There is growing speculation that the ‘second wave’ of blockchain technology has the potential to revolutionise the insurance industry, including captives.
Ned Holmes examines why its predecessor failed and whether this time we can embrace the hype
Common wisdom is that the sequel never lives up to the original, but when it comes to blockchain and the insurance industry, the second wave may well deliver what the first promised.
When digital ledger technology (DLT) first made a splash in the captive industry in the late 2010s, some big claims and predictions were made about the ‘substantial impact’ that it would have.
Words like ‘game-changer’ were bandied around, and it quickly became a hot topic, particularly for those keen to show they were at the cutting edge of the industry.
Seven years later, you could be forgiven for feeling as though we are still waiting for the other shoe to drop.
From an insurance perspective, the first wave of blockchain has not lived up to the high expectations set out at its inception, but there is a sense that the second wave, which may be about to break, could deliver what its predecessor could not.
The first wave
“We expected the first wave to have a tremendous impact,” says Marcus Schmalbach, CEO of Ryskex, one of those actively involved in exploring blockchain solutions for the captive industry.
“Many people invested a lot of money in it. It is not that it ended in disaster, but more that it ended in nothing,” he adds.
Meanwhile, Gavin Lillywhite, head of insurance distribution and client management at Axio, shares: “I was at Allianz at the time, and there was a big noise about the opportunity. If you can think about everything that blockchain can do, it is just so much more efficient.
"The challenge, of course, is that the insurance industry does not have a track record of adopting more efficient processes. It did not fall on its face but rather just sort of withered on the vine.”
The impression is that the first wave’s lack of impact was due to three key, interlinked factors: market conditions, a lack of regulation, and a misunderstanding about its true use case.
“At the time, the market was soft,” explains Lillywhite. “Post 9/11, you had a really hard market, which peaked for a couple of years and then went downhill into almost 20 years of a soft market.
“You held a macro position. A lot of reinsurers came back into the market and said: ‘The rates are good, so I am going to pile in’. So over time, there was an increase in capacity.”
He further adds: “After that, there was a 20 year rate reduction, and I think insurers were struggling to find something different that could help them out of the downward spiral, asking how they could be more efficient.
“That never really came to fruition. Many of the big players suddenly had chief innovation officers, but they had little to no teeth. The fundamental issue was that the implementation of blockchain would have required a change in infrastructure, a task that many large players find challenging.”
Lillywhite argues: “Then, naturally, the hard market reached its peak a few years ago. Consequently, the insurers were back to profit, so the appetite was just not there to try something a little bit different or outside the box.”
In terms of regulation, the issues were linked to creator Satoshi Nakamoto’s original motivation for the technology.
Schmalbach explains: “Normally, innovations start in the business-to-business (B2B) sector and then move to business-to-consumer (B2C), but blockchain really cut out the B2B and was mainly in the consumer-to-consumer (C2C) sector. It started with no regulation. Satoshi Nakamoto wanted to empower the people.
“There was a lot going on — Allianz wanted to develop a stablecoin, and we at Ryskex were working with Vermont to establish a blockchain-driven digital risk exchange — but we realised at a certain point that the blockchain itself needed to be regulated.”
He observes that in the industry, a captive domicile could not regulate the blockchain solution or the tokenisation itself. “Likewise, the German Federal Financial Supervisory Authority (BaFin) and the US Securities and Exchange Commission (SEC) saw opportunities from a financial perspective but did not want to regulate them. This resulted in the implementation of unconventional solutions, such as the bankruptcy of FTX in the B2C sector,” he remarks.
The lack of a true understanding of blockchain was another key factor. The hype surrounding it led some to believe it would be a silver bullet to revolutionise the insurance industry rather than a bespoke solution for specific issues.
Schmalbach notes: “Some were just using the blockchain to try to tell everyone that they were innovative, but no one really understood what the use case was. They thought it was the car, but it was actually the highway. Insurance is a traditional industry, and there were people who liked the way the market worked. Some people feared it would have a negative impact on their market.”
But while the first wave may have never lived up to the hype, Schmalbach believes it should not be looked upon as a failure but as a learning experience.
“The last six or seven years have been education and demystification,” he says. “A long, long process of making people aware of the technology, understand it, and not fear it. It has been an ongoing process — keeping the fire alive so that people still want to interact with blockchain.”
The second wave
It looks as though the patience of Schmalbach and others may now be about to pay off. Just as there were contributing factors working against the first wave, it now feels a little like the conditions are perfect for the second to succeed.
Not only is the market better prepared, but there is also a better understanding of what blockchain can actually do, and the support of big players like Lloyd’s and BlackRock has helped to solve the issues concerning regulation as well as legitimise the technology in the eyes of others.
Schmalbach explains: “I now believe that we are back on track and the second wave can be positive because Wall Street, for example, BlackRock, is now adopting it. Larry Fink carries weight, so if he gets in front of the SEC and tells them that they believe in blockchain and asks for an ETF on Ethereum and BitCoin, as they did, then the SEC agrees that it is time to regulate.
