Understanding DeFi Insurance in One Article

In the traditional financial industry, insurance is one of the most important cornerstones. In countries with more developed financial markets, total insurance assets usually account for about 25%-35% of total financial assets. Compared with traditional insurance, DeFi insurance is also a very broad market.

Currently, DeFi is in the early stages of development, with an overall market value of nearly US$100 billion, which means that the DeFi insurance market size is in the tens of billions and will grow with the growth of DeFi.

So how does DeFi combine with insurance, what advantages does it have over traditional insurance, what pain points and difficulties does it encounter during its development, and how can DeFi insurance break through the circle to protect off-chain events?

When insurance meets blockchain

"Blockchain technology is essentially a decentralized, distributed accounting, and consensus-based database. The best scenario for combining it with insurance is the blockchain alliance chain, which is a blockchain jointly managed by a number of long-term stakeholders from upstream and downstream of the insurance industry chain. Each institution runs one or more nodes, and the data is only allowed to be read, written, and traded by different institutions within the alliance system, and is in the form of smart contracts." Yan An, head of Ji'an Life Mutual Insurance Society (in preparation) and secretary-general of the China Mutual Insurance and Mutual Aid Forum, told Chain News.

The combination of blockchain and the insurance industry seems to have natural advantages. First, the characteristics of the information on the chain that cannot be tampered with and is open and transparent can effectively avoid the risk premium caused by information asymmetry in the insurance industry; second, the application of smart contracts can reduce operating costs and other expenses, providing policyholders with more competitive insurance premiums.

It is particularly noteworthy that in the decentralized and trustless environment of DeFi, the implementation of insurance will be very different from that of the mainstream financial market.

DeFi stands for Decentralized Finance, which means "decentralized finance" or "distributed finance". As the name suggests, DeFi insurance is "decentralized insurance". It actually refers to a decentralized protocol used to build an open insurance system, which aims to allow everyone to conduct insurance activities anytime and anywhere.

In the mainstream financial market, insurance is implemented in two ways, namely, joint-stock insurance companies and mutual insurance organizations. Among them, mutual insurance organizations have a more obvious decentralized feature, reflecting the characteristics of "shared benefits and shared risks".

Specifically, a mutual insurance organization is an organization jointly formed by policyholders who have protection needs for the same risks. It has no shareholders and no share capital.

The online mutual aid that has emerged in recent years is equally decentralized as mutual insurance organizations. It should be noted that online mutual aid does not belong to licensed insurance operating institutions, but is organized by online mutual aid platforms. It uses the information matching function of the Internet to realize an innovative mutual aid model in which members bear each other's risk losses. There is a clear community autonomy in insurance loss assessment and compensation.

On September 8, 2020, the China Banking and Insurance Regulatory Commission issued the "Analysis of Illegal Commercial Insurance Activities and Countermeasures and Suggestions", which clearly defined online mutual aid platforms as illegal commercial insurance activities that are not licensed. The China Banking and Insurance Regulatory Commission defines mutual aid platforms as "four no" states: no supervisor, no supervision, no standards, and no regulations. It also proposed to adhere to strict access and licensed operations for all insurance activities, and severely crack down on all kinds of illegal commercial insurance activities. Subsequently, many online mutual aid platforms were shut down.

"In the era of central bank digital currency and stablecoin, mainstream mutual insurance organizations and online mutual assistance will achieve better development." Zou Chuanwei, chief economist of Wanxiang Blockchain, believes that the group contracts involved in these two types of insurance activities can be expressed in the form of smart contracts. Insurance actuarial and insurance loss assessment require high professionalism, so they can adopt a relatively centralized + community autonomy (such as a jury), especially when the insurance subject is an off-chain risk. Premium payments can be directly executed by smart contracts to transfer central bank digital currency and stablecoins, which can significantly improve transparency and credibility.

However, in Yan An's view, DeFi insurance must also be subject to the "Insurance Law". Blockchain is merely a technological innovation and a technical means. Therefore, logically there is no "lawless place" for insurance. DeFi insurance is currently in a stage without supervision, regulation, standards or regulations.

Huge opportunities but still risks

"DeFi insurance has many advantages over traditional financial insurance. For example, DeFi insurance is very innovative in improving privacy, fairness, asset security, reducing financial costs, and decentralization. However, DeFi insurance is currently mainly concentrated in the crypto asset industry. If blockchain technology can be better coupled with the traditional financial industry and use DeFi insurance to solve problems in the traditional insurance industry, its potential and effectiveness will be enormous." Zhou Xinjian, senior researcher at MeChain Technology, told ChainNews.

