DeFi cover, often informally referred to as DeFi insurance, is designed to protect against decentralized finance’s unique risks from protocol hacks to stablecoin depegs.
DeFi insurance (often called cover or insurance alternatives) is a catch-all term for products that protect against decentralized finance’s unique risks, such as protocol hacks or a stablecoin peg loss.
Traditional insurance, such as FDIC insurance, protects against financial losses that result from custodian mismanagement (e.g. a bank becomes insolvent). By contrast, decentralized finance (DeFi) inherently protects against custodian risks because users retain sole control of their funds, using a self-custodial wallet, while transactions happen on public distributed ledgers (blockchains).
As a result, the main risks in DeFi are technological (e.g. protocol code misuse, oracle failure). DeFi insurance was developed to protect against these risks while aiming to solve some of the inefficiencies and misaligned incentive structures found in traditional finance.
Unlike home or car insurance which have been standardized over the decades so as to make policies and claim approval processes virtually indistinguishable from one another, DeFi insurance products vary significantly in terms of covered event type and approval process.
Most DeFi insurance covers can be categorized as one of the following:
Decentralized finance insurance providers such as Nexus Mutual, Risk Harbor, InsurAce, and Unslashed Finance differ from their traditional counterparts in terms of their claims assessment processes, sources of underwriting capital, functionality, and general regulatory landscape.
Claim assessment typically begins with submitting evidence of fund loss and proof of fund ownership through a protocol’s web app.
Next, the DeFi insurance protocol begins the provider-specific claim assessment process, which can be categorized into one or a combination of the following:
Traditional insurance companies do not publicly share their methodology for approving or denying claims or determining claim payouts, and the process of getting a claim approved or denied often takes months.
In most countries, the insurance industry is highly regulated, with specific parameters designed for the traditional financial world.
The vast majority of fund protection offered in DeFi is not, from a legal perspective, insurance, as it is not regulated, issued, or processed in the same way as traditional insurance.
As a result of regulatory ambiguity, many DeFi insurance products are referred to as insurance alternatives, cover, or fund protection.
In the traditional insurance industry, companies typically source capital in the form of insurance premiums (payments from cover holders) and equities (for insurance companies, as opposed to insurance mutuals). These are re-invested into low-risk activities to generate additional capital.
In traditional insurance, companies are only required to share their premium-to-surplus ratio or solvency capital requirement with the government. By contrast, many DeFi insurance providers are open-source and share their capitalization data publicly.
In the United States, the rules surrounding traditional insurance and reinsurance capitalization are state-specific and expressed in terms of the ratio of premiums (or capital) to surplus. Surplus is the insurance company’s assets minus its liabilities.
In broad strokes, the greater the surplus, the more assets the company has in terms of its liabilities, meaning that the company may legally continue to write new covers.
In the European Union, insurance and reinsurance companies must meet their solvency capital requirement (SCR): the amount of capital required to cover new and existing business expenses over the course of a year.
Though DeFi insurance alternatives differ significantly from those offered by traditional insurance companies in terms of offering, their baseline economics often functions similarly.
For example, DeFi cover providers typically have an internal solvency capital requirement that determines the maximum amount or cover they provide.
The biggest distinction between DeFi insurance and traditional insurance capitalization lies in how capital is sourced. Traditional insurance companies may raise capital through premiums or selling shares, whereas DeFi insurance companies can crowdfund capital from individuals. This means that protocol earnings are redistributed to the underwriting capital providers of DeFi insurance protocols.
In DeFi insurance, some providers offer what is called discretionary cover: It is entirely in the right of the DAO to deny claims they believe do not meet the cover’s criteria. For example, Nexus Mutual provides discretionary cover and makes all claim assessment decisions publicly visible via Nexus Tracker.
In traditional insurance, cover is not discretionary. However, the methods insurance companies use to determine which claims to approve or deny are not shared publicly and it is not uncommon for claimants to believe that their valid claims were denied or that they did not receive the appropriate compensation.