“When people like Fink and John Neal support it, markets follow. Those guys are in now, and I think we will see more serious solutions coming as a result.”
In agreement with this perspective, Lillywhite emphasised the significance of backing from major players in the industry.
“Having credence from the big boys, like Lloyd’s and BlackRock, is definitely important,” he states.
“There is a fear of the unknown, but things like the SEC approving a blockchain ETF, endorsing it, and BlackRock’s involvement give it more certainty and give people more confidence. Lloyd’s is giving it market-wide visibility through the Lloyd’s Lab, the whole premise of which is to recognise a protection gap or capacity issue and try to solve it with technology.”
The first wave may not have had the desired impact, but it has at least paved the way for the second by educating people about what the actual uses are. “People now have a clearer understanding of blockchain and now have the answers to why they should use it,” says Schmalbach.
“Now we can say that it cannot be a standalone solution — it is not the car, it is the highway. The tasks and challenges that we have faced in our industry in recent years make blockchain a better fit now than ever before. On one hand, we had the pandemic, and now there is a better understanding of why working more digitally can be more efficient and better.”
He explains: “We also see more exposure to big natural catastrophes and an increasing number of cyber attacks, so we need more capital in the market. We have also seen AI enter the market and have an impact, which has made people more aware of technology.
“The understanding is there, and the business cases done on the blockchain are becoming more and more realistic.”
The feeling is that this time there are more realistic expectations, and the second wave may be able to fulfil at least some of what the first promised.
Lillywhite says: “I think at the time of the first wave it was a bit of a marketing spin, but we are in a different world now. We have got AI breathing down our necks, which will come with its advantages and disadvantages.
“The risk landscape has changed an awful lot, so matching scenarios and using blockchain to make those contracts more secure around risk exposure is a must.”
Lillywhite anticipates that incorporating AI and blockchain smart contracts could enhance efficiency in the insurance industry, adding: “Market rates are decreasing, and clients expect us to take more of the cost out of the market. If someone like Lloyd’s does lead on using blockchain to do that, then I think it will shape the market.”
Impact on captives
However, what are the advantages of blockchain solutions for captives? And what part does the captive industry have to play? Schmalbach believes that smart contracts and parametric-type arrangements could be where we see a significant impact.
“Parametric solutions work perfectly with the blockchain because of smart contracts,” he remarks.
“With a smart contract, you have a trigger that you can programme, and then the claims adjustment and payout become an automated process. You can also include an independent third party and an independent referee. Blockchain technology could help with a 100 per cent safe and secure claim adjustment process, tokenisation, modelling, transfer, and any other necessary tasks.
“It might not be the best case that the founder Satoshi Nakamoto had in mind, but from my perspective, the blockchain is a perfect fit for risk transfer and hedging operations.”
According to Schmalbach, the more intricate the risk, the simpler it becomes to manage with such a solution. “This is a time when we require increased capacity from the capital market, as well as clarity, due to the growing complexity and scale of risks,” he says.
Meanwhile, Lillywhite predicts that there will be a growing interest in the solution over the next 10 to 12 months. He notes: “Captive managers and insurance buyers will assert: ‘The insurance industry won’t do it, so we’ll do it for ourselves’.
“Many people are just fed up with the insurance cycle — one minute it is down, the next it is up. Because of market forces, things do not tend to stay steady, but that is the draw for captives to say that if we can understand the risk, do things better, and take more of this in-house, we are not at the mercy of the insurance market.”
He adds: “That is where the opportunity may be for captives, who are more nimble and can adopt blockchain for their transactions, as they do not need to create this big infrastructure or update the big company markets to do it.
“We are on the verge of witnessing the democratisation of parametrics. The reduction in the margin of parametrics necessitates the creation of a more efficient process.
“This is another area where the blockchain can assist, as it handles all the administrative tasks, eliminating the need for numerous individuals to handle paperwork and sign contracts.”
Lillywhite highlights several benefits, including increased contract efficiency, faster risk-to-capital matching, and the attraction of new capital.
On improved efficiency, Schmalbach observes: “Working on the blockchain will decrease processing costs by a minimum of, say, 25 per cent, but even if it is only 15 or 20 per cent, we are talking about millions in terms of profitability and
cost efficiency.”
Beyond the realm of smart contracts and efficiency, he asserts that the blockchain by itself does not solve every issue in our industry.
However, he adds, it presents a remarkable technological prospect that aids in risk segmentation and transfer from captive to capital market members to alternative capital, a necessity given the escalating sustained risk associated with natural disasters.
“The blockchain is not the car; the blockchain is the highway that you drive on. If you are more innovative, then there are a bunch of opportunities using the blockchain, such as trading risks and making claim adjustments more efficient,” he confirms.
So what next? Schmalbach thinks newer players and big guns may make the first move.
He explains: “I expect that we will see some domiciles, perhaps the likes of Bermuda, Dubai, Abu Dhabi, and London, try to be ahead of the curve and offer creative solutions for captives using blockchain in a bid to become more attractive than the more traditional domiciles.”
