Decentralized Underwriting in Finance

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We propose the use of native Semada cryptocurrencies as claims on future cash flows of an underwriting business operated by a Decentralized Autonomous Organization (DAO). The structure of incentives embedded in our DAO design has the potential to substantially lower capital requirements and the related need for capital regulation. Further, it allows for trustless collaboration (i) among DAO underwriters as well as (ii) between underwriters and consumers. In this decentralized, trustless system, the tokens essentially substitute for reputation. Financial distress or bankruptcy of an individual underwriter does not have to affect either consumers or the DAO as the insurance contracts are backed by encumbered tokens.

Background

The novelty of our proposal lies in the decentralized and democratized underwriting functionality enabled by our DAO design. Asset tokens already exist that directly or indirectly serve as claims on future output or profits. Proposals to operate DAOs in the insurance field have also already been put forward and are under active development. Refer to IAIS (2017) for a survey of current and potential future impact of Fintech on new insurance products and the structure of the insurance industry. Marke (2018) contains an update relating to the B3i (Blockchain Insurance Industry Initiative), an initiative that was launched in 2016 by a consortium of international insurance companies with the goal of pilot-testing the blockchain for implementing highly complex reinsurance contracts. A report by Hogan Lovells (2017) contains not only an analysis of the legal and regulatory challenges involved in implementing the technology of the blockchain and smart contracts in the insurance industry, but also some examples of firms that have already started implementing some aspects of this technology.

In order to appreciate the innovative features of the current proposal and the resulting potential benefits to both underwriters and consumers, it is important to develop an understanding of the proposed design of the DAO. The next section contains an outline.

The Design of the Underwriting DAO

The Underwriting DAO we propose consists of a group of underwriters, who roughly correspond to the partners or shareholders of an insurance company. These underwriters each hold a certain number of tokens in the DAO. We will refer to these tokens on occasion as reputation tokens as an agent’s proportional holdings of these tokens is likely to increase over time only if the agent were to follow sound and successful underwriting practices. These tokens serve multiple purposes.

First, only token holders are allowed to participate in underwriting insurance policies. Inbuilt processes are used to assign new business to token holders. Policies may be underwritten either singly or jointly by these agents.

Second, these tokens serve as claims on the future cash flows generated by the DAO. Insurance premia collected by the DAO are distributed among the token holders in proportion to their token holdings. It is worth emphasizing that the premium from a policy is not considered the revenue solely of the underwriters. Instead, the premia are treated as the revenue of the entire DAO and shared among the DAO participants. Thus, the value of the tokens is a function of the expected future cash flows of the DAO.

Third, agents who underwrite policies by staking their reputation tokens are rewarded with a certain number of newly minted tokens as salaries, based on a predetermined formula. Thus, the total number of tokens grows over time. This implies that "passive" agents who hold the tokens purely to receive a share of future premia will find their proportional ownership in the DAO decrease over time. Their income may however still increase if the overall revenues of the DAO grow at a sufficiently faster pace. Therefore, the effect of the design is to incentivize agents to play an "active" role by participating in underwriting activities and thereby grow the business, while still allowing passive investors to derive income and speculate on growth.

Fourth, the design requires the underwriters to "stake" or “encumber” an appropriate number of tokens against each policy they underwrite. These tokens in effect serve to secure the promises of the underwriters. The number of tokens to be encumbered is based on a preset formula with the objective of ensuring that the value of the encumbered tokens is sufficient to meet any claims that may arise at any point in the life of the policy. Such encumbered tokens continue to remain under the ownership of the respective agents and entitle the owners to receive their share of future premia. In case, there is no claim on the policy, the tokens are "freed up" or become "unencumbered" when the policy matures. In case the insured event were to occur during the life of the policy, the agents who underwrote the policy can (in effect) reclaim these tokens (or receive replacement tokens) after meeting the claim. However, the underwriters of the policy may choose not to reclaim the tokens. For convenience, this is referred to as a "breach" by the underwriters. In such a case, the encumbered tokens, along with additional freshly minted tokens as needed, would be sold in an auction. All current DAO participants as well as outsiders interested in joining the DAO may bid for the tokens in this auction. The objective here is to generate enough proceeds from the auction so as to meet the claim on the policy. Note that a breach by underwriters on a policy does not imply a default by the DAO. Under normal market conditions, a well-designed DAO should experience very few breaches, if any; and in case of a breach, the mechanism outlined above should ensure that the customer suffers no losses on this insurance policy.

Under what circumstances would a breach occur? It would occur only if the underwriters concerned believed that the value of these tokens is less than the payment they need to make in order to reclaim the tokens. In general, this will happen only if there is a dramatic shift in the future prospects of the DAO, such as a sharp decrease in expected future revenues or a sharp increase in expected payments on outstanding policies.

