In the past years, we’ve seen a steadily growing interest in distributed ledgers and smart contracts. The financial industry has already been largely disrupted by these innovations. Although insurance has relied on conventional methods for decades, let’s explore the potential of smart contracts in the insurance industry, their limitations and the legal implications.
In very simple terms, a smart contract is a software program that automatically enforces the agreement terms when certain, predefined conditions are met. In other words, a smart contract acts as a virtual intermediary that executes transactions between two parties.
Ultimately, the insurance industry’s main challenge is a lack of trust and transparency between actors. According to Accenture, only 29% of customers trust insurers. This lack of trust is mutual. Fraudsters commonly make false claims in the hopes of receiving payouts, forcing insurers to put extra resources into the validation of every claim. With smart contracts in place, the trust problem can be at least partially eliminated while lowering administrative costs.
The Potential of Smart Contracts
Traditionally, the insurance industry relies on a trusted intermediary to execute the transaction. The involvement of a third party makes the process slower and more expensive. It’s not uncommon even for uncontested claims require months to be processed.
With a smart contract, no human interference is required. First, this helps mitigate the risk of manipulation by the mediator and increases transparency. Given that smart contracts are stored on a blockchain, both parties can see logged transactions. Second, it dramatically speeds up claim processing. Third, it lowers administrative costs for the insurer. As a consequence, companies can lower premiums, increasing market share. Fourth, neither insurer nor customer can "lose" agreement information, as policies are securely stored on the blockchain.
The Limitations of Smart Contracts
Smart contracts do have limitations. Currently, smart contracts can provide value only for the most primitive types of insurance cases. In very simple terms, smart contracts can operate only based on a conditional pattern of "if X, then Y."
Smart contracts become viable only when their conditions can be wholly transcribed into programming code. Unfortunately, this is a rather rare scenario, as a significant portion of today’s contracts are filled with nuances.
For example, industry-specific concepts like "good faith" or "reasonableness" can’t potentially be expressed by the simple rules that smart contracts are currently based on. It would take an innumerable amount of code and resources to describe all possible contingencies and complex scenarios.
Moreover, as insurance is a very conservative industry, many would hesitate to trust technology instead of a conventional third party. With smart contracts, we are not really eliminating the intermediary; we are just getting rid of the human factor and substituting computer code. While the code embedded in a smart contract has very little risk of being hacked, the code itself can be flawed. This is why smart contract security audit has now become a commonly outsourced service.
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With growing attention to blockchain and smart contracts, the first adopters of the technology have faced certain legal barriers. In 2019, the European Insurance and Occupational Pensions Authority set up Insurtech Task Force, which analyzes smart contracts in the legal context.
The formulation of a solid legal framework will most likely take at least a few years. Currently, the widespread adoption of smart contracts is either risky or impossible, depending on the jurisdiction. For example, some experts argue that, under current U.S. contract law, smart contracts are perfectly enforceable. However, such conclusions are largely based on the exploitation of ambiguities regarding the use of electronic signatures.
Smart contracts will most likely introduce new challenges in the legal landscape. The main value of a smart contract can be attributed to automated performance that can’t be altered. In insurance, this automation can complicate things. For example, if a party claims that there was no enforceable contract or that terms were not fulfilled, under the traditional approach the party could simply withhold payment, while the other party would open a dispute. With a smart contract in place, the funds would still be transferred, forcing one party to file a lawsuit to alter the transfer. Moreover, understanding smart contracts will require significant new skills for legal professionals.
However, such roadblocks should be considered short-term. The potential for smart contracts in insurance is undeniably significant. Given the current limitations of the technology, we will most likely see smart contracts used first for simpler insurance processes like underwriting and payouts. For smart contracts to scale, we will not only need dramatic technological improvements but also significant changes in the legal landscape.