Tag Archives: distributed ledger

Shifting Balance in Risk Markets (Part 4)

In the opening segment of this series on complexity, I discussed the three network graphs that have emerged in the risk markets and which business models embody them. For quick reference:

In the second segment, I discussed the emergence of peer-to-peer insurance, which will accomplish the three core functions of the risk markets that currently exist in a “black market” unformalized state by using distributed managerial methods, which are:

  • Risk transfer;
  • Escrow of funds for a defined purpose; and
  • Management of reallocation of escrowed funds.

In the third segment, on distributed ledger technology, I looked at how it can be configured as a cohesive platform that would embody all three network graphs. I discussed how the roles of individual peers, along with carriers and agents, can work together to formalize the P2P methods in the risk markets. For a quick reference:

In this final segment, I will look at the current balance of the market share of each graph type in the risk markets, how the balance may change and what the new equilibrium state might look like in the risk markets.

Before doing that, I would like discuss an important idea that emanates from the blockchain and cryptocurrency communities: the idea that there could be “one ledger to rule them all,” or, asked another way, “Could a single ledger be an all-encompassing ledger, accounting for all value?” The simple answer here is “no.”

No single ledger, technology or network will ever be all-encompassing. That would be silly, as it would reintroduce the systemic weakness inherent in centralized system structures, namely the risk that by taking out a single central node (or ledger, in this case), the whole system could collapse.

See also: 4 Marketing Lessons for Insurtechs  

Just as was realized in the blockchain and cryptocurrency communities, the idea of a “risk ledger to rule them all” is not a desired structure; in the risk markets, a single distributed risk ledger to account for all funds escrowed against all risk types is not a desired structure. Because of the nature of risk and the diverse set of risk exposures in the world, there will need to be a diverse set of risk ledgers. We may see something materialize that looks like the following as an example of four distributed risk ledgers, each for a specific category of risk exposure.

Hold on to that thought for now….

I would like to again reference some of the work done by the Ripple team and their thought leadership toward a solution to address the concern of “one risk ledger to rule them all.” The Ripple team has introduced a protocol that will enable value to move in a cryptographically secure way between two or more distributed ledgers. It is called the Interledger Protocol, and more information can be found on their site here.

Using the Interledger Protocol, the Ripple team has articulated how various types of distributed ledgers, each engineered for a specific strength, can be networked together to create a term they have coined the “Internet of Value.” Without a single shred of doubt, it is a true statement that “finance is getting its internet,” and it is already here, albeit in a state of maturity similar to the internet circa the late 1990s. Unlike the slow pace of the internet’s growth, however, finance’s internet will not take as long to mature — mainly because it received an advantage from the preexistence of the internet itself and all that has been learned. Insurance and the risk markets of all the various financial services are the lowest-hanging fruit.

This might seem like a stretch in today’s environment, but it is not hard to imagine that by connecting many risk ledgers (each escrowing funds against a specific risk type) and using the methods outlined with Interledger protocol, that we will see the emergence of an internet of risk. Just like with the internet of value we see emerging today, the internet of risk will be made of many different distributed risk ledgers networked together.

I would define the internet of risk as a network of distributed risk ledger networks. The technical name for a “network of networks” in complexity science is a “multiplex.” Risk markets have been operating with an informal and non-digital multiplex structure for some time. Because each insurance company manages a risk ledger and because reinsurance companies function to connect insurance companies’ risk ledgers together, the reinsurance industry effectively embodies a decentralized network of insurance companies — and both graphs combine to embody a multiplex of risk ledgers.

In all likelihood, over the coming years we will observe the digitization of the existing multiplex of risk ledgers that is the risk market into a network of digitally connected distributed risk ledgers, with each individual risk ledger serving the specific needs of a specific risk exposure.

KarmaCoverage is intended to be this “multiplex of risk,” organizing the connections between the risk ledgers of all types of P2P risk sharing. And it aims toward the goal of insuring that, as the P2P segment of the risk market grows, it maintains a high degree of resilience, enabling society to transfer risk efficiently among individual peers, successfully addressing the various risk exposures of those peers. You would expect to ultimately see this play out and create an internet of P2P risk ledgers that looks something like this:

To be fair, it is not possible to know the ultimate structure (or graph) of this multiplex of risk. It will emerge by a process of self-assembly. It must employ distributed managerial methods to avoid reintroducing the fragility inherent with its centralized structure. That said, many portions of it can (and should) be centralized for efficiency purposes. Distributed systems have weaknesses, as well, one of which is the introduction of some degree of inefficiency. We would not want to act out that behavior where “if all you have is a hammer, everything looks like a nail.” The functions that should be centralized combine a make the business case for something like KarmaCoverage.