Related Research

There is a growing literature on cryptotokens and their use for funding start-up ventures. Bakos and Halaburda (2018) provide a good review as well as a study of the network effects of Initial Coin Offerings (ICOs). In their model, platform-specific tokens provide funding for capital constrained firms while giving early adopters the opportunity to benefit from the possible future success of the venture. In the process, the token issue also helps solve the coordination problem relating to network adoption. The focus of Li and Mann (2018) is similar in that their objective too is to show how ICOs can solve the coordination problem.

Recent studies that focus on valuation of tokens include Catalini and Gans (2018) and Cong et al (2018). In the former, the focus is on ICOs as an alternative to equity financing for new ventures and on the challenges of pricing an ICO when the value of a token depends on the highly uncertain future demand for the services provided by the platform. In the latter, the focus is on valuation of tokens in a dynamic, continuous time setting in which agents take into account both the utility value of the token as well as possible value appreciation in making their decision regarding their token holdings.

Malinova and Park (2018) compare ICOs to equity financing and also study the question of how best to structure a token offering. As in Catalini and Gans (2018), the objective of the token sale is to fund development and growth, effectively a trade-off of future revenue for current funding. The question of interest is whether the tokens should represent a claim on future revenue or output. Interestingly, they find that the optimal way to structure the token offering is as a combination. Structuring it as purely a claim on one or the other results in the monopolist entrepreneur either under-producing or over-producing and therefore, a sub-optimal project net present value.

The current study is related to these prior studies in that we too study the valuation and design of cryptotokens, strategic decision-making by DAO participants, and the optimal structure of incentives. However, there are also several important differences between the studies mentioned above and the current one. The most important difference perhaps is that our focus is squarely on designing a DAO to conduct the business of underwriting. The focus is broader than may appear at first sight. By underwriting, we do not have in mind only traditional insurance policies, but a variety of use cases that may range from providing insurance to the Internet of Things (IoT) to guaranteeing settlements on online exchanges. In fact, almost any transaction on the blockchain that does not involve an exchange of purely digital tokens may require or benefit from underwriting. Another key difference is that in our study, the purpose of issuing tokens is not only to raise capital but also to provide the owners the opportunity and incentive to develop the business of the DAO. The focus is not on how the tokens help solve the coordination problem, but rather on how best to design the mechanism so as to provide utility and stability to all participants, both underwriters and consumers.

Research Objectives and Questions

The main objectives of this paper are as follows:

· To develop a mathematical model in order to study optimal decision-making by the DAO, its steady-state performance, and the impact of possible shocks. In particular, the model will help determine the viability of the business model outlined above, shed light on potential weaknesses, and help assess its advantages and disadvantages as compared to a traditional insurance firm.

· To address specific questions such as the following:

o What are the key variables that determine the DAO’s decisions regarding how much premium to charge, how much risk to take, and how to reward underwriters?

o How is the value of a token determined?

o What are the circumstances and the likelihood of a breach by an underwriter, and the likelihood of the related but distinct possibility of the DAO facing financial distress?

o How do the economic capital requirements of the DAO compare with that of a traditional insurance firm?

o What kind of a governance structure should be put in place in order to make decisions relating to changes in protocol and, more generally, to handle unforeseen contingencies?

In sum, the paper will address questions relating to optimal design of incentives for DAO participants and safeguards to ensure that the design is fair and just as well as sustainable.

Key Implications

This section summarizes the key benefits of this design for both underwriters and consumers.

The DAO structure can be used by traditional insurance companies as well as niche players specializing in a narrow range of specialty policies. In common with all applications of the DAO concept, insurers as well as consumers can enjoy the benefits of transparency, efficiency and cost-effectiveness. In addition, the particular design outlined above is likely to facilitate the entry of new players to the insurance market. It is possible for a DAO to allow the participation of non-traditional firms and even individual investors. Such participants could buy tokens when they come up for auction, and then use these tokens to participate in underwriting, or else, just hold the tokens as a passive investment.

The design allows for trustless collaboration (i) among DAO underwriters as well as (ii) between underwriters and consumers. The need to trust is minimized by appropriately designed economic incentives. The governance rules of the DAO can be set up so as to ensure that minority token holders are appropriately protected. In general, assuming all agents are active underwriters, the rules can be designed to ensure that the proportion of policies written by an agent in the long run is commensurate with the proportion of the agent's token holdings. Further, bad business decisions by one underwriter need not impact the other underwriters or the DAO. If a certain underwriter makes the mistake of underestimating the risk of the insured event, the losses will be suffered purely by the underwriter as long as the value of the staked or encumbered tokens covers the claim. As far as consumers are concerned, potential claims are fully backed or secured by the underwriters' encumbered tokens. In this decentralized, trustless system, the tokens essentially substitute for reputation. Even if the underwriters of a particular policy were to breach the contract, the auction of the encumbered tokens and the sale of additional tokens as needed ensures that the policy holder's claim is fully met. Thus, what we are referring to as a breach on a particular insurance contract does not necessarily imply any losses for the consumer.

