Crypto asset insurance: DeFi vs. CeFi

This content was written by Ben Davis, Head of Superscript’s International book of business and its emerging technology practice, on behalf of Team Blockchain. Team Blockchain is an independent platform providing insight and expertise on Blockchain, Tokenomics and the Crypto market.

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:

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 (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.