The application of blockchain to financial services makes a lot of sense. Blockchain technology is excellent for financial transactions, establishing trust between different parties, and settling disputes. All of these are frequent occurrences in the financial industry. But, what’s lesser-known is the benefit of using blockchain technology for reinsurance. Let’s take a look.
What Is Reinsurance?
Reinsurance is essentially insurance for insurers. Reinsurers are separate companies that underwrite the insurance of policies that another insurance company, known as the cedent, have already sold.
For instance, say that Insurer A has insured a business against all damages it incurs. In the case of a natural disaster such as terrible flooding or a hurricane, the business might suffer losses in the billions of dollars. Oftentimes, Insurer A will not have the assets or liquidity to cover this cost without going bankrupt. In order to still offer insurance while also avoiding bankruptcy, they pay another insurer or specialist reinsurer to take on some of this liability.
This practice allows smaller insurers to increase their revenue without risking financial collapse in the event of such a claim.
The process can actually be taken a step further through the introduction of another party called the retrocessionaire. Retrocession allows a reinsurance company to further share the burden of a policy with yet another reinsurance company.
Why Use a Blockchain?
The industry believes that blockchain could help make significant cost savings, increase transparency, and lower settlement times as well as add a layer of security that was previously impossible. In fact, PwC estimates that blockchain could save the industry between $5-10 billion.
Let’s dig into some of the areas that blockchain could help.
Blockchain is very good at automating tasks previously done by humans. It would be possible to use smart contracts in place of much of the existing paperwork in the industry.
PwC’s analysis has concluded that blockchains could eliminate between 15 – 25 percent of expenses. This reduction would be achieved by automated data processing, leading to a reduction in fraud, resulting in cost savings.
If companies implemented a consortium blockchain, they would be able to keep the information contained to just those with permissions. At the same time, they would ensure that all parties could gain complete transparency over transactions and smart contract executions.
As the reinsurance and retrocessional chain gets longer, it becomes harder for the original insurer to keep track of which parties hold what liabilities. By participating in a shared blockchain, all the parties can see exactly how and to whom risk is distributed. When the insured then puts in a claim, both the claim and the settlement between all parties can be concluded far quicker and with fewer disputes.
This greater transparency and access to reliable data means that all parties can maintain more accurate risk models.
Since a blockchain is immutable, that is its data cannot be altered, it offers an extremely high level of security for reinsurers. Industry leaders hope that it could reduce fraud both internally and between companies.
More centralized consortium blockchains are able to achieve high throughput and speed because they consist of fewer nodes. By using such a blockchain the reinsurance industry could significantly speed up settlements between parties. This should no doubt lead to higher standards and overall improvement for the entire industry.
Not only would blockchain offer a faster settlement layer but by removing the need for human interaction, payments could actually be automated between participating companies.
An Appropriate Type of Reinsurance Blockchain
Many of the benefits we have gone over so far depend on the type of blockchain that companies use. It’s highly unlikely that reinsurance companies will choose to operate on a public blockchain like Ethereum. If they were to do so, they would not only be limited to operating with the native asset of the blockchain, but all transactions would be publicly visible.
Instead, it’s far more likely they will use a federated or consortium blockchain. This approach means that only approved companies can participate both in terms of inputting new data and reading the blockchain itself. This ensures that only participating companies have access. The risk here, though, is that its more centralized design leaves open the door for some nodes to conspire with each other and change the blockchain, undermining the immutability and security coveted by the industry.
This, of course, is not a given and we will have to assess every proposal on its own merits.
Blockchain adoption is currently being led within the reinsurance industry by a consortium called B3i. They were founded in 2016 and currently consist of 38 members from across the globe. Their main purpose is researching applications of blockchain for reinsurance.
By joining as one group, the intent is to agree upon a common standard that can be easily used by all companies. It would be nearly impossible to collaborate with multiple different blockchain methods.
B3i is currently working on its prototype product, which they expect to move into full production in the near future. The product handles all calculations, settlements, and reporting through a Hyperledger design. It actually operates three different blockchain levels.
Every party has its own private blockchain on which it stores its contract data. There is then a master data blockchain that stores company information and general contract clauses. Finally, the shared communication blockchain contains the communication that agrees and verifies the state of each private blockchain.
It allows all parties, including reinsurers and cedents, to execute their contracts and encrypts all communication between the parties. In addition, the cedent can request quotes to all the parties and carry out communication until all parties agree on and sign the contract.
B3i’s product is certainly intriguing and we will have to wait to gauge its success until it is released for full deployment. Of course, without the game theory consensus mechanisms like proof of work and proof of stake, it’s hard to see how it can guarantee the level of immutability and security seen on public blockchains.
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