The insurance industry is an integral part of the global economy, providing financial protection to both individuals and businesses. With the proliferation of blockchain technology, there has been an increasing level of interest in the decentralized model of insurance; due largely to the trustless nature of blockchain transactions that enable the development of peer-to-peer business models.
Decentralizing the insurance industry could create new opportunities for innovative products and services, such as embedded insurance and microtransactions. It could lead to a safer and more efficient system, which would benefit purchasers of digital asset cover as well as those providing the underwriting capital.
The decentralized finance insurance sector (DeFi Insurance) is a new part of the cryptocurrency industry that has huge potential for growth and innovation.
What Is Decentralized Finance?#
Decentralized finance (DeFi) is an emerging financial technology that is different and complementary to the centralized banking system. DeFi works by enabling anyone to use financial services anywhere regardless of who or where they are. It eliminates the need for a centralized finance model by letting users buy and sell assets and financial services without involving a centralized intermediary. DeFi is based on peer-to-peer payments using trustless blockchain technology.
What Is DeFi Insurance?#
DeFi insurance is a decentralized form of insurance that provides protection for a variety of risks, primarily related to digital assets, that can include:
- Risk of losing funds due to a hack or theft
- Risk of losing funds due to a scam or fraud
- Risk of losing funds due to a mistake or error
- Risk of losing funds due to a natural disaster or other event
DeFi insurance is at an early stage in its development. This can be seen from the overall size of the DeFi insurance category in which there is around $300 million of TVL, in comparison to the DeFi finance sector as a whole where there is approximately $50 billion dollars worth of TVL. A considerable amount of attention is being given to how to scale DeFi insurance adoption to provide effective risk mitigation for a much more significant proportion of the $50 billion of digital assets that are currently at risk and without any form of cover.
Why Is There a Need for a DeFi Insurance Industry?#
There are a variety of reasons driving the need for DeFi Insurance. Firstly, traditional centralized insurance is not well suited to protecting digital assets that are, more–often-than-not, held in anonymous wallets. Traditional centralized insurance entities are heavily regulated and compliance requirements mean that each and every customer identity needs to be checked; this immediately puts a large proportion of digital assets outside of the framework within which traditional insurance can operate.
Secondly, traditional insurance works on the basis of pricing risk based on an extensive history of data and an in-depth understanding of the factors that influence risk. Blockchain technology was in its early stages of development in the early 1990s but it wasn’t until the creation of Bitcoin in late 2008 that a blockchain industry gradually started to emerge. This means that there is limited historic data for actuaries to create statistically significant pricing models. In addition, many of the risks related to digital assets are highly technical in nature and traditional insurance companies do not have the expertise to assess and price these risks.
One further challenge for traditional insurers is that unlike many forms of risk, such as property & casualty, or life insurance, the risks that digital assets are exposed to mean that they often impact many thousands of people all at the same time. This leads to difficulties in terms of resolving individual claims in a timely and effective manner.
Finally, digital assets are, by definition, digital. As traditional insurance companies typically raise underwriting capital in fiat, receive policy fees in fiat, pay expenses in fiat and pay dividends to their shareholders in fiat, this sets up a mis-match between the traditional insurance company and the system in which the digital assets are based. While on/off ramps exist and OTC entities can help institutions with converting fiat to cryptocurrency, and vice versa, this issue still remains a barrier because traditional insurance companies often do not have the systems in place to manage this type of work flow.
What Are the Advantages of DeFi Insurance?#
As with most peer-to-peer business models, the most obvious advantage is that the “profit”, or value extracted by the centralized intermediary in a traditional business model, can be shared between the buyer and seller, or in the case of DeFi insurance, between the cover purchaser and the liquidity provider. This means that both parties are better off when conducting business in a decentralized transaction than when conducting it through a centralized intermediary.
Secondly, whilst it is true that digital assets are held anonymously in the DeFi space, it is also true that transactions, and the corresponding data, are highly transparent. This provides a number of advantages in terms of data analytics, obviously a subject of particular interest when trying to analyze and price risk.
Finally, decentralized applications that use smart contracts to interact with the blockchain offer enormous potential for designing “intelligent” insurance policies that meet the needs of digital asset holders in a way that would be difficult to achieve with traditional insurance policies
Conclusion#
DeFi insurance has a crucial role to play in protecting individuals and businesses from financial losses. If more people learn about the benefits of a decentralized insurance model, the blockchain industry could become safer and better protected, which is vital if it is to reach mass adoption. For further insights into innovations and the latest trends in DeFi insurance be sure to subscribe to our newsletter.
