Professor Michael Mainelli is executive chairman of Z/Yen Group and principal advisor to Long Finance. His latest book, The Price of Fish: A New Approach to Wicked Economics and Better Decisions, written with Ian Harris, won the 2012 Independent Publisher Book Awards Finance, Investment & Economics Gold Prize.
In this special feature, Mainelli explores how distributed ledgers and blockchains could fully modernise an industry that still relies heavily on paper.
In April 2015, Lloyd’s of London launched the Target Operating Model (TOM) project. TOM is a central body responsible for delivering modernisation to the still heavily paper-based wholesale insurance transactions in the London insurance markets.
You can state ‘I Support TOM’ on a registration site or ‘like’ TOM on social media. There have been several ‘innovation’ events. There is an orange logo reminiscent of the 1990s when ‘orange was the new black’. The project has even tried to coin yet another tech mashup for the London insurance markets surrounding Lloyd’s – ‘InsTech’.
This is not the first time that the London insurance markets have tried to modernise. They are serial reformers, their attempts have had varying degrees of success, from total failure to middling impact.
Limnet (London Insurance Market Network) made progress with electronic data interchange in the 1980s and early 1990s. Electronic Placement Support (EPS) worked in the late 1990s, but few used it. Kinnect, at a cost conservatively quoted as £70m, was abandoned in 2006. Project Darwin, 2011 to 2013, achieved little. The Message Exchange Limited (TMEL) is a messaging hub for ACORD messages that has had modest success, but most people still use email.
Numerous private exchanges or electronic messaging ventures have gained only partial market shares. Xchanging Ins-Sure Services (XIS), a claims and premiums processing joint venture, was formed in 2000 and runs adequately, but there is still a lot of paper involved.
A swift walk round Lloyd’s, perhaps passing by the famous Lamb Tavern in Leadenhall Market, reveals a lot of heavy bundles of paper lengthening the arms of long-term insurers.
Does Ontogeny Recapitulate Phylogeny?
Ernst Haeckel (1834–1919) was a German biologist and philosopher who proposed a (now largely discredited) biological hypothesis, the ‘theory of recapitulation’. He proposed that in developing from embryo to adult, animals go through stages resembling or representing successive stages in the evolution of their remote ancestors. His catchphrase was “ontogeny recapitulates phylogeny”.
In a similar way, TOM seems to be going through all the previous stages of former wholesale insurance modernisation projects, databases, networks and messaging centres, but may come out at the end to realise the potential of mutual distributed ledgers (aka blockchain technology).
Information technology systems may have now evolved to meet the demanding requirements of wholesale insurance.
Wholesale insurance differs from capital market finance in some important ways.
First, insurance is a ‘promise to pay in future’, not an asset transfer today. Second, while capital markets trade on information asymmetry, insurance is theoretically a market of perfect information and symmetry – you have to reveal everything of possible relevance to your insurer, but each of you has different exposure positions and interpretations of risk. Third, wholesale insurance is ‘bespoke’. You can’t give your insurance cover to someone else.
These three points lead to a complex set of interactions among numerous parties.
Clients, brokers, underwriters, claims assessors, valuation experts, legal firms, actuaries and accountants all have a part in writing a policy, not to mention handling subsequent claims.
People from the capital markets who believe insurance should become a traded market miss some key points. Let’s examine two: one about market structure and one about technology.
People use trusted third parties in many roles in finance, for settlement, as custodians, as payment providers, as poolers of risk.
Trusted third parties perform three roles, to:
- Validate – confirming the existence of something to be traded and membership of the trading community
- Safeguard – preventing duplicate transactions, ie: someone selling the same thing twice or ‘double-spending’
- Preserve – holding the history of transactions to help analysis and oversight, and in the event of disputes.
Concerns Over Centralisation
The hundreds of firms in the London markets are rightly concerned about a central third party who might hold their information to ransom. They want to avoid natural monopolies, particularly as agreed information is crucial over multi-year contracts. They are also concerned about a central third party that must be used for messaging because, without choice, the natural monopoly rents might become excessive.
Many of the historic reforms failed to propose technology that recognised this market structure. Mutual distributed ledgers (MDLs) though provide pervasive, persistent, and permanent records.
MDL technology securely stores transaction records in multiple locations with no central ownership. MDLs allow groups of people to validate, record and track transactions across a network of decentralised computer systems with varying degrees of control of the ledger.
In such a system, everyone shares the ledger. The ledger itself is a distributed data structure held in part or in its entirety by each participating computer system. Trust in safeguarding and preservation moves from a central third-party to the technology.
Emerging techniques, such as, smart contracts and decentralised autonomous organisations, might in future also permit MDLs to act as automated agents.
Beat the TOM-TOM
Because MDLs enable organisations to work together on common data they exhibit a paradox. MDLs are logically central, but technically distributed. They act as if they are central databases where everyone shares the same information.
However, the information is distributed across multiple, or multitudinous, sites so that no one person can gain control over the value of the information. Everyone has a copy. Everyone can recreate the entire market from someone else’s copy. However, everyone can only ‘see’ what their cryptographic keys permit them.
How do we know this works? We at Z/Yen, a commercial think-tank, have built several insurance application prototypes for clients who seek examples such as motor, small business and insurance deal-rooms. The technical success of blockchain technologies in cryptocurrencies, such as bitcoin, Ethereum and Ripple have shown that complex multi-party transactions are possible using MDLs.
And we have build a system that handles ACORD messages with no need for ‘messaging’.
Z/Yen’s work in this space dates from 1995. Until recently, though, most of those in financial services dismissed MDLs as too complex and insecure.
The recent mania around cryptocurrencies has led to a reappraisal of their potential, as blockchains are just one form of MDL. That said, MDLs are ‘mutual’, and a number of people need to move ahead together.
Further, traditional commercial models of controlling and licensing intellectual property are less likely to be successful at the core of the market. The intellectual property needs to be shared.
A message is getting out on the jungle drums that MDLs, while not easy, do work at a time when people are rethinking the future of wholesale insurance.
If TOM helps push people to work together, perhaps this time market reform will embrace a generation of technology that will finally meet the demands of a difficult, yet essential and successful, centuries-old market.
Perhaps TOM should be beating the MDL drums more loudly.
Insurance image via Shutterstock
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