What is decentralised finance for insurance?

The traditional insurance model has remained largely unchanged for hundreds of years, and with good reason, for the most part insurance works effectively to allow individuals and businesses to manage their risk in a way which enables stability and growth.

However as new technologies emerge so too do new risks, which provides a challenge to traditional insurers.

With the emergence, and increasingly widespread adoption, of new technologies such as digital assets like Bitcoin, traditional insurers have found it hard to adapt to the new and unique risks businesses operating in this space face. In this guide we will uncover how decentralised finance could be the answer to the insurance needs of digital asset businesses, and how it differs from the traditional insurance model.

What is decentralised finance (DeFi)?

Decentralised finance (commonly known as DeFi) is a form of finance that does not rely on a single or central financial body such as a bank or an insurer to provide finance, instead drawing this from a collective.

Decentralised finance is typically blockchain-based, enabled via smart contracts, and can function for a range of financial requirements including banking, borrowing and insurance. The typical investor will invest their digital assets into a certain DeFi protocol to get a return on their investment, called Yield. The amount of risk taken on by the investor as well as how many other people are contributing to the protocol determines the amount of Yield you can make. Investors typically can see a much higher return than with other, more traditional investments, although if something goes wrong there is often no recourse to be found.

In insurance this means a business or individual seeking insurance through decentralised finance protocols would typically pay premiums to a decentralised autonomous organisation (DAO). This DAO would take premium from investors and share the risk amongst the collective and facilitate the vote for what claims are paid out. This means that instead of claims being paid by a centralised institution like an insurer, the claims are decided by every individual in the DAO.

How is DeFi different from the traditional insurance model?

In the traditional model of centralised finance (CeFi), insurers use historic data to try and predict the type of business profile that is more or less likely to make a claim. These actuarial models are generated from years and years of claims data and with every claim the market adjusts the rates and their confidence level in predicting future claims. In essence, an insurer is a data company that uses their data to place bets.

In this model the financial strength and security is owned by a centralised body; the traditional insurance market.

However with businesses that operate new and emerging technologies such as digital assets (including cryptocurrency), this historic data is far less mature and the lack of it creates a barrier to these businesses’ ability to take out insurance in the traditional model. Typically insurers will be more risk averse in taking on this type of business and if they do, the premiums are typically very expensive, complicated to write and oftentimes not tailored to the unique needs of these businesses.

Enter decentralised insurance.

Decentralised insurance is actually a bit of a misnomer as what this approach provides is not strictly insurance. For a contract of insurance to be legally binding there are a number of steps that need to be in place, for example a licensed insurer is regulated and mandated to have enough capital to meet its liabilities in the form of potential claims from their policyholders.

There is no company (yet) that is a completely decentralised licensed insurer, but there are companies that are filling the gap without the regulation and red tape. The most notable of which is Nexus Mutual. They’ve adopted a Decentralised Autonomous Organisation (DAO) structure where its members vote on the claims that come in. Unlike traditional insurance, in this model there is no obligation for a claim to be paid as each payment is put to a vote. If the majority agree there has been a covered claim then the claim is then paid out.

Whilst the likelihood of a claim being paid is reduced, the rate and the type of cover you can get through a protocol like Nexus Mutual is normally lower (for the rate) and broader (for the cover) than would be available through centralised finance for digital asset businesses. What’s more, if no claim is made the stake can be returned to the client with interest.

A comparison of centralised and decentralised finance in insurance

What does the future of insurance look like?

There is a place for both DeFi and CeFi to coexist. Using the relative strengths of each model to work together has the potential to bring better insurance solutions to the digital economy. It’s clear that the digital asset space will only continue to grow and, whilst the world of traditional insurance typically takes time to adapt to new and emerging technologies, there is undoubtedly an appetite to do so.

Here are a few examples of how businesses on both side could evolve to better cater to the insurance needs of emerging technologies:

• Traditional centralised insurance - Insurers would identify an industry segment closely aligned to the emerging technology that is to be underwritten and blend that with another to create a proxy for historic data, rate and expected loss ratio.
• Emerging decentralised insurance - The entrepreneurs behind these companies will continue to iterate far faster than their CeFi counterparts moving towards a significant milestone where we see the first decentralised licensed insurer.

As an insurance broker, it’s likely we will soon be at the point where we take business to both of these worlds for certain types of cover, much like how you may interact with both a crypto wallet and bank account in the same day. Insurance brokers who are educating themselves and learning about the digital economy will be best placed to take advantage of the coming digital asset tsunami and its corresponding opportunities and returns.

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Ben Davis has over a decade of experience in the insurance industry, with a career that spans broking, underwriting and consulting. He has a particular specialism in blockchain and crypto assets and wrote the first ever UK consumer Bitcoin theft insurance policy.

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