Vitalik on Who Wants to be a Millionaire

Only three years ago didn’t it seem like blockchains could do just about anything? Even I was writing whitepapers describing smart contract DAOs capable of running insurance entities. Maybe in some science fiction future there will be an insurance DAO, but in the next two years how can blockchain technology be practically used to provide insurance products that people actually need? What attributes do blockchains provide that allows us to create useful types of insurance architecture?

NOTE: My perspective in this series of posts is that blockchain technology has value within a narrow context. I am planning to use it to provide small communities of cannabis businesses with the ability to insure themselves. The features I discuss in this article are essential for policyholders who wish to have total control over the day to day operations of a group policy. Most of these features would not be valuable to policyholders who do not need this level of control or require such a high degree of transparency. Every feature on this list is likely unnecessary for traditional insurance products we see in the marketplace today. If you wish to try to apply blockchain technology to a traditional insurance product or service I don’t think anything in this series of posts is applicable to the accomplishment of that goal. Hopefully given this context this blog will be more relevant to the right groups of people.

New types of assets held by new types of escrows

Escrows on public blockchains such as Ethereum are special because the database isn’t merely an accounting tool for digital assets but a registry which holds tokens representing digital property. These tokens are assets that fall under the same asset class as that of a domain name. Databases like Ethereum prevent the misrepresentation of the accounting of an assets ownership that would contradict the actual ownership rights of said asset. Explained another way, the record provides proof of ownership because the database contains the asset itself thus there cannot be any falsification of ownership by said database.

Traditional insurance holds assets very differently. The only thing that prevents a traditional insurer from misrepresenting ownership of assets is regulation. Regulatory bodies enforce laws which mandate that insurance companies hold reserves to pay claims. The threat of an audit mandates that a corporation’s accounting correctly represents their reserves. But the relative infrequency of audits means that you don’t always know the value of assets an insurance company holds. It is impossible in such a system for policyholders to have perfect knowledge about their policy’s level of solvency. It should be noted here that private blockchains are mere extensions of this model where accounting of an asset is divorced from the actual ownership rights of an asset.

On a side note: At this point we need to put aside the volatility of the value of cryptoassets in pure dollar terms. Obviously claimants are trying to recover from a loss of property measured in dollars. In this sense a cryptoassets volatility makes it a terrible choice for paying an insurance claim. Bridging the world of assets held in crypto to losses measured in dollars is becoming easier as the ecosystem starts to develop. The latest developments have resulted in the launch of several tokens operating on Ethereum which are stable currencies tied to the dollar. Even with this development you need a special breed of policyholder to overcome these challenges. Stablecoins provide a relevant solution to this problem. As of this writing there did not exist any reliable stablecoins which could be directly held by Ethereum smart contracts, but today there are many.

Public blockchains are transparent banks where everyone can have perfect knowledge about an insurance policy’s solvency. Anyone can audit the current level of reserves a group policy holds and if claims are tokenized they can also audit a group policy’s outstanding obligations. Any premiums paid into the policy by policyholders are also recorded by the blockchain. This knowledge represents the actual present ownership of funds and the previous state of transactions.

This level of knowledge about an insurers financial state of affairs empowers policyholders to make better financial choices. This radical level of transparency allows policyholders the ability to understand much more than merely if a policy is solvent or not. The blockchain makes it possible for policyholders to know the past and current record of a policy’s reserves and premiums. Once this is known relative to the maximum claim liability for all underwritten policies then an insurance policy’s risk model starts to also become transparent. The more information people have about an insurer the better choices they can make about which insurer to trust with their premiums.

New types of products for new types of policyholders

Such a system requires far more active participation by a policyholder but it also provides them with more control as to how their funds are managed. This type of trade-off means that new blockchain insurance technology is likely not suited for traditional insurance products. This new technology requires new products and new types of policyholders who are willing to invest more of their time to learn about how their policy works. In exchange these policyholders are granted greater responsibilities and privileges. Blockchain insurance technology has the capacity to provide people with new forms of governance. Voting systems can empower individual policyholders by allowing them to participate in the administration process. Self-governance models would allow small communities of policyholders to set their own premiums and determine for themselves how to recover from a solvency crisis.

