October 15, 2014
What Insurers Need to Know About Bitcoin
by Dan Robles
The technology behind the crypto-currency can be applied in ways that mean just about anyone with the title "broker" should be concerned.
A bitcoin (lowercase b), as a currency, has several flaws that will continue to limit its ability to replace money, as we know it. There are millions of words published on the subject, so I’ll leave it to the reader to assess arguments on both sides. However, Bitcoin (upper case B) as a protocol for the transfer of value is an extremely important innovation that the insurance industry would be wise not to ignore.
This article looks at the issue from the point of view where the insurance industry meets the engineering profession; this combination could be where some of the most important and valuable new opportunities arise.
The Block Chain Protocol (BCP)
The Block Chain Protocol is a brilliant innovation that cannot be un-invented – it is here to stay, and it will appear in many forms long after it sheds its association with so-called crypto-currencies. Bitcoin was designed to solve an age-old problem: the possibility of spending multiple times a promissory note such as currency. In the case of virtual currency, the problem is especially acute because a currency created on a computer can be easily copied by a computer.
The BCP can be compared to a train leaving the station. When the train arrives, the door opens and everyone piles in. After a predetermined amount of time, the doors close. While the doors are closed – and only while the doors are closed – the people write contracts for each other to agree upon. When the doors open, everyone piles out, but the contracts stay. Soon after, the doors close forever.
After the doors close, absolutely no changes can be made, ever. Any changes must be renegotiated as part of a new “block” in a continuing “chain” of transactions. This prevents someone from printing “money”, i.e., issuing the same contract to many recipients.
Today, this function is performed by a legal system, brokers and intermediaries such as banks and credit agencies – it is easy to see how these institutions would be concerned that an upstart technology that is fully decentralized with no CEO or corporate structure could literally exterminate their brokerage fees. (While I used a mechanical analogy of door and trains, the BCP operates using time stamps and cryptography to manage identities, ownership, vetting, etc.)
The big deal with bitcoin as a currency is that the value of a contract can be cast in time. The “crypto-currency” simply represents that value outside of the block for that exchange inside of the block.
Many people, including the media, get hung up on the idea of currency because that is something that obviously concerns everyone in the age of impending financial doom. However, one must not be fooled by hype nor remain complacent and hope the bitcoin issue it will go away. The BPC is here to stay, and there are thousands of them in existence, not just bitcoin.
Yes, this means threats to the status quo, but there are also great opportunities for those who learn how to use smart contracts to transmit value without institutional friction. The part that the insurance industry should be concerned with is the ability to transmit contracts.
When contracts are executed on a block chain and locked cryptographically, these are called “smart contracts.” The seminal work on smart contracts was written by Nick Szabo and introduced in this 1997 primer: The Idea of Smart Contracts. The remainder of this article will focus on one very important type of smart contract: the adjudicated smart contract partnering the insurance industry and the engineering profession.
Adjudicated contracts are contracts involving three parties: the insurer, the insured and the adjudicator. The insurance adjuster should immediately come to mind, but the work of the adjudicator is much more flexible.
In an insurance claim, there is often a forensic investigation involved. In many cases, the investigation may reveal failures of design, quality, defects and workmanship and moral hazard. When a payout is warranted, claim money is drawn for reconstruction and remediation per a contract.
The insurance industry depends on actuarial statistics and forensics to manage these risks. What if forensics could be performed and actuarial data compiled before the failure occurs?
Adjudication can be integrated directly into the performance contracts as the project is designed and built. Licensed professional engineers can “flip the switch” that releases funding or seal coverage for specific perils as they oversee the design/build contracts during design, construction and service life of a property. This would allow insurance companies the ability to price risk and adjust exposure pools with extreme accuracy.
Assurance by Design
In other words, it is possible to develop Block Chain Smart Contracts. My firm is doing this for the engineering, construction and property management industries. The concept is to codify current standard contract templates, such as AIA contracts, into a series of smart contracts on a cryptographic block chain. Contractual events will correspond to payment milestones underwritten by bank and insurance institutions. As each milestone is reached, the professional engineer will verify the proof of work and flip the switch that released the contract to the next insurable component.
The Insurance Industry Is Threatened
Today, many insurance companies are not too concerned with construction risk as long as it is priced correctly. What the insurance industry may not realize is that if too many good properties are subsidizing too many bad properties, private parties with good properties will use these adjudicated contracts to self-insure. For example, if a 250-unit, high-rise condo spends $4 million on a new potable water system and the insurance premiums are not discounted accordingly, the condo could now easily form its own risk-sharing pool with communities known to have new water systems.
With Block Chain Protocol technology and readily available data, almost anyone can now form an insurance pool.
The challenge then for the insurance industry is to use new technologies to build more and better insurance products using the legacy tools that they are built on and rapidly adopting new technological solutions that are now available to them.
The Block Chain Protocol may be one of the most important innovations of the digital age. Pretty much anyone with the job title of “broker” should be seriously concerned.
History provides countless examples of companies and industries that failed to adapt to new changes. For this reason, insurance should take the Block Chain Protocol very seriously. The technology is simple by design and only requires some creative adjustment and strategic partnerships to assimilate into the business plan.
Nobody will do it for us. We need to do it ourselves.