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20 November 2017Analysis

The Future of Insurance - Blockchain Captives

Blockchain is a quantum leap for risk management. The mysterious newcomer to fintech revolutionizes current insurance practices and opens the door to new types of insurance. From commercial general liability policies to our social contract with the government, blockchain creates new possibilities. This article explores how blockchains work, applications of blockchain to insurance, and how the captive insurance industry stands to change the world.

What is Blockchain?

Blockchain is a distributed, peer-to-peer system resting on top of the Internet. There is no point of control. The system is a trust-based network of computers in competition with each other to mine for tokens. Bitcoin is, by far, the most popular token in a blockchain, but there are others: Dogecoin, Potcoin, and Ether are very popular. These tokens are traded like any other currency but have no coins, bills, or physical artifacts. In any other era this would create an unworkable, chaotic system, but new technology creates new possibilities.

Since the technology is new, and very complex, few practitioners really understand how blockchains work. Think of blockchains as a stack of Legos. Each Lego has its own serial number, called a hash. These hashes are a long string of nonsense characters that look something like this [v987vnwef908wednd0-sdc09j]. Each block links back to the previous block in the chain all the way to the first block, called the genesis block.

Now, further imagine that this stack is replicated in hundreds of other places. Every time a new block is added to one of the stacks, all of the stacks assess whether that new block is a genuine new block, or a fraud. If the majority of the stacks agree that the new block is valid, then all of the stacks add this new block. This synchronous engine is called a peer-to-peer (P2P) network.

In the real world, each of these Lego stacks are located in a computer. These computers which are creating new blocks are called nodes. This is the feature which makes the blockchain resilient – infinite redundancies. In a way, this reflects how the Internet started as it was created on a series of equal nodes on an IP network.

These nodes mine for new blocks by solving math problems all day long. The algorithms solved by the nodes are very hard to solve, but are easily checked on the backend. The computer which solves the algorithm first has its answer checked by the other nodes. Once the nodes agree whether the answer is correct, then the miner is awarded a token.

Mining is a continuous process of solving problems and checking the other nodes’ solutions. The answer to the algorithm is not pre-determined. Rather, the programs vote on the winner and the token is awarded to the miner who reaches consensus. This is why P2P blockchain networks are built on trust. The trust is not in the moral sense, but in the trust of mathematics.

Since the majority of the nodes have to agree on the answer solved by the winning node, it’s extremely difficult to hack a blockchain. However, nothing is impossible. There have been some hackers who have launched “consensus attacks” on blockchains by achieving a significant stake of the mining power of the blockchain. While this is bad, this technique cannot alter the blockchain’s history. In other words, if you’ve got 30 Bitcoin in the blockchain, consensus attack can’t take those away from you. The effect of a consensus attack is that the attackers can double spend new coins. This bad situation is relatively rare and there are armies of white hat professionals keeping the pirates at bay.

Effects of Blockchain

Value can be stored in a blockchain with complete anonymity. The absolute privacy of blockchain is a headache for anti-money laundering professionals in the FBI and other agencies as it is nearly impossible to prove the source of blockchain coins without an informant. The good news is that all of this financial data is secure. Consequently, we no longer need to rely on accountants, bankers, or dusty old documents.

More interestingly, blockchains remove the need for securities. While the definition of a security is very broad, most people think of stocks. Stocks are little more than a reflection of the amount of a corporation that you own. There is no reason that a stock certificate is necessary. New companies are conducting Initial Coin Offerings (ICO) to fund new ventures. These ICOs skirt around some of the Blue Sky rules from the SEC and are another headache for regulators as the government tries to keep up with the rapidly changing technological environment.

In April 2017, Estonia announced that it was considering an ICO for Estcoins. The concept was floated to raise money for the nation. While the ICO is a long way off, there is no doubt that governments will start issuing ICOs. In the long run, things are looking bad for paper money. The dream of every treasury is to issue non-counterfeitable currency desired by the whole world. Estonia is opening the door to this new reality.

Insurance Applications

With a single invention, blockchain eliminates society’s need for banks, securities, and even currency. Insurance is not immune from the sweeping changes.

Given that blockchains are trust-based networks, there is no need for humans to move money from one account to another. Blockchains open up the possibility of programmable money. This means that there are events that will trigger the payment of funds into an account. So long as there is consensus in the network of the occurrence of the event, the funds flow without need for human interaction.

