What should an ideal Blockchain-based Insurance infrastructure look like?
This question has consumed me for several months… This article is the first of a series where I share some thoughts about blockchain risks and associated insurance products.
Insurance is the safety net that enables fearless growth. As unsexy as it might sound to an average person, insurance products are of paramount importance for banking, trade, borrowing and lending, international commerce and pretty much everything in our everyday life.
As far as blockchain is concerned, DeFi (Decentralized Finance) apps are starting to see real traction and the smell of a new DeFi-fuelled bull-run is already in the air. We can see glimpses of the future; different layers stacked together, a new way of accessing and organizing data and money, and new asset classes emerging from a paradigm change. All of this is very exciting. But are we being complacent? There is almost nobody talking about the risks blockchain opens up. Worse, there is almost nobody willing to insure these risks.
Do we need insurance cover on the blockchain? Why aren’t insurance companies jumping at the opportunity?
It’s not like the risks aren’t there. We’ve seen Bitcoin Gold and Ethereum Classic suffer a 51% attack. We’ve seen numerous crypto exchanges hacked. And perhaps most notably, most of us will remember the historical DAO and Parity’s wallet hack. Smart-contract and blockchain risks are real. It’s the elephant in the room. There is an immediate need for an easily accessible insurance product. As traction grows, attack vectors will tangentially grow in size and sophistication.
Ironically, blockchain is undergoing tremendous growth with insufficient insurance coverage. This gap exists because traditional insurers are used to working with statistical models that are reliant on an abundance of historical data; something that we simply don’t have in the world of blockchain yet.
Therefore I think it’s safe to say we need insurance protection on the blockchain. No question about that.
So why aren’t insurance companies providing any? This question is harder to answer. Insurance is one of the most regulated industries in the world; capital requirements and risk management are high, it is a central piece of the modern financial system and at the same time, a very opaque industry as the AIG 2008 collapse showed. Today’s insurers either shy away from blockchain-related risks all together or simply overprice them. Most of them, however, accept they don’t have the expertise or data required to price this new type of risk.
The result is a love/hate relationship that insurance companies seem to have with blockchain. On the one hand, they claim the underlying technology is attractive. On the other hand, it opens up a lot of difficult questions around pricing structures that are simply easier to ignore or price so high that the risk-reward is undoubtedly skewed in their favor.
This leads to a situation where blockchain protection is unaffordable at best and non-existant by default. The consequences? Custodians prefer to create captives (GEMINI), some exchanges and Dapps have created insurance funds to cover black-swan events (Bitmex, Binance) and as this happens institutions still stay on the sidelines ignoring this new paradigm.
Why sit and wait for the traditional insurance industry to give us their green-light or to design the required products?
There is no reason for us to wait. Insurance companies, like banks, will eventually need to change their business models and adapt. Whilst there are examples of community organized mutuals and DAOs covering some blockchain risks, we are yet to see a solution that opens the doors for a trustless and permissionless risk market.
An accessible, easy to use, decentralized insurance offering will provide the much-desired safety which in turn will increase innovation and speed up adoption. In addition, decentralized insurance is a major pre-requisite for tokenizing traditional assets, institutional participation, and Dapp growth.
So why not just buidl it?
Building a risk market
Designing a risk market requires careful consideration. Below, we will outline what we think are the three properties that will ultimately drive a successful on-chain risk market and attract actors to becoming participants and beneficiaries.
Liquidity is defined as a high level of activity/volume in a market. The ability to easily go long protection (paying a premium for insurance) or short protection (underwriting someone else’s risk) is an attractive and necessary quality to have in an insurance marketplace and is not easy to procure.
So how do we kick start liquidity in the primary risk market? Like all multi-sided platforms, on-chain exchanges are confronted with the chicken and egg problem. Bonding curves may be the most viable solution as they allow liquidity to be kick-started by acting as automated market makers. Uniswap brilliantly paved the way over the last months and we can easily imagine primary risk markets attracting participation in a similar fashion.
Building a liquid risk market offers additional advantages. For example, one could discontinue their protection instantaneously by simply selling it. Moreover, tokenizing such risks can enable a more efficient secondary market for insurance claims. This can be a lifeline for someone who can’t afford to wait around indefinitely for claims to process. We can imagine a demand for “unprocessed” tokenized insurance claims in exchange for a discount to fair value or on a percentage/fee-based model. This isn’t a new concept, but it can be organized in a much more efficient and transparent manner on the blockchain.
Models stop working when there is not enough data to feed them. Every hypothesis for the occurrence of ‘X’ event that leads to ‘Y’ payout becomes worthless. This makes full collateralization of each underwritten risk the only viable solution. This is the main reason captives are used and insurance companies struggle with blockchain-related risks. Full collateralization has a capital cost that needs to be offset, either with high premium prices or by allowing that capital to be managed/invested while being used to underwrite risk.
Thankfully, the infrastructure required for managing collective assets has already been built by visionaries; the Melon Protocol empowers individuals to create funds and manage assets on-chain within predefined rulesets. The new web3 paradigm offers an exciting opportunity to underwrite risk while leveraging the Melon protocol for active management strategies of collateralized assets. Essentially, this means that capital could have a double use: collateralizing risk to receive premiums whilst earning returns as a result of careful portfolio allocation. This, of course, implies strict risk management policies for the collateral, something that has been carefully thought about in the design and architecture around Melon.
A transparent system will allow an insurance provider’s health to be audited based on their collateralization levels, asset management strategy, and risk exposure. Radical transparency for a cover buyer allows them to certify that risk is protected and that they will be paid in full when needed. This level of transparency increases confidence and allows the network to be auditable by the community. This design opens the possibility to have different insurance providers’ models and ratings by taking into account their collateralization rate, liquidity, and transparency.
Liquidity, collateralization, and transparency are the three major pillars that constitute an ideal decentralized insurance.
This is what we breathe, eat and live for.