DeFi insurance: insurance or investment?


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Summary of main points

The high risk of early maritime freight gave birth to an early insurance agreement with high risk and high return. While realizing risk transfer and dispersion, new investment opportunities also appeared. As the demand for risk protection in various fields increases, insurance products continue to be enriched. The risk of DeFi contracts also promotes the development of DeFi insurance. But compared to traditional insurance which has clear policy holders, insurers, and insurance targets, DeFi insurance is more like a “bet” by participants on whether a security incident occurs, making its investment attributes even exceed the risk transfer attributes.

DeFi security incidents occur frequently, and there is a necessity to build an insurance module

With the popularity of DeFi and the continuous participation of investors and speculators, crises in the market continue to emerge. Since the beginning of this year, the DeFi protocol has been attacked and caused frequent property losses. Lightning loan arbitrage attacks, protocol vulnerability attacks, and oracle operation attacks have all affected the stability of the market and the security of market participants’ assets.

2Month, bZx suffered from “attackers” who used flash loans to obtain capital by manipulating market prices to gain up to 290,000 US dollars. In June, Balancer suffered a lightning loan attack and was transferred assets worth about $500,000. In September, the internal protocol loopholes in bZx were attacked, resulting in a loss of USD 8 million. In October, Harvest suffered a loss of $34 million in a flash loan attack. In November, Pickle Finance lost nearly US$20 million due to vulnerabilities.

With multiple DeFi attacks, code audits no longer represent the security guarantee of the project. While the project party continues to improve the security of the protocol and mechanism, more efficient and practical safeguards need to be adopted. As an indispensable part of the traditional financial market, the insurance sector also urgently needs to participate in the establishment of the DeFi “Lego” ecosystem, providing customers with a choice of protection methods.

DeFi+ Insurance: You can “insure” without holding “property”

In the traditional insurance industry:

· Policyholder: the subject who purchases insurance to insure the subject matter of insurance;

· Insurer /Underwriter: The subject who bears the liability for compensation of insurance policies;

· Underwriting (Underwriting): The act of underwriting the prescribed insurance liability, usually by the insurance company.

In the DeFi insurance project, the project party only serves as a service platform for both parties. Both the insurer and the policy holder are borne by the users of the platform, and the two parties are distinguished according to different transaction strategies.

DeFi insurance projects are similar to property insurance in the traditional insurance industry. Using property as the subject of insurance protects the underlying assets from possible economic losses. The difference is that property insurance takes house insurance as an example, and policy holders are generally house owners or users. In DeFi insurance projects, in most cases, participants do not need to hold the “underlying assets” in order to purchase corresponding insurance products and apply for compensation in the event of an attack. For example, if the user does not participate in the Pickle Finance contract, but has purchased the Pickle Finance insurance product from Cover, the user can enjoy the corresponding compensation after passing the compensation evaluation.

Nexus Mutual is currently the DeFi insurance platform with the largest underwriting amount. As of December 15, 2020, the total underwriting amount is 55.09 million U.S. dollars and provides 65 insurance products. Due to the requirements of the entity company, users need to fill in the standard KYC/AML (Know Your Customer/Anti-Money Laundering) process. Nexus Mutual adopts a co-insurance model, which is similar to traditional co-insurance companies. It collects funds from policy holders and members form a community to share risks and share premium income. The user purchases Nexus Mutual token NXM and becomes its member (Member), has the right to vote in governance, participates in the assessment of claims by pledge of NXM; the funds purchased from NXM are injected into the fund pool for insurance compensation. Therefore, Nexus Mutual does not have a clear insurer to provide guarantees. All members (including policy holders) share the right to vote on all decisions including the assessment of claims and bear the responsibility for compensation.

The amount of funds held by the community, that is, the Capital Pool is used for insurance claims. On the one hand, the funds in the capital pool come from the direct injection of the insurer’s purchase of NXM funds, and on the other hand 50% of the insurance policy holder’s funds purchased Will be injected into the pool of funds. The price (premium) model of the Nexus Mutual policy is designed based on the risk cost (Risk Cost), the insurance amount (Cover Amount, the amount paid when a successful claim is made, that is, the actual insured amount), and the insurance period (Cover Period):

Nexus Mutual premium calculation method, source: TokenInsight

The calculation of insurance premiums for insurance products is generally based on actuarial models, comprehensive risk costs, insurance company operating and sales expenses, and product market supply and demand. DeFi insurance projects such as Nexus Mutual and Nsure use a relatively streamlined model for premium calculation.

The cost of risk depends on the probability of historical risks. For example, life insurance will calculate based on the experience rate of major diseases. Due to the short development time of DeFi and the insufficient number of experience cases, it is more difficult to calculate the probability of project safety incidents. Some DeFi insurance projects calculate risk costs based on the insurer’s confidence in project safety. Insurers will choose projects that they consider safe to pledge. Therefore, the greater the number of pledged tokens in a single project, the higher the insurer’s trust in it. The lower the project’s own risk cost, the lower the premium. Nexus Mutual does not have a clear insurer, but all members can pledge NXM tokens for specific projects that they consider safe.

The purchase limit of a single item of Nexus Mutual depends on the NXM pledge amount of the item. As the pledge amount increases, the purchase amount increases; at the same time, the premium decreases and the purchase amount increases. However, when there is insufficient pledge of a certain project or excessive demand, users will face the situation that there is no insurance policy to buy.


