DeFi insurance is disrupting the insurance industry, emerging as an innovative alternative to traditional insurance for digital asset companies looking to mitigate risk. We compare the two, looking at the pros and cons of each.
DeFi explained
DeFi, or Decentralised Finance, is a rapidly growing ecosystem of financial applications and services built on blockchain technology. DeFi platforms harness this technology to produce an incorruptible ledger of economic transactions which exist as a shared database on the computers of millions of people simultaneously. This decentralisation reduces the reliance on single points of failure and enhances security.
DeFi protocols can interact with each other enabling different DeFi services to be combined to create complex financial products and services. DeFi has succeeded in recreating traditional financial services, such as lending, borrowing, trading, and investing, in a decentralised manner, eliminating the need for intermediaries like banks and financial institutions.
DeFi is also being used in the insurance industry as an alternative to traditional insurance models.
The traditional insurance model
The legacy insurance model that has served as the norm for decades involves risk pooling. Customers mitigate the financial risk of certain events by paying premiums to an insurance company. The premiums collected by the insurance company are pooled and insurers calculate that the amount they collect from many individual policyholders with a low risk of incurring losses will exceed the amount they will have to pay out in claims.
This process involves the assessment of risk and setting of premiums. Claims are assessed and handled by human experts. Risk is pooled through a centralised entity and assessed by actuaries. Claims adjusters are used to verify losses and determine the payout a policyholder will receive. It can be expensive and time-consuming, but this model has endured for decades, and is only now being threatened by a new pretender.
The advantages of traditional insurance
Traditional insurance enjoys certain advantages that DeFi insurance cannot yet boast. These include:
- An established regulatory structure – oversight from government and regulatory bodies guarantees that insurers adhere to established norms and safeguards the welfare of policyholders. Consumers understand this compliance framework and trust that they are being protected.
- Longevity and financial stability – Individuals and businesses are reassured by the track record of established conventional insurers who they assume possess the financial reserves to cover claims and meet their contractual commitments. They trust these providers because of their long history.
- Familiarity bias – Consumers understand the traditional insurance landscape and how it works. There is a certain familiarity bias in the way policies are issued and claims are dealt with under the conventional model.
What is DeFi insurance?
Blockchain technology is revolutionising the traditional insurance model with the emergence of DeFi insurance, a decentralised model of insurance that many digital asset companies are turning to in order to mitigate risks including hacks, theft, scams, mistakes or natural disasters. With DeFi insurance, decentralised platforms use self-executing smart contracts to automate and streamline the insurance process without compromising security.
Predefined codes are written into the policies and executed transparently on the blockchain. The code is the policy and also manages the policy. This eliminates the need for intermediaries and centralised authorities such as claims adjusters.
Nexus Mutual is an example of a one such firm that provides discretionary mutual coverage for various DeFi projects. Essentially their platform is an automated version of a very old structure where members share risks together. Nexus does this by allowing members to decide how risks should be priced, along with how claim payments should be made.
The Benefits of DeFi insurance
Although DeFi insurance doesn’t (yet) have the proven track record and consumer trust that traditional insurance enjoys, it does offer numerous benefits:
- Decentralisation and transparency – Smart contracts operate on decentralised blockchain networks. No single entity controls them, and they are visible to all on the chain, guaranteeing transparency, security, and immutability of contract execution.
- Democratisation – All that is needed to access DeFi insurance platforms is an internet connection. Anyone can take out relevant cover irrespective of their location.
- Lower costs – Middlemen such as underwriters and claims adjusters become superfluous to the process. Cutting out these intermediaries simplifies the insurance process and lowers costs.
Of course, DeFi is not infallible. There are risks, which include smart contract vulnerabilities, a lack of regulation, and potential for hacking, theft, loss etc.
Insuring digital assets: DeFi insurance versus traditional insurance
For digital asset companies there are several compelling reasons to favour DeFi insurance over traditional insurance.
Conventional insurance is ill-suited to safeguarding digital assets. Traditional insurers are stringently regulated and must carry out strict KYC checks. These may not be possible for many digital assets that are primarily stored in anonymous wallets.
Secondly, traditional insurance relies on historical data and a deep understanding of risk-influencing factors for risk assessment. Blockchain technology emerged in the early 1990s and only entered the mainstream after the emergence of Bitcoin in 2008. The lack of historical data related to digital assets makes it very difficult to develop statistically significant pricing models. In addition, traditional insurers lack the expertise to assess the technical complexity of the risks associated with digital assets.
Another challenge for traditional insurers is that digital asset risks often impact a large number of individuals simultaneously, unlike other business risks such as fire, injury or professional liability. This creates difficulties in efficiently resolving individual claims.
Finally, there is an inherent misalignment between traditional insurance, which deals in fiat currency, and the digital asset ecosystem. This makes managing workflows effectively difficult for traditional insurers who lack the necessary systems to facilitate fiat-to-crypto conversions.
DeFi insurance for digital asset companies
DeFi insurance is still in the early stages of development and digital asset companies looking for effective risk mitigation currently have a limited choice. To date most of the focus has been on provide coverage for protocols rather than broader coverage for institutions but this is changing as the market matures and grows.
It has been estimated that only 1% of crypto investments are covered by insurance but with cryptocurrency hacks still on the rise – an estimated $3.1 billion was stolen in 2022 – it is foolhardy for digital asset companies not to protect against the risks.
Continuum is at the forefront of this nascent and rapidly evolving industry. We have been working with digital asset companies in Asia for over five years, helping many startups to find the right solution for their business. Whether you are a digital asset custodian, blockchain developer, miner or tokenisation platform, we can find appropriate solutions to protect your business and offer value to your clients. Whether this is with the traditional insurers or DeFi insurers or possibly a combination of both we will work with you to find the best solution.
Contact Us to discuss how we can assist on your journey to success in the brave new world of digital assets!
