What Is Blockchain and How Does It Work?

June 7, 2017 by

First of Two Articles

While everyone talks about blockchain, also known as mutual distributed ledger technology, just a few people actually know what this technology can do and how it could someday revolutionize the re/insurance industry, just by streamlining back-office processes.

As a result, Insurance Journal in this article provides a description of what blockchain is and how it works. The second article in this series covers some of the industry’s nascent steps into using the technology.

“Mutual distributed ledgers are records of transactions, which are shared, can’t be changed, are stored in multiple locations with no central ownership,” explained Michael Mainelli, executive chairman at Z/Yen, a London-based technology company and think tank.

“I can add transactions to the ledger — for example, correcting a misspelled name — but there’s always a permanent record of the original document as well as the corrected document,” he said. “In other words, it’s a multi-organizational data base with a super audit trail.”

Paul Meeusen, Swiss Re’s head of Finance and Treasury Services, uses an everyday analogy to explain blockchain. “I tell people to think of it as a 1) dropbox [the distributed ledger], 2) that is secure and 3) has intelligence.”

Meeusen leads Swiss Re’s involvement in the Blockchain Insurance Industry Initiative (B3i), which launched in October 2016 to explore the potential use of distributed ledger technology and now has 15 industry members.

Rather than everyone transacting business on their own, with a distributed ledger, for example, the broker, the cedent and the panel of reinsurers share information. Meeusen said such sharing makes business sense because “when a nat-cat loss event happens, it’s the same base underlying risk and data that affects all of us on the risk.”

While the concept of a “shared” ledger appeals to many people in the industry, they are worried about the security aspect of the process and want to be certain that a competitor can’t view proprietary information.

As a result, cryptography and public and private keys are being developed to “make sure that while we share, we are always certain about data privacy, security and anonymity—so that people should see only what they are supposed to see,” Meeusen said.

He then described the third blockchain pillar, “intelligence,” where so-called smart contracts are employed, protected with encryption.

Meeusen explained that the encrypted smart contract would include legal conditions such as triggers, the accumulation of loss events, what lines are covered, excluded risks and policy limits.

“With this intelligence, information is shared securely and gets processed and interpreted more quickly,” he said.

Of course, blockchain and distributed ledger technology is still very theoretical for the insurance industry, where it is in the proof-of-concept phase. Indeed, B3i is gearing up to use blockchain for the first time in a reinsurance contract in June.

Mainelli believes blockchain will help the wholesale insurance market work together as never before. “This technology for the first time may enable a sophisticated market— such as the London market—to automate itself,” he emphasized.

Historically, the London market has feared automation via platforms dominated or owned by market participants, which would create natural monopolies for central third parties who want to extract rents, or fees, for operating on the platform, he explained.

Indeed, the London market is littered with failed central exchanges (Limnet, Kinnect, Electronic Placement Support, Ri3K, Project Darwin, etc.). Some believe they didn’t receive market buy-in because of the potential dominance they might have created for industry participants that owned the exchanges.

Distributed ledger technology would overcome this problem because the platform is shared and becomes a mutual utility, said Mainelli.

He used the example of a shipping registry to explain how a ledger works when owned and controlled by a central third party, also known as a “trusted third party.” The registry validates the existence of a vessel and its ownership and also safeguards and preserves the transaction records so a ship isn’t sold twice to different people.

Blockchain can largely replace two of the three roles of a trusted third party – safeguarding and preserving transactions – while validation is an issue that can be addressed in a number of different ways, he continued.

For example, the party to the transaction might be able to rely on a digitally certified document for validation, he added.

Mainelli said there are many different applications for blockchain. “Anywhere you see a group of people trying to work together on shared data or processes, there is probably a potential application for a mutual distributed ledger.”

This ranges from wholesale insurance to other processes such as time stamping, regulatory reporting, archiving, know your customer (KYC) systems and identity systems.

Diving into a description of blockchain technology, Mainelli said the distributed ledger approach uses two techniques from computing: hashing and cryptography.

“With hashing you can take any document and put it into a computer and come out with a unique digital signature for that document containing a line of characters and numbers,” he explained.

Cryptography actually encrypts the document until the key is produced to decrypt it, Mainelli added.

“What makes the transaction really secure is to incorporate a hash from a previous entry into the hash you make for a new entry,” he continued, noting that this is where the term “chain” comes from.

The distributed ledger system is secure, Mainelli affirmed, because a hacker would have to go back to a specific entry and change the hash structures of previous and subsequent transactions. “This is believed to be computationally impossible.”

Blockchain technology has existed since the 1990s, but it was the 2009 introduction of bitcoins, the cryptocurrency, that actually brought the technology into the public’s awareness, he said, noting that bitcoins use a form of blockchain technology.

In a real-life example of the security of a shared ledger system, Mainelli said, the bitcoin system has not been broken in eight years, even with its huge monetary value of about $20 billion at the end of April 2017.

“Hackers have succeeded in stealing coins from online wallets and exchanges, but the bitcoin ledger never has been knowingly violated.”

In case you’re wondering where the “block” in blockchain came from, Mainelli explained that bitcoin transactions are processed in batches called blocks, although many of the new emerging distributed ledger chains are not using blocks.

However, along with the technology, the name “blockchain” appears to be here to stay.

A version of this article first appeared in Insurance Journal’s sister publication, Carrier Management.

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