Zou Chuanwei: Analyzing the Current Situation and Development Prospects of DeFi Insurance from Traditional Finance

This article was published on Chain News, authored by Zuo Chuanwei, Chief Economist of Wanxiang Blockchain.

Compared to other DeFi functional modules, DeFi insurance has received less attention, and the development of DeFi insurance projects other than Nexus Mutual and Cover has been relatively average.

However, in reality, insurance is an important component of the DeFi ecosystem, and there are many intersections between insurance and DeFi.

In the decentralized and trustless environment of DeFi, the implementation of insurance will differ significantly from that in mainstream financial markets. To accurately understand this issue, it is necessary to return to the core functions of insurance, first examining how insurance is implemented in mainstream financial markets, and then using that as a reference to discuss the implementation of DeFi insurance.

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 status of DeFi insurance through representative projects;

• The third part is an outlook on DeFi insurance.

Implementation of Insurance in Mainstream Financial Markets

The core function of insurance is economic compensation, which provides economic compensation to policyholders for unexpected losses based on the law of large numbers. In economic compensation, policyholders who do not experience unexpected losses compensate those who do through the premiums they pay. Unexpected losses can be personal or property-related, leading to the two main branches of insurance—life insurance and property insurance.

Insurance liabilities generally have long-term or contingent characteristics, with time uncertainty (especially in life insurance) from receiving premiums to payout, and future payout obligations are also uncertain. To ensure payout capability, the preservation and appreciation of insurance assets are crucial, thus there is an inseparable relationship between insurance and asset management. Insurance asset management must consider the complexity of insurance liabilities, making asset-liability matching somewhat unique compared to mutual funds, hedge funds, and private equity funds.

The profit model of insurance is the "three spreads."

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

• The second is the mortality spread, which is the difference between the risk premiums collected and actual claims paid.

• The third is the expense spread, which is the difference between the fees collected and the actual expenses incurred.

In mainstream financial markets, insurance is implemented in two ways—stock insurance companies and mutual insurance organizations. As of the end of 2017, mutual insurance accounted for 26.7% of the global insurance market share, making it an important component of the global insurance market, but it only accounted for 0.2% of China's insurance market. Currently, there are only three mutual insurance societies in China: Sunshine Agricultural Mutual Insurance Company, Zhonghui Mutual, Xinmei Mutual, and Huiyou Mutual.

Stock insurance companies are profit-oriented organizations. Shareholders provide operating funds, and the shareholders' meeting holds the highest decision-making power. Stock insurance companies adopt a fixed premium system, where any surplus in premiums is recorded as profit, and any shortfall is made up by shareholders, with policyholders not required to bear the obligation to cover additional premiums.

Mutual insurance organizations are non-profit organizations formed by policyholders with a shared need for protection against similar risks. They have no shareholders and no capital stock. Policyholders have dual identities, acting as both owners providing operating funds and customers with the right to choose the board of directors. Mutual insurance organizations adopt a variable premium system, where policyholders can receive dividends when there is a surplus, or accumulate funds to strengthen the organization's financial resources; in case of losses, policyholders share the premium costs or use previous surpluses to make up for the losses. Mutual insurance companies, like credit cooperatives, embody the principles of "self-governance, voluntary participation, mutual benefit, and democratic management" as well as "shared ownership, co-governance, and shared benefits."

In recent years, online mutual assistance has emerged in China, represented by Ant Financial's Mutual Treasure and Shuidi Mutual Assistance. Online mutual assistance does not belong to licensed insurance operating institutions; it is organized by online mutual assistance platforms, utilizing the information matching function of the internet to create an innovative mutual assistance model where members share each other's risk losses. The main area of mutual assistance is major medical expenses, where each member contributes a small mutual assistance fund for each member who falls ill, and when they themselves fall ill in the future, they receive a larger amount of medical funds contributed by other members. The participation threshold for online mutual assistance is low, the coverage is limited, and the payouts are not mandatory.

In mainstream financial markets, some derivatives also have risk protection functions, but they transfer and share risks not through the law of large numbers but through risk pricing, with credit default swaps (CDS) as a representative example. CDS is a fundamental credit derivative product that essentially acts as insurance against the credit risk of one or more companies or countries (referred to as the reference entity). In a CDS transaction, there are two participants: one is the protection buyer, and the other is the protection seller. The protection buyer pays a fixed fee (known as the CDS spread) to the protection seller periodically. In exchange, if a credit event occurs before the CDS matures (such as bankruptcy, default, or debt restructuring of the reference entity), the protection seller is obligated to compensate the protection buyer for their losses.

From the above discussion, we can summarize the key points of how insurance is implemented in mainstream financial markets, which provide a reference for understanding DeFi insurance (for convenience, online mutual assistance and CDS are discussed together):

• Insurance subjects: personal and health risks as well as property risks. The credit risk targeted by CDS can be viewed as a type of property risk. In mainstream insurance products, policyholders have risk exposure corresponding to the insurance subject. However, in CDS, the protection buyer can purchase the relevant CDS without holding the debt of the reference entity. This is known as a CDS "naked position," which caused considerable controversy during the international financial crisis.

