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.