"The financial attributes of blockchain technology have always been one of the most concerned topics. The popularity of DeFi-related industries has once again confirmed this. The review, settlement, mortgage and other aspects of traditional financial business can improve security and operational efficiency in decentralized technology. The credit system based on blockchain smart contracts will penetrate the financial market and promote its reform, which may be one of the future trends." VeChain Chief Scientist Zhou Ziheng told "Chain News".

However, as a profit-seeking investment, DeFi insurance is different from common applications such as over-collateralized lending and spot trading. It requires a more stable credit market and interest rate market, which is a challenge for the DeFi ecosystem that has yet to be improved in the areas of real-name KYC and credit scoring.

Zhou Ziheng believes that the starting point for technology to change the industry is that "business data is all on the chain", and the design of financial products and ecological frameworks is more suitable for professional institutions to lead, including financial institutions, government agencies, consulting and auditing agencies, etc. "At present, this starting point is not stable, so the timing may also be debatable."

Zou Chuanwei believes that a key to the future development of DeFi insurance lies in whether DeFi insurance targets off-chain risks or on-chain risks. When DeFi insurance targets off-chain risks, DeFi insurance needs to solve two basic problems: first, off-chain risks are denominated in legal currency, but insurance claims are paid in on-chain digital assets, which causes currency mismatch problems; second, insurance actuarial calculations and insurance loss assessments for off-chain risks can only be carried out off-chain, so it is necessary to write relevant results into the chain through an oracle. When DeFi insurance targets on-chain risks, it is necessary to expand the scope of risk coverage. In addition, although DeFi insurance actuarial calculations and insurance loss assessments are technical issues, they require high professional capabilities and will significantly affect the implementation of DeFi insurance.

"DeFi insurance is still in a very early stage of development, and its system construction and product innovation have just started. Excellent projects in the blockchain industry have never lacked capital." Zhou Xinjian believes that the current restrictions on the development of DeFi insurance are technical factors on the one hand and policy factors on the other. The technical factor is mainly that the openness of DeFi contracts makes the protocol very easy to be hacked; the policy factor is mainly that DeFi insurance is still mainly limited to assets within the digital asset chain, and the combination with traditional financial assets still requires the dual support of policy and technology.

DeFi insurance is gaining popularity

As the DeFi protocol continues to upgrade and iterate, the DeFi insurance market is rapidly changing and gradually taking shape in terms of code quality and operating model, supporting the growth rate of DeFi lock-up volume. At the same time, DeFi protocols are frequently attacked and cause property losses.

"Flash loan attack arbitrage, protocol attacks, etc. are all affecting the stability of the market and the security of the assets of market participants. While the project parties are constantly improving the security of the protocols and mechanisms, the insurance sector is also in urgent need of participating in the construction of the DeFi Lego ecosystem and providing users with protection methods that they can choose independently." Drey Ng, co-founder and product manager of the cross-chain synthetic asset protocol Linear Finance, told Chain News.

The past year was also a year of frequent security incidents. Origin Protocol suffered a loss of RMB 45 million due to a reentry attack, and Balancer suffered a loss of RMB 3 million due to a flash loan attack. In the face of the endless stream of smart contract attacks, the importance of insurance becomes more prominent.

With the popularity of DeFi and the continuous participation of investors and speculators, market competition has become increasingly fierce, and the test for projects and teams has become more severe.

"In the DeFi insurance ecosystem, DeFi projects actually account for a considerable share. A good insurance platform will eventually gain the favor of most DeFi projects, access and establish corresponding insurance policies, and even actively update some code-related information (such as audit updates). This is also an overall improvement in the industry level and positive feedback." Wu Zhouyu believes that a fair claims settlement method is also a very important point. The reason why some old projects (such as NXM) have been criticized is that their claims settlement mechanism is too "centralized."

"The future development of DeFi insurance must have the ability to break through the circle and expand the coverage from virtual assets to real assets." Kevin Tseng, founder of NAOS Finance, told ChainNews that NAOS Finance is building a DeFi lending ecosystem based on real assets, and DeFi insurance will play the most core role in this ecosystem. "The players who can finally stand out in this DeFi insurance track must be those who can perfectly connect virtual and real assets with insurance services."

"For a project, if it wants to stand out from many Defi projects, it must first be secure and innovative enough from a technical perspective, be able to differentiate itself from other projects and solve industry pain points; secondly, the quality, diversity and activity of the ecosystem. A high-quality and rich ecosystem is the key factor in the virtuous cycle of any project." Zhou Xinjian, senior researcher at MeiChain Technology, told "Chain News".

Zhou Xinjian believes that a forward-looking leader is the key to whether a project can be at the forefront of the industry, an excellent technical development team is the support for achieving technical feasibility, and the financing and operation team is the blood of the project's long-term development. "Only a team with the above qualities can stand firm in the fierce competition."