How Hybrid Smart Contracts Are Changing Insurance
The insurance space is changing fast, and it is time to pay attention. Climate change and high overall uncertainty are increasing the need for insurance products that work for everyone. Businesses rely on timely insurance payouts in the case of a sudden catastrophe. Yet, delayed payouts are a common occurrence in the industry because of the claims process, which is based on an adjuster’s subjective assessment of loss and damages (Zhou 2021). This mechanism is flawed because it does not provide fast enough relief. Moreover, the system relies on brand trust, which is problematic given the information asymmetry between policyholders and issuers. Hybrid smart contracts, which are already transforming the weather insurance landscape, can add a new dimension to the insurance industry that improves risk management globally.
Blockchain-based insurance is a form of decentralized finance (defi), which is powered by smart contracts running on blockchain networks like Ethereum. The Ethereum network is a platform for decentralized applications running without downtime and centralized authority. The network relies on a consensus mechanism whereby the majority of nodes must agree that a transaction is valid. Because the transactions are stored on a distributed ledger, the transactions are decentralized and tamper-resistant. Moreover, there is no downtime because the network does not run on a single machine. Network’s like Ethereum, therefore, provide a settlement layer for financial products that have clear clauses. Decentralized crop insurance contracts, for instance, aggregate weather data from multiple weather APIs and execute as soon as total rainfall exceeds a threshold. An API is a form of software that allows for the exchange of data. In the example mentioned above, a crop insurance smart contract can query Accuweather’s database via an API to verify total rainfall in the desired location. When a smart contract is connected to outside data sources like APIs, it is called a hybrid smart contract.
If-then statements are the foundation for both hybrid smart contracts and parametric insurance, which has been around since the 90s. Traditional insurance protects against losses sustained during an event, whereas parametric insurance guarantees a payout in the case of an event outlined in the agreement. To reach its full potential, parametric insurance requires settlement infrastructure that can handle the computation of a contract in a trustless manner. Trustless means removing any middleman from governing the exchange of value between two parties. Enter hybrid smart contracts, which provide computational functionality without sacrificing decentralization. Each transaction is independently verified without the need for a third party. Blockchain also removes the information asymmetry that exists between policyholders and issuers. In traditional models, an insurance company controls the data that determines the outcome of the parametric contract. On the blockchain, there are no data silos. All data is decentralized, which improves economic fairness between the two parties.
Because smart insurance contracts execute based on conditional statements, the settlement process is seamless compared to traditional insurance. In many cases, traditional insurance drives customers away with too many hurdles. For instance, small farm owners cannot afford to battle insurance companies in court over a claims dispute. Smart contracts are superior in this aspect because they omit the claims process entirely, which makes payouts faster and more reliable. Moreover, removing middlemen from the settlement process reduces insurance premiums and makes insurance more affordable for clients in developing countries.
Forward-looking investors are waking up to the idea of parametric insurance powered by hybrid smart contracts. Earlier this year, Mark Cuban invested in dClimate, the world's first decentralized network for climate data. Cuban highlighted the need for services that help businesses become climate resilient: "I'm excited to be working with a team that is using blockchain and smart contracts to solve a pressing, real-world problem” (Dixit 2021). When popular venture capitalists like Mark Cuban pick a trend, it helps bring attention, awareness, and liquidity to the emerging market. Mark Cuban's embrace of parametric insurance powered by smart contracts is a sign of high growth in the future.
As decentralized weather insurance marketplaces become more popular, demand for accurate weather data will attract more firms to participate in the decentralized insurance industry. For instance, Accuweather recently announced they will sell their API data to insurance contracts via a Chainlink node (Tiwari 2021). Chainlink is a network consisting of oracles that feed aggregated data into smart contracts. Accuweather is one of the world’s largest climate firms. Their decision to sell their data to blockchains via Chainlink is a sign that parametric insurance and smart contracts are increasing the demand for quality weather data, building entirely new business models for companies with APIs. More firms entering the space will lead to more robust data sets that will subsequently enable more robust insurance products. This will create a virtuous cycle of growth with strong economic incentives to push the parametric insurance industry forward.
Although parametric insurance is superior to traditional insurance in many ways, the two insurance types are complementary. One drawback of parametric insurance is higher basis risk. Basis risk refers to the chance that the predetermined payout outlined by an insurance contract does not cover total losses and damages fully. Basis risk is often higher with parametric contracts because it requires the insured to have a good understanding of the risks they are exposed to (Brettler and Gosnear 2021). Although basis risk will become increasingly manageable as more robust models and data inputs integrate with smart contracts, there is ample opportunity for both parametric and traditional insurance models to satisfy the needs of businesses. In the future, proper risk management may involve parametric and non-parametric insurance methods working together to achieve the best results.
