DeFi Insurance: Managing Risks of Digital Assets
Understanding DeFi insurance and its importance in mitigating DeFi risks and threats.
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In this blog, we have covered the basics of parametric cover in a simplified way.
Some losses are difficult to quantify. While it’s easy to quantify loss or damage to a car or the contents of a home, it’s not as straightforward when it comes to quantifying loss caused by agricultural and environmental disasters.
Hence why parametric covers exist.
A parametric cover is a type of cover that covers a policyholder against a specific incident or an incident of a specific magnitude.
So, how does it work?
Rather than paying a set amount for the magnitude of losses (covered by a traditional indemnity policy), parametric cover pays a set amount based on the magnitude of the event.
For example, a parametric policy could pay out a set amount if an earthquake of magnitude 5.0 or greater occurs. The contract for that policy would specify the amount of payment, the trigger parameters that determine whether or not the event has happened, and a third party responsible for verifying the status of the trigger parameters.
Some policies include a tier of third-party verifiers just in case the primary agency becomes incapacitated.
Trigger events depend on the nature of the parametric policy and can include environmental triggers such as wind speed and rainfall measurements, business-related triggers such as foot traffic, and so on. Examples of current parametric products include the Caribbean Catastrophe Risk Insurance Facility (CCRIF), the African Risk Capacity (ARC), and the protection of coral reefs in the state of Quintana Roo in Mexico.
A key attribute of a parametric cover is its elimination of the claim adjustment process. There will no longer be a need for an adjuster to investigate the loss, interpret the policy wording, and apply the policy based on facts discovered in the investigation.
As long as the parameter was triggered, the parametric policy will initiate a payout. This makes claims money reach policyholders faster. Unlike standard indemnity contracts that can take months or years to payout.
The beauty behind a parametric cover contract is its ability to deliver payouts within a matter of days.
The policyholder also has an incentive to minimize their losses with a parametric cover since the amount of policy payment is unaffected by the total loss. This reduces the company’s exposure to the problem of moral hazard. This is where a person with cover takes greater risks than they normally would because they know their policy will pay out if something bad happens.
The risk of insurance fraud is also reduced because trigger events are usually large-scale and independently verified, and payment is standardized.
Parametric covers can also work alongside standard indemnity policies.
Those seeking parametric cover do need to understand that removing the link between losses incurred and payout means that careful attention should be given to the amount of cover that is taken.
It is important to ensure that there is a reasonable match between the payout of the policy and the potential losses that might be incurred if the parameters are triggered.
So far we’ve looked at parametric cover in the physical world. Now, we come to examine how parametric cover protocols work in the blockchain industry.
The cryptocurrency ecosystem is still in its infancy. Participants face numerous risks including hacks of centralized exchanges and custodians, including exploits, and other forms of attack on decentralized protocols. Crimes like these can result in big financial losses for both service providers and consumers. For service providers, the drop in consumer confidence resulting from a hack or exploit can be more costly than the loss of funds themselves. Unfortunately, there are only a limited number of tools available to protect against such cybercrimes, some of which still need further development.
This may seem surprising given that decentralized finance (DeFi) has evolved into a robust, autonomous, and borderless financial ecosystem that provides disintermediated alternatives to core financial services including investing, borrowing, and trading. With attractive yield opportunities offered, the total value locked in DeFi protocols currently exceeds $230B across numerous popular blockchains.
The rapid growth of the DeFi ecosystem makes it crucial for users and platforms (exchanges and protocol teams) to manage the risk of hacks and exploits. However, only a handful of insurers are willing to tailor products that meet this demand, and insurance is still a very expensive option for providing financial protection.
As a result, not many exchanges have any insurance protection available. Only large platforms that have substantial financial resources can afford to reserve a certain percentage of profit to cover such risks. Many insurance protocols in the blockchain industry are focusing on DeFi, and it is perhaps surprising that in an industry that is well-known for its risks, all these insurance, and financial protection protocols combined have locked only $1.3B worth of assets, a tiny proportion of the overall assets within the DeFi space.
