How will decentralised finance affect insurance?

Not so long ago, cryptocurrency was viewed with a great deal of scepticism; it was for the dark web and not mainstream.

But, over the last couple of years, that changed and crypto is coming of age – disrupting the financial sector as it goes. How is that so, and how will it affect insurance?

A brief history of crypto

2009 was the year we celebrated Danny Boyle’s Slumdog Millionaire winning the Oscar for Best Picture, his namesake Susan Boyle won Britain’s Got Talent and – in non-entertainment related news – Bitcoin was traded for the first time.

Who – or which group of people – invented Bitcoin in the first place is unknown. However, the name Satoshi Nakamoto is credited.

It’s fair to say that Bitcoin remained a niche interest for a long time. However, this is no longer the case and big business is taking an interest. To put it in terms of hard cash, the total market funding of all crypto assets is now more than $2 trillion.1

What is blockchain technology?

In simple terms, blockchain is an information system that is incredibly secure. It’s almost impossible to cheat, hack or change the system.

Blockchain works as a digital ledger that is duplicated and distributed across the entire network of computer systems on the blockchain – each block in the chain contains a number of transactions. Every time a new transaction occurs on the blockchain, a record of that transaction is added to every participant’s ledger.

The decentralised database managed by multiple participants is known as Distributed Ledger Technology – DLT.2

Decentralised finance

Decentralised finance – DeFi – is more than a buzzword. It’s a flourishing area of finance that’s built upon blockchain, such as Etherium blockchain.

Ethereum is seen as the good guy of crypto – open-sourced and more environmentally friendly than some. With Etherium, many of the functions of the financial system have been recreated3, including:

  • Smart contracts
  • Wallets
  • Payment systems
  • Deposit and lending applications
  • Investment funds
  • Approaches to self-stabilise currency regimes

These features are what we know as decentralised finance.

Interest in DeFi is growing dramatically too. From less than $10bn in early 2020, some $100bn-worth of tokens are now locked up in financial smart contracts for use on decentralised exchanges or deposited to earn yields.

DeFi has many advantages over the old school approach to finance.

  • Cheap, fast payments
  • Settlement risk is pretty much eliminated due to pre-determined rules of transactions that can’t be messed with
  • Smart contracts can lock up collateral for a loan – eliminating the risk of defaulting
  • Compared to old school finance, barriers to entry are low

All of which means DeFi has sealed its place as an exciting area of innovation and disruption.

DeFi opportunities in insurance

Innovation and disruption in finance means there’s a world of opportunity ahead for insurance. The companies that can be agile and reactive to change can make the most of the new world.

How it works for insurance

How companies approach crypto can differ from company to company, but the underlying elements are shared.

Investors deposit cryptocurrency into a risk capital pool with funds locked together in a smart contract. These funds are then used as capital for policies.

The capital pools are designed in such a way that funds always match or exceed the minimum capital requirement for active policies. New policies are only written if there are enough funds in the pool to back them.

A new approach to insurance products

Using crypto would mean looking at how capital is set up from a new angle.

It could be as simple as replicating the current model where capital is denominated in cryptocurrency in the same way as current insurance capital. In this case, the capital is held by an insurance company and used to back regulated products.

Or DeFi could be fully embraced to give a decentralised insurance alternative.

Here, crypto investors’ investment decisions are used to price risk – creating protection products that can’t be regulated as insurance. This is because they cover against risk in a similar way to insurance products but lack the legal protections of regulated insurance products.4

The future is digital

Whichever way the future unfolds, it’s clear that cryptocurrency and other digital tools are evolving insurance towards a new digital era and in an unprecedented way.

The traditional elements of insurance – capital, insurance operations and risk – are moving ever closer and technology is the enabler.

20 years ago you needed a tie to secure a loan from a bank manager, or you had to visit a broker to buy your insurance. The next 20 years will see insurance and banking go through their biggest reincarnation.

Original post: Nuon

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