Critical insights on the potential of smart contracts and distributed ledger technology for the Insurance sector are explored in an interview with Director of Research and Technology at Nephila Advisors, Pascal Karsenti
Adjoint: Can you first tell us about your professional background?
Pascal: Nephila is a major provider of catastrophe and weather risk capacity in the world. As a member of our research team I work extensively with startups to develop and deploy better ways to assess our risk, improve internal systems and accelerate the growth of our (re)insurance distribution channels.
Adjoint: We have seen reports by many consulting companies on use of distributed ledgers and smart contracts in insurance. This covers a wide range: new products, fraud detection, underwriting, claims processing, cat bonds, and many more. Where do you see some good applicable use cases?
Pascal: Insurance companies are starting to make significant strides in improving underwriting through fairly traditional methods such as process automation, APIs and databases. However this has largely been limited to the initial customer interaction; getting an endorsement, making a claim or even simply requesting a complete copy of your policy is not nearly as smooth, with manual handoffs from system to system and team to team.
We see smart contracts as one way to improve on that state of affairs, with the customer, underwriters, risk managers, and outsourced service providers (such as claims administrators) each being able to refer to a single source of truth about the policy. Smart contracts will have to compete for that role against more traditional systems integration efforts; as such we don’t see them as some sort of “silver bullet”, but as another technological path to achieving greater transparency and efficiency over a contract’s lifetime.
Adjoint: Where do you see (which use case?) DLT and SC technology making the most impact in the insurance industry? Why?
Pascal: We’ve already discussed important but ultimately incremental improvements to automation, efficiency and transparency potentially enabled by smart contracts. The more transformational aspect is in my view the potential for further unbundling of the insurance stack.
Insurance today is already significantly unbundled when compared to the old monolithic insurer model. Agencies sell to customers, managing general agents (MGAs) handle underwriting, claims administrators deal with claims, some insurance companies “rent out” their balance sheet as fronts, and finally reinsurers and fund managers direct insurance risk to those parts of the capital markets most willing to bear it. It works, but each handoff generates friction in time, money and data loss.
If I look back over our 20-year history, one of Nephila’s key features has been our willingness to provide investors with vastly more data on the risk we’re taking on their behalf than they would otherwise get as the shareholder of a public (re)insurance company. In today’s environment managing that data comes with significant costs and limitations. Systems enabling seamless data transparency could revolutionize the insurance industry, similar to how Markit transformed loan pricing. What sort of new business models could arise in a smart contract world, where full end-to- end transparency was the standard?
Adjoint: What are the challenges that will need to be overcome for an insurance company to use smart contracts and distributed ledger technology?
Pascal: I can think of three; one for legacy insurance entities, and two for the distributed ledger/smart contract folks seeking to do business with them.
For insurers, the biggest difficulty I see in implementing smart contracts and distributed ledgers is that the technology works best as an end-to- end system, from underwriting to risk transfer to claims. As complex, highly regulated financial services entities, insurance companies typically prefer “drop in” technologies, where one part of their stack can be replaced with newer systems in a carefully controlled fashion. As such they may want to try it out first in a newer, less-regulated line of business where integration with legacy systems and processes will be less of an issue.
The second challenge is in how vendors structure their stack and communicate with insurance entities. Smart contracts, distributed ledger, cryptocurrencies, initial coin offerings etc. all came about as a sort of package, parts of which are attractive to insurance entities, but other parts less so. Smart contracts? Absolutely, the insurance world is all about forming and settling contracts. Distributed ledgers? Insurance is fundamentally a trust-based contractual agreement between two parties, so the distributed piece may be better suited to certain use cases at the edge of the system. Cryptocurrencies? Insurance companies are wired to avoid volatility, by culture and regulation, so any exposure to cryptocurrency is likely to be seen as a bug rather than a feature.
The last challenge I’d highlight is the smart contract world’s fixation with parametric insurance. Indemnity coverage is painful to settle, yes, but it’s also a fundamental part of the insurance value proposition. Indemnity insurance maximizes social utility by transferring uncertainty from those least able to support it, such as a homeowner with substantially all his or her assets locked into a single home, to those most able to handle this volatility, such as diversified capital markets. Is there a place for parametric protection? Yes, and smart contracts could make those more efficient. But parametric is a small market for a host of reasons, and unless smart contracts learn to work with indemnity, they will remain confined to a niche.
Adjoint: Finally, what are the top recommendations for your insurance industry colleagues as they engage with smart contracts and distributed ledgers? And to technology companies aiming to work in the insurance sector?
I would focus less on jargon and more on what efficiencies or new sources of revenues the technology enables. I would also recognize that certain components of the distributed ledger/smart contract/cryptocurrency ecosystem make more sense than others with regard to insurance. In particular, I think that a smart contract technology enabling greater efficiency and transparency, yet compatible with the regulated, trust-based, two-party contract, indemnity nature of insurance is most likely to succeed.