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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.

Complexity Theory Offers Insights (Part 1)

In the first of this series of four segments, we will look at the current state of the risk markets and the insurance industry; the emerging peer-to-peer (P2P) segment of the risk markets; how blockchain technology is enabling a new taxonomy in the risk markets; and what changes may occur as a result of these new technologies and methods.

The purpose of this series hails from the open source movement in the software industry. Key to the open source philosophy is the transparent and voluntary collaboration of all interested parties. While this work has been kept fairly close to the vest for the past few years, I have taken meetings with two Fortune 500 insurance companies’ strategy and venture teams, both of which asked for a proof of concept — as well as with a handful of other large international insurance companies and one of the big four accounting firms.

At the other end of the spectrum, I have also spoken with other founders of P2P insurance startups around the world, and I have participated in the communities surrounding blockchain technology. I feel that these handful of folks have already enjoyed early access to these concepts, and my motivation with this series is to achieve a more level playing field for all parties interested in the future of the risk markets.

There are links at the bottom of this article to join the conversation via a LinkedIn group and get access to the whole series.
To begin, let’s take a look at the current state of risk markets. It is important to distinguish between drivers of economic systems and the impact they have on business models in the industrial age vs. in the information age.

See also: Should We Take This Risk?  

Hardware and technology was a key driver throughout the industrial age, which saw a growing batch of new technologies — from cars and planes, to computers and smart phones, to industrial robots, etc.

Industrial age business models were almost always “extractionary” in their nature. The business model engages with some market, and it profits by keeping some portion of the market’s value.

Extracting value from the market

The strategies of the industrial age were:

  • Standardization — interchangeable parts
  • Centralization — big factories, vertical integration, economies of scale
  • Consolidation —an indication that an industry is about to experience a phase change

In the information age, business models almost always embody some creation of “network effect.” When the business model engages with a market, the individual actors all benefit as more actors engage with the business model. The value creation is usually tied to a network’s graph, and the value creation will grow exponentially as the network’s density grows.

Creating value for the market, not extracting value from the market

The strategies and efficiency-drivers in the information age are:

  • Cheap connections — enabling multiple paths through the network’s graph
  • Low transaction cost — in terms of time, effort and money
  • Lateral scaling — not vertical structures, which will be flattened out (“top down” increases network fragility)
  • Increase in node diversity — and in the ways each node can connect

All of these drivers lead to increasing network density and flow. Things are moving away from large, brittle centralized organizational structures and toward “distributed,” P2P, “crowd” or “sharing economy” types of organizational structures.

Moving away from command-and-control organizational structures is almost impossible for organizations that profit from efficiency gains derived from a centralized effort. It is this attribute of their business model that necessitates startups and new business models coming in and bringing improvements to the market — challenging incumbent economic and business models.

The information age is all about networks (not technology), and building graphs that create positive network effects.

The conceptual framework best suited to understanding networks and the networked world we now live in is complexity science. The study of complex adaptive systems has grown out of its roots in the 1940s and has proliferated since the 1990s and the explosion of computer networks and social networks. Here is an introduction:

When looking at complex systems, we start by looking at the system’s graph. To get an idea of what a graph is, let’s look at a few examples of “graph companies.”

  • Facebook built the “social graph” of acquaintances; it did not create acquaintances.
  • Linkedin built the “professional graph” of coworkers and colleagues; it did not create coworkers and colleagues.
  • Google built the “link graph” for topics searched; it did not create back links for the topics searched.

Notice that, in each of these cases, the company built and documented the connections between the things or nodes in the network and did not create the things or nodes themselves. Those already existed.

To start looking at the risk markets, we must first understand what is being connected or transferred between the nodes (a.k.a. the users). It should be of little surprise that, in the risk markets, it is risk that is being transferred between nodes, like a user transferring risk to an insurance company. In terms of risk graphing, there are currently two dominant graphs. A third is emerging.

Let’s take a look at the graphs that make up the risk markets and the insurance industry.

  1. Insurance — is the “hub and spoke” graph.
  2. Reinsurance — is the decentralized graph connecting risk hubs.
  3. P2P Coverage — will be formalized in a distributed graph. (This is the one that does obviously not exist formally, but, informally, you see people calling parents/friends and using GoFundMe/their church/their office/other community organizations to spread risk out laterally.)

In today’s risk markets, insurance companies act as centralized hubs where risk is transferred to and carried through time.

The reinsurance industry graph is enabling second-degree connections between insurance companies, creating a decentralized graph. In the current industry’s combined graph structure or stack, only these two graphs formally exist.

While an insurance company’s ledgers remain a hub where risk is transferred to and carried through time, reinsurance enables those risk hubs to network together, achieving a higher degree of overall system resilience.

See also: Are Portfolios Taking Too Much Risk?  

The P2P distributed graph currently exists via informal social methods.

Stack all three graphs, and you can observe how total risk is addressed across all three graph types. Each has its strengths and weaknesses, which leads to its existing in its proper place within the risk markets.

The fact that insurance as a financial service gets more expensive per $1,000 of coverage as coverage approaches the first dollar of loss means that, as a financial service, there is a boundary where insurance’s weaknesses will outweigh its strengths.

My expectation is that much of the risk currently being carried on the hub-and-spoke insurance graph will accrue to the P2P distributed graph because of improved capital efficiency on small losses via a trend of increasing deductibles. This may lead to some of the risk currently carried on the reinsurance decentralized graph being challenged by centralized insurance.

