DeFi insurance, or decentralized insurance, is a natural application of decentralized finance. There are two main branches to consider in the fast-growing field of DeFi insurance. The first is blockchain-based insurance used to replace traditional insurance policies. The second is blockchain-based insurance that mitigates the risks associated with DeFi activity. This covers people investing in cryptocurrency, for example, from things like smart contract exploits and attacks on DeFi protocols. This guide on DeFi insurance will consider both cases.
How does decentralized insurance work?
Insurance is a pooling of risk. When a potential event presents the risk of being financially punishing, individuals seek insurance to cover the risk. Insurance companies enable the individuals to pool that risk by having each one pay premiums. Each consumer's premium is far less than they would pay if catastrophe struck. Insurance companies bet that the amount they collect from individuals will be far less than what they would have to pay for claims.
Just as the pooling of risk is done through a centralized entity, so is the payment of claims. Traditionally, a policyholder must show that a loss has occurred and a claim is justified. The insurance companies use claims adjusters to verify this and determine the payout. This claims process is a significant expense in the insurance market.
What if there were a decentralized way to handle claims? Well, parametric insurance does away with claims altogether. Instead of paying based on the damages suffered, parametric insurance pays out if parameters set in a policy are met. It's the perfect system for decentralized smart contracts.
Parametric insurance and decentralized insurance
Let’s use farming insurance to explain how decentralized insurance works. A farmer buys drought parametric drought insurance. The policy stipulates what constitutes a drought. It could be rain gauges on the property, and/or certain declarations by a government body. Whatever the stipulation is, a parametric insurance policy pays a certain amount, also determined as the policy is written. The farmer doesn't need to prove damages. No claims adjuster is required.
This type of insurance contract can be, and is, written without the use of blockchain technology. However, the financial industry is seeing that a smart contract can handle this type of insurance very economically. Consumer interest in this data-driven approach is growing as it promises lower premiums.
With DeFi insurance, the policy describes the oracle or oracles – outside sources of information that confirm that the parameters for payouts have been met. The policy also describes payout amounts and other terms and is written in the form of a smart contract using blockchain technology. Since smart contracts are self-executing, the computer code is the policy and also manages the policy. In the drought scenario, you could use internet-connected rain gauges as the oracle that informs the smart contract that a drought has occurred. Once that, and any other terms, have been met, the smart contract sends the payout to the predetermined account.
With decentralized insurance products, much of the fees and friction has been removed from the process. There is no need to file claims. Payments can be made much more quickly.
Let’s take hurricane insurance as another example. When sustained winds over a geographical location hit a certain speed, people in that area with DeFi insurance would get paid compensation based on their policy terms. How? Internet-connected weather gauges will communicate with the smart contract in real time. If all the conditions are met and the wind hits a certain speed, compensation will be sent.
Flight delay insurance provides another example. This provides compensation for travelers who experience flight delays and cancellations. An insurance smart contract, operating on a public blockchain, would include details of your booked flights. It would also be programmed to monitor flight data and react accordingly, triggering an instant payout using real-time flight data.
With smart contract-powered parametric insurance, human involvement can be greatly reduced – and so can costs.
What are the benefits of DeFi insurance?
Reduction of fraud
False claims plague the insurance industry. They result in overpayments and increased costs for claims adjusters, investigators and litigators. Decentralized insurance systems can minimize people's ability to interject themselves into the process.
Smart contract technology means automated payment of claims. Also, insurance companies are using artificial intelligence algorithms to set the price and terms of insurance.
DeFi never sleeps. Let’s go back to our example of hurricane insurance. If you’re hit with a hurricane overnight, the weather data feed could trigger the smart contract to release compensation to the policyholder instantly. By the morning, with the distributed compensation, the policyholder could begin to fund house repairs without delay.
Smart contract technology enables more effective ways to manage risk. When you take out a traditional policy, the insurance company will do actuarial calculations to assess your risk. With decentralized insurance systems, the algorithms do all the hard work. This often means you can set up a policy in a fraction of the time.
A DeFi safety net
A new type of insurance is taking the industry by storm: DeFi insurance. This is coverage for people and organizations using blockchain technology. Despite the tremendous promise of blockchain technology and all it brings, there are inherent risks attached to its applications and systems. This is why many choose to take out insurance.
Let’s take exchange hacks as an example. If you currently hold a significant amount of crypto assets on an exchange, you may consider taking out insurance to cover these assets against the risk of an exchange hack. There were over 20 hacks in 2021 in which $10 million in crypto was stolen from an exchange or project.
Here’s another example: stablecoin price crashes. The stability of certain stablecoins has been thrown into question, leaving many stablecoin holders measuring the possible risks of price crashes and thinking about insurance.
You can think of decentralized insurance as a safety net for the DeFi ecosystem. Naturally, this type of insurance is offered in a decentralized form – fully embracing the potential of smart contract technology.
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