Now, let’s take a look at how this may have an impact on the existing balance of market share where each graph serves as a percentage of total risk. Using data on the currently formalized methods of total risk and by assigning a percentage to each graph in the risk markets, you find that the graphs settled at roughly these percentages:

  • Reinsurance: 40%
  • Insurance: 60%
  • P2P coverage: 0% (This does not account for all the risk transfer activity that occurs informally in the black market of P2P risk transfer.)

There are two factors to consider when thinking about how the equilibrium state of the risk markets will balance out in the information age. To answer this, first we need to consider market growth and look at how the size of the risk markets will grow as a result of formalizing the P2P black market activity. Second, we need to consider the market share split among the three graphs, given that P2P will no longer continue to be 0% of the formalized market.

Let’s look at Uber and the taxi market for a benchmark.

Uber CEO Travis Kalanick, speaking at the 2015 DLD conference in Munich, said the taxi market in San Francisco was about $140 million per year, while Uber’s revenues in San Francisco were running at $500 million per year and still growing at 200% per year. Ignoring the continued growth, these numbers indicate roughly a 350% growth in market size.

See also: How to Outfox Our Brains About Risk  

Approaching this question about the growth in market size from another angle, and after reviewing various sources, the global formalized taxi market size is roughly $20 billion in revenue per year, while Uber’s annual revenue is only about $5.5 billion. These numbers would indicate roughly a 25% growth in market size.

While this is a simple and quickly obtained benchmark, it would be easy to conclude that the process of formalizing the P2P segment of the risk markets will drive somewhere between 25% and 350% growth to the size of the risk markets. This would take the roughly $5 trillion in global annual premiums of the combined insurance and reinsurance industries and, after adding the P2P industry segment, bring the size of the risk markets to somewhere between $6.35 trillion (on the low side) and $17.5 trillion (on the high side).

Reality check: There is a big difference between risk and taxi rides! Taxi rides are more prone to growth in market demand because of economic activity and population growth than the risk markets are.

Risk, on the other hand, is more prone to shrinking demand because of improved mitigation of actual risk because of safer technology and other factors driving the reduction of risk. As one example, let’s look at auto risk as we make the transition into driverless cars, which stand to make a very significant dent in auto risk exposure. We are already seeing a 40% decrease in accident rates from mere “accident-less” cars equipped with accident-avoidance technologies.

Using these benchmarks (and my crystal ball), the fact that the frequency of small loss events is much higher than large and catastrophic loss events leads me to predict that the formalizing of P2P methods in the risk markets will result in the doubling of the size of the formalized risk market at some ambiguous point in the future. I will also assume that the ratio between insurance and reinsurance shown above does not change. This would end up with risk markets growing to nearly $10 trillion, with the market share being split among the three segments like this:

  • Reinsurance: 20%
  • Insurance: 30%
  • P2P coverage: 50%

Surely these assumptions and predictions are wrong, but this is more of an exercise in trend observation, not an attempt to actually predict the state of the risk markets at some specific future point.

There will be other drivers that will have an impact on the shifting balance. One easy-to-understand but powerful and potentially market-driven force would be consumers voluntarily choosing significantly higher deductibles. This trend is already in motion. One indication of this trend on home insurance policies is that in California, on policies covering more than a million dollars, the lowest deductible that is compliant with regulatory rules is for $10,000. While that example is imposed on the industry, here in Florida, we saw the industry self-impose an increase in deductibles from hurricane losses after the 2004-05 seasons — while, at the same time, many large carriers simply pulled out of the state, leaving a vacuum to be filled by newer, smaller Florida domestic carriers.

Using formalized P2P “networked self-insurance” methods, it is possible for consumers to achieve an average of $10,000 in coverage on an annual basis for less than $100 per month and to simultaneously fill the deductible gap all the way down to the first dollar of loss, fully addressing total risk exposure. That could easily lead to enabling consumers to request $10,000 deductibles on all their insurance policies, which would have a material impact on gross premiums.

On home and auto insurance losses, more than 90% of claims are less than $10,000. If the consumer behavior of requesting ever-higher deductibles on their traditional insurance policies occurs, it becomes easy to consider that premiums on traditional insurance may currently be at or near their historical high.

See also: 4 Steps to Integrate Risk Management  

Obviously, this process of formalizing the P2P segment of the risk markets will face headwinds, but since I entered the industry with an eye on the intersection of risk markets and crowdfunding methods back in 2013, we have seen the number of P2P insurance companies grow from one to dozens all over the world. It seems like the moment for the formalization of P2P methods in the risk markets is here.