There is still no order to buy when the project pledge is greater than the average, source: Nexus Mutual

In the next development direction planning, Nexus Mutual also proposed to add demand factors to the pricing model. This year’s new project, Nsure, is dedicated to building a decentralized Lloyd’s of London. It adopts a shareholding system. Users pledge Nsure tokens NSURE to become insurers, similar to shareholders of traditional joint-stock insurance companies, and enjoy insurance coverage. Distribution of profits. For the platform party, the method of obtaining funds under the shareholding system is more flexible than the co-insurance model. Nsure is not online yet. The dynamic pricing model is used in the beta version to price different DeFi agreement insurance products according to the scale of demand, mortgage scale and project risk level. Compared with Nexus Mutual, Nsure adds a demand factor to its pricing model. The demand scale is estimated based on the total value locked (TVL) of the DeFi market, its estimated market share, and insurance penetration. The effectiveness has yet to be tested.

Total insured demand = market TVL * Nsure market share * insurance penetration rate

On the other hand, each project currently uses the same market share (1% in the beta version) and insurance penetration rate (8% in the beta version), and the demand depends only on the TVL of the insurance subject item. When the pledge amount is small , TVL changes will cause greater fluctuations in insurance premiums and insurers’ rate of return.


Comparison of operating models of traditional insurance companies, Nexus Mutual, Nsure, and Cover; Source: TokenInsight

Insurance project rooted in DeFi ecology

Compared with Nexus Mutual and Nsure, it is more like a translation based on the traditional insurance company operating model and premium calculation model. Cover protocol is almost born from DeFi. It provides users with a way to diversify risks through decentralized gameplay, without premium calculation. The model has no agreement on the amount of compensation, and the insurance process is completed completely through the adjustment of the fund pool market.

The Cover protocol operates based on a formula. For each DAI mortgage, the user gets a CLAIM and a NOCLAIM two tokens:

1 CLAIM token + 1 NOCLAIM token ≈ 1 collateral (currently only DAI is supported)

There are three types of participants in the Cover Agreement market. Depending on their currency holdings, CLAIM and NOCLAIM can be obtained by collateralizing DAI or directly purchased in the market:

· Market Makers: Hold CLAIM and NOCLAIM tokens and provide liquidity in the 80/20 CLAIM/DAI and 98/2 NOCLAIM/DAI capital pools;

· Insurance providers (Coverage Providers): only hold NOCLAIM tokens and provide liquidity for them;

· Coverage Seeker: Only hold CLAIM tokens and provide liquidity for them.


Cover operating mechanism, source: TokenInsight

If an insurance item is paid within the insurance period, the value of NOCLAIM corresponding to the mortgaged DAI of the item is zero, and the value of CLAIM is about 1 DAI which can be used to redeem the collateral; if there is no claim or the claim fails, it corresponds to CLAIM The value is zero and NOCLAIM is used to redeem the collateral.


Cover protocol The corresponding value of the two tokens, source: TokenInsight

Cover also allows partial payments. When the total amount of contract loss is less than the total lock-up value in Cover, it will be distributed to depositors in proportion to the loss, and the payment ratio x will be less than 100%. CLAIM tokens can redeem x collateral, while NOCLAIM can redeem (1-x) collateral.

Of course, in addition to the projects that provide insurance specifically for the risk events of the DeFi protocol, there are also some projects that use the traditional insurance targets provided by DeFi, such as Etherisc through the development of DApp to provide insurance products such as flight delays, hurricane protection, and crop protection.

More difficult to pay, stronger investment attributes

At present, most DeFi insurance projects have made detailed and smaller scope divisions for the coverage, and only support the loss caused by hacker attacks due to the vulnerability of the smart contract itself. As Nexus Mutual clearly stipulates:

① The designated smart contract address or the smart contract address directly related to the smart contract system is subject to hacker attacks due to accidental use of its smart contract code during the insurance period;

② Due to hacking, the smart contract or smart contract system suffers a major capital loss, and the capital is moved to another address beyond the control of the original owner, or it is permanently unrecoverable (major: far exceeding the gas fee related cost in contract operation; loss The amount is at least 20% of the total insured amount);

③ The policy holder files a claim within the insurance period or within 35 days after the end of the insurance period.


Cover and Nsure claim assessment process, source: Cover, Nsure

After the user pays the claim application fee and initiates the claim application, under the condition that the above conditions are met at the same time, after the claim evaluation, the compensation can be realized through multi-step evaluation and voting. The project party has increased the claim application fee and designed multi-step claim assessment to prevent false claims and protect the rights and interests of insurers, but on the other hand, it has also increased the difficulty and cost for policyholders to seek compensation.

System risks, personal operating errors, oracle feeding errors, public chain security issues, etc., are not covered by these DeFi insurance projects. As of December 16, 2020, a total of 69 claims have been submitted on Nexus Mutual. Only 3 claims related to the bZx attack at the beginning of this year have been successfully paid after two evaluations. Users who wish to reduce risks through insurance programs are faced with narrow coverage and difficulties in identifying the source of losses.

On the other hand, in some insurance projects, since the policy holder does not need to prove the ownership of the underlying asset, or even clarify the role he wants to play in the insurance process before the purchase, the purchase and sale of tokens To change roles or even across multiple roles. Therefore, we believe that, compared to traditional insurance policyholders who purchase insurance out of fear of possible losses, DeFi insurance is more like a bet by both parties on whether there will be safety issues within the insurance period. It is an investment channel provided to users.

to sum up

On December 14, the personal address of the founder of Nexus mutual was attacked and 370,000 NXMs were stolen. Is the insurance project really insured?

How the DeFi insurance project can truly provide users with property safety protection, so that users have insurance to buy and compensation, and even how to ensure the security of their own contracts, such as mutual assistance between insurance projects to provide insurance services for each other, all need to be further resolved The problem. At the same time, as the number of users continues to increase and the form of DeFi contracts continues to expand, how to meet the multi-dimensional insurance needs of users, provide differentiated insurance products for different types of contracts, and whether it can reduce the loss of the insurer in the face of large compensation orders For compensation, I believe there will be projects that will bring satisfactory answers in the future.


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