When claims are tokenized then the same currency which is used to award a claim can also be used for creating new voting models. Claim award tokens are used to approve claims for eligibility to receive a claim payment. They represent ownership of resources belonging to all policyholders. In a weighted voting model these same tokens can allow a minority opinion to pass legislation or favorably settle a dispute. This can even be done without a 51% majority. This would allow a minority opinion to pay the appropriate cost to have a greater say in how a policy is administrated. This leads to better forms of self governance and outcomes that are more fair for everyone. In exchange for allowing a minority opinion to pass favorable legislation this group is required to pay the appropriate cost. This cost subsidizes everyone's future claims which is why this model for self governance is so attractive. The act of passing legislation where voters don’t have a majority or super majority makes the entire community better for everyone.

In this case, blockchain technology is not merely providing a new type of “database” which traditional insurers can leverage. It does not provide benefits in the context of traditional insurance products people have always purchased. Instead the technology is able to serve a new type of policyholder who purchases an insurance product that previously was unavailable in the market. These products require more effort and participation by policyholders, but they also afford greater privileges and can be tailor made to the needs of smaller communities. These types of features would therefore be ideal to servicing the needs of regional communities of cannabis growers and dispensaries.

New types of payments for new types of claims

The world of traditional insurance utilizes payment systems which are slow, outdated and expensive to use. No insurance company would divide a claim payment up into thirty pieces and pay these as increments over thirty days. The cost to print and mail 30 checks, and the frustration policyholders would face with such a system, means that this is not a useful idea. Blockchain-based payment systems could empower incremental claim payments but what benefit could they provide?

I’ve written at length about how Bancor creates a special type of escrow called a fractional reserve escrow. This blog post generalizes what the Bancor formula is doing. My previously written blog posts give the reader the specific mechanism Bancor uses to gradually decrease an exchange rate. The mechanics allow one to understand how it provides the below mentioned features.

A traditional insurance company can become suddenly insolvent* after a large claim event. Bancor fractional reserve escrows have gradual reductions in solvency but never become completely insolvent*. This is because fractional reserve escrows enable a policyholder to accept a claim write down if they choose to do so. The picture below illustrates the difference between traditional escrows with immediate insolvency and fractional reserve escrows with gradual solvency reductions:

Left: traditional escrow — Right: fractional reserve escrow

The entire area of the square represents the maximum claim liability of all policies within a group. The green part represents funds available to pay a claim. The red part represents claim obligations not matched with available reserves (referred to as unmatched claim obligations). The vertical slice represents a claim payment.

Insurance carriers never carry sufficient funds to cover the maximum claim liability of all policies they have underwritten. Instead they carry enough funds to match the probable value of future claims they expect will open within a certain time frame. To determine what these future claims might be, an insurer employs actuaries who work together with underwriters to create risk models. In addition to the value of expected future claims, they may add some padding (or purchase reinsurance) in case their model fails to predict some future loss event. If their risk model is wrong then the loss from claims will exceed reserves and if there is no reinsurance then the policy will become insolvent.

Going back to our image, what happens if there isn’t enough money to pay all outstanding claims in full?

With a traditional escrow claims fall off a payment cliff once outstanding claims exceed funds available. This payment cliff signals immediate insolvency. With a fractional reserve escrow, claims gradually become less solvent* over time because payments decrease over time. Although claim payment decrease these escrows never become completely insolvent*. The architecture on the right represents a gradual hill in the face of a catastrophic event. The architecture on the left represents a sheer cliff in the face of a catastrophic event. If claim payments fall off a cliff this means that valid claims go unpaid. If claim payments roll down a hill this means that valid claims go underpaid.

The architecture on the right affords greater protections to policyholders by rationing out reserves to pay their claims. The architecture on the left creates the potential peril that policyholders will have their claims unfairly denied. Blockchain technology moves a new class of policyholder from a world of peril to a world of greater protections. The small blue triangle in the picture on the right represents the cost to policyholders who decide to gain these additional protections. The goal of incremental claim payments is to provide a mechanism by which this blue triangle can be equal for all claimants and as small as possible.