Because of the convergence of factors discussed in this series (and a few others), I believe we will see a Napster-, an Uber- or an AirBnB-type of service emerge for the risk markets in the coming years.

I have started a LinkedIn group for discussion on blockchain, complexity and P2P insurance. Feel free to join here.

The whole mini-series is available for download at KarmaCoverage.com.

Distributed Ledgers in the Risk Markets (Part 3)

In the opening segment of this series on complexity, I discussed the three network graphs that have emerged in the risk markets and which business models embody them.

For quick reference:

In the second segment, we discussed the emergence of P2P insurance, which will formalize the three core functions of the risk markets that currently exist in a “black market,” unformalized state. These functions are:

  • Risk transfer;
  • Escrow of funds for a defined purpose; and
  • Management of reallocation of escrowed funds.

This formalization will occur via the emergence of a platform that enables all of these functions to be accomplished by the users of the platform, bringing the existing P2P economic activity out of its black market state and into the light of day.

Risk is the killer app for distributed ledgers!

The focus of the blockchain community on banking has been an interesting side effect of the timing of the Bitcoin innovation that coincided with the collapse of the U.S. banking industry. The blockchain technology software went open source in January 2009, while the markets (DJIA, S&P 500 and NASDAQ) bottomed out in March 2009.

The term “distributed ledger” is synonymous with blockchain. Both refer to the technology of a shared digital ledger, upon which transactions are validated by a distributed set of servers using chronological, public and cryptographically secure methods. I prefer the term “distributed ledger” because, at its core, this technology is an accounting tool that enables a set of capabilities not previously attainable.

In a distributed ledger:

  • All transactions — or, in accounting vernacular, “ledger entries” — are validated using a distributed method, without requiring users to trust in a central authority who has control over all entries on the ledger.
  • There will be lower transaction costs — both in terms of less time and lower labor costs — because there will no longer be a need to coordinate a multitude of private, centralized corporate ledgers.
  • It will create an ability for end users to publicly escrow value on a platform that enables them to connect directly with each other, creating a P2P distributed graph and enabling both the trusted communication of and individualized control over the reallocation of their escrowed value.

I would like to introduce the idea of a “risk ledger,” which is any ledger where value is escrowed as a hedge against a risk so that the risk can be safely carried through time. Currently, insurance carriers operate risk ledgers as they escrow money against a risk over a segment of time. (I wonder if this is why insurance companies are called “carriers.”) The same goal can be easily accomplished using distributed ledger technology, albeit with some advantages over private, opaque, centrally controlled corporate ledgers.

See also: 5 Steps to Profitable Risk Taking  

Distributed ledgers enable individuals to escrow value in the light of day against a risk, carrying the risk safely through a segment of time until a loss event necessitates the reallocation to the user who experienced a loss event and the removal of that value from the distributed ledger. Risk is the killer app for distributed ledger technology; as such, I believe the timeline for adoption in the risk markets will be shorter than observed in the banking markets, where the technology itself needed time to mature.

Trust is a fundamental ingredient in all financial services, and trust is something that distributed-ledger technology has a unique ability to enable. Because all money that is escrowed on a distributed ledger as well as the movement of that money is visible to all, users can trust in the system without needing to trust any single validator, company or peer participating in the network.

It must be understood that all distributed ledgers are, inherently, a network. There are many distributed ledger networks out there, but I will use Ripple’s to exemplify how a P2P distributed risk ledger platform may look. Thankfully, Ripple spearheaded acceptance by international regulatory bodies on issues associated with distributed ledger technology. Another reason I choose to use Ripple is because of its two technical features: 1) It has built-in “trust lines,” which enable individuals to create an explicit network of other peers whom they trust, and 2) it has the built-in ability of order books, which can be used to make markets between different stores of value. There are other technical advantages of Ripple, but these two elements combine to make a powerful and open-source solution.

Trust lines function as roads upon which value can move around the ledger. If I trust you, then you can send me value. If I do not trust you, then you cannot send me value because there is no path for the value to travel upon. This capacity for individuals to control who they are willing to trust enables individual peers to self-assemble a “trust graph” mirroring and to document the reality of who is trustworthy. Because all financial services are predicated on trust, this can be thought of as the finance industry’s equivalent to Google’s link graph, Facebook’s social graph and LinkedIn’s colleague graph, etc. Whoever ends up building this “trust graph” will likely be capable of creating much more value for society than those other graph types because of the significant role that finance plays in society.

Peers can extend trust lines to other peers they personally know, trust and are willing to help. These trust line connections create a trust graph in the same way as friend connections on Facebook create the social graph. In this way, a P2P distributed trust graph can be self-assembled and emerge out of the actions of the individual peers. Building a distributed graph of roads and creating many paths upon which value can travel across the distributed risk ledger network is an example of a distributed managerial process.

