Blockchain and Reinsurance: The new way to transfer risk.
The financial revolution has begun. Blueprints for decentralised institutions are being drawn up and certain securities are embracing the blockchain. In this article I want to talk about how Reinsurance will benefit from being placed on the blockchain. This article is part of a series on blockchain and finance that is potentially going to be sponsored by SmartCash. (More on SmartCash at the end of this article)
I’m going to start off with an explanation of what Reinsurance is. I’m then going to describe Non Fungible Tokens on the blockchain. I’ll conclude with how trading Non Fungible Tokens will make Reinsurance more efficient and the benefits that this will bring to society.
Reinsurance is when a party that has accepted a risk, transfers some or all of that risk to another party. Let me explain with an example.
An insurance company is set up to insure houses in Cape Town from fires. Home owners pay the insurance company a premium and they will receive a benefit from the insurance company if their house burns down. The insurance company understands the Cape Town market, they have relationships with the brokers in the city and they know how to market their service in such a way that it fits in with the local culture. However, the insurance company knows that a great fire could strike the city and burn down multiple houses. If this rare event was to occur, the insurance company wouldn’t be able to pay everyone their benefit due and they would become ruined.
An insurance company in Mexico City has the same problem and so does an insurance company in Rio. To address this problem a Reinsurance Company is set up that insures the insurance companies in Cape Town, Mexico City and Rio. The Reinsurance Company will be ruined if their is a great fire in all three cities at exactly the same time, but their actuaries assure them that the chance of this happening is very small.
The insurance companies have to give up substantial profit when they take insurance from the Reinsurance Company. Isn’t there a better way?
A Reinsurance Company is essentially taking risks from multiple locations and shuffling them together so that the risks become more independent of each other. If risks are independent then they reduce overall volatility of claims which is a good thing as it reduces the chance that the insurance company is ruined.
Let us look at a diagram:
Here we see that each insurance company insures some houses in their own city and transfers some houses to the Reinsurance Company. This is a centralized system and gives the Reinsurance Company the advantage when it comes to business negotiations.
Now compare it to this diagram:
Here we see that each insurance company is insuring some houses in their own city as well as some houses in other cities. The Reinsurance Company is still there to pick up any residual risk but this system is decentralised and removes the Reinsurance Company’s advantage over the Insurance Companies.
How can this be achieved? Most of us are familiar with Bitcoin, a fungible token that can traded over the blockchain. Fungible means mutually interchangeable. A Non Fungible Token has a unique set of parameters. Houses that are insured can be placed on the blockchain as Non Fungible Tokens (Smart Contracts).
Some of these parameters could be:
Location co-ordinates, City, Original Insurer, Value at Risk, Duration of cover, Premiums paid, Risks covered, Price, etc.
Insurance companies could then swap their Smart Contracts with other insurance companies in different parts of the world and achieve a more independent book of risks. They could also sell these Smart Contracts to Reinsurance Companies or they could even pay a Reinsurance Company to take the Smart Contract. The price for paying or selling a Smart Contract depends on its expected loss ratio that either an Actuary or an Artificial Intelligence calculates.
Insurance companies will still make sure the claim process is upheld even for houses that they sold off. This is because insurance is a long term business and each company will work hard to maintain integrity so that other insurance companies will do business with them in the future. The blockchain will help to make this process more efficient and transparent as the past entries are immutable.
So how does this benefit society? Well if insurers can better manage their risks at lower costs then they can afford to offer insurance to the people at lower premiums. This means more people will be able to enjoy the benefits of insurance and be able to live in a peaceful state of mind knowing that if their house is burnt down, not all is lost.
So how does SmartCash fit into the above discussion? SmartCash understands the importance of governance and community interaction. For a global reinsurance blockchain to be developed, a coalition of insurance companies is needed. Lessons can be learnt from the SmartCash community.
SmartCash also uses MasterNodes (they refer to them as SmartNodes). A Reinsurance Blockchain would most likely need a similar structure. These nodes keep a full copy of the blockchain in real-time and perform special functions such as instant transactions and governance. To get a SmartNode in SmartCash you need 10000 SmartCash (around $3000 at the time of writing). This financial commitment or collateral acts as a barrier to entry to prevent malicious attacks.
So a Reinsurance Blockchain could be modeled off of SmartCash’s. Each insurance company would be required to stake collateral and set up a Masternode. Governance and communication would be critical as how to adapt and improve the decentralised system. It would be different in the sense that this blockchain would facilitate the transferring of Non-Fungible Tokens in the form of Smart Contracts that resemble Insurance Contracts. Since everything is decentralised, the public might even be able to invest and purchase some of these smart contracts from insurers which would add diversification to their portfolios.
If you would like to learn more about SmartCash please visit: https://smartcash.cc/
You may also be interested in my upcoming posts:
- Blockchain and Foreign Markets: How international barriers have been broken down.
- Blockchain and Tax: How cryptocurrencies can invent a more efficient economy.
Or my previous post: