Discretionary vs Parametric Insurance for Crypto

9 min read

An article on the differences between parametric and discretionary covers in blockchain

As blockchain technology carves its niche across various sectors, it brings a unique set of risks.

This growing sector demands insurance mechanisms tailored to its specific needs, leading to the rise of two main types of on-chain cover policies: discretionary and parametric. Although they share common objectives in mitigating risk and safeguarding assets, their methodologies are fundamentally different.

This blog explores parametric and discretionary insurance models, shedding light on how they operate and differ, especially in the blockchain environment. In the context of blockchain, where risks are constantly present and losses are increasingly challenging to measure, which model proves to be more effective? Let’s find out.

Understanding Discretionary Insurance Model#

Discretionary insurance can be described as a compensation model where the decision to pay a claim rests on the discretion of the insurance provider. This means there’s no contractual obligation for the insurer to compensate for losses, even if the claim appears valid under the policy terms.

In discretionary insurance, a valid claim may be rejected for several reasons based on the judgment of the insurance provider. This could result in the policyholders not receiving payouts, even if the incidents resulted in their losses.

Brief Overview of the Parametric Cover Model#

Parametric cover is focused on predefined events as opposed to the assessment of individual loss claims. When events occur that meet the criteria specified by the parameters of the policy, all policyholders become eligible for a payout, irrespective of whether they have suffered an actual loss or not. This model is particularly effective for managing hard-to-predict, high-impact risks that affect many people at the same time.

In the blockchain space, where the risk landscape includes complex issues like security breaches or smart contract vulnerabilities, parametric cover provides much-needed reassurance. The efficiency of this model is further enhanced by embedding the event-based trigger parameters directly into the smart contracts. In the event that these parameters are accurately met, the payout condition is automatically fulfilled, ensuring prompt and unequivocal disbursement. This automation is critical in the dynamic world of blockchain, where quick and clear responses to incidents are essential.

The essence of parametric cover lies in its simplicity and efficiency. The policy parameters must be clearly defined—for instance, a specific type of hack or security breach.

Comparative Analysis of Discretionary and Parametric Models#

Let’s see the difference between parametric and discretionary insurance models in the following aspects:

Differences in Claim Assessment#

The claim assessment process in discretionary and parametric models varies significantly.

In discretionary models, every claim undergoes an individualized evaluation based on the specific cases of policyholders. This involves scrutinizing the specific nature of the loss and determining if it aligns with the policy's scope. This process can be time-consuming and complex, as it requires a thorough examination of each case.

Conversely, parametric models streamline the assessment process by focusing solely on the event parameters. If an event meets the policy's predefined criteria or parameters, it triggers a payout. This model's binary nature simplifies the assessment, leading to quicker and more efficient claim processing.

How Payout Policy Differs in Parametric and Discretionary Models#

Payouts in discretionary models are based on the indemnity principle, where compensation is aligned with the value of the loss incurred. This means higher losses typically result in higher payouts. However, this also implies that the actual compensation might not always fully cover the loss, depending on the policy's terms.

In parametric models, payouts are predetermined and not directly tied to the actual loss. Once the specified event occurs, policyholders receive a payout based on their coverage amount, regardless of their individual loss. This can sometimes lead to over or under-compensation but ensures a swift financial response to the triggering event.

For example, if a token holder has a cover worth of $1,000, they will receive a payout for that specific amount in case a hack occurs, activating the predefined parameter. This is regardless of the amount the user has in their account.

Loss Claim Process in Parametric and Discretionary Covers#

The claims process in discretionary models involves each policyholder initiating the claim, often requiring substantial evidence of loss. The insurance company goes through a lengthy and complex process of reviewing all the claims individually. Importantly, the insurer evaluates whether the damage is covered according to the policy terms and conditions. Policyholders will receive the payout only if every policy term checks out and the claim is validated.

Parametric models, however, have a more streamlined claims process. It doesn’t require every individual to file a claim. Once the triggering event is confirmed, the payout is settled in a shorter time frame.

Every parametric insurance protocol may have different methods of confirming the triggering events. For Neptune Mutual, it’s the community members who flag the occurrence of incidents through voting. The correct voters are even eligible for additional rewards.

We’ll talk more about Neptune Mutual below.

Difference in Insurance Premiums for Parametric and Discretionary Insurance Models#

A premium is the amount that you pay to cover your risks.

Premiums in discretionary models are often based on the perceived level of risk of being lost and the value of the covered assets. Determining the premium amount can be challenging as the blockchain industry is in its infancy and there’s not much depth in the historical data. Moreover, the evolving nature of risks makes premium calculations complex.

The parametric model’s premiums are the statistical likelihood of the event and the potential magnitude of payouts. In contrast to discretionary models, parametric cover premiums tend to be higher. This could be because of the certainty of the payout once the occurrence of the event triggers the parameters.

Challenges and Limitations of the Discretionary Model in Decentralized Environments#

Discretionary cover operates similarly to traditional insurance, but it’s adapted to suit the decentralized nature of blockchain, where anonymity and peer-to-peer interactions are common.

