How Blockchain Smart Contracts Are Reinventing the Insurance Industry

If 2020 has taught us anything, it's that the world is growing increasingly unpredictable. Be it from pandemics, market swings, wildfires, and more, we’ve gone through global shocks that we never dreamed would happen in our lifetime. The insurance industry needs to prepare itself for this increasingly volatile future with a reliable infrastructure that can quickly and objectively settle claims around even the most unforeseeable events. 

Recent advances in blockchain technology, combined with increased demand for insurance products across the world, has set the stage for the rise of parametric insurance, or insurance that automatically pays out when certain events occur. The rise of smart contract technology along with increased demand for insurance products in the developing world could make 2021 the year that parametric insurance model finally moves from pipe dream to production. 

The Advantage of Parametric Insurance

Today, the insurance claims payment process still largely relies on an adjuster’s subjective assessment of damages and loss. Everyday people can’t afford to challenge a large insurance company in court, so most customers are ultimately forced to trust their insurance providers to pay out fair claims. 

Parametric insurance has emerged as an objective and data-driven approach to insurance payouts. In a parametric insurance model, claim payouts are based solely on the occurrence of a clearly defined event and with a pre-agreed upon payout should such an event occur. For example, if an earthquake occurs within a 10 mile radius of a policyholder’s home, then the insurance provider, per the terms of the contract, automatically pays out $1.5M.

While the concept of parametric insurance has been around since the late 1990s, it has been slow to gain adoption and generate consumer interest because, until recently, no reliable infrastructure existed for quickly and securely settling contracts.

However, all that is changing with the arrival of blockchain technology and smart contracts.

The Technology Has Finally Caught Up

Blockchains are a new infrastructure system for validating, storing, and transferring data in a highly secure and reliable manner. Smart contracts, which run on blockchains, are conditional logic that execute certain transactions upon the occurrence of a defined event. For example, if A happens, then trigger B. Many in the insurance industry have already realized that smart contracts can perfectly mirror the way parametric insurance contracts work today.

There are several unique advantages to smart contracts compared to traditional parametric insurance. Notably, the contract is hosted and executed in a decentralized environment that is “tamper-proof,” meaning no party can unfairly control or manipulate the contract to their own advantage. Its execution is only triggered once it receives verifiable data about an insurable event. In many instances, the contract is immediately settled by a transfer of assets on the blockchain and without any human intervention. 

Until recently, smart contracts could not connect with data from outside the blockchain in a highly secure and reliable manner, meaning they were unable to trigger insurance transactions in response to an insurable event. However, the past few years have seen major advances in the realm of blockchain oracles—entities that can bridge blockchains with live, real-world data. Unlike in the past, smart contracts are now able to interface directly with traditional API and IoT infrastructure. This means data can be sourced from outside the blockchain and used to trigger the execution of parametric insurance smart contracts without major concerns about data manipulation and inaccessibility to premium data sources. 

Parametric Insurance for Weather Risk

Similar to how web apps opened up a multitude of services to anyone with a smartphone, blockchains are bringing parametric insurance products to anyone with an Internet connection. These easily accessible products help manage risk are especially important for applications like crop insurance, where climate change is expected to generate high levels of uncertainty for local farmers. 

Today, there are over $1 trillion dollars of uninsured crops around the world. To date, insurance companies have largely been unable to service smaller plots of land in developing countries, forcing farmers into unstable livelihoods dependent on rainfall. This problem is expected to compound with climate change, which will result in unpredictable weather patterns (excessive rainfall or drought) that will affect farmers and crop production more than ever. 

Moreover, the increasing unpredictability in climate is happening in parallel to the uncertainty in financial markets. In such a volatile economic environment, technologically-enforced, tamper-proof insurance contracts are increasingly in demand. 

Companies are already beginning to roll out parametric insurance products built using blockchain networks and oracles to respond to real-world, insurable events. Insurtech Arbol offers crop insurance policies using smart contracts that execute based on oracle-delivered weather data from National Oceanic and Atmospheric Administration (NOAA). Farmers in the US, Costa Rica, and Cambodia are already using these crop insurance contracts to receive automatic payouts when certain weather conditions are met. For these farmers, Arbol has finally overhauled circuitous legal systems and subjective insurance assessments with data-driven, automated processes. 

A Parametric Future

While crop insurance is shaping up to be the first field where parametric insurance scales to meet demand, it is by no means the only industry where this technology could have an impact. Already, other companies like Etherisc are using blockchains like Ethereum to build parametric smart contract insurance on everything from hurricanes, to life insurance, to even flight delays. 

Already, stakeholders in the “Decentralized Finance” or “DeFi” industry, are begin to tokenize these types of insurance contracts (representing the insurance contract as a blockchain token) and selling them on the open market or depositing them as collateral in new types of decentralized money market, enabling policyholders to earn yield. The technology for parametric insurance has quietly already arrived, and traditional insurance companies would do well to begin paying attention, as the widespread adoption of this technology could have huge implications for those in dire need of protection in an unstable world.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.