To give some example of how escrowed funds would flow through this distributed trust graph, let’s look at a hypothetical loss event. When a loss event occurs, a user documents the loss, and other peers who trust that user can choose to send a small amount their own escrowed funds to help their friend. (There is a formalized financial model  I will not detail.) However, I was surprised to discover, after working out the model’s details, that the model actually existed 1,000 years before modern insurance methods came about in the mid-1600s.

Order books — and the ability to make markets — enable agents and insurance carriers to retain their relative roles as they exist in the industry today.

The platform can be set up in a way that agents can capture a fixed fee as a spread or a percentage of the money that flows through the users that trust the agent by extending the agent a trust line. This is akin to commissions.

The platform can be set up in a way that carriers can manage the funds, which users put on escrow, and can control which agents are allowed to access the carrier’s gateway. This enables carriers to essentially mirror the same function that the appointment process accomplishes today. Carriers can do this activity without invoking the regulatory burden of insurance laws; they only need to comply with MSB regulations. This would also enable carriers to earn float income on the newly escrowed balance.

Phase change innovations typically emerge to address an order of magnitude more complex than what preexisting methods could in the prior industrial age paradigm. Consider how much economic activity and the number of actors Uber can organize on a global scale versus the top-down methods of an industrial-age taxi company. In the risk markets, coming out of the industrial age, we can see many companies operating independently in each of the three graphs (which are intentionally siloed). To achieve an order of magnitude improvement, we must encompass and coordinate all three graphs structures onto a single platform.

See also: Are Portfolios Taking Too Much Risk?  

Currently, agents function as a hub of client trust. Agents enable clients to navigate the complicated insurance product space and achieve the distribution of insurance products backed up by carriers. On a Ripple ledger, the agent would be a centralized hub of trust lines, and the graph would show that many users trust the agent node.

Currently, carriers function as an access point and product provider, lifting the burden of regulatory compliance, administration and product creation from agents. Engaging with the platform, each carrier can independently escrow client money without hampering the client’s ability to connect with other peers who they trust but who may not be clients of the same insurance carrier. With order books, the carriers can trade escrowed funds to enable a user who has experienced a funded loss event to receive a single check from the carrier that that user does business with, even though many of the peers funding the coverage are not clients of that carrier and do not have funds escrowed with the carrier issuing the check. Via these order book connections, carriers’ relationships will create a decentralized graph on the platform.

Combining the peer-to-peer distributed trust line graph, the centralized graph that is the hub of trust connections surrounding the agent and the decentralized graph of carrier-to-carrier order book connections, the platform can facilitate the coordination of all three graphs within a single system — all while relinquishing ultimate control of the flow of funds to the individual peers of the platform. This achieves a distributed managerial method of the reallocation process applied to the escrowed funds. This also alleviates the cost of adjusting claims and the exposure to fraud from the participating carrier’s perspective, as well as the distribution of the costs associated with the adjusting process across the peers participating in the network.

As is explained in his book “Why Information Grows: The Evolution of Order from Atoms to Economies,” MIT’s Cesar Hidalgo argues that we are at a point when firms need to network if they desire to continue to create value for society in excess of what any single firm can create alone.

Via a distributed risk ledger network, many carrier firms can run the servers that maintain the whole ledger. This gives each carrier an equal vision into the ledger and removes the need for any carrier to submit control to another carrier that is tasked with running the entire system. Most importantly, these methods function as a shared back office so that no single firm bears the burden of the costs associated with managing all of the small loss events. Additionally, the cost of the system’s management does not need to be duplicated and absorbed by each participating firm. This is essentially how Ripple is being implemented in the banking industry to reduce the costs of international payments and increase the speed of international flow of funds.

Some examples:

  • Firms in the home and auto insurance business can network to facilitate a ledger with other home and auto insurance firms, helping homeowners who experience losses that are under the deductible or excluded from the policy form.
  • Life insurance firms can facilitate their own ledger networking with other life insurance firms, enabling coverage for clients who do not meet underwriting requirements, such as those over the age of 75 or with a terminal disease.
  • Firms in health insurance can network to facilitate a ledger with other health insurance firms to better enable users to cover high deductibles, only invoking their traditional insurance contracts for unexpected, large incidents.

By networking, firms can enable the existing P2P risk transfer behavior to occur with less friction and bring this important economic activity out of its black market state and into the light of day on a formalized platform. Once the economic activity is occurring on a formalized platform, one would expect to see, like was observed with Uber and AirBnB, a resulting boom in the aggregate amount of the economic activity, growing the entire risk market’s pie and improving the risk market’s value add to society.

