The Volokh Conspiracy
Mostly law professors | Sometimes contrarian | Often libertarian | Always independent
Five years ago, I wrote an article entitled "Cryptoinsurance," describing the possibility of a peer-to-peer insurance system implemented through cryptocurrency. I have recently found out about a company called TandaPay, which is seeking to implement a version of decentralized cryptoinsurance and was awarded its first patent last month.
TandaPay's vision of how cryptoinsurance might work is fairly simple (but is explained in more detail by founder Joshua Davis here). Individuals may choose to join a mutual insurance group, containing others they know and trust, by monthly contributing funds in the form of cryptocurrency. If a member of the group makes a claim, a designated secretary determines whether it is valid, and members of the group are then supposed to allow their funds to be released to the claimant. However, any member of the group may choose to refuse to release their funds, in which case that member is banned from further participation in the group. If claims fall short of contributions in any month, then the difference is refunded. If, on the other hand, claims exceed contributions, then the contributions are divided to claimants in proportion to approved claims.
One interesting aspect of this arrangement is the principle that all premiums are distributed to policyholders every period, either in the form of claims or as refunds when there is money left over. Nothing in this principle is dependent on the crypto-aspects of the broader proposal, and indeed Davis of has argued (see here, half way down) that full distribution of premiums might help overcome some difficulties in existing insurance markets. If there are a sufficient number of policyholders, one could even imagine a contract in which the insurer is required to spend all premiums on claims each policy period. Insurers have to make money, of course, so they would charge an administrative fee separate from the premiums.
In existing insurance markets, the primary function of the legal system is to prevent insurance companies from taking advantage of policyholders. It is widely understood that insurance companies will pay as little as they can get away with, which often means underpayment but sometimes means that they make payments on claims that the parties would have excluded had it been possible to contract ex ante concerning the precise scenario. In a regime in which insurers must pay out all premiums each period as claims, the insurer and the insured are no longer in an inherently adversarial relationship with insureds. An insured would look for an insurer who has a reputation for fairly judging claims and who charges relatively low administrative fees. In such a regime, the appropriate role of the legal system ought to be quite limited, focusing solely on whether the insurer in fact has distributed the premiums, whether any bribery has occurred, and whether the insurer has made proper disclosures, clearly identifying the portion of the payment that will be kept by the insurer as an administrative fee.
This model thus provides the insured with a different form of assurance than the conventional insurance model. In the conventional insurance model, the insured knows that the contract promises certain payments in the event of a loss and that the insured can sue if the insurer fails to pay. In this alternative version of the mutual model, the insured knows that the insurance company's incentive is to assess claims fairly, but it may be hard to predict precisely how much will be paid on a claim that is clearly covered by the insurance contract. The most significant advantage of the model is that it may have lower transactions costs, both because underwriting is unnecessary (only filed claims need to be examined) and because of the lack of need for enforcement in the courts, at least if the legal system respects a contractual term giving the insurance company final say over how to distribute premiums to claimants. The case for such respect is that the insurer is serving a role as arbitrator among competing insurance claims.
The required-payout model could work reasonably in a context like automobile insurance in which claims are fairly predictable (even if there is a small risk of a very bad month in which claimants will receive less than they would have expected). It could, however, also be adapted to a context in which there might be highly correlated losses. For example, homeowners in a particular geographic region might purchase a policy where the insurer promises to use the premiums to buy catastrophe bonds relating to that region. In a period in which a catastrophe such as a hurricane occurs, the insurer's job would be to collect on the catastrophe bonds and then distribute the money to insureds. An insurer would give more money to an insured suffering a larger loss, taking into account how much the insured contributed and how large the risk was that the insured faced ex ante. For example, if two insureds had contributed the same premium, an insured with a house on stilts would receive more than an insured whose house was sure to be flooded in a rainstorm. An insurer with a reputation for not making such adjustments would end up with an insurance pool of only bad risks.
TandaPay does not work quite like this—it relies on individual group members to police insurance payments. That approach, however, reinforces that insurance requires trust, but the trust can come in many existing forms. With conventional insurance, insureds must trust that the legal system will require insurers to meet their obligations. In the mutual approach that I have described, insureds recognize that insurers have incentives to compete on price and on fairness, thus trusting market incentives. And in TandaPay, insureds must trust the fellow insureds in their group, taking into account that an insured who defects and refuses to pay may suffer in the future, both reputationally and by being barred from further participation in the insurance scheme.