Crypto asset insurance: DeFi vs. CeFi

The traditional centralised insurance industry has historically been slow to act when new innovations come around the corner. There are a number of reasons why this is, but the  main one centres around the fact that insurers have to think about future liability for past writes. What does this mean? This means that insurers need to try and predict where they  may have a claim for the businesses that they currently insure. With new and emerging  technologies, this is hard to do. For example, if you speak to any property or casualty insurer, they’d be able to show you their actuarial models illustrating why they charge a  certain rate for a given peril. These models have been generated from years and years of  claims data; with every claim the market adjusts their rates and, more importantly, their  predictions for future claims. In essence, if you boil down an insurance company, it’s a data  company that uses their data to place bets. Data and betting. Welcome to traditional  insurance. 

So, understanding this model, we can see why insurers have been reluctant to adopt  emerging technologies – as the claims data is not mature enough to base their models on.  Coupled with the general risk averse nature of most underwriters in the market, it’s no  wonder the crypto asset insurance market is so far behind where we should be. However,  even though the market is small, it is growing. Anecdotally, we’ve been having more  conversations with traditional insurance players that are interested in crypto and are looking at insuring some element of the ecosystem. We’ve not only had a flood of new  business interest from companies in the crypto community, but have also been having  success in our discussions with traditional insurance companies in helping them understand  the opportunities in writing risks in this area. As written in a previous article, the way to  make up for lack of claims data is to underwrite by proxy. Find an industry segment that is  closest to the one you want to underwrite, blend it with another and you have some  semblance of a rate and expected loss ratio. However, it’s not just the centralised finance  (CeFi) world that’s slowly coming around to the opportunities in insuring digital assets; the  decentralised finance (DeFi) world is moving quickly and the companies in this space are  starting to gain widespread popularity. 

Some ways to think about the different placement mechanisms are below: 

Centralised Finance (CeFi) Decentralised Finance (DeFi)
Mandated to pay claims if policy conditions  are metClaims are voted by the members of the DAO
Slow turnaround times, anywhere between  1-6 months of underwriting depending on  risk and appetite.Almost instant.
Premiums are more expensive Rates are very competitive for the cover  given
Financially rated and typically around for the  long termNot financially rated and could cease to  function
Client does not get their premium back, but does help the CeFi insurance space  understand the digital asset space more. Each  policy is another step in bringing more  capacity to the space.If no claim, the stake can be returned with  interest.

DeFi: A New Hope? 

Decentralised Insurance is a bit of a misnomer as the insurance protocols aren’t actually  able to sell insurance. For a contract of insurance to be legally binding there are a number of  steps that need to be in place for that to happen. Most importantly, a licensed insurer that  is regulated and mandated to have enough capital to meet its liabilities in the form of  potential claims from their policyholders. There is no company (yet) that is a completely  decentralised licensed insurer, but there are companies that are filling the gap without the regulation and red tape. The most notable (and my favourite) is Nexus Mutual, they’ve  adopted a Decentralised Autonomous Organisation (DAO) structure where its members  vote on the claims that come in. Each member that has their native token (NXM) can stake  these tokens on decentralised applications (DApps); in the event that the DApp is hacked,  and the value contained in that DApp is lost, the stake is burnt. This means that the person  staking on the contract would lose their entire stake. However, if there is no hack and the  stake isn’t burnt then the individual receives their entire stake back plus interest. It is important to note that this is not insurance as in an insurance contract the insurer must pay  if the conditions in the policy are met; in the mutual business model there is no obligation  for payment as each payment is put to a vote. If the majority agree there has been a  covered claim, then the claim is then paid out. However, the rate and the type of cover you  can get through a protocol like Nexus Mutual is normally lower (for the rate) and broader  (for the cover) than what would be available through centralised finance.  

Client Case Study 

For example, I’ve been on a number of client calls where they want to insure their assets  held in a DeFi protocol. From experience, I know this cover is almost non-existent in the  centralised world, and the cover that does exist is very expensive and limited to only a few  million. Until more options are available, I’m referring these clients to protocols like Nexus  Mutual as they would be able to stake on the protocols they want to insure and if there  aren’t any claims they would not only get their premium back, but with interest. This is  where DeFi excels, nimbly bypassing the centralised world which is bogged down in process  and innovation theatre to provide any substantial benefit to emerging digital economies like  the DeFi space. 

CeFi strikes back 

That being said, all is not lost for the CeFi industry. What these insurance companies have is  deep pockets, and rated capacity – which is what companies that are contracting with  entities in the digital asset space are looking for. We look at contract requests, as well as  other documents, and it’s clear that the financial security provided by a DeFi protocol would  not be adequate for contracting with bigger companies or attracting higher profile board  members. Although there are many pain points within the traditional financial industry,  having the backing of a well-established insurance carrier is still a strong signal that your  business is worth transacting with. That’s notwithstanding the many benefits a company can  reap from going through the insurance application process, as this process can bring to light  some areas where the company may be deficient in risk management. A great example of  this is what’s happening in the cyber insurance space, as capacity has dried up and  underwriting standards are being imposed across the board, widespread change is  happening to companies purchasing cyber if they want to have a reasonable premium at  renewal (or cover at all). Cyber insurance companies are mandating these standards and  companies are complying. This is a win-win, as proactively helping your business manage  risk is much better than a claim payout after it’s already happened. It’s the same thing when  it comes to applying for Crime, Technology Professional Indemnity or D&O insurance – going  through a business’ risk profile is illuminating and can actually help the business in a few  areas that they need help with.  

Client Case study 

A good example of this would be a client I was working with who was operating two  completely different business models under the same company; both were in digital assets  and I knew I could cover one of them, but the second was ill-thought through and insurers  would have hated it. I advised him to carve out that second business into a new entity so  that we could just focus on placing the business that we could find cover for and (who  needed it for a contract). By doing this, we got him the cover he needed for a business critical contract and saved him a large amount of money by separating out the entities, which simultaneously helped insulate that business from unnecessary risk brought on by the  other business model. 

There is definitely a place for both DeFi and CeFi to coexist and work together in order to  bring better insurance solutions to the digital economy. However, the CeFi world does need  to bring its game. Although the DeFi economy is still new and burgeoning, the  entrepreneurs behind these companies are iterating far faster than their CeFi counterparts.  As an insurance broker, I imagine our jobs will change to the point where we will go to both  of these worlds for certain types of cover, much like how I interact both with my crypto  wallet and bank account in the same day. Insurance brokers who are educating themselves  and learning about the digital economy will be best placed to take advantage of the coming  digital asset tsunami and its corresponding opportunities and returns. 

Superscript is the first UK insurtech to become a Lloyd’s broker and is one of the global leaders in the market  for digital asset insurance having been selected in the latest Lloyd’s of London Lab cohort for cryptocurrency