Blockchain part 1: Captives in a volatile world
One cannot plan for or predict the impact, or the extent, of disruptive inventions. Companies need to investigate and analyse megatrends and the latest developments on the market. These in turn lead to a constant flow of new buzzwords that dominate press coverage and penetrate the jargon used by companies and research institutions alike. One of the latest is “blockchain”. Is this just a trend or a real game-changer? This question has yet to be answered.
Not only the banking and insurance sectors are engaging in heated debate about the opportunities, risks, and potential applications offered by blockchain technology. What sets this technology apart? Is it really disruptive or just a short-lived trend? If this is Internet 2.0, how will blockchain affect alternative risk transfer—and especially the captives market? This and the following article present case studies for the existing captives market and show the potential growth opportunities presented by this elite product.
What is blockchain technology?
Technology journalist Chris Dannen described blockchain in 2017 as follows: “Blockchain is a fully-distributed, peer-to-peer software network which makes use of cryptography to securely host applications, store data, and easily transfer digital instruments of value.”
Blockchain is a new technology for verifying data transactions. It is a way of securing data by breaking it down into chains of ‘blocks’ to allow many functions of centrally organised information systems to be decentralised. Blockchains can be used anywhere information needs to be securely managed and verified. Blockchain technology is based on a decentralised open source network managed by all the network participants and consistently, verifiably, efficiently, and unambiguously documents transactions on a continuous basis using signatures. The open source aspect and the integrated redundancies based on the number of participants in the block protect the data against manipulation and deletion.
This allows transactions, digital goods, values, processes, and tasks to be identified, validated, and exchanged. The disruptive potential is created by the secure management and verification of information and values, which allows users to circumvent the trustworthy intermediaries previously required for such tasks. The roles previously assumed mostly by financial and insurance service providers could now potentially be usurped. With peer-to-peer communication, the parties no longer have to depend on reputations of trust because the information is unambiguous and fully retroactively visible.
It is clear that academic research and the media are confusing the different manifestations of blockchain technology and, in some instances, misinterpreting it. It can exist as a technology concept, a platform, an application, and as a simple service.
How does the blockchain work?
The blockchain describes a publicly accessible ‘cash ledger’, which cannot be edited retrospectively. Data (for example, transaction data) is entered into the ledger in the form of blocks.
Data is collected over a certain timeframe, added to a block and then checked for validity. Verification of validity is dependent on the type of blockchain. It is generally distinguished between proof-of-work and proof-of-stake; other procedures are used more rarely.
Proof-of-work requires a resource-intensive computing task, which can be solved by several attempts. A fraud attempt becomes economically unattractive due to the required resources. The technical prerequisites for a fraud attempt currently do not exist; it is technically hugely difficult to impossible.
With proof-of-stake, it is the respective technology concept’s stakes that are decisive, independent of the use of resources. These can be tokens of the respective blockchain technology such as bitcoins but they do not have to be a cryptocurrency. As can be seen in Figure 1, this can also be the transfer of previously defined ‘risks’—which is in turn the basis for insurance solutions or alternative risk transfer. This will be discussed in more detail in part 2.
After checking the validity, a ‘checksum’ is created from each block and its contents. This is known as a hash and is used for unique referencing. Each block contains a reference to the hash value of the previous block. This creates a continuous dependency on the previous block and chains the blocks together. New blocks are attached to the existing blockchain and are arranged temporally.
Figure 1: How a blockchain works
Source: Own concept
Advantages and opportunities of blockchain technology
- Decentralised consensus formation without intermediaries. The trust is placed in the network and the blockchain technology and not so much in individual participants or transaction partners.
- Lower costs for operators will also have a positive effect on the transaction fees.
- Transparent costs and the further development of the technology through open source code, coordinated via “consensus mechanisms”.
- Highly redundant and fail-safe.
- High network and process transparency while preserving anonymity and pseudonymity of the participant. This reduces imbalances in power, abuses, and arbitrary decisions.
Disadvantages and risks of blockchain technology
- The environmental impact of energy consumed by the widespread proof-of-work method is a strong counterargument to the potential offered by this increasingly attractive technology.
- Transactions cannot be made retroactive, which may result in irreversible errors. There is already some uncertainty and ambiguity with smart contracts and how to handle flaws in the contracts.
- Scalability is another critical issue for all blockchain solutions as the number of subscribers and transactions to be processed will increase as the technology becomes increasingly attractive. For this reason, work on options for thinning out the information content, interlinking the blockchains, and creating so-called sidechains is under way. Sidechains run parallel to the main blockchain and are often designed for a specific application. They only write relevant information on to the main blockchain and reduce the data exchange.
- An unclear legal situation, particularly in Germany, poses the risk of new blockchain applications running foul of future changes to the law.
- The digitisation and transfer of existing documents, objects, and processes into the blockchain environment will be a challenge.
- Anonymity cannot be guaranteed in certain blockchain environments.
- The values traded in a blockchain also attract criminal activity from those seeking to make use of security gaps in the blockchain technology concept. One prominent example is the Decentralised Autonomous Organization (DAO), an attempt to build a blockchain-managed investment company, which failed due to a security breach. Unknown perpetrators stole $53 million, which led to the first intervention and correction of an existing blockchain with the coordination of all participants in the network.
The concept of blockchain technology continues to grow rapidly and will become more accessible to a wider audience with the advent of user-friendly applications. There already exists a clearly identifiable potential and application scenarios that individual providers are addressing with their solutions. Decentralisation and the concomitant independence, security, transparency, and trust will allow completely new, disruptive business models to develop.
However, the legal obstacles still being discussed are a challenge facing German businesses compared to their international competition, which can already offer such solutions. Companies with a variety of infrastructure landscapes will therefore promote technology standardisation and harmonisation.
In the second part, I will present various examples of how blockchain technology can be used in the captives sector, not only to administer, but also to create or expand the captive insurance company as a profit centre.
Coming next part 2: Use cases for captives solutions by blockchain technology
Marcus Schmalbach is a lecturer in business administration at a University of Applied Sciences in Southern Germany and a PhD student in the field of captive insurance companies at the University of Gloucestershire, UK. He is head of BlockART Institute which is doing research in the field of blockchain and alternative risk transfer. He can be contacted at: email@example.com