The future of smart contracts in insurance

Publication | September 2016

Introduction

Smart contract technologies underpinned by blockchain technologies could have a transformative impact on the insurance market. There are, however, a number of factors that could impede the uptake of smart contracts. 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.

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, know your customer, anti-money laundering 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).

Lower costs

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 policy-holders will get paid more quickly 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.

Short-term risks

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 peer-to-peer transactions as well as business-to-consumer and business-to-business.

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, smart contracts or hybrids between “old-fashioned” and smart contracts are likely to be used more widely, including in the retail market. There is already a range of Internet of Things-related insurance products on the market, such as “smart home” products, where developers are looking to use smart contracts to connect the devices with the underlying insurance policy.

Impediments

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 made worse by insurance-specific nuances such as pre-contractual disclosure obligations. Insurance is also a regulated market and so the concerns of regulators, particularly in relation to consumer outcomes, must be considered and catered for. Added to that, there are difficulties arising from the fact 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 was first published in Insurance Day.


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