A new legal model for blockchain based insurance
We founded Etherisc in 2016, and in the past four years we spent a lot of time to explore the regulatory frameworks for blockchain based insurance. And it was hard, and many times we thought “it’s impossible to fulfill the regulatory requirements, anywhere in the world”.
Though, we did not give up, and today, we can show you a new promising legal model for blockchain based insurance.
Its a genuine new approach, and it works only with blockchain, so we think it is a very natural and typical application of blockchain technology to the financial industry.
But let me tell you the whole story from the beginning.
Two years ago, we called the German financial authority BaFin.
Etherisc: Hello, this is Etherisc. We want to build an insurance business.
BaFin: OK, the only thing you need is 5 Mill. Euros.
Etherisc: We don’t have that. Arent there any exceptions?
BaFin: No. No exceptions.
(Actually, the above is not *exactly* true. E.g. the formal minimum capital requirement is 2,5 Mill. EUR and there are *some* exceptions — but to build up the business with all the other formal requirements you will most likely end up with a two-digit Mill. EUR amount — like coya.com (30 Mill. EUR), ottonova (> 15 Mill. EUR) or wefox (>33 Mill. EUR))
This year, we called again.
Let me explain what happened.
Insurance is highly regulated in most countries. Usually, one core feature which makes a financial instrument an insurance is the legal promise to pay a compensation in case of a loss. Luckily, Germany has a formal definition for this, but it is similar in other countries, for example, in the US.
This legal promise to pay in case of a loss is the root cause for a pile of regulations and the reason for high minimal capital requirements.
These are usually in the millions, creating a high entrance barrier for new market participants and disruptive products like ours.
Why do we need all of this?
Regulations have been created for good reasons.
Regulatory requirements have three main objectives:
- To avoid monopolies
- To avoid negative externalities (negative effects on third parties)
- To avoid information asymmetries.
These objectives shall mitigate unfair and unethical behavior of market participants. Consumers need to be protected. If someone promises you something, you should get what you expect, even if you are not an expert.
And consumers need legal guarantees so they could sue the company in case of misbehavior. Same for investors.
And you need legal enforcement because regulators need effective measures.
All of this shall create trust between market participants, be it consumers, investors or producers, and trust is key for functioning markets.
But in many cases, trust implemented by formal and external regulation can be very expensive. And People can build trust by other means. Especially for retail products, legal enforcement is pointless due to time and cost of enforcement. You won’t sue an insurance company for $500 disputed payout, because you don’t have the time, the money, and the know-how. One gets a little annoyed and goes back to the agenda. The best revenge in this case is to tell your friends about it. If this is their standard behavior, they will lose customers in the long run.
So, for many retail products, we don’t need and want legal enforcement. Instead, simple market mechanisms provide much better consumer protection. Think of a vending machine: If the machine doesn’t work, you won’t sue the owner; it is in his own interest that the machine is working properly. Otherwise, he’ll lose his customers.
But how can consumers trust an insurance product without legal enforcement?
The answer is: Blockchain and Smart Contracts.
Give the consumer a (technically) bullet proof insurance product based on smart contracts, and she won’t need a legal guarantee.
Replace legal guarantees by technical guarantees everybody can check.
Let’s see how this could work in practice. Maybe you remember our flight delay insurance. Select a flight and pay the premium.
You are informed that you don’t get a legal guarantee for your payout.
Your policy is processed by a smart contract and you can check the proper processing directly by examining the code and the transaction.
(Maybe you ask: Really? Who will ever be able to check the code and the transaction? Answer: because the code and transactions are transparent, the community of experts who do this job for you — in the same way as it is done elsewhere in DeFi land)
If the code is correct, your policy will be processed correctly. The provider — Etherisc in this case — won’t be able to mess with it.
What’s the consequence?
We explicitly exclude any legal guarantees for a payout in case of a loss. Therefore, one crucial element of an insurance contract is missing. Therefore … this is not an insurance contract (under German law)!
And if it’s not an insurance contract … there is no formal regulation, no regulatory costs, and no X Mill. EUR minimum capital.
Of course, consumers need to be well informed, that they don’t get a legal guarantee.
So, this year, we called the German regulator BaFin again.
We explained our concept and asked: IF we exclude a legal guarantee, will it still be an insurance contract?
They said: No, it won’t be an insurance contract.
We asked: IF we offer such a product, then we are not subject to the whole pile of insurance regulations?
And the answer was:
Yes indeed! It will be a simple service contract, no regulation, no minimum capital requirements!
No X Mill. EUR needed anymore — we can start our business with much lower capital. And we think that this could be the blueprint for a whole class of innovative insurance products.
But beware: formally, there is no insurance contract, and therefore we may not call it “insurance”. Instead, we use the term “protection”. And you don’t pay a premium, but instead, a service fee. Because actually we only offer the service to run a set of smart contracts. Confusing? Let’s compare.
In traditional insurance, you have a statistical model for proper pricing and derivation of minimum capital requirements (MCR). In addition, you get a legal guarantee to receive a payout in case of a loss.
In our model, the mathematics are the same. We also have a statistical model and we also calculate the minimum capital requirements (MCR). We are even much stricter: We will underlie our risk with a much higher collateralization then traditional insurance. But unlike Solvency II, we do not have an absolute lower limit of X Mill. EUR for capital in our model. We can start with much less and we also don’t have the extremly complex organizational requirements from Solvency II.
This will enable quicker, smaller and much cheaper products and allow for much more experimentation.
What’s up next?
We are currently preparing the relaunch of FlightDelayProtection — this time as a regular product which can be purchased using ETH (and maybe other tokens). We are happy to collaborate with three of the best-known oracle providers — Oraclize, ChainLink and BandProtocol to bring you the best experience and truly decentralized control on your protection contracts!
This will involve a registration process — it’s not a full-blown KYC process, but the German regulator requires us to inform our future customers on the special features of this new model by an old-fashioned written letter.
Next week we’ll show you how to register — stay tuned!
