DeFi insurance (often called cover or insurance alternatives) is a catch-all term for products that protect against decentralized finance’s unique risks, such as protocol hacks or a stablecoin peg loss.
Traditional insurance, such as FDIC insurance, protects against financial losses that result from custodian mismanagement (e.g. a bank becomes insolvent). By contrast, decentralized finance (DeFi) inherently protects against custodian risks because users retain sole control of their funds, using a self-custodial wallet, while transactions happen on public distributed ledgers (blockchains).
As a result, the main risks in DeFi are technological (e.g. protocol code misuse, oracle failure). DeFi insurance was developed to protect against these risks while aiming to solve some of the inefficiencies and misaligned incentive structures found in traditional finance.
DeFi insurance takeaways
- DeFi insurance products are not one size fits all. Just as SIPC and FDIC insurances protect against different risks in traditional finance, DeFi insurance products are tailored to protect against specific adverse events regarding specific protocols or tokens.
- Cover falls into three main categories: protocol cover, stablecoin depeg cover, and yield token cover. Some providers also offer custody cover, which protects against fund loss resulting from the use of custodian (CeFi) products.
- Since the industry is so new, DeFi insurance is not recognized as formal insurance by regulatory bodies. As a result, many insurance products are referred to as cover, insurance alternatives, or DeFi fund protection.
Types of DeFi insurance
Unlike home or car insurance which have been standardized over the decades so as to make policies and claim approval processes virtually indistinguishable from one another, DeFi insurance products vary significantly in terms of covered event type and approval process.
Most DeFi insurance covers can be categorized as one of the following:
- Protocol Cover: Protection against losses resulting from the use of a DeFi protocol, such as smart contract exploits and/or hacks, economic design failure, attacks leveraging oracle data manipulation and governance attacks (malicious players gaining enough voting power to reshape protocol rules, leading to a loss of funds).
- Stablecoin Depeg Cover: Protection against losses resulting from a stablecoin (e.g. USDT, DAI) losing its peg to its target fiat currency (e.g. USD), resulting in the user’s inability to redeem a stablecoin for the intended amount of its pegged currency. This typically offers protection against pre-specified drops in price.
- Yield Token Cover: Protection against losses resulting from the face value of a yield-bearing token (e.g. yvDAI, cUSDC) significantly diverging from its market value in a reference currency (e.g. USD). This typically offers broader protection than protocol cover, by safeguarding against failures in a potential chain of protocols composed to generate yield.
Some providers also offer Custody Cover: protection against losses resulting from the use of a centralized or custodial (CeFi) cryptocurrency product (e.g. Coinbase, BlockFi). This typically offers protection against custodian exploits and/or hacks, fund mismanagement, and account lock-ups (inability to access funds without prior notification from the custodian).
DeFi insurance vs. traditional insurance
Decentralized finance insurance providers such as Nexus Mutual, Risk Harbor, InsurAce, and Unslashed Finance differ from their traditional counterparts in terms of their claims assessment processes, sources of underwriting capital, functionality, and general regulatory landscape.
Claims assessment
Claim assessment typically begins with submitting evidence of fund loss and proof of fund ownership through a protocol’s web app.
Next, the DeFi insurance protocol begins the provider-specific claim assessment process, which can be categorized into one or a combination of the following:
- Community vote: Members of a DAO vote to approve/deny claims
- Third-party assessment: An external group decides which claims to approve/deny
- Parametric: Most of the claim assessment process is automated by a smart contract and payouts are made in a matter of minutes when a specific on-chain condition is met
Traditional insurance companies do not publicly share their methodology for approving or denying claims or determining claim payouts, and the process of getting a claim approved or denied often takes months.
DeFi insurance regulations
In most countries, the insurance industry is highly regulated, with specific parameters designed for the traditional financial world.
The vast majority of fund protection offered in DeFi is not, from a legal perspective, insurance, as it is not regulated, issued, or processed in the same way as traditional insurance.
As a result of regulatory ambiguity, many DeFi insurance products are referred to as insurance alternatives, cover, or fund protection.
Capitalization
In the traditional insurance industry, companies typically source capital in the form of insurance premiums (payments from cover holders) and equities (for insurance companies, as opposed to insurance mutuals). These are re-invested into low-risk activities to generate additional capital.
In traditional insurance, companies are only required to share their premium-to-surplus ratio or solvency capital requirement with the government. By contrast, many DeFi insurance providers are open-source and share their capitalization data publicly.
United States
In the United States, the rules surrounding traditional insurance and reinsurance capitalization are state-specific and expressed in terms of the ratio of premiums (or capital) to surplus. Surplus is the insurance company’s assets minus its liabilities.
