What is DeFi insurance?
The evolution of decentralized finance (DeFi) has promised a new financial system that offers improved efficiency and one that is not limited by dependencies on centralized entities. However, this is not without risks as the centralized parties are now replaced by smart contracts that live on the blockchain. These smart contracts are still coded by humans, which means a DeFi project is only as secure as its code quality and protocol design.
The continuous growth of DeFi has also led to a rise in many types of vulnerabilities. According to on-chain data, over $2 billion have been stolen due to DeFi hacks and scams, as of 2023. This uncertainty has resulted in a need for new insurance models to protect user funds and provide them with peace of mind. Enter DeFi insurance protocols. DeFi insurance involves providing or obtaining protection against financial losses caused by adverse events, such as hacks, scams, or stablecoin depegs, within the DeFi ecosystem. These insurance products are highly customizable and the coverage (and premiums) will depend on the specific events you want to be insured against.
Insurance in DeFi can refer to both blockchain-based replacements of traditional insurance policies and insurance that covers blockchain-related activity, such as hacks, exploits, or bugs. For example, if a smart contract failure on Aave results in the loss of the insured DAI deposit, the insurance provider will pay a claim to the insurance seeker according to the terms of the policy.
So how does this all work? In DeFi, insurance coverage is crowd-funded by users who want to earn a premium on their crypto assets. The basic premise is that people come together to deposit insurance money to cover various events. This pool of insurance funds is then set aside for those who wish to buy insurance (and pay premiums) against that event. If a covered event occurs, such as a protocol hack, the money that insurance providers pledged are distributed to the affected parties. If the event does not occur, then the insurance providers’ funds remain in the pool and continue to earn yield over time from premiums.
Who makes the decision on what is a covered event? While each protocol has its own spin on the deliberation process for claims, they all involve a decentralized decision-making process that’s used to decide which insurance claims should be paid.
Where does the yield come from in DeFi insurance?
The yield or income that insurance providers earn comes from various sources, such as:
- Premiums: This is the yield that is received from insurance seekers who pay a premium to obtain coverage from the insurance providers. For example, if an insurance seeker wants to insure their DAI deposit on Aave against a smart contract failure, they will pay a premium to the insurance provider who offers such coverage.
- Token rewards: This is the amount of money or tokens that insurance providers or seekers receive for participating in a platform or protocol. For example, if an insurance provider or seeker uses Nexus Mutual, they will receive rewards in the form of NXM tokens.
Is DeFi insurance safe?
Insurance within the DeFi ecosystem represents a more speculative financial instrument, carrying with it the inherent risks associated with emerging technologies and the possibility of principal loss. It is crucial for participants to conduct thorough due diligence on the protocols they intend to insure. Ensuring that the potential returns justify the risks is an essential step in this relatively new domain.
In the instance of a claimable event, providers of DeFi insurance are obligated to compensate the insured parties. Such compensations are typically facilitated through a process known as 'slashing,' where a portion of the provider's staked capital is deducted to cover the insurance payouts.
What are the advantages of DeFi insurance?
Insurance in DeFi can offer several benefits to users, such as:
- Peace of mind: DeFi insurance can protect against a variety of risks inherent in the crypto space, such as smart contract vulnerabilities, exchange hacks, or the failure of a DeFi protocol. Users who participate in DeFi platforms can purchase insurance to safeguard against potential losses, giving them the confidence to invest or lock in their assets without worrying about losing their entire investment due to unforeseen events.
- Additional income source. For those who choose to provide capital to DeFi insurance pools, it can be a source of additional income. Contributors can earn rewards by providing liquidity or underwriting risks, usually in the form of interest payments, insurance premiums, or tokens. This can be particularly attractive in the DeFi space where various platforms may offer competitive returns compared to traditional finance.
- Improved risk management. DeFi insurance introduces an element of risk management that is dynamic and flexible. It allows users to tailor their coverage to the specific risks they are most concerned about, and they can adjust their coverage as their risk profile changes. In traditional insurance, policyholders may have limited options and little ability to customize their policies without significant costs or administrative hurdles.
Where can I learn more about DeFi insurance?
If you want to start providing insurance coverage in DeFi, you can check out some of these insurance protocols: