Zou Chuanwei: Analyze the status quo and development prospects of DeFi insurance from traditional finance

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The DeFi insurance agreement requires more exploration of risk targets, organizational forms, actuarial and insurance loss determination methods inside and outside the chain.

Author: Zou Chuanwei, Chief Economist of Wanxiang Blockchain

Compared with other DeFi functional modules, DeFi insurance has received less attention, and the development of DeFi insurance projects other than Nexus Mutual and Cover is also relatively general.

But in fact, insurance is an important part of the DeFi ecosystem, and insurance and DeFi have many integration points .

Under the decentralization and trustless environment of DeFi, the implementation of insurance will be very different from the mainstream financial market. To understand this problem accurately, we need to return to the core function of insurance , first look at the implementation of insurance in the mainstream financial market, and then discuss the implementation of DeFi insurance based on this.

This article is divided into three parts:

  • The first part summarizes the implementation of insurance in mainstream financial markets;

  • The second part introduces the current situation of DeFi insurance through representative projects ;

  • The third part is the outlook for DeFi insurance.

Realization of insurance in mainstream financial markets

The core function of insurance is economic compensation , which is based on the law of large numbers to provide policyholders with economic compensation for accidental losses. In economic compensation, policyholders who have not suffered accidental losses compensate policyholders who have accidental losses through their own premiums. Accidental losses can be personal or property, resulting in two major branches of insurance-life insurance and property insurance.

Insurance liabilities generally have long-term or contingent characteristics. The time from receipt of premiums to payment is uncertain (especially for life insurance), and the liability for future claims is also uncertain. In order to ensure the ability to pay, the preservation and appreciation of insurance assets is very important, so there is an inseparable relationship between insurance and asset management. Insurance asset management must consider the complexity of insurance liabilities, and match assets with liabilities, which is unique compared with mutual funds, hedge funds, and private equity funds.

The profit model of insurance is ” Three Differences “.

  • The first is the spread , which is the difference between actual investment income and customer income.

  • The second is the dead margin , that is, the difference between the risk premium and the actual claim.

  • The third is the fee difference , that is, the difference between the collected fee and the actual fee.

In mainstream financial markets, insurance can be realized in two ways- jointstock insurance companies and mutual insurance organizations . As of the end of 2017, mutual insurance accounted for 26.7% of the global insurance market, an important part of the global insurance market, but only 0.2% of China’s insurance market. At present, there are only three mutual insurance companies in China: Sunshine Agricultural Mutual Insurance Company and Zhonghui Mutual, Xinmei Mutual and Huiyou Mutual.

Joint-stock insurance companies are profit-making organizations . Shareholders provide operating funds, and the general meeting of shareholders holds the highest decision-making power. Joint-stock insurance companies adopt a fixed insurance premium system. When the insurance premium is surplus, it is included in the profit. When the insurance premium is insufficient, the shareholders try to fill it. The insured does not have to bear the obligation to recover the insurance premium.

Mutual insurance organizations are non-profit organizations . They are organizations formed by policyholders who have protection needs for the same risks. They have no shareholders and no equity. The insured has a dual identity, as the owner provides operating funds and has the right to choose the board of directors, as well as a customer. Mutual insurance organizations adopt a variable insurance premium system. When there is a surplus, the insured can receive dividends or accumulate to strengthen the organization’s financial resources; when a loss occurs, the insured will pay premiums or use the previous surplus to make up. Mutual insurance companies, like credit cooperatives , embody the principles of “autonomy and voluntariness, equality and mutual benefit, and democratic management” as well as “common ownership, co-governance and sharing.”

In recent years, China has developed network mutual assistance, represented by Ant Financial Mutual Bao and Water Drop Mutual Assistance . Network mutual assistance is not a licensed insurance business organization, but is organized by a network mutual assistance platform . It uses the information matching function of the Internet to realize an innovative mutual assistance model in which members bear each other’s risks and losses. The main area of ​​mutual assistance is critical illness medical mutual assistance. Each member who joins will share a small amount of mutual assistance for each ill member, and will receive a relatively large amount of medical funds shared by other members in the future when he is sick. Network mutual assistance has a low participation threshold, few guarantees, and no compulsory payment.

