionary and more evolutionary pace of development and testing in this area, as well as hopefully leading to interoperability standards.”
The London Market Group (LMG), set up to help develop a vision for the future of insurance between members of the International Underwriting Association, Lloyd’s Market Association and London and International Insurance Brokers’ Association, has run two blockchain proofs of concept through its Target Operating Model Innovation work stream.
The first was a claims (bordereau) submission and the second a ‘know your customer’ coverholder application. Following successful outcomes, the LMG recommended moving to pilots and ensuring that distributed ledger solutions are considered as part of any future work.
In addition, distributed ledgers may in future form the basis for new financial instruments, LMG said in a January 2017 report. For example, they may be used to distribute micro-insurance, which provides cover for a short time period. Micro-policies could become tradeable commodities in a blockchainbased marketplace, allowing units to be bought and sold. Another new class of policy could be a binary bet/event protection contract, providing an alternative means of risk transfer, LMG said, though there is some debate over whether this type of contract would contain an ‘insurable interest’, which distinguishes an insurance contract from gambling.
A related trend is raising interest among investors. London-based Eos Venture Partners is one of a few independent specialists looking at applications in the insurance sector.
“The potential associated with blockchain is clear, although to date practical applications in insurance have been relatively limited,” says Eos founder and General Partner Sam Evans. “In the immediate future we are focused on solutions with artificial intelligence at the core and blockchain at the edge, but we believe blockchain has the potential to drive market leading cost models if applied correctly.”
Certainly, there is palpable excitement in the industry around the potential for a more efficient and safer infrastructure. However, for all their promise, distributed ledgers inhabit the frontiers of the insurance technology landscape. Very little investment has progressed beyond proof of concept, and there are significant questions over whether the ledgers can perform at the volumes necessary for modern insurance markets. The jury is still out for the new kid on the block.
Away from established industry players, new entrants are also looking to leverage the power of shared cryptographic ledgers. Among recent initiatives, start-up Everledger is working with insurance companies to provide transaction verification, while Plex.ai is an automotive telematics platform that uses blockchain technology, artificial intelligence and machine learning to provide insurance for self-driving cars. InsurETH uses distributed ledger technology to allow aeroplane passengers to purchase flight delay insurance. Insurance payments are recorded as a smart contract transaction, with compensation released contingent on the terms of the contract.
“Blockchain has been described as an enabler for a disrupter, distinguishing between what it actually does, which is transmit data already in circulation, and what it can facilitate, which is a radical increase in speed and lowering of costs,” says Miller.
Start-ups are able to access blockchain technology relatively inexpensively by building solutions onto platforms such as Ethereum. Dynamis is a start-up that is building smart contracts on Ethereum for peer-to-peer insurance. The company is working on a supplementary unemployment insurance contract, using the LinkedIn social network as a reputation system. Applicants for a new policy can use LinkedIn to verify their identity and employment status, and claimants can use their LinkedIn connections to validate that they are looking for work. “The exercise of one’s social capital within one’s social network enables participants to obtain a new policy or open a new claim,” the company claims on its website.
“With transformational technologies, early adopters often kick-start major players into action,” says Peeters. “This seems to be the case here, but the sector’s leaders need to continue to invest and innovate in collaboration with the new technology suppliers, which will minimise the risk of new entrants causing wholesale disruption. The next few years will be crucial.”