In the image on the left it doesn’t matter if you make lump sum payments or incremental payments, the outcome is the same provided that claims remain solvent. In the case of the fractional reserve escrow on the right however, it does matter. Every claim payment will result in future claims being paid at reduced rates. The only way to make sure that all claims are treated fairly is to use incremental claim payments. Adding premiums to these escrows is done once daily as all outstanding claims are paid in increments once per day. After all claims are paid out together (daily), more premiums are added back into the fractional reserve escrow to rebalance it. This payment resets the conversion rate (given by the Bancor formula) between claim awards and claim payments. If you want to know why this makes sense you can read my previous blogs but once we accept this is true we come up with the following result:

Adding premiums resets the decline of the exchange rate of claim award tokens (local currency) to claim payment tokens (global currency). As soon as we run out of premiums to add to a fractional reserve escrow our claim payments start to gradually reduce again.

This mechanism seems simple enough but the results gained from such a mechanism are profound:

Policies never become suddenly insolvent*. This minimizes the risk of policyholders being exposed to a financial loss. A policyholder’s exchange rate between claim award currency and claim payment currency tells them immediately how solvent* the system is at a glance. A community is provided adequate time to solve a crisis by raising additional reserves while claim payments are slowly rationed to claims that are currently opened. If there is no way a community can inject additional reserves in a solvency crisis everyone has the guarantee that all open claims will be discounted fairly. This means that all open claims are paid at the same rate as a policy’s solvency gradually decreases over time. Policyholders have time to find a new insurance provider as soon as a solvency crisis begins. No one pays premiums to policies that have solvency issues because everyone knows how much reserves are available and how much outstanding claim liabilities are yet to be paid. Because claims are paid out using a new type of escrow architecture, which uses a new type of token, this affords for new types of governance models. You cannot utilize weighted voting for governance with traditional escrows. This type of voting requires escrows created using Bancor’s fractional reserve architecture.

The takeaway

The cost to gain these benefits requires that we put insurance policies on a public blockchain. There are obvious drawbacks to paying out claims with cryptocurrency assets. The volatility of such an asset makes it difficult to use it in insurance architecture (NOTE: at the time of this writing there were no trusted implementations of stablecoins available for ethereum smart contracts to utilize, as of today there are at least four major stablecoin providers operating on Ethereum. Stablecoins built on Ethereum are no longer merely theoretically possible but are now a practical tool for decentralized applications). I̶’̶m̶ ̶n̶o̶t̶ ̶g̶o̶i̶n̶g̶ ̶t̶o̶ ̶m̶i̶n̶i̶m̶i̶z̶e̶ ̶t̶h̶i̶s̶ ̶c̶o̶s̶t̶,̶ ̶b̶u̶t̶ ̶I̶ ̶h̶o̶p̶e̶ ̶i̶t̶’̶s̶ ̶c̶l̶e̶a̶r̶ ̶f̶o̶r̶ ̶s̶o̶m̶e̶ ̶t̶y̶p̶e̶s̶ ̶o̶f̶ ̶i̶n̶s̶u̶r̶a̶n̶c̶e̶ ̶p̶r̶o̶d̶u̶c̶t̶s̶ ̶t̶h̶e̶ ̶b̶e̶n̶e̶f̶i̶t̶s̶ ̶a̶l̶m̶o̶s̶t̶ ̶c̶e̶r̶t̶a̶i̶n̶l̶y̶ ̶o̶u̶t̶w̶e̶i̶g̶h̶ ̶t̶h̶e̶ ̶c̶o̶s̶t̶s̶.̶ I think cannabis insurance has the highest potential to benefit from this type of architecture. Blockchains make insurance funds immune to federal seizure. This is why we need blockchain based insurance policies to provide guarantees that cannabis businesses can pay premiums into a secure policy.

Future blog posts will highlight what blockchain insurance architecture cannot do. We still need human beings to run every aspect of approving policies, setting premiums and evaluating claims. We just don’t need the humans to hold onto the physical money, and in 10 years we will wonder how we ever lived in a world where this was a requirement.

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* Insolvency technically means the inability to pay debts in full. I am excluding partial claim payments from the definition of insolvency because policyholders are accepting a claim write down if they convert their claim award tokens for less than 100% of their value. Once a claim write down is accepted then technically the claim IS paid in full.

In this case I define insolvent as the inability to make any payment even partially to a policyholder. This is because many insurance policies do not make partial payments when they only have partial funds. Regulations incentivize insurance companies that cannot make full payments to deny claims outright or to seek bankruptcy protection. This is harmful to policyholders when most policyholders would be willing to accept a partial payment rather than receive no payment at all. A policy which offers them the option of accepting a claim write down is therefore a much better policy.