Insurance: Token-based solutions on blockchain — A summary
This article summarizes the chapter “Token-based Insurance Solutions on Blockchain”, written by Jiahua Xu, Nikhil Vadgama and myself from UCL CBT. The chapter is part of a book called “Blockchains and the Token Economy: Theory and Practice”, which will be published later this year.
Managing risk has been crucial for humankind for a very long time. Two thousand years ago, Indian, Chinese and Babylonian traders practiced methods of pooling risk. For example, Chinese seafaring merchants pooled together their goods into a collective fund that would pay out if there was any damage to any of the members’ ships. Today, the insurance industry collects approximately $6 trillion USD of premiums globally.
But the insurance industry needs to evolve in order to tackle the following major problems:
- The emergence of new risks
- The transformation of existing risks
- Shifts in consumer needs
- Continuous advancement in techniques applied in insurance fraud
Because of this, flexible solutions that are transparent and easily manageable are in high demand. Let’s take a look at token-based insurance solutions, which bear the nature of programmability, traceability and transparency because of the blockchain infrastructure they are developed on.
Concepts in Token-based Insurance Solutions
Actors
Insureds are people who seek protection against a certain risk. They are the true customers of insurance products. Insureds are compensated when the hazard they are insured against occurs.
The role of the insurer is made easy by smart contracts. They redistribute funds to insureds with approved claims.
Underwriters assess the risk tied to uncertainty. Risk assessments can be performed by external participants or by the protocol itself. The element of risk will prove to be crucial in determining the premium an insurer has to pay.
Reinsurers provide extra protection by increasing an insurance protocol’s solvency. In return for taking part of the risk of the insurer, the reinsurer shares part of the protocol’s profit.
Claim assessors are internal or external parties that either approve or object a claim from the insured. This can happen automatically, through oracles, or manually, through group voting.
Decentralized autonomous organizations (DAOs) govern the protocol and, more specifically, the smart contracts. By holding governance tokens, a user holds decision-making power in a protocol’s governance. When a protocol is fully decentralized, no single entity controls the smart contracts anymore, but the rules of the game, including the mechanics of the processes and the tokenomics, are decided upon by a community of governance token holders.
Assets and Tokens
In many protocols, there is a specific token for premium payment, called a “payment token”. With this token, the insureds pay for their cover.
In return, the insureds could receive an insurance token, which represents a certificate of cover. Insurance tokens can be fungible or non-fungible, depending on the specific cover. It’s important to notice that not every insurance protocol makes use of insurance tokens. Instead, sometimes they rely on hybrid bookkeeping systems with a central database to record the transaction history.
Finally, a governance token ensures distributed sovereignty, by giving the holders voting rights.
Keep in mind that in some protocols, one token can have multiple use cases. Governance tokens can be used for payments, or the insurance token might also be the governance token. Designing the “token economics” of the protocol is a critical task.
Processes and Operations
Insureds pay a premium when they purchase cover against risks. This premium is paid with the payment tokens.
The price of buying a cover is either defined by e model that uses historical data, or based on the community’s opinion. It is the task of the underwriter to assess the risk level and signal correct behavior regarding the premium.
In case insurance has to be paid out, insureds have to file a claim. The approval or objection of that claim can be handled through automatic data provision, or can be processed manually by human claim assessors. The legitimacy of a claim is often determined by human judgment, as the immaturity of oracle technology still requires a careful approach with sufficient oversight.
Every protocol has a capital model that determines the minimum capital to be held, a metric often set to similar standards as EIOPA’s Solvency II, which ensures a confidence level of 99.5% in solvency over a one-year period. Managing the capital ensures that the protocol’s income is sufficient to protect the company against insolvency in case of mass pay-outs.
A comparison
Benefits of token-based solutions
Secondary Markets
By tokenizing most elements in the protocol’s workings, secondary insurance markets can be created. Selling and buying of tokenized covers can happen outside of the protocol’s own ecosystem. This would enhance the customer’s experience, it allows him or her to transfer the bought cover to someone else, and it creates an overall more efficient market through arbitrage.
Transparency
Because all actions and steps happen on a blockchain, the entire insurance process is visible end to end. Because of this transparency, participants have the opportunity to research a protocol’s trustworthiness themselves.
Customization
Tokens can have multiple functions. Maintaining and overseeing those functions is done by the smart contracts and thus does not rely on a single entity intermediary. Endless opportunities arise in the wider ecosystem when a cover is tokenized. It can be transferred to any wallet, it could be used as collateral for a loan, or it can be used to generate yield. Providing specific use cases to the customer connects the insureds with the insurer faster.
Challenges
In Case of Insolvency
Today’s protocols often don’t have a plan in place for when insolvency occurs. Although most protocols follow the Minimum Capital Requirements (MCR) standards from EIOPA’s Solvency II to a certain extent, it is hard to do extensive modelling as there is not enough data available.
Low Competition and Participation
This currently immature market is primarily dominated by one player, Nexus Mutual. Other projects seem to have little participation. A lack of sufficient service providers is not attractive for customers, who want multiple options to assess their product choice.
Fragile Incentive and Penalty Mechanism
Just like traditional insurance companies, a DAO has the incentive to keep funds to its own whenever possible, at least in the short run. This results in reluctance to approve claim requests from customers, as this would result in a money outflow for the protocol. Of course, in the long run, if the DAO keeps acting like this, customers will lose interest in the protocol, which will lead to a depreciation of protocol tokens. This is bad for all stakeholders, also for the DAO. It is clear that the tokenomics should include an explicit way of incentivizing good behavior for all parties.
Centralization
Most protocol teams are pre-screening claims or they have the final say in deciding upon the legitimacy of claims. This leads to concentration of power, and a single point of potential failure, which defeats the purpose of decentralizing the process.
Conclusion
This article is a short summary of token-based insurance solutions. We discussed the actors, tokens and processes involved in a typical decentralized protocol. A number of benefits, as well as disadvantages arise from tokenizing the industry, which is still at a very early stage.
Secure protocol design and strong tokenomics are absolutely critical in growing the token-based insurance industry. Most attention up until now has primarily gone to one protocol, Nexus Mutual, which had over 1billion USD in cover at its peak in 2021. Other protocols seem to struggle with their design, but interest in the insurance industry is increasing, as the whole DeFi sector is expanding.
Nevertheless, token-based solutions are able to challenge the traditional insurance market, and with further exploration of blockchain infrastructure in the traditional insurance industry, the use of tokens may be an inflection point in this challenge.
UCL Centre for Blockchain Technologies
Official Website: http://blockchain.cs.ucl.ac.uk/
Paper: https://arxiv.org/abs/2109.07902
Twitter: Simon DeFi , UCL CBT
