Article by SundaeDriver8 Edited by Zero Mass & Trewkat Cover Art by AB Colours

Insurance is essentially the practice of sharing risk among many in order to reduce the burden on a single entity. If we want to enable people to go Bankless, shedding reliance on centralized institutions, how can Web3 replace what insurance companies like GEICO and State Farm are offering? How can businesses and DAOs purchase the coverage needed to interact with each other without going to the TradFi giants? 

Web3 brings with it an opportunity to invent something new — just like those who worked on the original concept of insurance, as well as those who innovated and created alternative risk transfer methods. For example, in 1962 Frederic Reiss introduced an insured-owner structure known as captive insurance; this was a significant innovation for the field that has since grown to a $60 billion industry. 

Web3 technology will enable us to innovate and improve upon conventional methods and develop entirely new offerings as well, such as a tokenized insurance model.

To date, product growth has focused on coverage for Web3 issues such as smart contract bugs and de-pegging events. More recently the application of data from a decentralized oracle to on-chain smart contracts has reshaped parametric insurance, which is where a particular event — or set of parameters —  triggers the payment of a claim.

Although you might assume that settlement of claims is automated in DeFi-based insurance protocols this is not always the case, as the following examples illustrate:

• InsurAce is a popular DeFi insurance platform with over $339 million covered on 139 protocols on 20 chains at the time of writing. Their offering is limited to smart contract vulnerabilities, centralized custodian risk and stablecoin de-pegging incidents. Their advisory board investigates each claim and there is a voting process for claim approval.

• Nexus Mutual is another growing platform, limited to the same three coverages as InsurAce. They also have an advisory board to investigate claims as well as voting to determine if claims should be processed.

• Cover Protocol attempted to create a decentralized peer-to-peer insurance platform in 2020, but likewise were limited to those same products and claim approval processes. The protocol faced structural and personnel issues and shut down in 2021.
  

• Etherisc is a decentralized insurance platform which has partnered with Chainlink Oracles to offer parametric coverage and autonomous payouts for events such as flight delays or crops impacted by weather events.

Insurance adjusters are essentially professional ‘oracles’ for the insurance companies. The insurance adjuster is the person who comes out, takes a look at the damage, determines whether the loss is claimable under the policy, and if so, how much the claim is worth. This ambiguity around what’s covered and not covered is what gives rise to the insurance litigation industry and carriers that try to avoid claims payouts, but the adjuster is the first step in determining the merit and value of a claim. Their ‘yes’ or ‘no’, along with their valuation of the claim, is the single source of data that the insurer validates and uses.

Oracle companies in Web3 will begin to offer third-party adjustment services that will allow traditional insurance contracts on a blockchain to become more practical. However it is crucial that oracle services are decentralized, lest contaminated or compromised data from a single source be applied to an irreversible smart contract execution.

Efficiency will be achieved not only through technological improvements, but also from the trend analysis of the structured loss data pools that come from these systems. At some point, insurance companies will also accumulate enough data from these analyses and will find ways to profit. There is potential for new revenue-generating services such as validation of insurance certificates on a blockchain to emerge with the integration of this technology.

A mutual insurance company is one where the policyholders are the owners and the company’s only purpose is to provide them with the most affordable insurance. Mutuals were invented in the 17th century to help address the risk of fire losses. These insurers were community-based and access would typically require working in a certain business or geographical location to qualify. The weakness of mutuals is that they struggle to raise capital and cannot grow as competitively through mergers and acquisitions as their stock counterparts. This makes them less popular in corporate TradFi. As a result, modern mutual insurers tend to include a stock component in order to raise capital and compete in the traditional insurance space.

Web3 and DAOs can help foster a renaissance of this type of shared risk ownership. 

Established protocols could build risk transfer functionality into their existing tokens, allowing community members with qualifying NFTs or soulbound tokens to tap into liquidity in times of crisis while aligning incentives to earn the treasury yield. Private businesses or DAOs can also leverage the trustlessness of blockchains to build closed risk-transfer networks for other businesses or DAOs.

There is a specific challenge in bringing insurance to the blockchain. The process of adjusting some claims is so subjective it can’t ever be put into a smart contract. In order to innovate in Web3, we need something entirely new. Earlier, we defined insurance as the spread of risk, but the fundamental question is: why do people purchase insurance? It is to access liquid capital in a time of crisis. A new concept, tokenized risk transfer, can similarly align incentives to provide this immediate liquidity.

Proof-of-stake blockchains give us an opportunity to leverage the yield earned from staking. Imagine a new DAO to provide this service called ‘InsureDAO’, utilizing two smart contracts, which we will call Protocol A: “Stake” and Protocol B: “File a Claim”.

