Solvency 2 on the Blockchain #regtech #insurtech


Image courtesy of SolvencyIINews

Solvency 2 is a massive headache for Insurance. It is compicated (leading to big investment in IT and new processes), but worse is that it forces Insurance companies to allocate more capital to low risk (aka low return) investments. In this note we look at where the puck is headed when Insurance moves from vertically integrated value chains (aka Insurance companies) to a network or marketplace model using blockchain technology.

Entrepreneurs 30 second Solvency 2 Briefing

  • Why: Protect consumers from insolvency of an Insurance company (ie they cannot pay on an insurance claim because they went bankrupt).
  • What: Specific to Insurance. Defines how much capital they need. Like Basel 3 but specific to Insurance rather than Banks.
  • When: Implementation during 2015, Live in 2016 .
  • Where: Specific to Europe (but some variant is likely to go global).
  • Takeaway: European insurers will be more conservative, which may make premiums go up but will also lessen chances of them not being able to pay a claim due to insolvency.

Basel 3 and Banks Analogy

Banks that need to allocate more capital to capital adequacy to avoid a run on the bank like in 2008, lend less and that left the market open to AltFi (aka Marketplace/P2P Lending).

AltFi unbundles the Deposit part of Banking from the Lending part of Banking.

The same could happen to Insurance.

Insurance is a two sided market – insuring & investing

  • Selling insurance & claims processing. This is the equivalent of Deposits in Banking. It is the source of cash flow (explains why Warren Buffet, who understands cash flow very well, loves Insurance).
  • Investing the premiums. This is like the Lenders in a Lending Marketplace. They could be Banks, Reinsurance, Hedge Funds, wealthy families etc – the full spectrum of the wealth market.

In the vision of a marketplace model for Insurance, investors can bid for the insurance premium. By bidding they are confirming total commitment to pay out a claim in the event that a valid claim is needed.

In the original insurance at Lloyds, the “names” were wealthy people who had unlimited liability who committed to paying Insurance claims. That way the people buying Insurance knew that the “names” had the capital when the time came.

Nobody wants unlimited liability. The modern alternative might be a Blockchain based smart contract with automatic payout and embedded escrow. Let me unpick that:

Automatic Payout Based on a Trustless Smart Contract

Consumers don’t need to trust an insurance company to pay a claim. The claim is automatically paid by a DAO smart contract.

This holds out a win/win promise. Customers know that payout is automatic and immediate (no more hassling for payout during the most stressful times when the bad event has actually happened). Insurance companies get two benefits:

  • Elimination of fraud. The Insurance company does not rely on the customer’s version of truth. There is independently verified data.
  •  Elimination of claims processing cost. This is a consequence of elimination of fraud.

For this to work, it has to be binary simplicity. An algorithm has to make a yes/no decision instantly. Something with complexity (such as who is at fault in an accident or whether a medical procedure is covered) needs human intervention (this will come later when independent oracle services mature).

One example of where we see that binary result is flight insurance. The flight was either cancelled or it was not. Blockchain systems use external data sources (e.g via the Oraclize service ) to get this proof of what happened.

One mainstream use case is Life Insurance. Life or death is pretty binary. Smart Contracts can look at online death registers and make payout to the designated account. Given the stress that grieving relatives are under, this would score high on Net Promoter Scores.

In more complex claims processes it is more about enforcing rules on where a customer spends the money. For example, in an auto accident, only go to these garages or in a ski accident, only go to these doctors. This is a win/win as the customer has confidence of getting reimbursement and the insurer gets lower and more predictable claims. Using geo location and smart phones it is pretty simple for the customer to make a decision where to go even in stressful situations and will take this action if there is 100% confidence in auto payout via a Blockchain resident smart contract. Ideally the vendor (garage, doctor etc) gets notification on their phone of incoming customer and notification from the smart contract of what they can charge, so the customer does not have to pay and reclaim later.

Blockchain embedded escrow

A simple way to look at Blockchain based smart contracts is as an escrow service. If money is in escrow, you know you will get the money when the payout is triggered. This is Solvency 2 on the Blockchain. Given how long real change takes, it will probably be Solvency 3 or Solvency 4. Networks always win in the end, but it can take a long time. How much needs to be in Escrow will be debated vigorously by regulators, their political masters and the Insurance and Wealth Management industry.

Daily Fintech Advisers provide strategic consulting to organizations with business and investment interests in Fintech. Bernard Lunn is a Fintech thought-leader.

One comment

  1. Blockchain insurance contracts are interesting, but the solvency margin will (probably) still exist with a Blockchain contract. This is because the regulator will want certainty that a customer will be paid out, and solvency capital is the way they make sure of this. To manage the capital down will require the involvement of large capital providers who can pool risks and provide the capital at an acceptable cost.

    To understand this, consider traditional life insurance. In a traditional life insurance contract, the insurer holds a reserve on its balance sheet equal to the probability that a person will die in the current year. This probability, and resulting reserve held in cash, is very low relative to the sum assured, allowing the insurer to invest excess premiums in higher yielding asset to generate a return.

    However, there is a risk that the person will die (even with very low probability) in the current year. If there were no diversification of risk and sharing of capital, the insurer needs to hold additional capital (equal to the full sum assured) in readily available (i.e. liquid, low yielding assets) to satisfy the regulator.

    On a large portfolio, risks can be diversified (i.e. the solvency capital and underlying risk can be shared across lots of life insurance contracts) creating a more efficient use of the capital and reducing the investment “cost” of the capital to the insurer and customer. This is why many life insurers reinsure the payout risk to reinsurers who “pool” risks across a larger portfolio and effectively allow different insurers to “share” capital.

    If a blockchain life contract exists, someone in the chain will still need to hold solvency capital. For example, if only 1 life insurance contract exists in the blockchain contract, the escrow account needs to match the full sum assured, and needs to be invested in (low yielding) cash, significantly increasing the cost of the contract for the insurer and customer and reducing its efficacy.

    To solve this problem, there are 2 conditions required:

    1) The blockchain contract needs to be backed by a risk taker with capital (eg a reinsurer or a large insurer). They will ensure the escrow account is kept “topped up” with cash in the event of a claim (as the claim will be paid instantly on the insurance event occurring), and will charge a fee for this risk. This reduces the amount that has to be held in escrow.

    For the reinsurer, the payout risk should be no different than any other life insurance contract, however the payment mechanism will need to be evaluated for additional (or reduced) risks compared to a standard life insurance contract. For life insurance, fraud on payout tends to be low, but it’s the underwriting upfront needs to be well managed.

    2) The blockchain contract will need a critical mass of customers to make it work.

    If there is only one customer, the account will either need to constantly hold the sum assured, or there will need to be a delay on the event occurring while the reinsurer transfers the sum assured into the escrow account. In this situation, it removes many of the benefits of the blockchain insurance (i.e. security and speed of payment). If there are many customers, the account can operate more like an insurer, e.g. holding an amount equal to the maximum payout on 1 insured life, and being topped up immediately by the reinsurer if there is a claim. This may need to be greater if more than 1 claim could occur in a given time period.

    Clearly, there is a lot to consider here, and solvency is just one aspect of it. What seems clear though is that bigger players (such as reinsurers) will need to back blockchain insurance contracts to make them viable, and competitive with traditional contracts. It also implies that scale matters.

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