See also: 4 Steps to Integrate Risk Management

In the next segment of this series, I will consider possible changes to the risk market’s current equilibrium state and what that equilibrium may look like after the phase change has occurred.

Does Peer-to-Peer Fit in Risk Markets? (Part 2)

In the first of this series of four segments, we looked at the current state of the risk markets and the insurance industry. In this segment, we will look at how peer-to-peer (P2P) fits.

First, P2P is not mutual insurance. While the mutual insurance model is in more of the same spirit as P2P than corporate insurers are, mutuals are still operating primarily with the same business methods that corporate insurance companies use, and the financial service is still an indemnity insurance contract. The same would apply to the fraternals.

P2P is also not just a behavioral economic twist on insurance to reduce fraud. While elements of P2P methods do invoke (and should employ) behavioral economic principles, employing these principles alone will not qualify a service offering as P2P. P2P is hyped to get insureds to convert their social network into insurance leads.

When done correctly, a P2P service offering should demonstrate a level of virility in excess of existing insurance offerings. But traditional insurance already achieves some virility — I am an insurance broker, and much of our business is already generated via client referrals — so virility alone would not be a key differentiator for P2P.

P2P, today, is not actually disruptive. Rather, it is only an iteration of insurance as we know it today. To believe otherwise is a route to strategic disaster.

But there are other methods that more fully embody P2P methods and will prove to be quite disruptive to the current balance existing in the risk markets.

See also: Examining Potential of Peer-to-Peer Insurers  

Okay, so what is P2P?

In the first segment of this series on complexity, I discussed the three network graphs that have emerged in the risk markets and which business models embody them. For quick reference:

To dive into this, we first need to define the activity that the risk markets perform for society. Why did the risk markets emerge, and why does society engage with the market? There are three core societal functions that risk markets perform for society:

  • Risk transfer;
  • Escrow of funds for a defined purpose; and
  • Management of reallocation of escrowed funds.

Let’s take a look at each of these functions and the methods deployed to accomplish them.

Risk Transfer

One of the core elements required to legally define a contract as an insurance contract is indemnity. Inherent in the term “indemnity” is the idea of risk transfer. Indemnity is defined as “compensation or payment for losses or damages,” which essentially means that experienced risk from a loss event has been transferred from one party to another.

While insurance is a highly efficient method of accomplishing some portion of total risk transfer, an insurance contract is only one of many methods humans use to transfer risk around society, and the method has its limitations.

Other formal risk transfer methods include: companies that offer consumers a warranty on their products and service companies that are bonded by creating the same effect as a warranty does for consumers of their service. In the financial markets, we see options and swaps, as well as letters of credit. Formalized charity efforts also amount to risk transfer. In the public sphere, as was demonstrated in 2008, society has formalized methods for transferring risk from systemically important private companies to the public, all backed by the government’s access to taxation revenue.

Informal methods of risk transfer that can be routinely observed include families and friends compensating each other for some risk that the other has experienced. The same behavior also emerges within groups and communities, both with and without the intentional purpose of risk transfer. These methods amount to “black market” methods because they are not formalized, and the economic activity is not taxed and does not contribute to GDP. However, the economic activity does and always will occur.

Escrow of Funds

With indemnity insurance and other formalized methods, every insured has paid a premium for the legal right to transfer their risk exposure to another party. Presumably, this transfer shifts risks from individuals to a group as a whole. These premium funds are held in escrow to assure participants that the system will work. This behavior can be viewed as an “escrowing of funds for a defined purpose.”

With informal methods, we do not observe this escrow pattern. Indeed, many families and friends have received news that someone has experienced a loss that they do not have the means to bear. It is important to note that the person who has experienced the loss, in many cases, has already engaged with the available formalized methods that the risk markets have on offer — but the risk is in excess of what those methods can cover. With insurance, this uncovered risk amount can take the form of a deductible, the exclusion of a peril or a limitation of coverage on a covered peril.

See also: 3rd Wave of P2P Insurance  

Informal methods of risk transfer emerge to fill these segments of total risk, which formalized methods do not address. Because there are no funds that have been pre-paid and escrowed for the purpose of addressing these segments of risk, we observe informal methods of risk transfer employing a post-pay method of achieving coverage. This can be observed in the digital environment on crowdfunding platforms such as GoFundMe, where coverage for a loss is achieved after the event has occurred.

Management of Reallocation of Escrowed Funds

Formalized methods of redistributing escrowed funds, like insurance methods, employ a legal contract. In black and white, rules specify for what purpose escrowed funds will and will not be paid out by the system as coverage, and how the dollar amount of that coverage will be calculated. This legal contractual methodology creates the requirement for actuarial work.

