Case Study: Decentralized Insurance

The beauty of Smart Contracts is in their ability to remove centralization, trust and middlemen. However, smart contracts can only work with what they are given, which without oracles excludes any information from the outside world. That is why, in the first few years since Ethereum took off, smart contract technology has mostly been used to create gambling dApps, ICOs and financial services. With the creation of more advanced Oracle solutions like ORAO, however, we are on the verge of unlocking completely new markets and applications. In this article we will examine one such possibility; decentralized insurance contracts.

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Drawbacks of the Traditional Insurance Industry

Insurance as a concept is fairly straightforward. There is a small chance that something very bad happens, so you pay an insurance premium, taking on a small guaranteed loss to avoid a small chance of a much bigger one. The logistics of this can get pretty complicated, however, leading to insurance over time having grown into an absolutely enormous industry, with a global market turnover of over 5 trillion USD a year.

Much of that is premiums coming in and payouts going out. However there is also significant bloat; offices to be maintained, wages and bonuses to be paid out, shareholders to reward, lawyers to retain and claims adjusters to send traveling to examine cases more closely. All this creates quite a lot of ‘wasted’ money, from the perspectives of people buying insurance. It also causes delays in payouts, and creates unfortunate friction where even after a contract has been signed, insurer and buyer have diametrically opposed interests from the second a claim has been filed.

Removing the Middleman

Smart Contracts remove middlemen, and the insurance industry is a very large market, prime for cannibalization. So far insurance companies have been needed because someone at the end of the day has to determine whether any particular claim is justified. If you just take the claimant’s word for it when they file, fraud would be rampant and the model would be unsustainable.

With the aid of oracles, however, Smart Contracts can be set up for many insurance policies that pay out based on easily verifiable, objective measurements. You can have flight insurance, which pays out in the event that a commercial flight is cancelled or sufficiently delayed. The way this would work is you pay into a contract and take out a policy on a particular flight. Some time after the flight was scheduled, the smart contract then purchases information from an oracle on whether that flight took place as scheduled. If not, it can pay out automatically. No bureaucracy, no delays, no room for human bias. Your flight was either cancelled or it was not.

Premiums for such an insurance contract could be calculated by parsing past flight data from the airline for that particular regularly scheduled flight. If one in a hundred trips gets cancelled, the premium to pay would be not much more than a hundredth of the cost of the ticket. The smart contract would have to charge a little extra, of course, to cover the cost of oracle queries and other transactions. Still, compared to the bureaucracy of an insurance company, a smart contract can run very lean indeed.

A second example is drought insurance. Farmers work in an industry that is incredibly sensitive to natural variations in weather from year to year. A drought can wipe out whole harvests, a disaster against which many farmers already take out insurance, or sell their produce ahead of time in the futures markets. Better to give up a little profit every year than to risk a complete loss of revenue.

A smart contract could be set up that calculates the premium based on historic precipitation levels in the farmer’s area, defines how much rain is required to avoid a drought, then purchases data from oracles on how much rain there was during the period the insurance policy covered. If it didn’t rain enough, the farmer receives their payout.

Not every situation makes for an easily defined decentralized insurance policy, of course. If we consider a homeowner’s insurance that covers damages and repairs to a house, some human judgement is necessary to determine if the policy holder is making reasonable requests or if they are taking the opportunity to have more work needed than the policy really covers. The traditional insurance industry is not going to die in the next decade. But for many insurance policies, facts are easily verifiable through oracles and payouts can be safely automated. And if decentralized insurance can grab even just a 1% market share from the traditional insurance industry that’s a 50 billion dollar market, with middlemen cut out, premiums reduced and objectivity guaranteed by mathematics.

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