Blockchain Technology and Smart Contracts for Reinsurance


Image from Wikipedia

This is a guest post by Howard Tolman

So the old and politically incorrect joke goes, If you’re in Ireland and you ask an Irishman how do I get to “so and so”, you’ll probably get the response that it all depends on where you’re starting from.

The same thing applies to the usefulness of Blockchain combined with Smart contracts in Commercial Reinsurance.

So where would you start from?

Reinsurance is insurance that is purchased by an insurance company from one or more other insurance companies (the “reinsurer”) directly or through a broker as a means of risk management.

Almost all insurance companies have a reinsurance program. The ultimate goal of that program is to reduce their exposure to loss by passing part of the risk of loss to a reinsurer or a group of reinsurers.

The ceding company and the reinsurer enter into a reinsurance agreement which details the conditions upon which the reinsurer would pay a share of the claims incurred by the ceding company. The reinsurer is paid a “reinsurance premium” by the ceding company, which issues insurance policies to its own policyholders.

Ceding companies often choose their reinsurers with great care as they are exchanging insurance risk for credit risk.

The reinsurer may be either a specialist reinsurance company, which only undertakes reinsurance business, or another insurance company.

A healthy reinsurance marketplace helps ensure that insurance companies can remain solvent (financially viable), particularly after a disaster such as a major hurricane, because the risks and costs are spread and there’s sufficient capital available in the event of claims.

Many reinsurance placements are not placed with a single reinsurer but are shared between a large number of reinsurers. The reinsurer who sets the terms (premium and contract conditions) for the reinsurance contract is called the lead reinsurer; the other companies subscribing to the contract are called following reinsurers. Alternatively, one reinsurer can accept the whole of the reinsurance and then retrocede it (pass it on in a further reinsurance arrangement) to other companies.

This is an enormously complicated process with many prior dependencies that are difficult to monitor and follow back to the original source.

Some people would look at this and probably compare it to the subprime mortgage crisis in the United States, where a complex series of opaque and illiquid financial instruments were sliced and diced into a series of increasingly complex derivatives, the notional value of which ended up being many times greater than the size of the underlying mortgages.

When homeowners, who were the people responsible for paying the underlying mortgages, defaulted on those mortgages, investors in these derivatives (collateralized debt obligations (CDOs), CDOs-squared, synthetic CDOs, credit default swaps, etc.) lost a lot of money.

So what could have prevented this? One theory is that had Blockchain-enabled smart contracts been used in the financial system, there would have been fewer opportunities for this to happen as the problems through the chain could have been instantly highlighted as they began to occur.

As smart contracts reside on a Blockchain, they allow a real-time auditing of who owns what.

Smart contracts and all of the transactions (including those transactions that create derivatives from underlying assets) would be fully auditable; in this case you would know who owned what tranche of a CDO, who issued which mortgages that made up the different tranches of the CDO, and, even, if the system were designed well, which homeowner signed which mortgage documents.

Is this the way of the future for reinsurance in making sure potential claims are properly covered using Blockchain and Smart Contracts? Possibly. Not yet a mature model, but heading in the right direction and very much better than what exists currently. Needs a few more real live solutions and an increase in new features and functions; as the recent hack of the Ethereum blockchain technology clearly demonstrates.

Blockchain as a technology – it’s great but it’s a bit “immature and under the hood” – and it really has to start making real businesses significant money or provide asset protection or significant cost saving, otherwise it will be slow to take off. But there is not any doubt it will be able to play a major role.

So back to the original question where would you start from?

As the technology matures,  Blockchain type technology and Smart contracts can be used to initially  manage post-trade lifecycle events for Primary Risk and thus the source for Reinsurance including payments, amendments, novations and claims.

So besides a synchronized, distributed “golden record” of transactions on the blockchain, smart contracts will provide economic terms, as well as computational logic to monitor and flag and manage permissions and control event processing to ensure possible similar unfettered activity in Reinsurance as happened in subprime mortgage crisis is a thing of the past.

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  1. Exiting prospective. What is unclear to me is how to manage in a smart contract the complexity of the various wordings applied today to regulate those risk transfers. How to manage this?

    • My understanding is that the complexity of the wording would become essentially redundant in smart contracts. The contract behaves according to the algorithm and decentralised consensus. The algorithm is programmed to take certain actions upon consensus etc. The complex wording is used to design the allocation of legal risk (including and especially in the event that litigation occurs). This becomes irrelevant when the contract manages the risk for you.

      • Agree. There are attempts at what I think of like Composable contracts – put them together like Lego

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