Most of the DeFi insurance solutions currently available are either discretionary or based on predictions (options). Some solutions require Know Your Customer (KYC) while others do not. However, nearly all protocols require that individual policyholders submit claims with a proof of loss, and await a centralized or third party jury to assess the nature and amount of loss for each claim before any payout can occur.
Backlogs and delays in approvals and payouts can be caused if large numbers of claims need to be processed at once. This cumbersome claims assessment process results in significant inefficiency. In addition, and arguably more importantly, in many cases less than half of policyholder claims that are submitted ever get approved.
One could argue that this low proportion of claim acceptance defeats the purpose of having insurance in the first place.
The big risk of discretionary insurance on the blockchain is that it’s not always clear what these policies actually cover. As they say, it pays to read the small print.
A surefire recipe for all-round dissatisfaction is a crypto hack, followed by an announcement from the insurer that the policyholders will not be able to claim a payout because the type of hack exploit was not covered by the terms of the policy.
The challenge of protecting consumers in a digital environment against a wide range of highly technical scenarios can potentially create a disconnect between the insured and the insurer.
Many insurance policies that one can take out to protect against hacks and exploits look quite similar, however, people need to be aware that there is a significant risk they won’t receive the payout they expect after a hack. A quick analysis of Nexustracker, which lists Nexus Mutual’s most recent claims, reveals that of the 95 most recent claims at the time of writing, 77 were denied and only 17 were accepted.
Scenarios where claims are denied and not paid out also put a protocol’s reputation at risk.
First, the lengthy insurance process causes uncertainty, frustration, and impatience in the community. Then, the investing community naturally expects action. But, they may quickly lose confidence if insurance claim assessments get rejected because of policy exclusions or discretionary rejections.
Later this year, Neptune Mutual will be launching an alternative to discretionary insurance on the blockchain.
Neptune Mutual’s parametric covers will provide policyholders with protection against specific hacks or events on the blockchain.
To start with, Neptune Mutual selects high-quality cover creators; typically entities strongly linked to the CeFi/DeFi project being covered. The platform guides cover creators through the process of setting up a dedicated cover pool. The first step defines the parameters of the risks that the cover will protect against. Parameters need to be binary and there should be at least one specifying a minimum size of loss to the community.
Parametric cover policies are generally defined by only a few parameters, with a very limited number of exclusions (for example, the exclusion of deliberate or malicious action by the cover creator or protocol team).
After that, the floor and ceiling price of the cover policies offered by the cover pool are set and the next step is to attract liquidity providers. Liquidity providers benefit from a variety of revenue streams including the fees paid by cover policyholders. One of these revenue streams arises from the option to stake the Proof of Deposit (POD) that is provided when supplying liquidity to a cover pool.
To compensate and alleviate some of the risk taken by the liquidity providers, cover creators can provide a reassurance token that will re-capitalise a portion of the dedicated cover pool in the event an incident arises.
Dedicated cover pools provide a guaranteed payout to policyholders because:
From purchasing cover from a Neptune Mutual pool, reporting an incident, dispute resolution, to claims payout, everything is fully transparent and decentralized. Anybody can purchase a protection from Neptune Mutual cover pools without having to go through a complicated onboarding process. Most importantly, cover purchasers never have to worry about their claims not getting paid upon incident resolution.
The Neptune Mutual protocol is based on a parametric cover model that offers policyholders protection against financial loss resulting from a predefined set of parameters or events (also known as cover incidents). The policyholders pay a premium (also known as a policy fee) to get cover for a fixed duration and desired amount. As a result, faster claims payout becomes possible because a claim does not require any back and forth between the underwriters, claims assessors, loss adjusters, or any middlemen or centralized party.
There is no need for individual assessment of each claim or the accompanying proof of loss documents. Once resolution is reached in the cover incidents, the payout is validated for every policyholder. The payout amount does not change during the term length and the policyholders cannot file a claim exceeding the agreed upon amount.
It’s easy to see how discretionary insurance can fail to live up to expectations when it comes to covering the risks of hacks and exploits. The claims assessment process is highly inefficient, and too few claims get approved. Fortunately, a fast and reliable solution for blockchain investment protection can be found in Neptune Mutual’s parametric cover protocol.