Although blockchain technology is still in its infancy, there are clearly many powerful future possibilities and we are seeing interest in its potential commercial application growing.
In this newsletter we consider some of the developments in blockchain technology, how the technology supporting digital currency could transform the financial industry and the potential issues surrounding replacing paper-based processes with blockchain technology for insurers.
Blockchain: a distributed ledger
Much has been written about bitcoin since its creation in 2008, particularly its volatility and potential for criminal usage, but interest has now shifted to other uses for the ‘blockchain’ technology that underpins bitcoin. A blockchain is a peer-to-peer public ‘distributed ledger’ – a decentralised record of information that is open to multiple operators. The bitcoin blockchain is the public ledger that records every bitcoin transaction. But the technology has other possible uses.
Financial services firms are now looking to ‘distributed ledger’ technology and considering whether there are opportunities to extend its use into mainstream financial services. Financial institutions are interested in the technology, partly from a genuine interest to push forward and innovate but also, in some cases, from a defensive perspective – part of the original intention behind bitcoin was to disintermediate banks from the payment system. The technology has the potential to change how the financial services sector works including improving back office functions, reducing settlement risk and facilitating faster settlement. So-called ‘smart contracts’ show how contracts might operate and evolve in the future and how the financial system’s resilience could increase if it is not reliant on one set of records.
One of the key areas in the financial services sector where the blockchain could transform current working practices is in banking structures and the speed at which financial transactions may be concluded. The technology has the potential to be applied in financial areas where a central third party has traditionally been used ie trade reporting, custody arrangements, central depositaries and trade finance. For insurers, the potential uses of the blockchain are equally as exciting. A recent Deloitte paper on the use of blockchain in insurance considers uses beyond facilitating payments, into records of the history of particular assets (such as diamonds), preventing multiple claims arising from the same incident and using the Internet of Things to connect insured items to the blockchain, with an automatic transfer of cash from an insurer for repairs when the item is broken.
Most financial assets (like shares or bonds) are already in digital form, recorded on centralised ledgers. Decentralisation would mean reduced costs and no central point of attack – this should decrease the risk of a cyber attack bringing down the system and might mean fewer institutions being considered ‘too big to fail’.
The blockchain could even bring financial services to millions of people with internet access but no bank account, by providing another way of transferring money directly between individuals. This could facilitate opening up the insurance market to places where individuals have limited access to banking services, but still need to insure assets, without insurers being reliant on banks or needing a physical presence.
Detection and prevention of fraud
Reducing and deterring fraud remains a priority for the insurance industry. Every hour of the day, 15 fraudulent insurance claims are exposed in the UK. The ABI estimates that fraud adds, on average, an extra £50 to the annual insurance bill for every UK policyholder. In 2014, insurers uncovered 130,000 fraudulent claims worth £1.32 billion across all insurance products. Accordingly, the ABI estimates that insurers invest at least £200 million each year to identify fraud. In addition to improving their own anti-fraud systems, insurance firms fund industry initiatives including:
- the Insurance Fraud Bureau (IFB), a not-for-profit organisation specifically focused on the detection and prevention of organised fraud;
- the Insurance Fraud Enforcement Department (IFED), a specialist police unit dedicated to prosecuting insurance fraudsters;
- the Insurance Fraud Register (IFR), an industry-wide database of known insurance fraudsters; and
- the MyLicence data sharing initiative with Government which aims to help tackle application fraud in motor insurance.
The blockchain offers a way of creating a public, tamper-proof database to track ownership and transfer of assets – including property and valuables. Using the diamond market by way of example, the cost of fraud in the diamond and jewellery market to insurers amounts to millions of dollars per year globally. Blockchain technology has the power to create a digital history of assets, which could ultimately help in the battle against insurance fraud and theft. This technology is currently used in the market by Everledger who provide a permanent ledger for the certification and transaction history of individual diamonds. With this information, Everledger knows who owns which diamond and where it is at any given point in time. It has the capacity to trace the movement of diamonds on platforms such as eBay and Amazon as they are bought and sold and works together with insurers when diamonds are reported stolen, and alongside Interpol and Europol where diamonds are crossing borders and entering black markets.
Home insurance is the area where the largest proportion of fraud is detected with an estimated 71,000 fake or exaggerated claims. Dishonest personal motor insurance frauds are the second largest area of insurance fraud with an estimated 37,000 frauds uncovered. These are also stated by the ABI to be the most costly with these ‘crash-for-cash’ scams estimated to cost the industry £400 million a year. Claims may be made against a number of policies held by different insurers and detection of the fraudulent claim relies on the sharing of data between insurers. This is where blockchain technology has the potential to significantly reduce fraud. ‘Smart contracts’ powered by the blockchain have the ability to provide policyholders and insurers with the means to manage claims in a transparent and indisputable manner and would allow policyholders to self-administer their own insurance products.