The structure of incentives embedded in this design has the potential to substantially lower capital requirements and the related need for capital regulation. We note that the burden of maintaining sufficient liquidity in order to meet claims is not on the DAO, but rather on the individual underwriters that make up the DAO. Each underwriter would of course need to maintain sufficient liquidity and economic capital in order to be able to reclaim tokens as and when claims occur. (By economic capital, we mean the buffer that needs to be maintained in order to meet "unexpected" losses - i.e., losses in excess of the expected level.) However, it is possible under certain conditions that the total amount of capital that these agents will collectively hold is lower under this design than if the burden of meeting the liability were to be on a traditional insurance firm. This result is based on the premise that the amount of capital each underwriter will hold will be based on the risk of the underwriter's overall portfolio. The overall portfolio of an individual underwriter, especially a non-traditional one, may benefit from the addition of underwriting due to diversification, as attested to some extent by the existence of insurance-linked securities such as catastrophe bonds. As a result, the sum of the incremental VaRs (Value at Risk amounts) of the individual underwriters may be less than the VaR of an insurance firm that has underwritten the same contracts. Therefore, the total amount of capital the underwriters would need to hold against these insurance contracts may be less than the capital a corresponding traditional insurance firm would need to hold.

More importantly, how much capital an underwriter holds is a matter of their personal risk preference. An underwriter who is willing to tolerate fluctuations in their token holdings need only provide for expected losses. The key point is this: from the viewpoint of consumers and regulators, the encumbered tokens (which as we know derive their value from the DAO's future cash flows) essentially serve as a substitute for capital. Financial distress or bankruptcy of an individual underwriter does not have to affect either consumers or the DAO. As mentioned previously, in case of a breach on a particular contract, the policy holder’s claim can still be met by an auction of the encumbered tokens. Additional resources if required can be raised by minting new tokens. Barring highly adverse market conditions, the availability of "capital on tap" protects the DAO from default and bankruptcy. Thus, the design has the potential to greatly simplify capital regulation.

In sum, many of the innovative features of this design stem from the fact that the tokens serve multiple purposes: as reward for risk-taking, and a substitute for reputation and capital.

References

Bakos, Yannis and Halaburda, Hanna (2018), “The Role of Cryptographic Tokens and ICOs in Fostering Platform Adoption,” Available at SSRN: https://ssrn.com/abstract=3207777 or http://dx.doi.org/10.2139/ssrn.3207777

Catalini, Christian and Gans, Joshua S. (2018), “Initial Coin Offerings and the Value of Crypto Tokens,” MIT Sloan Research Paper No. 5347-18; Rotman School of Management Working Paper No. 3137213. Available at SSRN: https://ssrn.com/abstract=3137213 or http://dx.doi.org/10.2139/ssrn.3137213

Cong, Lin and Li, Ye and Wang, Neng (2018), “Tokenomics: Dynamic Adoption and Valuation,” Columbia Business School Research Paper No. 18-46; 2nd Emerging Trends in Entrepreneurial Finance Conference. Available at SSRN: https://ssrn.com/abstract=3153860 or http://dx.doi.org/10.2139/ssrn.3153860

Hogan Lovells (2017), “Blockchain/DLT in the Insurance Sector,” Available at https://www.hlengage.com/_uploads/downloads/5425BlockchainininsuranceV7FORWEB.pdf

IAIS (International Association of Insurance Supervisors) (2017), “FinTech Developments in the Insurance Industry,” Basel, Switzerland. Available at https://www.iaisweb.org/page/news/other-papers-and-reports

Li, Jiasun and Mann, William (2018), “Initial Coin Offerings and Platform Building,” 2018 WFA, 2019 AFA. Available at SSRN: https://ssrn.com/abstract=3088726 or http://dx.doi.org/10.2139/ssrn.3088726

Malinova, Katya and Park, Andreas (2018), “Tokenomics: when tokens beat equity,” Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3286825

Marke, Ken (2018), “Blockchain Is Tech Evolution That Will Create Re/Insurance Revolution,” Insurance Journal, Available at https://www.insurancejournal.com/news/international/2018/07/11/494638.htm