Decentralized Insurance

VeradiVerdict - Issue #128

Traditional insurance is big business. By some estimates, around $6.3 trillion in insurance premiums were paid globally in 2020—for reference, that’s about half of China’s GDP. While the lion’s share is occupied by life, health, and commercial insurance, a diverse array of insurance products extend to cover almost every risk imaginable.

Source: OECD

In short, the world runs on insurance, and it’s only accelerating. As the middle classes of countries abroad continue to boom, developing countries have become adoption engines for existing and new insurance products. According to one report, these developing nations are responsible for around 80% of the insurance industry’s growth, with no sign of slowing down. 

For such a large, booming industry, there has been a disappointingly slow pace of innovation. Incumbents typically have a few traits in common: slow claims processes, opaque policy mechanics, and low customer satisfaction ratings. Lacking a true technological challenger, insurance giants have been able to get away with these frustrating, outdated characteristics for decades. Now, though, the industry is facing a tectonic shift that it can’t ignore: blockchain-native insurance protocols.

What benefits does blockchain bring to the insurance industry?

  1. Speed. Typically, there’s a weeks- or months-long process of filing a claim, interacting with an insurer, and finally receiving a payout. On the blockchain, thanks to on-chain data and smart contracts that contain the “if, then” statements of an insurance policy, claims can be theoretically settled within minutes of an event. 

  1. Transparency. Existing “big insurance” has an incentive to keep information—such as their risk models and policy details—shielded from the public. As a result, policyholders often feel left in the dark and, to some degree, exploited. Insurance doesn’t need to be this mystifying, though. On the blockchain, policyholders have access to an unprecedented degree of information about their own policy, the financial health of the underwriters, and the open-source code dictating the protocol’s rules. For example, insurance companies can be created that are unprofitable by mathematical design; all of the funds are redistributed to the pool’s participants. Users can have full confidence in the destination of their funds.

  1. Second- and third-order innovations. Blockchain-native insurance also allows insurance policies to be tokenized, creating new possibilities. Policies can be traded if the user doesn’t need them anymore, or seamlessly bundled with other digital assets. Many of these newer applications remain in their infancy but are immensely exciting.

Source: Accenture

Smart contract risks: decentralized insurance’s first “killer app”

2020, for many in the crypto community, will be remembered as the “Year of DeFi.” Usage of decentralized finance (“DeFi”) protocols grew from around $1B in total value locked (TVL) to over $40B today.

This rapid growth, though, has created a completely new type of risk: smart contract risk. DeFi protocols expose their users to new types of risk that aren’t in the traditional finance world, due to their full reliance on code and smart contracts. A few examples are: critical coding bugs, transaction completion failure, flash loan exploits, oracle attacks, wallet hacks, unexpected collateral liquidation, and the list goes on. In 2020, over $100M was estimated to have been stolen from the ecosystem by attackers. 

The risks mentioned above are typically referred to as “smart contract risk”: the risk that a user’s funds will get lost or stolen by malicious hackers due to bugs and flaws in the underlying code of a DeFi protocol. For many, this uncertainty has been an unpleasant but unavoidable part of engaging in the nascent DeFi space. 

Unsurprisingly, smart contract insurance has been the first and most widely-adopted use case of decentralized insurance. Any DeFi user, from a crypto hobbyist to a money manager at a large institution, can now purchase a contract that pays out a premium if a predetermined event occurs. In addition, insurance providers leverage all of the aforementioned benefits of the blockchain: fast settlement, no (or minimal) KYC/AML, and end-user transparency.

The potential is enormous. Despite being a multi-trillion dollar industry gaining institutional interest, crypto-assets remain 96% uninsured. Insurance products could also expand DeFi’s accessibility to those sitting on the sidelines; perceived “riskiness” and steep learning curves are the biggest hesitations for those looking to dip their toe in the space.

There are a number of players in the DeFi insurance industry, offering smart contract cover and other crypto-specific products such as insurance against exchange hacks. While more protocols are sure to crop up, some of the biggest names are: Nexus MutualCover ProtocolOpium FinanceCDx ProjectNsureUnslashed FinanceOpynUNIONInsureAce, and Nayms.