A ‘smart contract’ is essentially a contract between two or more parties that is created and stored on the blockchain. Blockchain computer protocols will facilitate, verify and enforce the performance or negotiation of a contract. In effect, they are agreements that have been written in code and are enforced by software. These smart contracts can be hosted on the blockchain and can self-execute when certain conditions are met (much like a computer program). In the event that a pre-programmed condition is triggered, the smart contract executes the corresponding contractual clause. The cost of paper becomes almost entirely removed from the process, together with the risk of fraud. Contracts together with claims in respect of those contracts would be logged onto the blockchain and confirmed by the technology to ensure that only valid claims are paid.
An example would be a life insurance policy that pays a sum to a designated beneficiary upon the death of the policyholder. By virtue of being a smart contract, the blockchain technology that underpins the contract would perform real time checks on online death registers that are linked to the blockchain – the moment of pay-out would be automatically determined. For fraudulent motor claims for example, multiple claims for the same accident would be rejected as the blockchain would have each claim recorded. The smart contract itself would enforce the claim and the pay-out in respect of a valid claim would be triggered automatically. The intention is to use the technology to streamline the payment process, the claims handling process and to reduce the risk of fraudulent claims. Ideally, it would be possible to include multiple insurance contracts on the same blockchain, so that it would prevent the claim being made in full on different contracts.
The smart contract itself would be self-sufficient following its creation and its self-executing features would increase the speed and efficiency of claims handling. The terms and conditions of the smart contract would be programmed at its inception and any pay-outs would be wholly dependent on fulfilment of those terms and conditions. This could lead to pay-outs only being made to the insurer’s designated third party – for example, for repairs.
Particular difficulties with smart contracts arise for insurers when there is no binary outcome. Taking flights as an example, pay-outs in the event of a cancelled flight are easy. Flights being cancelled are a matter of public record and either the flight was cancelled, or it was not. However, if the flight was missed for a reason that may or may not be part of the insurance contract, human engagement would still be needed on both sides in order to determine whether a pay-out is necessary.
Accuracy of pricing
Blockchain technology could be used to streamline payments of premiums and claims. There has been much discussion about the use of blockchain technology in telematics and its power to provide autonomous insurance for autonomous cars where the insurance policy with the policyholder itself is built into the blockchain. The policyholder would have an account from which virtual currency payments are drawn on a continuous basis in proportion to the miles the policyholder has driven. Non-payment risk is virtually eliminated and to the extent that the policyholder’s account is exhausted, the policy terminates – coverage simply exists up until the point of termination. The telematics system in each autonomous vehicle will record and relay the miles driven by the vehicle in real time and premium is calculated and paid automatically. Ultimately, motor risk would be priced more accurately.
Blockchain also has potential uses in reinsurance. A company called Blem, which makes IT systems, has recently announced that it will be using blockchain in a live product. Blockchain will be used to record details of claims so that insurers and reinsurers can accurately divide costs between them. In this case, since the blockchain provides an immutable record of claims, including time-stamping when those claims were made, this provides reinsurers with certainty that the information provided existed at that point in time.
Blockchain – will it be used?
A key concern which will ultimately shape the extent to which financial institutions adopt and rely on blockchain technology is security. Ultimately, the blockchain is a decentralised system and current blockchain systems are public. In principle, everyone has the power to participate and with this comes significant risks and uncertainties. The blockchain is only processing around $50 million a day and it is unclear if it could cope with the scale that its advocates envisage. Unwinding transactions is virtually impossible and the ledger is public, which can make it hard to protect privacy. Over time the constraints of the system mean processing transactions is bound to become more expensive. Additionally, the blockchain certainly introduces new risks, like the ‘51 per cent attack’ – where a malicious user tries to gain control of a majority of the processing power of a blockchain network to use it to validate fraudulent transactions.
One alternative to the 51 per cent risk, as well as the natural antipathy of financial institutions to completely open, publicly accessible networks and, potentially, processing limits, is the idea of the ‘permissioned ledger’. A permissioned ledger would be a network where only certain users have direct access. Structures like this seem more viable, in part because this sort of network more closely resembles the current system.
Discussions around whether individual companies could create their own blockchain protocol continue, however the system would no longer be fully decentralised and this is clearly where many of the benefits lie. Insurers need to consider how the use of blockchain technology in the insurance industry is shaping what insurance may look like in the future.