• Organizational forms: centralized, decentralized, and peer-to-peer. Stock insurance companies are centralized. Mutual insurance organizations and online mutual assistance are decentralized, reflecting the characteristic of "shared benefits and shared risks." Derivatives represented by CDS are peer-to-peer. The nature of insurance contracts, insurance actuarial practices, insurance loss assessment, and claims payout methods vary significantly under different organizational forms.

• Nature of insurance contracts: In stock insurance companies, the insurance company and the policyholder form the contracting parties, and policies are difficult to transfer. In mutual insurance organizations and online mutual assistance, participants form a "group contract." In derivatives represented by CDS, the buyer and seller form the contracting parties, but the contract can be transferred.

• Insurance actuarial practices: Insurance actuarial practices determine premiums by analyzing the probability of future risk events and their potential financial impacts. Corresponding to the classification of insurance subjects, insurance actuarial practices are divided into life insurance actuarial and non-life insurance actuarial, with the former using net balance principles and life tables, and the latter using compound risk models and experience rating methods. With the application of biotechnology and wearable devices in life insurance, as well as sensing devices in property insurance (such as in-vehicle sensing devices and usage-based insurance), insurance actuarial practices based on big data and artificial intelligence algorithms will better reflect individual differences among policyholders and can be dynamically adjusted, thus methodologically aligning more closely with the dynamic risk pricing methods represented by CDS.

• Insurance loss assessment and payout: Stock insurance companies must follow systematic standards and methods in insurance loss assessment. Recently, the application of remote sensing technology and climate indices in agricultural insurance loss assessment has received significant attention. Ideally, the total premiums paid by all policyholders in a stock insurance company should exactly cover their collective unexpected loss exposure, with the insurance company acting as an intermediary for premium transfer payments. In mutual insurance organizations, Xinmei Mutual has introduced a jury system to address frequent disputes in insurance claims, unclear liability determinations, and ambiguous clause designs, thereby enhancing credibility. In online mutual assistance, Mutual Treasure publicly announces each case of mutual assistance on Alipay, and controversial cases can apply for a jury to decide on payouts. It is evident that stock insurance companies are completely centralized in insurance loss assessment and payout, while mutual insurance organizations and online mutual assistance exhibit decentralized and community self-governance characteristics.

Representative DeFi Insurance Projects

DeFi insurance is currently in its early development stage, with Nexus Mutual and Cover being the most notable projects, primarily addressing risks arising from hacker attacks due to smart contract vulnerabilities in DeFi.

Nexus Mutual

Nexus Mutual is currently the largest DeFi insurance platform in terms of insured amounts, and its organizational form is similar to that of mutual insurance organizations. Users become members by purchasing Nexus Mutual's token NXM, but they must undergo KYC verification. Members have governance voting rights.

Nexus Mutual adopts a streamlined actuarial model. Premiums are influenced by three main factors: risk cost, insurance amount, and insurance duration. Among these, risk cost depends on the amount of NXM staked by members in the relevant insurance project; the higher the staked amount, the lower the risk cost and the premium. Therefore, the determination of risk cost has a certain voting nature.

The funds for insurance payouts in Nexus Mutual consist of two parts: first, the funds from members purchasing NXM; second, 50% of the premiums paid by policyholders. Both parts are injected into a fund pool.

In Nexus Mutual, policyholders must submit claims within 35 days after the insurance period or upon expiration. Members participate in claims assessment by staking NXM and voting. Claims requests must also be confirmed through auditing before they can proceed to payout.

Cover

Cover has an organizational form similar to CDS. For each insurance project, users receive 1 Claim Token and 1 No-claim Token for every 1 unit of collateral they stake (currently only Dai is supported):

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

Subsequently, users can trade these two tokens on the secondary market based on their risk assessments, thus forming market prices for these tokens.

Both tokens have the characteristic of contingent claims:

Table 1: Contingent Claims in Cover

Economically, these two tokens are typical Arrow-Debreu securities. Holding 1 Claim Token is equivalent to being the buyer in a CDS, providing protection against future risk losses; holding 1 No-claim Token is equivalent to being the seller in a CDS, essentially profiting by betting that risks will not occur in the future.

The market prices of these two tokens represent the concept of state prices. Like CDS, they are priced through market transactions.

Finally, it should be noted that some DeFi insurance projects provide insurance for off-chain risk events, such as Etherisc, which offers insurance for flight delays, hurricane protection, and crop protection. However, the actuarial practices and loss assessments for these projects occur off-chain and need to be read into the chain through oracles.

Outlook on DeFi Insurance

From the first two parts, it is evident that compared to insurance in mainstream financial markets, DeFi insurance is in a very early stage of development, but this also indicates significant growth potential for DeFi insurance.

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

Whether DeFi Insurance Subjects Are Off-chain Risks or On-chain Risks

When the insurance subjects of DeFi are off-chain risks, DeFi insurance needs to address two fundamental issues.

• First, off-chain risks are priced in fiat currency, but insurance payouts are made in on-chain digital assets, leading to a currency mismatch problem. However, with the development of central bank digital currencies and stablecoins, if insurance payouts are made using central bank digital currencies and stablecoins, this issue will be resolved.

