[This is a multi-part series covering blockchain technology and its transformative impact on the insurance industry. In part 1, we reviewed the WHY and WHAT of blockchain. In part 2, we discuss smart contracts and their implications on the entire insurance value chain.]
The concept of smart contracts dates back to 1994, when Nick Szabo – a cryptographer widely credited with laying the groundwork for bitcoin – first created the term “smart contract.” A smart contract is essentially a computer program set up with all the conditions agreed to by the parties involved and can automatically execute the terms of a contract. Like normal contracts they help you exchange money, property, shares, or anything of value but do so in a transparent, conflict-free way while avoiding the services of a middleman. For example, pharmaceutical and medical device companies have used software programmed with a contract’s conditions to monitor ERP and other systems and issue rebates and chargebacks depending on their sales channels meeting or exceeding certain conditions.
A smart or automated contract works like any other software’s “if-then” statements but, in this case, it works with real-world assets. When a pre-programmed condition is triggered, the smart contract executes the corresponding contractual clause.
Today’s current technology has made smart contracts more powerful and relevant due to:
- Access to finance tools via the internet
- Access to sensors and live data streams in the physical world, aka “Internet of Things”
Imagine creating an insurance policy that protects a homeowner from flood damage. You create a smart contract that is connected to the government’s data feeds for water levels in the homeowner’s district. Additionally, you install water sensors in the basement of the homeowner’s house. A flood occurs, the data feeds report rising water, the sensors in the basement go off and the policy automatically issues a payment directly to the homeowner’s bank account without any human intervention.
So, what makes blockchain1 relevant to smart contracts?
- Blockchain provides a single ledger as a source of trust
- Blockchain increases management efficiency due to its accuracy, transparency, and automated system
- Blockchain supports cost reductions due to eliminating middlemen; There is only one ledger, one source of truth accessible by designated parties
Applications for smart contracts on blockchain can help you exchange money, property, stock, or any asset of value in a transparent, frictionless way while eliminating the services of a broker/ agent.
There are a number of current applications, including peer-to-peer flight insurance. Insureth.mkvd.net has implemented a flight insurance policy application built on blockchain using smart contracts. Payouts are initiated when cancellations or delays are reported from verified flight data sources such as the airline web sites. Another InsurTech startup, DynamisApp.com, has developed a supplemental unemployment insurance application that uses social network profile data (think LinkedIn.com) for verification of the employer’s status. Here smart contracts are automating the underwriting of policies and claims handling and combines the approvals and verifications from other policyholders, who are designated as evaluators.
What are the benefits of using blockchain for smart contracts?
- Automation of claims handling of reconciliation and verification of transactions
- Reliable and transparent payout mechanism
- Fairly enforce contract-specific rules with no/minimal intervention
- Act as a complement or substitute for legal contracts
Now let’s expand our view by considering the “Internet of Things,” (IoT) defined as “the interconnection via the Internet of computing devices embedded in everyday objects, enabling them to send and receive data.” The IoT universe is large and growing:
- 46 million wearables
- 534 million Bluetooth accessories
- 2.7 billion computing devices
- 8.0 billion RFID chips
- 21 billion microcontrollers
- 80 billion apparel items
- 5-10+ trillion consumables
From a commercial perspective, “Industrial Internet of Things” (IIoT) is an important technological breakthrough. IIoT incorporates machine learning and big data technology, harnessing the sensor data, machine-to-machine (M2M) communication and automation technologies that have existed in industrial settings for years.” IIoT is a major trend with significant implications for the global economy spanning industries representing 62 percent of gross domestic product (GDP) among G20 nations, according to Oxford Economics2. Conservative estimates of spending on the IIOT are expected to reach $500 billion by 2020 and optimistic predictions of the value created by the IIoT range as high as $15 trillion of global GDP by 20303.
For insurance purposes, smart contracts can be used across industries and be made to connect to consumers’ car, electronic devices or home appliances having their own insurance policies registered and administered in a blockchain network. These smart contracts will automatically detect damage and then trigger the repair process, as well as claims and payments.
Think smart contracts are still waiting to happen? Then you are already behind the eight ball. In 2015, the Depository Trust & Clearing Corp. (DTCC) used a blockchain ledger to process more than $1.5 quadrillion worth of securities, representing 345 million transactions. UPS just recently announced it has joined the Blockchain in Trucking Alliance (BiTA) to look at increasing transparency and efficiency among shippers, carriers, brokers, consumers, vendors and other supply chain stakeholders. UPS could create a contract that programs “if” a payment is received on delivery, “then” notify the manufacturer or warehouse many levels up the supply chain, to create or order a new item.
But smart contracts based on blockchain have had some significant problems. Early this year a Canadian exchange accidentally trapped $14 million in its own broken smart contract4. Another form of smart contract, known as a “multi-signature wallet” (think joint account) that was based on the Ethereum platform5, allowed hackers to run off with $32 million6. And recently a new version of the wallet became frozen to the tune of a total of more than $USD150 million due to a hacker7.
Despite these risks, the world is moving forward with smart contracts. So much of the digital transformation in insurance relies on data, and blockchain technology has the ability to enable almost all data-related transactions for an insurer through so-called smart contracts. Since the contract is digitally powered, it creates efficiency in the entire insurance value chain wherever time, effort or money is spent to confirm information before processing transactions. Further, insurance contracts are typically difficult to understand because of industry complexities and legal jargon. In an industry facing shifting consumer expectations (and consumer-friendly regulations such as Treating Customers Fairly), smart contracts can help manage of claims in a highly transparent and responsive way. Stay tuned for our next installment in this Blockchain Simplified series – Reinsurance.
2Global Industry Databank, accessed on June 12 2014. Copyright Oxford Economics Ltd.
3David Floyer, “Defining and Sizing the Industrial Internet,” Wikibon, June 27, 2013; Peter C. Evans and Marco Annunziata, “General Electric: Industrial Internet, Pushing the Boundaries of Minds and Machines,” November 2012.
4Ethereum Client Update Issue Costs Cryptocurrency Exchange $14 Million
5What is Ethereum? A Step-by-Step Beginners Guid
6$32 million worth of digital currency ether stolen by hackers
7Accidentally Killed It’: Parity Wallet Bug Locks $150 Million in Ether