Blockchain, Distributed Ledgers, and Smart Contracts

June 10, 2019

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This year for the first time the National Bureau of Economic Research (NBER) organized a conference on the impacts of blockchain, distributed ledgers, and smart contracts on financial and insurance institutions, firms, and markets. As a member of the insurance markets group of NBER, I was invited to present on this subject, and to participate in an industry panel discussion.

My proposition was to start by reviewing four fundamental challenges that the (re)insurance industry faces. On the side of liabilities these challenges are primarily in the areas of managing climate and cyber risks and their respective coverage gaps. On the operational side, firms are faced with constant pressure to reduce costs and to increase market share and distribution scale. The principal point of my discussion was to establish how the attributes of distributed ledgers and smart contracts may address and contribute to the resolution of any of these industry-wide challenges.

What a Distributed Ledger Does Well

A distributed ledger has been described as “an asset database that can be shared across a network of multiple sites, geographies or institutions.” A distributed ledger with smart contracts can, by the very nature of its design, perfectly reflect the attributes of joint ownership of a (re)insurance contract, as it does with any other financial or trade contract. The network design of a distributed ledger of smart contracts as a joint ownership certificate—secure, immutable, and chronologically tracked, where even the minutest change needs to be accepted and validated by all parties involved—renders the nature of the contracting relationship between the insurer, reinsurer, broker, and regulator well.

Because all parties involved in the ledger own all certificates with equal ownership rights, blockchain is not currently well suited to solve scalability problems. An example would be supporting a large-scale distribution chain of index insurance to solve a coverage gap such as the lack of insurance penetration for farmers; small and medium income households; or businesses in the growing market economies.

The distributed ledger does not address well the one-to-many relationship that will be needed for an insurance distribution network of millions of index-based policies that undergo very little chronological change. The distributed ledger is, however, a perfect tool to support the relationship of a few entities with multiple shared certificates of many classes, where each entity or institution needs to have equal ownership rights of the contract. This perfectly describes the relationship between the insurer, broker, and reinsurer—which was the central argument of my presentation.

A Promising Future

The distributed blockchain ledgers’ fitness of purpose is understood in the industry and pilot projects are already under way. I suggested that a system can be designed where quantitative triggers and indices produced by a catastrophe model and a real-time catastrophe tracking software product will someday control the acceptance, rejection, modification, re/negotiation, and binding of smart contracts. In this context, I was able to bring up the pioneering work led by Gayatri Natarajan, Vice President, Product Management, at AIR on real time, open source, and transparency in delivering NAT/CAT software products.

In summary, I covered the promise of distributed ledgers in the form of attributes that will enhance the industry value chain from immutable record, mandatory collaboration, mandatory reconciliation, joint ownership and authority, mandatory replication, and evidence of tamper, to stickiness and difficulty to modify. I did not miss the opportunity to observe that seeing such a list Sir Arthur C. Clarke might have quipped that “any sufficiently advanced technology is indistinguishable from magic.”

The properties of distributed ledgers hold promise to decrease intra-organizational and operational frictions and costs, as well as the same class of costs between institutions partnering in complex and large contracts, which undergo frequent changes and require constant quantitative and legal monitoring. The multiple pilot projects being sponsored by the large brokers and (re)insurers will show in due time if this theoretical promise will hold to the test of market practices.

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