Read part two: Peer-to-peer in the risk markets
In the opening segment of this series on complexity, I discussed the three network graphs that have emerged in the risk markets, and the business models that embody them.
In the second segment, we discussed the emergence of peer-to-peer (P2P) insurance, which will formalise the three core functions of the risk markets currently existing in a “black market” unformalised state.
- Risk transfer.
- Escrow of funds for a defined purpose.
- Management of reallocation of escrowed funds.
This formalisation will occur via the emergence of a platform enabling all of these functions to be accomplished by the users of the platform, bringing existing P2P economic activity out of its “black market” state and into the light of day. A successful P2P platform will have to accomplish all three of these key functions using distributed managerial methods.
Risk is the killer app for distributed ledger technology!
The focus of the blockchain community on banking has been an interesting side effect of the timing of the bitcoin innovation coinciding with the collapse of the US banking industry. The blockchain technology software went open source in January 2009, while the markets DJIA, S&P 500 and Nasdaq bottomed in March 2009.
The term ‘distributed ledger’ is synonymous with the term ‘blockchain’. Both refer to the technology of a shared digital ledger, upon which transactions are validated by a distributed set of servers using chronological, public and cryptographically secure methods. I prefer the term distributed ledger, because at its core, this technology is only an accounting tool that enables a set of capabilities not previously attainable.
- All transactions, or in accounting vernacular “ledger entries”, are validated using a distributed method without requiring users to trust in a central authority that has control over all entries onto the ledger.
- Lower transaction costs, both in terms of less time and lower labour costs due to not needing to coordinate a multitude of private, centralised corporate ledgers.
- The ability for end users to publicly escrow value on a platform that enables them to connect directly with each other, creating a P2P distributed graph, enabling both the trusted communication of, and individualised control over, the reallocation of their escrowed value.
I would now like to introduce the idea of a ‘risk ledger’, which is any ledger where value is escrowed as a hedge against a risk, so that the risk can be safely carried through time. Currently, insurance carriers operate risk ledgers as they function to escrow money against a risk over a segment of time. (I’ve wondered if this is why insurance companies are called “carriers”.) The same goal can be easily accomplished using distributed ledger technology, albeit with some advantages over private, opaque, centrally controlled corporate ledgers.
Distributed ledgers enable individuals to escrow value in the light of day, against a risk, carrying the risk safely through a segment of time until a loss event necessitates the reallocation to the user who experienced a loss event, and the removal of that value from the distributed ledger, with the value being given to the user. Risk is the killer app for distributed ledger technology. As such, I believe the timeline for adoption in the risk markets will be shorter than observed in banking markets, where the technology itself needed time to mature, and is a bit of square peg in a round hole.
Trust is a fundamental ingredient in all financial services, and trust is something that distributed ledger technology has a unique ability to enable. Since all money that’s escrowed on a distributed ledger, and the movement of that money is visible to all, users can trust in the system without needing to trust every single validator, company or individual peer participating in the network.
It must be understood that all distributed ledgers are inherently a network. There are many distributed ledger networks out there, but I will use Ripple’s to exemplify how a P2P distributed risk ledger platform may look. Thankfully, Ripple spearheaded acceptance by international regulatory bodies on issues associated with distributed ledger technology. Another reason I choose to use Ripple is due to two technical features of the ledger:
- It has built-in ‘Trust Lines’ that enable individuals to create an explicit network of other peers who they trust.
- It has the built-in ability of ‘orderbooks’, which can be used to make markets between different stores of value.
There are other technical advantages of Ripple, but these two elements combine to provide a powerful and open source solution.
Trust Lines function as roads upon which value can move around the ledger. If I trust you, then you can send me value. If I don’t trust you, you cannot send me value as there’s no path for the value to travel upon. This capacity for individuals to control who they’re willing to trust enables individual peers to self-assemble a ‘trust graph’, mirroring and documenting the reality of who’s trustworthy to whom. Since all financial services are predicated on trust, this can be thought of as the finance industry’s equivalent to Google’s link graph, Facebook’s social graph and LinkedIn’s colleague graph, and so on. Whoever ends up building this trust graph will likely be capable of creating much more value for society than those other graph types due to the significant role finance plays in society.
Peers can extend Trust Lines to other peers who they personally know, trust and are willing to help. These Trust Line connections create a trust graph in the same way as friend connections on Facebook create the social graph. In this way, a P2P distributed trust graph can be self-assembled and emerge out of the actions of the individual peers. This is an example of a distributed managerial process; building a distributed graph of roads, creating many paths upon which value can travel across the distributed risk ledger network.
To give some example of how escrowed funds would flow through this P2P distributed trust graph, let’s look at a hypothetical loss event. When a loss event occurs, a user documents the loss, and other peers who trust that user can choose to send a small amount of their own escrowed funds to help their friend. There’s a formalised financial model I will not detail. However, I was surprised to discover after working out the model’s details that the core model originates from the 600s, and actually existed a thousand years before modern insurance methods came about in the mid-1600s.
