Insurance industry investment in blockchain-type technologies to date has largely focused on the ability of these technologies to improve existing processes, for example record keeping and claims management and administration. Smart contract technologies underpinned by such technologies could have an equally transformative impact on the insurance market. There are however a number of factors that could impede the uptake of smart contracts.
Below we consider the key commercial, legal and regulatory issues which innovators of these technologies will have to consider as they move from proof-of-concept trials to commercially viable products which can be profitably commoditised.
What is a smart contract?
A smart contract is both an instance of coding and a software program that encodes performance conditions and outcomes. In its most extreme form, all the contents of a traditional contract could be written purely in code form within a smart contract, perhaps with no natural (spoken) language equivalent. Contractual provisions would in effect be replaced by code.
The performance of a smart contract is mediated by technological means. This means the release of payments and other actions are enabled by technology and rules-based operations. The smart contract is not reliant on a human third party or central operator.
Smart contracts are typically automatic and irrevocable. Once initiated, the outcomes for which a smart contract is encoded to perform cannot usually be stopped, unless an outcome depends on an unmet condition or specific rules have been provided to the contrary.
Nick Szabo is widely credited for inventing the idea of a smart contract. He gives the example of a drinks vending machine as something embodying its characteristics. When the money is paid, an irrevocable set of actions is put in motion. The money is retained and a drink is supplied. The transaction cannot be stopped in mid flow. The money cannot be returned when the drink is supplied. The transaction’s terms are in a sense embedded in the hardware and in the software that runs the machine.
Blockchain and smart contracts
The security and transparency afforded by blockchain technologies have been widely commented on, and there are clear applications for them without any smart contract aspect in insurance placement, data sharing, KYC, AML and fraud prevention, the claims process and claims and general insurance record keeping.
The modern conception of a smart contract typically depends on blockchain technologies. In simple terms, a blockchain is in effect a database that records each transaction in a “block”. Typically, each block contains a hash that is unique to, and references, the previous block in the “chain”. If any data in any block in the chain are later altered, this is immediately apparent to all participants of that blockchain, as that block’s hash (and that of any subsequent block) will no longer correspond to the later block’s record of that hash. The result is an indelible record.
Blockchain technologies are known as “distributed ledgers” as they operate on a distributed basis. That is to say, the record or ledger of all transactions is replicated in full on each participant’s computer. They are highly transparent, because each participant has a complete, traceable record of every transaction recorded on the blockchain.
Smart contracts operating within a blockchain operate on a distributed basis. The participants (which could be a party to, or have an interest in, the smart contract) have access to the block within which it is contained. The relevant block can be public (for all to view) or accessed on a “permissioned” basis (and so only open to limited participants with such permission).
Smart contract uses in insurance
The benefits of smart contracts in insurance are clear and in theory should reduce insurer costs and lower premiums for policyholders and, importantly, improve customer experience of insurance products.
Automated claims payment processes linked to smart contract technologies will mean policyholders will get paid more quickly than in comparison to today’s manual processes, where even non-contested claims payments can take weeks or months to be paid. Smart contract processes should reduce claims administration costs, the risk of fraudulent claims and lead to reduced administrative costs for the insurer. With data fed into such technologies, policy adjustments could be made automatically in response to certain pre-determined events or information received.
Smart contract developments in the banking sector are more progressed than those in the insurance market. Developments thus far have largely been limited to contracts such as ISDAs underpinning simple financial transactions such as swaps and trade finance deals.
In the next five years, we see smart contracts in the insurance sector being developed in relation to short term risks where there are clear parameters as to payment, the potential for disputes is low and the claims management process is uncomplicated or pre-determined.
In view of the upfront costs of setting up a smart contract transaction platform, we expect smart contracts will be largely limited to large short-tail commercial risks, particularly property and catastrophe risks, before they are used in more long-term markets or in the retail space. It is likely smart contracts will have applications in P2P transactions as well as B2C and B2B.
Insurance transactions where the actual payment trigger and contractual flow in relation to the insurance risk are simple, but which feature high upfront structuring and ongoing costs for both the beneficiary and underwriters as a result of having multiple participants or simply a complex structure, seem obvious candidates for the deployment of smart contracts.
An example of such a transaction would be an insurance-linked security cat bond covering weather or other risks with a parametric trigger, where the linking of loss to an event, rather than the actual loss of the insured, makes smart contract based automation a possibility. Under such transactions, pay-outs are triggered based on the physical parameters of a catastrophic event, such as wind speed, the location of a hurricane, or the magnitude and location of an earthquake. A leading global insurer has reportedly trialled a variant of such a transaction recently.
Over time, it is probable smart contracts or hybrids between “old fashioned” and smart contracts will be used in wider markets including the retail market. There is already a range of ‘Internet of Things’ related insurance products on the market, such as “smart home” products, where we understand developers are looking to use smart contracts to connect the devices with the underlying insurance policy.
Factors that could impede uptake of smart contracting
Although it is simple to automate a transaction, it is difficult to code in a smart contract what happens when parties to a contract do not perform as they are expected to or are simply in breach of a term of the contract.
In insurance, this problem is increased by insurance-specific contractual nuances such as pre-contractual disclosure obligations. Insurance is also a regulated market and so concerns of regulators, particularly in relation to consumer outcomes, need to be considered and catered for. Add to that the difficulties arising from the fact that decisions of underwriters and regulators are often of an extra-contractual nature.
Given the difficulties with automating such matters, it is possible that in the short term more complex matters may be a hybrid of smart contracts automating the deal fundamentals (such as payment) with a linked written document dealing with the more complex or sensitive aspects of the arrangement.
A key question for businesses looking at the technology is whether they are satisfying their legal and regulatory objectives. In particular, if they are seeking to enter into a binding contract they need to be satisfied that that contract is going to be legally binding and otherwise enforceable. The legal analysis may differ depending on (among other things) the type of smart contract deployed (for example, does the smart contract purport to constitute, or to merely perform aspects of, a contract?), the particular circumstances surrounding such use, and the applicable law determining the issue. Businesses proposing to use smart contracts would be well advised to obtain a regulatory and legal assessment for any deployment that is likely to pass the proof-of-concept phase.
Perhaps the main obstacle to smart contracts becoming the norm in the insurance market is that decision makers may not commit sufficient human and financial capital to their development. As smart contracts represent more of a revolution than an evolution in the way business is transacted, they will require significant strategic long term resources committed to their development.
This article first appeared in InsuranceDay.