In broad strokes, the greater the surplus, the more assets the company has in terms of its liabilities, meaning that the company may legally continue to write new covers.
Europe
In the European Union, insurance and reinsurance companies must meet their solvency capital requirement (SCR): the amount of capital required to cover new and existing business expenses over the course of a year.
DeFi vs. traditional insurance capitalization
Though DeFi insurance alternatives differ significantly from those offered by traditional insurance companies in terms of offering, their baseline economics often functions similarly.
For example, DeFi cover providers typically have an internal solvency capital requirement that determines the maximum amount or cover they provide.
The biggest distinction between DeFi insurance and traditional insurance capitalization lies in how capital is sourced. Traditional insurance companies may raise capital through premiums or selling shares, whereas DeFi insurance companies can crowdfund capital from individuals.
This means that protocol earnings are redistributed to the underwriting capital providers of DeFi insurance protocols.
Cover approval and denial processes
In DeFi insurance, some providers offer what is called discretionary cover: It is entirely in the right of the DAO to deny claims they believe do not meet the cover’s criteria. For example, Nexus Mutual provides discretionary cover and makes all claim assessment decisions publicly visible via Nexus Tracker.
In traditional insurance, cover is not discretionary. However, the methods insurance companies use to determine which claims to approve or deny are not shared publicly and it is not uncommon for claimants to believe that their valid claims were denied or that they did not receive the appropriate compensation.
The argument for DeFi insurance
As decentralized finance grows in popularity, DeFi protocols are increasingly targeted by hackers with over $2.4 billion in DeFi funds stolen or lost since 2020.
In the past year, DeFi insurance products has saved protocol users from millions in lost funds in some of the biggest exploits:
- After hackers stole $11 million from Yearn Finance, Nexus Mutual paid out claims of over $2.7 million to Yearn Finance protocol cover holders, according to their claims tracker.
- When UST, a stablecoin, broke its peg to the US dollar, Risk Harbor paid out over $2.5 million in depeg insurance when UST dipped below $0.95.
How to purchase DeFi cover
- Determine which type of cover is most relevant
- Assess the scope of coverage
- Understand claim assessment and payout
- Compare protocol capitalization
1. Determine which type of DeFi insurance equivalent is most relevant
As cover is protocol and token-specific, the potential purchaser must determine which type of insurance is most relevant. In decentralized finance, this means choosing one or a combination of:
- Protocol Cover
- Stablecoin Depeg Cover
- Yield Token Cover
There is also Custody Cover: protection for centralized cryptocurrency assets, such as those stored on a custodial cryptocurrency exchange or cryptocurrency interest account.
If the cover purchaser has multiple areas of concern, it is possible to purchase more than one type of cover or bundle cover.
2. Assess the scope of coverage
Potential purchasers should ensure that the events they are most concerned about are covered, per the official cover wording. In case of doubt, one can ask in the provider’s community. Events that are not explicitly included in the cover wording are very likely to be denied.
For example, protocol cover is mostly restricted to technological failures or attacks. These could include protocol economic attacks, validator slashing, oracle malfunctions, or smart contract failures.
A cover will most likely not cover rug pulls — when the founders of a product attract investment to their product, then abandon it — or off-chain risks such as phishing.
3. Understand claims assessment and payout
A DeFi insurance alternative provider’s type of claim assessment — tokenized voting, third-party assessment, and parametric — may affect:
- How much effort it takes to file a claim
- How long it takes for claims to be processed
- Incentives within the insurance provider
In broad strokes, the more human input is put into a claim process, the longer it will take — especially in instances of large hacks. As parametric insurance fetches some information from the blockchain, the process will be faster.
Though two DeFi cover providers may have the same type of claims assessment, how they align incentives between claimants and claims assessors within the protocol may differ.
Some DeFi cover is discretionary
In DeFi, discretionary cover is usually provided by a DAO in which members vote on whether to approve or deny claims. In other words, it is entirely in their right to deny claims that they do not believe meet the cover's criteria.
4. Compare DeFi insurance protocol capitalization
Potential purchasers may consider a protocol’s capitalization when selecting the protocol from which to buy cover. This may include the ratio of the provider’s capital pool (amount available to pay out claims) to the amount needed to pay out all claims.
Another consideration is how capital pools are structured. Some providers have a single capital pool, whereas others have unique capital pools for different insurance products.
5. Consider cover pricing
Cover pricing varies based on a protocol’s expenses and their assessment of specific DeFi protocols’ inherent risk. When comparing cover prices, note that some DeFi insurance providers display the weekly cost of purchasing a cover, whereas others display annual costs.
For more information, please read How to Choose DeFi Cover.