Orderbooks, and the ability to make markets, enable agents and insurance carriers to retain their relative roles as they exist in the industry today. The platform can be set up in a way that agents can capture a fixed fee as a spread or a percentage of the money that flows through the users that trust the agent, by extending the agent a Trust Line. This is akin to commissions.
The platform can be set up such that carriers can manage the funds users put on escrow. Carriers can control which agents are allowed to access the carrier’s financial service gateway. This enables carriers to essentially mirror the same function, which the appointment process accomplishes today. Carriers can do this activity without invoking the regulatory burden of insurance laws; rather they only need to comply with MSB regulations. This would also enable carriers to earn float income on the newly escrowed balance, while bearing zero risk exposure.
Phase Change innovations typically emerge to address an order of magnitude more complex than what preexisting methods could in the prior industrial age paradigm. Consider how much economic activity and the number of actors Uber can organise on a global scale, versus the top-down methods of an industrial age taxi company. In the risk markets, coming out of the industrial age, we see many companies operating independently in two of the three graphs, and all three graphs are siloed. To achieve an order of magnitude improvement, we must encompass and coordinate all three graph structures onto a single cohesive platform.
Currently, agents function as a hub of client trust. Agents enable clients to navigate the complicated insurance product space, and achieve the distribution of insurance products backed up by carriers. On a Ripple ledger, the agent would be a centralised hub of Trust Lines, and the graph would show that many users trust the agent node.
Currently, carriers function as an access point and product provider, lifting the burden of regulatory compliance, administration and product creation from agents. Engaging with the platform, each carrier can independently escrow client money without hampering the client’s ability to connect with other peers they trust, but who may not be clients of the same insurance carrier.
With orderbooks, the carriers can trade escrowed funds to enable a user who has experienced a peer-funded loss event, to receive a single check from the carrier who that user does business with, even though many of the peers funding the coverage are not clients of the same carrier, and do not have funds escrowed with the same carrier issuing the check. Via these orderbook connections, carrier relationships will create a decentralised graph on the platform.
Combining the peer-to-peer distributed Trust Line graph, the centralised graph that is the Hub of Trust connections surrounding the agent, and the decentralised graph of carrier-to-carrier orderbook connections, the platform can facilitate the coordination of all three graphs within a single system, all while relinquishing ultimate control of the flow of funds to the individual peers of the platform. This achieves a distributed managerial method of the reallocation process applied to the escrowed funds.
From the participating carrier’s perspective, this also alleviates the cost of adjusting claims and exposure to fraud, as well as the distribution of costs associated with the adjusting process across the peers participating in the network.
As is explained in his book, ‘Why Information Grows, The Evolution of Order from Atoms to Economies’, MIT’s César Hidalgo argues that we are at a point in time when firms need to network together (if it’s desirable) to continue to create value for society, in excess of what any single firm can create alone.
Via a distributed risk ledger network, many carrier firms can run the servers that maintain the whole ledger. This gives each carrier an equal vision into the ledger, and removes the need for any carrier to submit control to another carrier tasked with running the entire system. Most importantly, these methods function as a shared back-office, so no single firm bears the full burden of the costs associated with managing all of the small loss events.
Additionally, the cost of the system’s management doesn’t need to be duplicated and absorbed by each participating firm. This is essentially how Ripple is being implemented in the banking industry to reduce the costs of international payments, compliance and increase the speed of international flow of funds.
In complex flow networks, like your arteries, a healthy system will exhibit high flow. A distributed ledger, as an accounting tool, is quintessentially a tool that enables a multitude of firms to cooperatively work on some link in the value chain, while no single firm has full control over the books. Flow should increase when coverage that was allocated via P2P methods can flow inter-firm, to fund a single check to the user rapidly.
- Firms in the home and auto insurance business can network together to facilitate a ledger with other home and auto insurance firms, helping homeowners who experience losses under the deductible, or excluded from the policy form.
- Life insurance firms can facilitate their own ledger networking with other life insurance firms, enabling coverage for clients who do not meet underwriting requirements, such as those over the age of 75, or with a terminal disease.
- Firms in health insurance can network together to facilitate a ledger with other health insurance firms to better enable users to cover high deductibles, only invoking their traditional insurance contracts for unexpected large incidents.
By networking together, firms can enable the existing P2P risk transfer behaviour to occur with less friction, and bring this important economic activity out of its black market state and into the light of day on a formalised platform. Once the economic activity is occurring on a formalised platform, one would expect to see (as was observed with Uber and Airbnb) a resulting boom in the aggregate amount of economic activity, growing the entire risk market’s pie and improving the risk market’s value-add to society.
In the next part of this series, I will consider possible changes to the risk market’s current equilibrium state, and what that equilibrium may look like after the phase change has occurred.LinkedIn Group
Image by Lightspring, Shutterstock.com