This model involves pooling premiums from policyholders, which are then used to pay out valid claims. However, the decision to pay a claim is at the discretion of the cover provider, often based on a thorough assessment of each individual claim. This model is particularly challenging in blockchain due to the difficulty in assessing and verifying claims in a decentralized and often anonymous environment.

Verifying individual claims in a decentralized and anonymous setting is complex and resource-intensive. The need for detailed claim assessments can lead to significant delays in payouts, which is problematic in the fast-paced blockchain world.

Since the claim approvals and payouts fully depend on the discretion of the insurer, this can lead to trust issues. Policyholders could get a perception of unfair claim denials.

Similarly, there’s a scalability concern; the model may struggle to persist due to the intensive nature of claim assessments as the number of users and claims grows. This shows that a discretionary cover protocol may not be the best option to cover exploits that affect large projects and communities.

Benefits of the Parametric Model over the Discretionary Model in Blockchain#

The speed, efficiency, and simplicity of payouts are significant benefits of parametric insurance models.

The absence of individual claim assessments simplifies the process, making it more user-friendly and less prone to disputes. In addition, the clear, predefined criteria for payouts enhance transparency and trust among policyholders.

Once the incident matches the cover parameters, the policyholders will receive payouts quickly. Parametric models only review whether the incident has indeed occurred. Generally, the payout period is processed quickly, within a matter of days.

In the case of Neptune Mutual, it takes a total of eight days to complete the payout from the time of the incident report. However, it should be noted that only valid incident reports will result in payouts.

Furthermore, parametric cover models don't require users’ identities. So, it aligns well with the decentralized nature of blockchain, where rapid, transparent, and automated processes are preferred.

Considering scalability, this model can easily scale to accommodate a growing number of policyholders and claims, as the payout process is largely automated and not dependent on individual claim assessments.

Choosing the right cover model for blockchain risks involves a careful analysis of your project's specific needs, risk profile, and the preferences of your user base. Both discretionary and parametric models have their strengths and limitations, and the best choice often depends on a balanced assessment of these factors.

Case Studies on the Response Time for Discretionary and Parametric Protocols#

The Exactly Protocol Hack Covered by a Discretionary Cover Protocol#

On August 18, 2023, Exactly Protocol suffered a hack, resulting in a loss of $7.3 million. InsurAce, a DeFi insurance protocol operating on a discretionary model, announced the initiation of the claim voting process on November 30, 2023, via a tweet.

As per the announcement, the voting process goes on from November 30 and will last three days until December 3. This means that the claim voting started three and a half months after the hack, which is a significant delay.

The announcement was made after a lengthy incident investigation conducted by InsurAce Advisory Board, which involved vulnerability assessment, communication with the Exactly team, proof of loss verification, expert feedback, and the impact of the incident.

While there’s been no update on the completed payout settlement as of December 18, 2023, it can be expected that it will take some time.

The Curve Finance Exploit Covered by a Parametric Cover Protocol#

On the other hand, Curve Finance was exploited on July 30, 2023, leading to a loss of $73.5 million. Neptune Mutual, a parametric cover solution, flagged the incident as ‘Incident Occurred’ after the incident was reported by community members.

Following this, the incident reporting period began, allowing community members to participate in incident resolution voting over a period of seven days. After a 24-hour wait period, the incident was resolved.

Neptune Mutual announced that Curve Finance policyholders were eligible to receive payouts. The policyholders were provided a seven-day window to claim their payouts, which started on August 9, 2023, nine days after the incident.

This rapid response, without individual loss assessments, underscores the parametric model's effectiveness in providing timely financial relief.

About Neptune Mutual’s Parametric Cover Solution#

Let’s talk about our parametric coverage protocol, Neptune Mutual.

Neptune Mutual is a parametric DeFi insurance solution marketplace operating on the Ethereum Mainnet. We cover users’ funds against the hacks and exploits in DeFi, CeFi, and Metaverse projects.

Being a cover protocol operating on a parametric model, we facilitate easy and quick payouts. We let our community flag the incident and vote if it had occurred. This reflects our approach to users’ participation and governance, a major entity of a decentralized system.

There’s a period of seven days for community users to vote on incidents, evaluation of exploits from our team, and incident resolution, and a cooling period of 24 hours. With successful evaluation after the period, the policyholders will receive the payouts at once; there is no need for individual loss assessment.

Visit our documentation page to learn more about how Neptune Mutual works.

We encourage crypto holders and investors to protect their funds through Neptune Mutual. Though we operate on Ethereum, we offer protection for users in ArbitrumBNB Smart Chain, and Polygon, along with the Ethereum chain, offering protection for several projects in different networks.

Our marketplace lets projects create cover pools for their projects that need protection. Users who have invested in the project can purchase coverage from our marketplace.

If you are a liquidity provider looking to receive yields, you can also add liquidity to the cover pools and increase the cover purchase capacity of the pools.

Projects in need of protection can reach us through our contact page so we can discuss further about creating a cover pool for your project.