DeFi Insurance: What It Is and How It Works

Posted in Legal Alerts on May 18, 2022

The decentralized finance (DeFi) market is a new one with limitless possibilities. Along with the excitement come a number of risks in this nascent field. A lack of regulation, bad actors, and unstable systems have the potential to cause large losses. However, a new industry has emerged to meet the needs of people who want to participate in DeFi while protecting themselves against some of the potential risks. Now, people can purchase insurance against many of the losses they might encounter. However, like DeFi itself, this fledgling insurance market also has its own risks and challenges.

Crypto Hacks and Scams are at an All-Time High

There have been numerous stories in the news of people who have lost large sums of money in cryptocurrency hacks. There have been reports of state-sponsored actors hacking cryptocurrency exchanges and wallets and engaging in large-scale theft. The amount of money lost to DeFi hacks and scams is growing exponentially as the industry gets larger. In 2021, it is estimated that roughly $10 billion was lost in the DeFi industry to illicit activities.

The way DeFi is set up makes it conducive to hacks and scams. Without a centralized enforcement mechanism, the bad guys can be one step ahead and swipe millions of dollars from owners’ accounts in an instant. This is one of the downsides of the decentralized nature of the system.

DeFi Insurance Protects Against Adverse Events

You can buy insurance against events that happen in the DeFi space. Some people are turning to DeFi insurance as a means of protecting themselves. This industry itself is still in the growth phase and is thus continuing to work to perfect its own protocols. 

With DeFi insurance, you are not necessarily dealing with an insurance company. There are DeFi insurance companies, but they are not the ones who underwrite your coverage. They simply run the platform where you would connect with a coverage pool.

Anyone Can Provide DeFi Insurance

DeFi insurance is decentralized because anyone can decide to provide insurance to another person against DeFI risks. There is a decentralized pool of coverage providers, as opposed to a traditional insurance company providing a policy. These providers will charge a percentage for each cryptocurrency unit to protect against hacks on certain exchanges or other adverse events.

There Are Different Types of DeFi Coverage 

Before purchasers buy DeFi insurance, they need to know exactly what they are getting. DeFi prices and policies can vary based on the following: 

  • Coverage type
  • Provider
  • Duration 

There are different policies that you can buy to protect against certain events. For example, in addition to insurance against exchange hacks, you can also purchase coverage for: 

  • Attacks on DeFi protocols
  • Smart contract failures
  • Stablecoin price crashes

Individuals Provide Coverage by Joining a Pool

Individual cryptocurrency owners can become insurers by joining a coverage pool for each insured-against event. Coverage providers earn a return on their own cryptocurrency by taking in premiums. They can decide they want to provide insurance against certain events, such as hacks. Individuals decide which coverage pool to join, but they are not insuring a cryptocurrency owner directly. Each coverage pool is governed by a smart contract designed to ensure transparency. 

When you buy coverage, you must be specific and clear about what protection you are seeking. You must carefully study the insurance before purchasing it and make sure you buy enough coverage, both in terms of protecting yourself from particular adverse events and in relation to the amount of cryptocurrency you own.

The DeFi Claims Process Can Vary by Pool

Since the market is decentralized, the same regulatory structure and industry practices that exist in the traditional insurance industry are not present. One question to ask is how claims are verified, given that there is no centralized structure nor is there a traditional insurance company with whom to file a claim.

There are two different ways that claims can be verified:

  • Token holders can vote on community acceptance of the claim, followed by another level of review by a committee of experts
  • Oracles can be automatically set up to verify external data and automatically approve a claim 

In addition, there are different participants in the DeFi claims process: 

  • Governance token holders are the owners of the decentralized pools and have the right to make decisions.
  • A group of claims assessors is the initial voting group. Some pools reward people for voting with the consensus and penalize those who vote against it.

Different coverage pools may have their own rules about claims. Insurance products are not fungible between pools because of the varying policies.

The DeFi Industry Is Growing in Spite of an Uncertain Claims Process 

The lack of a centralized authority is still an issue with DeFi insurance. Insurance holders can theoretically go to arbitration if their claim is denied, but the mechanism to challenge an adverse decision is not as robust as you would find with a traditional insurance contract. The claim challenge mechanism needs to be built out in order for DeFi insurance to truly have a chance to be sustainable. Many coverage pools have the prospect of mixing governance with claims management, which can be detrimental to the insured party.

Nonetheless, the DeFi industry is growing. At this point, few people have purchased insurance coverage on their crypto holdings even though they are vulnerable to hacks and other events. The more that scams and hacks victimize crypto owners, the more that people will look to purchase insurance to protect themselves against these losses.