Insurance companies employ statistical and actuarial methods to ensure that enough money is escrowed to accomplish the purpose for which the society agreed to escrow the funds but also that there are additional funds to pay for the costs of centralized managing of the reallocation process, including some additional funds for profit for the insurance company.

The degree to which these formalized methods necessitate the burning of escrowed funds is a reduction in efficiency. Internal process inefficiencies that exist in the companies managing the process effectively add to society’s realized risk from engaging with the insurance system’s methods.

Currently, informal methods obviously do not employ legal methods, as no funds have been put into escrow for any specific purpose. These informal methods for the redistribution of funds to achieve a transfer of risk unfold as individual peer decisions, directly between the two peers involved. This is an example of an emergent P2P behavior.

The Question

Now, let’s get back to the original question. What is P2P?

Whether we are taking about music files via Napster, transportation via Uber, housing via AirBnB or work via TaskRabbit, the amount of economic activity resulting from those P2P methods blossomed — but only after a platform enabled the formalization of the behavior that already existed in the world, albeit informally. In each of these markets, society built wonderful centralized organizations to accomplish the fundamental economic activity of the market.

In each of these markets, when a P2P platform was built — offering just the right degree of formalization, but not too much, to enable, but not inhibit, the connection of individual peers on the platform — economic activity grew drastically.

This is, fundamentally, an expansion of the market’s economic pie.

In the risk markets, we will see the emergence of a P2P platform that enhances the individual’s ability to network using distributed methods of management and to accomplish the process of reallocation of escrowed funds. With this platform, the three core functions driving society to engage with the risk markets will be accomplished by the individual actors without necessitating a central authority.

New technologies (such as distributed ledgers) and methods that, as it turns out, predate insurance by 1,000 years will converge, and the risk markets will see a P2P network come about. This network will be designed to accomplish a positive financial network effect that will create financial leverage, amplifying the amount of risk that individuals can cover with their own individually escrowed funds. P2P will effectively give users the option of “networked self-insurance” to better cover the gaps in total risk left by already formalized methods.

Insurance methods will not go away. The methods play an important role in how our existing financial system works.

But note what is not necessary for P2P: indemnity legal contracts, actuarial methods and a centrally controlled escrow account for processing the reallocation of those escrowed funds.

There is nothing wrong with these methods. They work quite well and systemically serve to mitigate the risk housed on lending banks’ balance sheets, albeit at the borrower’s cost. Lending activity also serves a systemically important role of enabling financial leverage for large capital purchases. However, that leverage comes with a risk. If a bank lends on a mortgage or auto loan and the underlying asset is destroyed, the loan on the bank’s balance sheet will have lost value. Indemnity insurance is likely to remain the only method of mitigating this balance sheet risk exposure that lenders will agree to accept. It would not be surprising to see the rise of insurance policies sold to banks on their loan portfolios — much like we see today occur in the process of securitization of the loan portfolios and somewhat similar to what we see with forced placed insurance.

See also: Is P2P a Realistic Alternative?  

It appears that we are observing in the risk markets that the insurance industry has been behaving in a way that can be described as: “If all you have is a hammer, everything looks like a nail.” Great, but just be sure you insure the risk exposure.

There are new tools available to the risk markets, along with new behavioral patterns, and we should not be a surprised when we see new methods — P2P and otherwise — emerge to employ these new tools for the benefit of society.

In the next section of this series, I will dive into one of those tools: blockchain, a.k.a. distributed ledger technology.

The Dawn of Digital Reinsurance

The physical science of matter and motion provides valuable insight for the effective digital management of risk.

In this first installment of the DelphX Innovation Series, we describe how a new reinsurance facility powered by transparent distributed ledger technology is employing digital parallels to physical science to diffuse the impact of adverse events.


The physics of diffusion enables the force of a speeding bullet to be absorbed and rendered nearly harmless by the energy-distributing property of graphene lattice incorporated within a bulletproof vest. That diffusion results from the efficient random-walk distribution of the bullet’s force among the graphene fibers – conveying its energy down a gradient from cells of greater concentration to those of lesser concentration.

That property of absorption also causes fluid collected in a sponge to be efficiently distributed among its cavities in proportion to the relative size and fluid concentration of each cavity. Correspondingly, fluid contained in a saturated sponge placed in a vacuum will be released from each cavity in proportion to its relative size and concentration – with those containing higher concentrations sourcing respectively higher amounts of the outflowing fluid.

