Around the Block #14: DeFi insurance(May 14, 2021)



  • Underwriter yield must compete with DeFi yield. When DeFi yields are subsidized by yield farming, even “risk-adjusted” positions often favor participating directly in DeFi protocols instead of acting as an underwriter or participating in insurance markets.
  • Yield generation for underwriters is generally limited to payments on insurance premiums. Traditional insurance markets earn a majority of revenue from re-investing collateral into safe yield-generating products. In DeFi what is considered a “safe” investment for pooled funds? Placing them back in DeFi protocols re-introduces some of the same risks they are meant to cover.

  • Proof of loss is an important guardrail. If payouts are not limited to actual losses, then unbounded losses as a result of any qualifying event can bankrupt an entire marketplace.

  • On-chain or off-chain: Is the insurance mechanic DeFi native (and perhaps subject to some of the same underlying risks!) or more traditional with structured policies from brick-and-mortar underwriters?
  • Resolving claims: How are claims handled, and who determines validity? Are payouts manual, or automatic? If coverage is tied to specific events, be careful to note the difference between economic and technical failure, where faulty economic designs may result in loss even if the code operated as designed.
  • Capital efficiency: Does the insurance model scale beyond committed collateral? If not, there may be natural constraints on the amount and price of available coverage.

Specific DeFi insurance models

Hybrid insurance markets: Nexus Mutual

Prediction markets and futures


 contracts: Polymarket and Augur


Bundling these models together, there are several projects building either prediction markets or futures contracts, both of which can be used as a form of insurance contracts.



Automated insurance markets: Risk Harbor



Exploits in DeFi protocols are discrete attacks, bending the code to an attacker’s favor. They also leave an imprint, stranding the state of the protocol in a clearly attacked position. 


What if we can develop a program that checks for such an attack? 


These programs could form the foundation for payouts on insurance markets.



Tranche-based insurance: Saffron Finance


DeFi yields can be significant, and most users would happily trade a portion of their yield in return for some measure of protection. 


Saffron pioneers this by letting users select their preferred risk profile when they invest in DeFi protocols. Riskier investors would select the “risky tranche” which carries more yield but loses out on liquidation preferences to the “safe tranche” in the case of an exploit. 


In effect, riskier participants subsidize the cost of insurance to risk averse participants.



Traditional insurance

For everything else, traditional insurance companies are underwriting specific crypto companies and wallets, and may someday begin underwriting DeFi contracts. 


However this is usually rather expensive, as these underwriters are principled and currently have limited data to properly assess the risk profiles inherent to crypto products.



Takeaways

The fundamental challenges around pricing insurance coverage, competing with DeFi yields, and assessing claims, in combination with limited capital efficiency, has kept insurance from gaining meaningful traction to date.



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