This streamlines insurance but raises questions: How do you program insurance policies? For example, if half of a house burns down, how do you assess the claim without sending out an adjuster? You don’t. Without sufficient sensors or other future technology, simple house fires, fender benders, and many other traditional insurance functions still require adjusters, claims handlers, and financial professionals dedicated to moving funds.

But what about binary situations? What if you know that the occurrence of an event triggers a pre-determined amount of money?

Now you’ve got a blockchain application. For example, if a category 5 hurricane passes over a neighborhood, then it is very likely that the insured properties will suffer losses at the limits. Catastrophic events frequently pay the maximum a policy can pay. Thus, if sensors placed in strategic locations all indicate winds above a certain speed for an amount of time, then the blockchain may trigger the automatic payment of funds. This application can easily be molded for fire, hail, earthquake, and other catastrophic events. These insurance policies are called Smart Contracts as the insurance policy is paid upon the occurrence of an event based on rules in the program.

If you eliminate an insurance company’s claims department, then the insurance company is almost a decentralized autonomous organization (DAO). A DAO is a robot company. Once set up, the company operates based off of a set of rules written by the creator. For insurance companies, this means that insureds will pay premiums into an organization that could theoretically have no humans working in it at all.

Theoretically, DAOs incur very few expenses past the initial expenses of setting them up. In a DAO were to offer a pre-determined indemnification upon the occurrence of an event, the DAO could offer ultra-cheap insurance policies. For example, if sensors in your car record an accident occurring at less than 10 MPH, then it would automatically distribute $XXX to your bank account, but an accident at 45 MPH automatically releases $X,XXX. These pre-determined claims payments keep the costs of insurance to a bare minimum, which opens the door to car insurance policies for a dollar or two per month.

While the insured likely waives the right to sue in the event of a disagreement (how do you sue an anonymous online insurance entity?), there is a huge market out there for ultra-cheap insurance.

Captive Insurance Applications

Autonomous captive insurance companies are an owners dream. A parent company decides it wants to self-insure an exposure, so it sets up a DAO which pays claims upon the occurrence of an event. The captive managers set up the company, walk away, and now the business owner pays premiums into a company that runs itself and never wants payment for its services. Dividends automatically remit from the DAO once the reserves are no longer encumbered. Further, if the captive qualifies for the 831(b) election, the dividends will be remitted tax free back to the captive stakeholders.

With current technology, captive insurance DAOs are too expensive for the vast majority of businesses. However, blockchain technologies applications are astounding. Since many reinsurance policies contain follow the fortune clauses, it is conceivable to set up a captive taking a layer of risk paying out upon the occurrence of an event. Once the captive’s blockchain achieves consensus that the clause was activated, the payment would automatically occur. Or, captives could be used to automatically pay the deductible for any losses in catastrophic events in a deductible buyback policy.

Protected cell companies can use blockchain applications as well. The core can run its own blockchain and create individual cells operating as separate insurance companies. Each of these companies could insure separate risks and pay claims upon the occurrence of an event. Assuming the cells share capital with the core, the core company can automatically add capital to individual cell’s reserves on an as-needed basis if reserves dip below certain thresholds. Further, assuming a favorable loss history, the cells can reduce premiums charged to the insureds so long as capital rates maintain certain ratios. While these applications of cell companies are nothing new, these functions generally require the interplay of accountants, actuaries, and underwriters. Through blockchain security and proper programming, these features can be automated into robot insurance companies.

The Future of Insurance

The road ahead is exciting. As blockchain technology reaches ubiquity, the ability for governments to regulate insurance will become increasingly difficult. Once a safe and secure insurance DAO is established, there is no reason that the company needs to be domiciled in one jurisdiction versus another. A blockchain established in the Philippines is indistinguishable from Russia, the US, or New Zealand. Quality insurance will be available via the Internet without any ability for governments to tax or regulate.

Whether distributed, autonomous insurance companies are good or bad is irrelevant – the fact that the technology exists is sufficient to ensure their eventual birth. Consequently, new forms of insurance will arise. For example, people can universally pay into a supranational social security program which pays out a stream of income upon the filing of a claim. The amount paid to the insureds would be a function of the amounts paid in premium over time, but there is no reason that citizens across the globe can’t pool resources for universal social security. Or unemployment. Or basic income.

This is the zenith of captive insurance. Insurance initially started with wealthy merchants pooling their resources to create large companies. Then individual companies create their own insurance policies due to inefficiencies in the market. With blockchain, individuals can band together to create their own insurance policies free of any government regulation. This is the future and we’re lucky to witness it all come together.