In mainstream financial markets, some derivatives also have a risk protection function, but they are not transferred and shared through risk pricing through the law of large numbers, represented by credit default swaps (CDS). CDS is a basic credit derivative product, which is essentially equivalent to the debt and credit risk insurance of one or more companies or countries (called target institutions). There are two participants in a CDS transaction, one is the buyer of protection rights and the other is the seller of protection rights . The buyer of the protection right pays a fixed fee (called the CDS spread) to the seller of the protection right at regular intervals. As a consideration, if the CDS target institution becomes bankrupt, refuses to pay, or restructures its debt before the expiry of the CDS (called a credit event), the protection right seller is obliged to compensate the protection right buyer for losses.

Based on the above discussion, we can summarize the main points of the implementation of insurance in the mainstream financial market. These points provide a reference for understanding DeFi insurance (for the convenience of writing, the network mutual assistance and CDS are discussed together):

  • The subject of insurance : personal and health risks and property risks. The credit risk targeted by CDS can be regarded as a type of property risk . In mainstream insurance products, policyholders have risk exposures corresponding to the subject of insurance. However, in CDS, the buyer of the protection right can purchase the relevant CDS without holding the debts of the target institution. This is called the CDS “naked position”, which caused a lot of controversy during the international financial crisis.

  • Organizational form : centralized, decentralized, and peer-to-peer. Joint-stock insurance companies are centralized. Mutual insurance organizations and network mutual assistance are decentralized, embodying the characteristics of ” shared benefits and shared risks .” The derivatives represented by CDS are point-to-point. The nature of insurance contracts, insurance actuarial calculations, insurance loss determination and insurance compensation methods differ significantly under different organizational forms.

  • The nature of the insurance contract : In a joint-stock insurance company, the insurance company and the insured constitute both parties to the contract, and it is difficult for insurance policies to change hands. In mutual insurance organizations and network mutual assistance, a ” group contract ” is formed between participants. In the derivatives represented by CDS, the buyer and the seller constitute both parties to the contract, but the contract can be transferred.

  • Actuarial insurance : Actuarial insurance determines the premium by analyzing the probability of future risk events and the possible financial impact. Corresponding to the classification of insurance subject matter, insurance actuarial is divided into life insurance actuarial and non-life insurance actuarial . The former uses the net equilibrium principle and life table, and the latter uses the compound risk model and the empirical rate method. With the application of biotechnology and wearable devices in life insurance, as well as the application of sensor devices in property insurance (such as vehicle-mounted sensor devices and usage-based insurance), actuarial insurance based on big data and artificial intelligence algorithms will be able to improve It reflects the individual differences of policyholders and can be adjusted dynamically, so as to approach the dynamic risk pricing method represented by CDS in methodology.

  • Insurance loss determination and compensation : Joint-stock insurance companies must follow systematic standards and methods in insurance loss determination. In recent years, more attention has been paid to the application of remote sensing technology and climate index in agricultural insurance loss determination . In an ideal situation, the premiums paid by all policyholders of a joint-stock insurance company should just cover their exposure to accidental losses as a whole, and the insurance company plays the role of premium transfer payment in the middle. In terms of mutual insurance organizations, Xinmei introduced a jury system to deal with issues such as frequent disputes, unclear liability determination and unclear clause design in insurance claims, and also increased credibility. In terms of mutual assistance on the Internet, each case of mutual assistance is publicized on Alipay. Disputed cases can apply to a jury to decide whether to pay. It can be seen that joint-stock insurance companies are completely centralized in terms of insurance loss determination and compensation, and mutual insurance organizations and network mutual assistance have the color of decentralization and community autonomy.

Representative DeFi insurance projects

DeFi insurance is currently in the early stages of development. The two projects that have attracted more attention are Nexus Mutual and Cover , which are mainly aimed at the risk of hacker attacks due to smart contract vulnerabilities in DeFi.