Source: Hugh Karp (on Medium)

While DeFi insurance is still only used by a minority of cryptocurrency holders, some protocols have already made headlines for large payouts in response to high-profile smart contract failures and hacks. Nexus Mutual, one of the space’s earliest and most successful platforms, has paid out claims for multiple incidents and recently surpassed $300M in TVL, an important milestone for the industry. 

Where does it go from here?

Decentralized insurance solves a pain point for many of the ecosystem’s users and illustrates many benefits of the blockchain, which explains the widespread building, usage, and funding of new insurance protocols.

While most projects in the space focus on smart contract risks and other crypto-related incidents, they could extend beyond crypto and into real-world events. Decentralized insurance protocols can grow into marketplaces for all kinds of insurance as long as there is data and capital available. Etherisc, another one of decentralized insurance’s progenitors, offers disaster insurance for droughts, floods, and hurricanes. Nexus Mutual, while currently focused on smart contract insurance, was originally founded to insure earthquakes. Insureum offers ski resort snow cover, in addition to other niche real-world events. Arbol, fresh off of its $7M Series A, offers over 20 blockchain-based insurance contracts, ranging from loss of fertilizer application days to rice damage, to agricultural giants. 

Source: Etherisc

Other platforms are experimenting with what I call “social insurance,” a way of pooling and distributing funds to individuals based on particular rules. Teambrella, an early example of this, allows individuals to join a “team” and insure one another. Vote delegation, risk modeling, and a variety of other concepts are all at play here—it will be fascinating to see how it evolves. 

Given the explosive growth of NFTs, protecting digital assets, similar to the multi-billion dollar fine art insurance industry, may be an emerging opportunity for decentralized insurers. Some have even suggested that a decentralized form of title insurance could be attractive for many NFT holders.

This is just the beginning—some ambitious protocols are tackling health, car, and other multi-billion dollar insurance offerings. While these are heavily regulated spaces, oftentimes with unreliable data feeds (or subjective claims processes), it is exciting to see the open finance movement push new boundaries.

What about the incumbents?

It would be foolish to assume that the insurance giants will simply watch this transformation take place. They have regulatory advantages, highly advanced risk modeling, decades of experience in highly-specific industries, and large capital pools. And they are beginning to take blockchain seriously.

According to Accenture, more than 80 percent of insurance executives have reported using “distributed ledger technology” (DLT) in their internal business operations. Furthermore, “65 percent of insurance executives agreed that their organization must adopt DLT to remain competitive.”

This sentiment shift has been reflected in several blockchain-based projects from existing insurance companies. B3i, a consortium of 21 legacy players, has used smart contracts and payment systems to improve reinsurance for “large commercial applications.” Tokio Marine, a Japanese company, piloted a marine cargo insurance product on the blockchain. AXA, one of the largest multinational insurers, created a “parametric insurance” product for flight delays, named fizzy, but unfortunately had to shut down from a lack of adoption.

There are endless examples of press releases and pilot projects from traditional insurers, but none match the technological sophistication provided by truly decentralized protocols. Despite lofty promises, these institutions will choose to build closed, opaque, and censored blockchains. For many use cases, traditional insurance may remain competitive. But, in alignment with the broader goals of open finance, decentralized, trustless, and censorship-resistant protocols will become increasingly attractive to users and expand global access to insurance. Decentralized insurance is here to stay, and we’re just seeing the beginning.

The bottom-line: The multi-trillion dollar insurance industry will be revolutionized by the blockchain. Smart contract insurance, the first decentralized insurance product to find product-market fit, reveals the speed and transparency of blockchain-powered insurance. In the future, an explosion of new contracts, from weather risk to “social insurance,” will be developed, permanently changing the way that we view and use insurance.

- Paul

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ABOUT ME

Hi, I’m Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing in blockchain companies and cryptocurrencies. I’ve been in the industry since 2014, and the firm invests in equity, early stage token projects, and liquid cryptocurrencies on exchanges. I focus on early-stage investments and share my thoughts on what’s going on in the industry in this weekly newsletter.