A user deposits the blockchain’s native token as collateral into the smart contract front end. This is analogous to the premium paid to a company for insurance. For this example, we’ll base it on ETH. This “premium” is actually collateral for a loan, if one is needed in a crisis of some sort (see below). The collateral goes into a pooled on-chain staking node to earn block rewards and a yield. Yield is earned in kind, with a small fee for the protocol treasury, on par with other staking pool protocols (similar to Lido or Rocket Pool). The rate would be dynamic to provide a mechanism to incentivize liquidity or deter abuse of the system.

When a user requires liquidity in a crisis, the smart contract can lock the deposited collateral for a period of years and issue enough of its ‘InsureDAO’ governance token to provide a loan amount higher than the locked collateral’s value. The loan is paid back using the yield from that locked collateral (similar to Alchemix, but on a significantly longer time horizon). The protocol fee also increases when locking the collateral, again the rate would be dynamic to incentivize liquidity and prevent attack.

This example assumes ETH block rewards of 12%, with 1% of that [8.3% of yield rate] going to the protocol treasury. The total amount in the contract at the end of 30 years would be 30 ETH with the protocol earning 2.4 ETH for the InsureDAO treasury (8% of total value after 30 years).

This tokenized risk transfer model uses two smart contracts to provide the liquidity that the user will access for their crisis. The protocol itself could integrate a stablecoin into the system or use an existing one like DAI from MakerDAO. Neither the loan for the governance tokens nor the stablecoins can end before the term is complete (30 years in the example). There is minimal-to-no slippage and no price crash because the two contracts execute at the same time and the newly minted inflationary tokens are immediately locked.

The governance token, $INS, is backed by the original collateral of ETH which, if ever broken from the second smart contract by default or liquidation, is stuck in the first smart contract forever to back the $INS. This makes the governance token appealing collateral to a stablecoin lender like MakerDAO because the assets backing it grow from staking plus the treasury fee. $INS is required to unlock the original ETH collateral and also has claim to the treasury’s earnings from providing the service. This also gives the governance token a minimum value backing it (similar to Olympus).

Finally, if a user defaults on the stablecoin portion of their loan (Protocol B), the stablecoin lender would be left holding the $INS governance tokens that now cannot be returned since they are broken from the original contract. The lender just needs to hold the asset and at the end of the term the token is permanently backed by the full value of the original loan in the chain’s token plus the treasury fees over the entirety.

Startup costs for the trustless risk transfer protocol like InsureDAO would vary based on a few factors. The first one is the proof-of-stake blockchain used. On Ethereum, for example, you would need to have 32 ETH to launch these protocols based on Ethereum staking. Feasibility would depend on the size of the expected community — a larger community would have higher claims which could push the time element too high for the smart contract to be practical. It would also take some analysis of the specific type of insurance and potential risk to determine the amount of native crypto that an idea like InsureDAO would need to get started.

A protocol built on top of a proof-of-stake blockchain is just one basic idea of many potential applications for tokenized risk transfer. Protocols and communities could adjust the parameters to fit their individual needs. One can quickly imagine the different chain-, protocol-, DAO-, and NFT-based communities that could embrace such a concept for their members with varying levels of permissions and restrictions around accessing liquidity.

It doesn’t have to be fully Web3 to begin – TradFi insurance companies could use tokenized risk transfer to create closed networks behind their current insurance products and update the “plumbing” of the TradFi risk transfer marketplace. Companies can also use it to enhance traditional alternative risk transfer techniques like captives or group captives. A captive is an insurance company owned by the insured(s) for one business or a group of businesses. They are used to create coverage that is typically difficult or too expensive to buy. Both cases would increase transparency between businesses and help insurers cut operating costs, which typically exceed one third of premium amounts paid.

Trying to bring current insurance models straight to Web3 is going about it the wrong way. Instead, what we want is to bring Web3 to insurance. Insurance is a great invention that has allowed for innovation to flourish and still has its place in global finance. The trustlessness of blockchains allows us to move past putting our trust in a centralized oracle or adjuster as we do with traditional insurance. Instead, we can put our trust in aligning incentives and leveraging smart contracts. This step forward allows any network participant’s ‘claim’ to be paid if liquidity is available.

sundaedriver8 is an Etherian and insurance professional looking to bring Web3 to risk transfer. If you are interested in discussing these concepts further or working on something like this, please contact him on Discord (@sundaedriver8.eth🏴#0646) or on Twitter.

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