Nexus Mutual

Nexus Mutual is currently the DeFi insurance platform with the largest underwriting amount, and its organizational form is similar to a mutual insurance organization. Users become members by purchasing Nexus Mutual’s Token NXM , but they need to go through the KYC review process. Members have the right to vote on governance.

Nexus Mutual adopts a streamlined actuarial model . There are three main factors affecting premiums: risk cost, insurance amount, and insurance period. Among them, the risk cost depends on the amount of NXM pledged by the member on the relevant insurance project. The higher the pledge amount, the lower the risk cost and the lower the insurance premium. Therefore, the determination of risk cost has a certain voting nature.

The Nexus Mutual insurance compensation fund consists of two parts: first, the member’s funds to purchase NXM ; second, 50% of the insurance premium of the insured. Both parts of funds are injected into a pool of funds.

In Nexus Mutual, the policyholder needs to file a claim within the insurance period or within 35 days after expiration. Members participate in the claim evaluation by staking NXM and voting. Claims must be audited and confirmed before they can be paid.

Cover

Cover is similar in organization to CDS . For each insurance project, for every unit of collateral that the user mortgages (currently only Dai is supported), he/she will get 1 Claim Token and 1 No-claim Token at the same time:

1 Dai = 1 Claim Token + 1 No-claim Token

After that, users can trade these two Tokens in the secondary market based on their own risk assessment, thereby forming the market price of these two Tokens.

Both Token have the right to obtain a copy or characteristic (contingent claim) is:

Zou Chuanwei: Analyze the current situation and development prospects of DeFi insurance from traditional financeTable 1: Contingent claims in Cover

In economics, these two Tokens are typical Arrow-Debreu securities. Holding 1 Claim Token, which is equivalent to the buyer of CDS, can provide protection for future risk losses; holding 1 No-claim Token, which is equivalent to the seller of CDS, is essentially profiting by betting that risks will not occur in the future.

The market price of these two tokens is the concept of state price . This is the same as CDS, which uses market transactions to price risk.

The last thing to see is that some DeFi insurance projects provide insurance for off- chain risk events . For example, Etherisc provides insurance for flight delays, hurricane protection, and crop protection. However, the actuarial and insurance loss assessments of this type of project occur outside the chain and need to be read into the chain through an oracle.

The outlook for DeFi insurance

It is not difficult to see from the first two parts that DeFi insurance is at a very early stage of development compared to insurance in the mainstream financial market, but this also shows that DeFi insurance has a lot of room for development.

The following points are the key to understanding the future development of DeFi insurance:

Is DeFi insurance subject to off-chain risk or intra-chain risk?

When the subject of DeFi insurance is off-chain risk, DeFi insurance needs to solve two basic problems.

  • One is that off-chain risks are priced in legal currency, but insurance claims use digital assets in the chain, which causes currency mismatch problems. However, with the development of central bank digital currency and stable currency, if the central bank digital currency and stable currency are used for insurance compensation, this problem will be solved.

  • The second is that insurance actuarial and insurance loss determination for off-chain risks can only be done off-chain, so the relevant results need to be written into the chain through the oracle . At present, DeFi oracle is also an ascendant field, and the accuracy and efficiency of oracle have great room for improvement. When the DeFi oracle is not yet fully developed, you can consider using a more centralized oracle.

When the subject of DeFi insurance is intra-chain risk, the impact of the above two issues is much weaker, but the risk coverage needs to be expanded . The second part has pointed out that representative DeFi projects such as Nexus Mutual and Cover mainly target the risks caused by hacker attacks due to smart contract vulnerabilities. In the future, the intra-chain risks targeted by DeFi insurance should be extended to the design vulnerabilities of the DeFi economic model, incorrect oracle quotes and untimely updates, in-chain transactions not being processed in time, excessive gas fees, deficits caused by collateral liquidation, Ethereum 2.0 The progress of the transformation is not as fast as expected, and even the security of the public chain itself.

