The decentralized finance (DeFi) sector has immense long-term potential, especially in light of an event such as the fall of FTX. Smart contracts and their programmability have the potential to disrupt the insurance industry. On the other hand, the possibility of covering one’s funds in DeFi will undoubtedly strengthen the development of this sector. Comprehensive overview of DeFi and decentralized insurance.
What is DeFi insurance?
Decentralized insurance refers to insurance born from the application of the blockchain to the insurance sector.. Decentralized insurance protocols are then developed using smart contracts, liquidity pools or decentralized autonomous organizations (DAO).
Decentralized insurance may aim to replace certain types of traditional insurance contracts by offering numerous advantages to the insured, or to cover the risks inherent in the decentralized finance sector.
👉 What is DeFi? All about decentralized finance
Why use decentralized insurance?
Insurance is a contract by which the insurer undertakes to indemnify the insured in case of calamity in exchange for payment of an insurance premium.
Thus, if a person wishes to cover himself against a specific risk which could cause financial losses, he seeks to take out insurance. The insurance company assesses the likelihood of the risk occurring depending on various factors to establish the amount of the insurance premium invoiced to the insured, in exchange for the indemnification guarantee.
The insurance premium paid by the insured is lower than the amount he would have to pay in the event of a claim. So, in a simple way, insurance companies make their profits on the difference between the total amount collected from policyholders and the amounts to be paid in the event of a claim.
Traditional insurance is therefore managed through a centralized entity : the insurance company. In the event of a claim, the insured must demonstrate that it did indeed occur and that his claim is justified. The insurance calls on experts to verify these elements and determine the amount of compensation.
This process is long and very expensive in the insurance market. Costs that could very easily be eliminated if there was a decentralized way to manage claims.
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Parametric insurance applied to the blockchain
Parametric insurance is a type of insurance which, instead of compensating according to the damage suffered, compensates the insured if the parameters defined in the contract are respected.
Concretely, it allows the compensation of a claim when an index exceeds a certain threshold fixed in advance in the contract. The insured does not need to prove anything and receives the compensation. For example, it could be a weather index (temperature, precipitation, wind speed, etc.) or quantifiable data.
This type of insurance is usually used without the intervention of blockchain technology. However, some actors have realized that parametric insurance is the perfect system to work with smart contractswhich work with a blockchain.
In addition, consumer interest in this type of data-based solution is growing since it allows them to take advantage of lower insurance rates.
To work, decentralized parametric insurance needs one or more oracles. Indeed, smart contracts execute only if previously set conditions are met. However, the smart contract needs a way to retrieve data from the real world, i.e. off-chain data. This is where oracles come in, since they provide this data to the smart contract.
So, this type of insurance incorporates in its smart contract one or more oracles that follow the compensation parameters in real time. The amount of compensation and other conditions are also listed there.
Let’s take a simple situation. imagine that a farmer subscribes to a decentralized parametric insurance to protect himself from the risk of drought for his activity. The compensation parameter entered in the smart contract is linked to the rainfall index.
The oracle follows the evolution of precipitation in real time, and as soon as there is a drought, informs the smart contract. The latter runs automatically to compensate the insured. Concretely, no intermediary is neededthe code entered in the smart contract manages the insurance automatically until compensation is paid.
So, much of the cost and friction is eliminated of the process. The insured does not need to file a claim and the payment of the indemnity is granted much more quickly.
Parametric decentralized insurance can thus be used for any risk that is quantifiablesuch as hurricanes (wind speed in a geographical area) or the delay of an airplane flight (real-time flight data).
To conclude, this grants two very interesting advantages:
- Automatique : the smart contract is executed automatically without the intervention of an intermediary;
- Fast : the data flow triggers the smart contract, instantly releasing the insured’s compensation.
Faster, without intermediaries and therefore less expensive, there is no doubt that when the data is quantifiable, this type of insurance has immense potential to disrupt the insurance market.
👉 Learn more about how oracles work, one of the pillars of decentralized insurance
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DeFi insurance to cover its cryptocurrencies
Decentralized finance is a booming sector, promising and presenting many innovations. Nevertheless, it is a relatively unstable industry to date and DeFi users still face many risks : hacks / thefts, flaws or errors in a smart contract, collapse of the price of a stablecoin to name a few.
There is an added problem since traditional insurance companies are very hesitant or even completely closed to the idea of entering the DeFi market because of the lack of regulation governing cryptocurrencies and the unpredictability of the market.
However, we can observe a growing influx of institutional capital towards DeFi and the progress made recently by many countries to put in place a legal framework around cryptocurrencies: DeFi insurance is gradually becoming accessible.
DeFi insurance thus offers a safety net for the DeFi ecosystemwhich is essential to gain the confidence of investors and for the development of this market over the long term.
There are three options for hedging funds on DeFi:
- Use of a traditional insurance company;
- The use of decentralized parametric insurance;
- The use of a DeFi insurance protocol whose governance is decentralized.
For the first option, there are not as many choices as in other sectors, but there are more and more that offer DeFi insurance, even if coverage remains relatively limited.
The second option takes advantage of the programmable properties of smart contracts. Parametric insurance could be one of the most promising solutions for the decentralized finance sector. An investor can resort to it when the data is quantifiable, so it can cover many situations in DeFi.
Say an investor deploys some of their capital on the Curve protocol. This could use decentralized parametric insurance to protect against a hack or manipulation of a whale in a specific pool.
In the latter case, if a whale leaves the pool and causes a loss for the investor due to higher slippage than tolerated, the insurance smart contract could be triggered automatically to compensate the investor. The parameters could therefore relate to the number of tokens leaving the pool and the threshold of tolerated slippage.
The third and last option evokes THE DeFi insurance protocols governed by decentralized autonomous organizations (DAO). They are essentially decentralized insurance companies operating around pools of liquidity, and whose members of the DAO can vote on certain parameters and the claims of policyholders. This type of DeFi insurance relies less on its code and more on the decentralization of its governance.
Figure 1: Illustration of a claim on InsurAce, a DAO-governed DeFi insurance protocol
Note that there are DeFi insurances that take advantage of the advantages of the last two options mentioned, namely the programmable properties of smart contracts and decentralized governance via a DAO.
Be that as it may, there is no doubt that the insurance protecting against the risks inherent in DeFi is crucial to the development of the sector, and have great potential with decentralized insurance. The correct implementation of the latter, however, represents a major challenge.
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Source – Figure 1: InsurAce
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