What is insurance for DEFI?
The anonymous, distributed nature of decentralized finance (DeFi) leaves this sector prone to hacks and scams because there is no enforcement system in place. As such, many users are turning to insurance for DEFI platforms.
Decentralized finance insurance refers to insurance bought using blockchain against events that occur in the DeFi space.
A company or individual seeking insurance for DEFI protocols would normally pay premiums to a decentralized autonomous organization (DAO). This DAO would collect premiums from investors and divide the risk among the group.
How are insurance claims verified?
As a DAO participant, you hold the token associated with the insurance protocol and therefore have governance rights. When claims arise, participants vote to accept or deny them, so rather than being paid by a centralized organization such as an insurer, claims are settled by each participant in the DAO.
Sometimes claims may be verified automatically. This is done via “oracles,” or decentralized information mechanisms that verify external data. Oracles can be designed to track the outcome of certain events and distribute this information across the internet. This is useful for DeFi insurance protocols because such automations decrease the chances of a dispute.
The downside of insurance for defi is that if your claim is denied, arbitration is not as easy since robust mechanisms to challenge an adverse decision have not yet been developed.
What are the drawbacks of the traditional insurance model?
In the traditional centralized finance (CeFi) approach, insurers use historical data to try to anticipate which business profiles are more or less likely to file a claim. These actuarial models are built using years of claims data, and the market adjusts the rates and their confidence level in projecting future claims with each claim. In essence, an insurer is a data corporation that places bets using its data.
In this approach, a centralized entity owns the financial strength and security; this is the typical insurance market.
However, with new and developing technologies like digital assets (such as Bitcoin), historical data is significantly less developed, and the lack of it makes it difficult for these enterprises to obtain insurance under the traditional model.
Insurers are often more risk-conservative when it comes to taking on this type of business, and if they do, the premiums are typically very expensive, difficult to write, and not suited to the specific needs of these enterprises.
A comparison of Centralized Finance Insurance and Decentralized Finance Insurance
What are the benefits of a Decentralized Finance Insurance system?
Decentralized finance insurance is not just more inclusive for those benefiting from coverage; it also opens insurance opportunities to an entirely new class of investors who could redefine the definition of risk capital.
Beyond greater inclusivity, decentralized insurance promises benefits like:
According to the Coalition Against Insurance Fraud, fraud costs Americans approximately $308.6 billion every year. Insurance fraud results in overpayments and increased costs for claims adjusters, investigators, and litigators. Decentralized insurance systems anonymize and automate many processes, thereby reducing the opportunity for people to interject themselves into the process.
Automation & expediency
Oracles and other automations reduce the likelihood of disputes and bureaucratic backlogs to expedite payment of claims. Weather data, for instance, could cause your DeFi insurance contract to immediately release payment to the policyholder if a tornado hit your home. Decentralized insurance companies are also using artificial intelligence algorithms to set the price and terms of insurance.
Smart contract technology enables more effective and efficient risk management because algorithms do all the heavy lifting. This means you can create a policy within a fraction of the time it takes for traditional insurance companies make actuarial calculations.