Exploring the Exciting Use Cases of Decentralized Finance (DeFi) – Part 4

Exploring the Exciting Use Cases of Decentralized Finance (DeFi) – Part 4

Continuing the series about DeFi applications in everyday life. In this article, let's explore with FinFan the 4th application of this new financial segment Decentralized Insurance and Risk Management.

What is Decentralized Insurance and Risk Management?

Like an insurance company in the Web 2.0 world, in the Web 3.0 world, insurance and risk management companies also exist. However, the only difference between Web 2.0 and Web 3.0 insurance company insurance lies in its decentralization and it’s only for crypto assets.

Example of Centralized and Decentralized Insurance

Centralized Insurance

We can name many forms of insurance in the centralized world such as Life Insurance, Car Insurance, etc. All the above types of insurance have one purpose: to help property owners feel more secure about their assets or their own health when problems occur.

For example, car insurance will be effective if your car is in a collision or has certain parts damaged due to an objective factor. At this time, car insurance agents will pay you part or all the cost of repairing that car.

A similar situation also happens with life insurance when the participant has a health problem that requires hospitalization or if unlucky enough to encounter unforeseen situations, the insurance will pay part of the hospital fee or will send the amount of Insurance for beneficiary relatives stated on the insurance contract (of course within the valid insurance period).

Decentralized Insurance

In the decentralized financial market, insurance is created to ensure and prevent risks when errors occur in crypto transactions or activities on this market, leading to users losing money.

  • Some use cases of the Decentralized Insurance industry:
    • DAO is hacked.
    • Polkadot parity multi-sig froze.
    • YAM Finance governance token rebase contract.
    • Maker's vaults are liquidated.
    • bZx smart contract exploited.

Decentralized Insurance - P2P risk sharing model.

In the Centralized Insurance market, an insurance company will collect information, assess risks, and pay the insurance amount on the contract that the customer has participated in.

This will lead to conflicts when the insurance company's appraisal team often performs actions that benefit the insurance company.

Therefore, in the decentralized world, the model will share risks with three parties: buyers, risk assessors, and claims assessors.

  • The buyer will buy insurance for situations that he thinks may be due to an error in the code or decentralized system leading to loss of money.
  • The risk assessor is someone who thinks that the errors will not happen, who is unlikely to lose money, and who is willing to pay that risk to the buyer.
  • The claim assessor is the person who will evaluate whether the buyer’s claim is accepted or not.

A more specific example is that the insurance contract for Uniswap's Smart Contract has a compensation ratio of 1:500 (because it is relatively safe).

  • You are a user of Uniswap, you are trading 500 ETH there, but you are afraid the system will be hacked. You will spend 1 ETH to buy this contract. If the system is okay, you lose 1 ETH. If the system is truly hacked, you will receive 500 ETH back and only lose the original 1ETH.
  • Risk assessor: Those who believe in Uniswap's Smart Contract will spend 500 ETH to guarantee you, in return, they will receive 1 ETH from you.
  • Claim assessors: People who will assess whether your claim is accepted or not. As in Protocol Nexus Mutual, because it is a decentralized Protocol, those who own NXM governance tokens will have the right to participate in voting.

The potential of the decentralized insurance market

Although this is just the beginning of the decentralized insurance market, this market still has a lot of potential. The following statistics will show that in the market:

  • Current capitalization of the entire insurance industry: $5 trillion USD.
  • Capitalization of online insurance: $31 billion USD.
  • Capitalization of Insurance in Crypto (via NXM): $213 million USD.

We can see that although it is only a small niche of the insurance market, online insurance also has a market capitalization of up to 31 billion USD. Furthermore, crypto (or decentralized) insurance is an even smaller niche, but data has shown that, on the NXM platform alone, the capitalization has reached 213 million USD.

What problems make online insurance (especially crypto insurance) ineffective?

Lack of trust is the big problem of crypto insurance.

The crypto industry in general has not received high trust from participants due to its decentralization (both a strength and a weakness).

The strength of this industry lies in the fact that they will not be controlled by a third party, thereby increasing their security and information processing speed.

Besides, it is also because of this decentralization that the crypto market will raise unnecessary problems such as market manipulation or price manipulation.

Returning to the insurance industry, this industry inherently exists thanks to the trust of customers in insurance service providers. Can crypto insurance companies guarantee this reliability (because some insurance smart contracts will have very high compensation ratios and sometimes up to 1:500).

Information that is not transparent or clear

This is also a weakness of the crypto market in general when the original purpose of the market was created to ensure user information security, so information is sent to insurance companies or insurance buyers. as well as the risk appraiser will also not be clear.

Accordingly, there will be cases where the risk appraiser only receives a notice saying "There has been a system error, and you must pay the insurance compensation amount" even though they do not know the origin and information of the buyer.

In short, the decentralized insurance industry is still a very potential industry and can develop very strongly in the future. In addition, insurance companies need to consider the risks when participating in this market as well as correct the limitations of this segment such as:

  • Clarifying the information (doesn't need to be too detailed, just the wallet address) lets the risk appraiser know which party they must pay and why they have to pay for it.
  • Increase trust with customers by offering insurance products that target common problems customers face in the crypto world, while also being responsible for getting the amount of money the risk assessor pays for insurance buyers on time.