The well-known economist Kenneth Arrow put forward the perfect risk transfer model in the article ” Insurance, Risk and Resource Allocation “-voluntary, free, and fair risk transfer, and: 1. Enrichment of insurance products, with regard to personal and property For each of the risks, there may be corresponding insurance products; 2. The premium is determined by the principle of fairness ; 3. The risk is transferred to people with corresponding risk preferences in the society, and they are voluntarily assumed. The perfect risk transfer model proposed by Arrow should become the direction of DeFi insurance.

Organizational form of DeFi insurance

Discussion in conjunction with the first two parts, I think DeFi the insurance joint-stock insurance company should not take the form of centralized, decentralized should take a similar form of mutual insurance organizations and networks of mutual aid, or a similar point in the form of the CDS.

In the era of central bank digital currency and stable currency , mainstream mutual insurance organizations and network mutual assistance will develop better. The group contracts involved in these two types of insurance activities can be expressed in the form of smart contracts . Actuarial insurance and insurance loss determination require a relatively high level of professionalism, so a relatively centralized + community autonomy (such as jury) approach can be adopted, especially when the subject of insurance is off-chain risk. The payment of premiums can directly use smart contracts to perform central bank digital currency and stable currency transfers, which can significantly improve transparency and credibility.

Another representative of decentralized DeFi insurance is the MKR in MakerDAO . The previous analysis rarely looked at MKR from the perspective of insurance. Under normal circumstances, all MKR holders have positive cash flow income through the stability fee channel. For example, when Dai is redeemed, the issuer sends Dai and the stability fee paid with MKR to the mortgage debt warehouse smart contract. Dai is a credit contract at the level of mortgage debt warehouses. All mortgage debt warehouses are subject to uniform over-collateralization rate requirements. If the market value of the collateral falls, the issuer needs to replenish the collateral or return part of the Dai to maintain the mortgage rate. If the mortgage rate is lower than the liquidation rate, it will trigger the liquidation of mortgage debt, similar to the liquidation mechanism in equity pledge financing. If the collateral disposal is not enough to cover the debt gap, then MKR will be issued and auctioned to obtain Dai, diluting all MKR holders to absorb losses.

On March 19, 2020, MakerDAO launched the MKR auction for the first time, through the newly issued MKR to repurchase Dai in the market, and repay MakerDAO’s losses suffered in the market crash on March 12. Therefore, MKR is equivalent to providing insurance for Dai , ensuring that Dai has sufficient collateral as value support, and MKR can be regarded as a distributed CDS. This also shows that there is no insurmountable boundary between decentralization and peer-to-peer DeFi insurance. It is expected that many innovative designs of DeFi insurance will appear in this regard.

In a more general sense, if an asset pool is divided into files with different repayment order and risk-return characteristics such as claims and equity through tranche, then the equity file corresponds to the residual claim right and bears the loss first. Insurance will be provided for the debt files. This is the insight revealed by the Merton model. Because the equity file can be held by multiple people, the underlying insurance is decentralized. In fact, Cover embodies the practice of grading according to the future state.

DeFi insurance actuarial and insurance loss determination method

Although DeFi insurance actuarial and insurance loss determination are technical issues, they require high professional capabilities and will significantly affect the way DeFi insurance is implemented. In summary, there are four methods.

  1. It is done in a centralized way outside the chain, and then written into the chain through the oracle. This method is more suitable for situations where the subject of DeFi insurance is off- chain risk .
  2. It is carried out by algorithm in the chain, which is suitable for the situation where the DeFi insurance subject is the risk in the chain, and the probability of risk occurrence and economic impact are easy to quantitatively evaluate.
  3. Evaluation by voting in the chain can reflect the spirit of community autonomy, but it is necessary to ensure the participation of voting and the credibility of voting results. Staking is a common requirement before voting to alleviate the Nothing at stake problem. But even so, allowing non-professional groups to vote on professional issues is still facing great challenges.
  4. Through market transactions , market mechanisms are used to gather information about the probability of risk and the extent of loss. The market is naturally decentralized, but it is necessary to ensure that the market has sufficient liquidity and the price formation mechanism is smooth.

These four methods are not all-or-nothing and can be used in combination. For example, Nexus Mutual uses the second and third methods.