Science of Digital Reinsurance

A digital corollary to that balanced distribution process has been integrated into the patent-pending technology of a new risk-pooling reinsurance facility, styled “Quantem” to reflect its risk/collateral-minimizing utility. The facility will be operated by a major global reinsurer to optimally diffuse the impact of loss among risk holders – rendering even a material event nearly harmless to any individual holder.

Ceded risks will be distributed within a transparent digital ledger that allocates each risk among all cedents in proportion to the net current size and concentration of risk ceded by each. While all cedents will have full viewing access to all elements of the ledger, their identity will never be disclosed.

Operation of the Quantem ledger will be perpetual and open-ended, with the level of concentration of each new risk being determined at origination by the anonymous interaction of competing participants in the SEC-regulated DelphX Alternative Trading System (ATS) market. Demand in that market will be sourced from participants seeking to cost-effectively transfer (or speculate on) risk, and its supply will be sourced from participants seeking to assume referenced risks in return for their continuing receipt of a negotiated annual premium/spread.

The aggregate size of the ledger will dynamically increase as new risks are added and decrease as existing risks expire due to their maturity or settlement. As each new risk is added, its size and premium/spread (risk concentration) will determine its positioning along the ledger’s concentration gradient – incrementally adjusting the proportionate quota-share exposure of each other risk.

See also: The Need to Automate Reinsurance Programs  

Credit Market Solution

The Quantem facility will be initially deployed in the global credit market to provide participants a low-cost and more efficient alternative to single-name credit-default-swap contracts. Quantem will diffuse the impact of adverse credit events and provide a regulated security-based solution to the dwindling derivative-based CDS market.

To accommodate that efficient transfer of credit risks and the supporting cash flows among investors, Quantem will commoditize those risks/flows within a new form of digital default compensation receipt (DCR) securities that provide:

  • Fixed negotiated spreads and maturities;
  • MTM-collateralization by cash-equivalent assets held in trust by a highly rated custodian bank;
  • Lump-sum compensation payments to holders upon occurrence of a qualifying credit event involving the referenced corporate, municipal, sovereign, structured or other security; and
  • Anonymous negotiation, origination and trading within the transparent DelphX ATS market.

To source the collateral required and minimize the cost of DCRs, Quantem will also commoditize and reinsure the related DCR risks through the sale of digital collateralized reference obligation (CRO) securities that provide:

  • Fixed negotiated coupons and maturities;
  • Full collateralization by cash-equivalent assets held in trust by a highly rated custodian bank;
  • Deeply discounted purchase prices reflecting the lower risks resulting from Quantem’s reinsurance facility; and
  • Anonymous negotiation, origination and trading within the transparent DelphX ATS market.

Note: All CRO sale proceeds are available to Quantem solely for use in funding the collateral requirements and compensation of DCR holders.

The risk-mitigating utility of Quantem results in DCR spreads well below the cost of comparable CDS protection and low purchase prices for CROs. The enduring benefit of that lower cost of purchase is economically evidenced in the considerable post-claim yields payable to CRO investors. For example, an assumed annual loss ratio of 4.0% (which is more than twice the aggregate mean default rate of all U.S. corporate bonds since 1981), would produce the following post-claim CRO yields:

Market-Based Underwriting

The fixed risk concentration of each new DCR added to the ledger is determined at origination by the clearing premium/spread resulting from the competitive interaction of participants in the transparent DelphX market. That risk-concentration thus reflects the market’s then-current equilibrium of supply and demand for protection relating to the risk of the subject CUSIP/ID.

That transparent interaction among symmetrically informed market participants facilitates the efficient market-based underwriting and selection of new risks – avoiding adverse selection and subjective/uninformed assessments of risk concentration. While the current DCR pricing for each referenced CUSIP/ID will increase and decrease on the DelphX market, the ledger’s design facilitates the aggregate behavior of pooled DCRs to gradually converge onto a normal (Gaussian) distribution.

As the market’s current risk assessment of each CUSIP/ID increases and decreases, the MTM collateral requirements of holders of the related DCRs will correspondingly increase and decrease in response to those changing market prices. Consistent with the law of large numbers, however, as risks of some DCRs are increasing others will be decreasing – resulting in an increasingly predictable mean exposure within the ledger.

As exhibited by the historical behavior of participants in the single-name CDS market, demand for DCR protection (and speculation) for a given CUSIP/ID is expected to increase in proportion to the collective assessment of participants of the likelihood of a loss involving that security. If the risk assessment increases, the pricing and volume of DCR purchases for the subject issue will correspondingly increase.

As those new, freshly priced DCRs are ceded, their higher price/risk concentration will cause the aggregate concentration of risk for the subject CUSIP/ID in the ledger to correspondingly increase. Thus the collateral sourced by those higher risks will proportionately increase the ledger’s aggregate collateral available for MTM adjustments and minimize the impact of a related loss on all other DCR risks.