• Second, the actuarial practices and loss assessments for insurance against off-chain risks can only be conducted off-chain, which requires using oracles to write the relevant results onto the chain. Currently, DeFi oracles are also an emerging field, with significant room for improvement in accuracy and efficiency. In the absence of well-developed DeFi oracles, it may be worth considering the use of oracles with a stronger centralized nature.

When the insurance subjects of DeFi are on-chain risks, the impact of the above two issues is much weaker, but it is necessary to expand the risk coverage. The second part has pointed out that representative DeFi projects like Nexus Mutual and Cover mainly address risks arising from hacker attacks due to smart contract vulnerabilities. In the future, the on-chain risks targeted by DeFi insurance should expand to include vulnerabilities in DeFi economic model designs, incorrect oracle pricing and untimely updates, untimely processing of on-chain transactions, high gas fees, losses caused by collateral liquidation, slower-than-expected progress in Ethereum 2.0 transformation, and even the security of the public chain itself.

Renowned economist Kenneth Arrow proposed a perfect risk transfer model in his article "Insurance, Risk, and Resource Allocation"—voluntary, free, and fair risk transfer, which includes: 1. Diversification of insurance products, where corresponding insurance products may emerge for every type of personal and property risk; 2. Premiums determined by fair principles; 3. Risk transferred to individuals in society with corresponding risk preferences, who voluntarily bear it. Arrow's proposed perfect risk transfer model should become the direction of efforts for DeFi insurance.

Organizational Forms of DeFi Insurance

Combining the discussions from the first two parts, I believe that DeFi insurance should not adopt a centralized stock insurance company form but should take a decentralized form similar to mutual insurance organizations and online mutual assistance, or a peer-to-peer form similar to CDS.

In the era of central bank digital currencies and stablecoins, mainstream mutual insurance organizations and online mutual assistance will achieve better development. The group contracts involved in these two types of insurance activities can be expressed in the form of smart contracts. Due to the high professional requirements for actuarial practices and loss assessments, a relatively centralized + community self-governance approach (such as a jury) can be adopted, especially when the insurance subjects are off-chain risks. Premium payouts can be executed directly through smart contracts for transfers of central bank digital currencies and stablecoins, significantly enhancing transparency and credibility.

Another representative of decentralized DeFi insurance is MKR in MakerDAO. Previous analyses have rarely viewed MKR from the perspective of insurance. Under normal circumstances, all MKR holders receive 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 collateralized debt position smart contract. Dai is a debt contract at the collateralized debt position level. All collateralized debt positions are subject to a uniform over-collateralization requirement. If the market value of the collateral falls, the issuer must supplement the collateral or return part of the Dai to maintain the collateralization ratio. If the collateralization ratio falls below the liquidation ratio, it triggers the liquidation of the collateralized debt position, similar to the margin call mechanism in equity pledge financing. If the disposal of collateral is insufficient to cover the debt gap, MKR will be issued and auctioned to obtain Dai, absorbing the losses by diluting all MKR holders.

On March 19, 2020, MakerDAO initiated the MKR auction for the first time, issuing new MKR to repurchase Dai in the market to repay the losses MakerDAO suffered during the market crash on March 12. Therefore, MKR effectively provides insurance for Dai, ensuring that Dai has sufficient collateral as value support, and MKR can be viewed as a form of distributed CDS. This also indicates that there is no insurmountable boundary between decentralized and peer-to-peer DeFi insurance, and many innovative designs in DeFi insurance are expected to emerge in this regard.

In a more general sense, if an asset pool is divided into different tranches (tranche) with different repayment orders and risk-return characteristics, such as debt and equity, the equity tranche, corresponding to residual claims and bearing losses first, will provide insurance for the debt tranche. This insight is revealed by the Merton model. Since the equity tranche can be held by multiple parties, the inherent insurance it provides is decentralized. In fact, Cover embodies the practice of tranching based on future states.

Actuarial and Loss Assessment Methods for DeFi Insurance

Although the actuarial practices and loss assessments for DeFi insurance are technical issues, their high professional requirements will significantly influence the implementation of DeFi insurance. In summary, there are four methods.

1. Conducting assessments in a centralized manner off-chain first, then writing the results onto the chain through oracles. This method is more suitable when the insurance subjects are off-chain risks.
2. Conducting assessments on-chain through algorithms, which is suitable when the insurance subjects are on-chain risks and when the probabilities of risk occurrence and economic impacts are easily quantifiable.
3. Conducting assessments on-chain through voting, which reflects the spirit of community self-governance but requires ensuring participation in voting and the credibility of voting results. Staking before voting is a common requirement to alleviate the Nothing at Stake problem. However, even so, allowing non-professional groups to decide professional issues through voting still faces significant challenges.
4. Through market trading, gathering information about the probabilities of risk occurrence and the extent of losses through market mechanisms. Markets are inherently decentralized, but it is necessary to ensure that the market has sufficient liquidity and that the price formation mechanism is smooth.

These four methods are not mutually exclusive and can be used in combination; for example, Nexus Mutual employs both the second and third methods.