The proportion of total risk — or “market share” — that each graph carries will shift in this phase change.

When people say insurance is dropping the ball, they are expressing that there is a misunderstanding or poor expectation-setting about how much of total risk the first two graphs should be absorbing. Users are unhappy that they end up resorting to informal P2P methods to fully cover risk.

To increase the resilience of society’s risk management systems and fill the gaps left by the insurance and reinsurance graphs, we need the third risk distribution graph: a distributed P2P system.

Society needs a distributed system that enables the transfer of risk laterally from individual to individual via formalized methods. This P2P service must be able to carry un-insurable risk exposures, such as deductibles, or niche risk exposures that insurance is not well-suited to cover.

Much of this activity already occurs today and, in fact, has been occurring since the dawn of civilization. KarmaCoverage.com is designed to formalize these informal methods and enable end users to benefit from financial leverage created by the system’s network effect on their savings.

When observing a system through the complexity paradigm, another key measure to observe is a system’s level of resilience vs. efficiency. Resilience and efficiency sit on opposite sides of a spectrum. A system that is 100% resilient will exhibit an excess of redundancy and wasted resources, while a system that is 100% efficient will exhibit an extreme brittleness that lends itself to a system collapse.

When we look at the real world and natural ecosystems as an example, we find that systems tend to self-organize toward a balance of roughly 67% resilient and 33% efficient. Here is a video for more on this optimum balance.

Industrial-age ideas have driven economics as a field of study to over-optimize for efficiency, but economics has, in recent years, begun to challenge this notion as the field expands into behavioral economics, game theory and complexity economics — all of which shift the focus away from solely optimizing for efficiency and toward optimizing for more sustainable and resilient systems. In the risk markets, optimizing for resilience should have obvious benefits.

Now, let’s take a look at how this applies practically to the risk markets, by looking at those three industry graphs.

Centralized network structures are highly efficient. This is why a user can pay only $1,000 per year for home insurance and when her home burns down get several hundred thousand dollars to rebuild. From the user’s point of view, the amount of leverage she was able to achieve via the insurance policy was highly efficient. However, like yin and yang, centralized systems have an inherent weakness — if a single node in the network (the insurance company) is removed, the entire system will collapse. It is this high risk of system collapse that necessitates so much regulation.

In the risk markets, we can observe two continuing efforts to reduce the risk of an insurance system collapse. We observe a high degree of regulation, and we see the existence of reinsurance markets. The reinsurance markets function as a decentralized graph in the risk markets, and their core purpose is to connect the centralized insurance companies in a manner to ensure that their inherent brittleness does not materialize a “too big to fail” type of event.

Reinsurance achieves this increase in resilience by insuring insurance companies on a global scale. If a hurricane or tsunami hits a few regional carriers of risk, those carriers can turn to their reinsurance for coverage on the catastrophic loss. Reinsurance companies are functionally transferring the risk of that region’s catastrophic loss event to insurance carriers in other regions of the globe. By stacking the two system’s graphs (insurance and reinsurance), the risk markets’ ability to successfully transfer risk across society has improved overall system resilience while still retaining a desired amount of efficiency.

Observations of nature reveal what appears to be a natural progression of networks that grow in density of connections. Therefore, it makes sense that the reinsurance industry came into existence after the insurance industry, boosting the risk markets’ overall density of connections. Along the same line of thought, we would expect to see the risk markets continue to increase in the density of connections from centralized to decentralized and further toward distributed. A distributed network in the risk markets will materialize as some form of financial P2P, “crowd” or “sharing economy” coverage service.

A network’s density is defined by the number of connections between the nodes. More connections between nodes mean the network has a higher density. For example, a distributed network has a higher density of connections than a centralized network. However, a higher density of connections requires more intense management efforts. There is a limit to how much complexity a centralized management team can successfully organize and control.

See also: 5 Steps to Profitable Risk Taking  

When a network’s connections outgrow centralized management’s capacity to control, the network will begin to self-organize or exhibit distributed managerial methods. Through this self-organization, a new graph structure of the network’s connections will begin to emerge. As this process unfolds, an entirely new macro system structure will emerge that shows little resemblance to the system’s prior state, much like a new species through evolution.

What emerges is a macro phase change (aka “disruption”) that does not necessitate any new resource inputs, only a reorganization of the resources. For example, the macro state of water can go through a phase change and become ice. The micro parts that make up water and ice are the same. The macro state, however, has undergone a phase change, and the nature of the connections between the micro parts will have been reorganized.

In his book “Why Information Grows: The Evolution of Order from Atoms to Economies,” MIT’s Cesar Hidalgo explains that, as time marches forward, the amount of information we carry with us increases. That information ultimately requires a higher density of connections as it grows. This can be understood at the level of an individual who grows wiser with experiences over time. However, as the saying goes, “The more you know, the more you know you don’t know.”

In the history of human systems, we have observed the need for families to create a tribe, tribes to create a society and society-organizing-firms to achieve cross-society economic work. We are now at the point of needing these firms to create a network of firms that can handle increased complexity and coordination.

It is this network of firms that will be achieved via distributed methods because no individual firm will ever agree to let another single firm be the centralized controller of the whole network — nor could a single firm do so.

In the next segment of this series, we will look more closely at the distributed graph that will become formalized, creating a P2P system in the risk markets.

I have started a LinkedIn group for discussion on blockchain, complexity and P2P insurance. Feel free to join here: https://www.linkedin.com/groups/8478617

If you are interesting exploring working with KarmaCoverge please feel free to reach out to me.