See also: Transparent Reinsurance for Health  

Market-Based Adjudication

Quantem will also employ its diffusion protocol to distribute the cost of claims among risk holders based on the net size and concentration of each holder’s ceded risk at the time of adjudication of each claim. That adjudication process is transparently accomplished through anonymous single-price auctions conducted within DelphX.

Upon the reporting of a credit event meeting the definition and conditions specified in the DCR documentation, a single-price auction is scheduled within DelphX to facilitate the sale of the collective offerings of the referenced CUSIP/ID by its holders. The clearing price of that auction is then subtracted from the par value of the referenced security, with the remainder determining the compensation payable to holders of DCR(s) referencing the sold issue.

Next Series Installment – Digital Risk Speculation

Why Blockchain Matters to Insurers

First, a definition. Distributed ledger/blockchain technology, increasingly abbreviated as “DLT,” transfers value in a decentralized, consensus-based and immutable manner using cryptographic tools and is different from technology today because it offers transactions occurring between unknown counterparties that are mathematically trusted in real time. DLT is at once a network and a database that can host applications like Smart Contracts, with the potential to be interoperable across trade ecosystems. This technology seems tailor-made to help administer the claims end of insurance.

Let’s talk about claims. It is well known that insurance claims are the storefront of an insurance business. Claims processing and resolution provide touchpoints for extended customer engagement, and a bad experience can poison an insurer in a customer’s mind, which can affect policy renewal. The claims experience should be seamless and easy to manage for all.

Imagine if you could smooth out your claims process so that it is more accurate, frictionless and cost-efficient and can even provide easy access to data for benchmarking and analysis to improve your customer’s digital experience.

See also: What Blockchain Means for Insurance  

I had my “aha” moment when I first learned about DLT technology. I was struck with an immediate vision of how things could be made better within the insurance industry. As a prior general counsel of an insurer, and now a consultant specializing in the strategic use of this technology, I understand how it can be implemented (once fully developed) and can envision how it can change and improve business from end to end.

Practically speaking, on the claims side, at the very least, the industry would never again have to suffer “the dog ate my homework” excuse for lost documents, duplicate or other document mishaps and related lawsuits. Claims provenance could be automatically established and adjudicated by so-called “smart contracts” (in the most general sense, they are protocols that have deterministic outcomes) in real time with an easily auditable and immutable trail. Identity proof would be less onerous. Those developments alone go a long way to reducing fraud and risk and their associated costs.

While modernizing claims processes is not a “sexy” thought, it is one that directly affects all insurers and their bottom lines by reducing risk. A small shift in the actuarial calculation based on a risk reduction goes a long way. There is not a business person on earth who does not want to increase revenue.

While there is a lot of hype, I believe we are only seeing the beginning of its potential. Education is needed. Imagination is needed. And innovation and execution are needed. The financial services industry has looked at this technology over the past year and is engaging with it, and some practical applications are expected to go into production in 2017. Insurers/asset managers should take notice. For instance, Delaware will begin using blockchain technology for UCC filings powered by Symbiont. Financial industry regulators, both domestically and internationally, are evaluating this technology and are listening and learning. In part, we owe the financial services sector a debt of gratitude for creating awareness overall.

Generally speaking, insurers have been slow to the table to learn about this technology, but it is imperative that they engage as early as possible because DLT has the potential to be very valuable for them. Some reinsurers already understand this and are experimenting. The diamond industry understands this and is experimenting with digital representation of hard assets on a blockchain for asset management and insurance purposes through Everledger. Other insurers have made some attempts to test similar concepts.

Indeed, the insurance industry can benefit on more than just the claims side.

We all know customer acquisition is the most uncertain and expensive part of the process in any business. Well-designed digital processes can prove invaluable in customer acquisition and retention. On the front end of the insurance industry, smart contracts can aid in creating easy-to-manage customer policies, which can be fed into databases and tailored and segmented in any way that makes business sense. Data management and security can be enhanced using blockchain technology. In fact, the Estonian company Guardtime has embraced the cyber security end of this technology and evolved a keyless signature infrastructure (KSI) that DARPA is verifying.

See also: Blockchain: What Role in Insurance?  

Blockchain/DLT technology is not a panacea for all. But it is worth exploring as the technology evolves. We are at an inflection point in the development of this technology—a point in time where insurers and others can have a say in how it evolves. Once standards emerge and practical applications are in production, it may be too late.

Time to get on board, insurers, and weigh in! All you need do is participate to make sure your interests are heard and accounted for.

To the insurance industry, I ask you: How do you see this technology affecting insurance?