As parametric insurance becomes widely used, new use cases will expand into other sectors by addressing all sorts of business needs. Advancements in big data analytics and modeling processes will enable more customized parametric contracts in different sectors. Currently, the rise of Internet of Things (IoT) devices, which are sensors that capture real-time data, will allow vast amounts of data to flow into decentralized data marketplaces, which will enable new smart insurance contract use cases (Maaghul 2019). For instance, IoT devices can keep track of the temperature inside a shipping container with fresh produce. If the temperature reaches a certain threshold, an insurance contract can immediately payout to the policyholder to mitigate losses. Life insurance, flight insurance, shipping insurance, and much more are already becoming digitized and decentralized thanks to blockchain. Moving forward, “cyber, data breach or even reputational damage” (Markovic and Harry 2021) will be insured by smart contracts.
Because these technologies are relatively new, regulatory risks are a concern for firms that want to enter the world of blockchain. Naturally, future regulation has the potential to transform the digital landscape dramatically. However, regulations are unlikely to derail the rapid growth of smart contracts because programmable contracts are a dramatic technological leap in terms of efficiency and transparency. Any regulatory hurdles will likely influence the boom and bust cycles of crypto, but they are unlikely to change the inherent utility of these decentralized, programmable ledgers. On top of regulatory hurdles, blockchains like Ethereum have yet shown the ability to scale. Currently, the Ethereum network can handle about 13 transactions per second (Sigalos 2021). Ethereum’s scalability will improve as it transitions to v2.0 over the next few years. Even if Ethereum fails to scale, other blockchains like Solana, Cardano, and Avalanche have shown potential to scale. The competition between blockchains suggests a multi-chain future where firms utilize blockchains optimized for their sector.
Reliability is a defining feature of parametric insurance powered by smart contracts. By replacing brand trust with mathematically guaranteed outcomes, clients can hedge against risk with fewer hurdles. As climate change worsens and global uncertainty increases, parametric insurance for climate-based products will become increasingly appealing to businesses around the world. Most importantly, decision-makers throughout the insurance industry need to understand that this tech is not going away. This industry is reaching an inflection point in its maturity where its best applications are around the corner.
References
Adelyn Zhou, Adelyn. “How Blockchain Smart Contracts Are Reinventing the Insurance Industry.” Nasdaq. Nasdaq Inc, January 29, 2021. https://www.nasdaq.com/articles/how-blockchain-smart-contracts-are-reinventing-the-insurance-industry-2021-01-29.
Brettler, Daniel, and Timothy Gosnear. “Parametric Insurance Fills Gaps Where Traditional Insurance Falls Short.” Insurance Journal. Wells Media Group, May 26, 2021. https://www.insurancejournal.com/news/international/2020/01/09/553850.htm.
Dixit, Ankita. “Arbol's Climate Data Network DClimate Gets Mark Cuban Investment - Artemis.bm.” PostInTrend. PostInTrend , June 29, 2021. https://postintrend.com/insurance/arbols-climate-data-network-dclimate-gets-mark-cuban-investment-artemis-bm/.
Maaghul, Cyrus. “Trends in Blockchain-Based Parametric Insurance.” ITIJ. Voyageur Publishing and Events, September 12, 2019. https://www.itij.com/latest/long-read/trends-blockchain-based-parametric-insurance.
Markovic, Tom, and Steve Harry. “Parametric Insurance: A Tool to Increase Climate Resilience.” Marsh McLennan. Marsh & McLennan companies Inc. Accessed November 3, 2021. https://www.marshmclennan.com/insights/publications/2018/dec/parametric-insurance-tool-to-increase-climate-resilience.html.
Sigalos, MacKenzie. “Ethereum Had a Rough September. Here's Why and How It's Being Fixed.” CNBC. CNBC, October 4, 2021. https://www.cnbc.com/2021/10/02/ethereum-had-a-rough-september-heres-why-and-how-it-gets-fixed.html#:~:text=Ethereum%20can%20only%20handle%20roughly,Institutional%20money%20is%20flowing.
Tiwari, Aisshwarya. “AccuWeather to Run Chainlink (Link) Node for Accurate Weather Data on Blockchain.” BTCMANAGER. BTCmanager, August 5, 2021. https://btcmanager.com/accuweather-chainlink-link-node-weather-blockchain/#:~:text=In%20an%20announcement%20made%20yesterday,onto%20blockchain%2Denabled%20smart%20contracts.&text=Among%20other%20weather%2Drelated%20data,speed%2C%20and%20natural%20disaster%20classifications.