How is DeFi Trying to Replace the Insurance Professional?

Some of the DeFi/Web3 Insurance projects I have been speaking with have the luxury of not being jaded by experience in the industry. This is far from being an insult – many of the successful Web 2.0 Insurtech companies were built largely by outsiders, who saw a slow moving and conservative industry, and thought they could do something about it.

Decentralization is in the DeFi name. What exactly does this mean? In a broad sense, a decentralized system will have no single decision maker. Responsibility for decisions are instead up to a collective, consisting of computers, individual people or both.

What does this mean for the insurance industry? DeFi Insurance projects which lean into this ethos attempt to replace individual departments within an insurance company with a decentralized system. In this article we’ll explore a number of insurance careers these DeFi projects are attempting to disrupt, and the viability of their success.

Underwriters

What do they do?

Underwriters assess the risk characteristics of potential policyholders and apply actuarial pricing models to determine appropriate premiums. The work that underwriters do ensures insurance companies have an accurate view of the insurance risk on their books and are charging adequately to cover them.

How is DeFi disrupting them?

There are two major ways that DeFi insurance protocols have tried to replace underwriting functions. In the ‘liquidity pool’ model, any member of an insurance collective can choose to ‘stake’ their cryptocurrencies against a certain risk. By doing so, they’re locking the value of their crypto into a pool that acts as the reserve for that risk, allowing policies to be written against these reserves.

Most models currently back 1:1 – $1M of locked capital will allow $1m of limits (see my article on the reserving problem). As an example, one may stake their Ethereum towards the Uniswap protocol via a DeFi Insurance protocol, and if Uniswap were to suffer a hack, that staked Ethereum would be used to cover claims. Underwriting functionality is effectively offloaded to a decentralized collective – risks which are perceived as higher risk will receive less staked capital in its liquidity pools, unless compensated by higher premiums.

Alternatively, Smart Contracts can be used to automatically apply actuarial models, bypassing the need for underwriting review. This is not dissimilar from modern Web 2.0/Insurtech models, which often provide an instant quote online based on information provided from the policyholder.

The major downside of this model is loss of verification of the risk characteristics. With no underwriter in the middle, how can the insurer be sure that what they’re being told is true?

How successful will it be?

I am skeptical of the ‘layman’ underwriter model, and the ability of non-insurance professionals to determine riskiness levels of potential policyholders. What I could see happening is an adaption of the Syndicate model – instead of staking coins towards specific risks, Joe Everyman could stake his coins towards a specialized Underwriting Smart Contract, controlled by an expert on a certain line of business. This expert would be responsible for risk selection, and the Smart Contract would automate collecting a fee and disseminating profits/losses – If the Underwriter had unfavourable results, liquidity providers could choose to unstake their coins at pre-determined intervals.

In the automated underwriting model, however, I could see a future where multiple DeFi ecosystems work together to abstract away the trust issue. When applying for a Homeowners Policy, perhaps the Policy Quote Smart Contract could make a call to a state-owned tax information blockchain to determine the last assessed value of the address. Maybe you need to sign a transaction with the NFT deed to your property to allow the quote to include non-public information also available from this ‘tax blockchain’. Of course, this is a chicken and the egg situation, and not something I expect in the immediate future.

Brokers

What do they do?

Brokers act on behalf of those interested in buying insurance to find the best products to suit their clients needs. They typically have relationships with many different insurers and a deep understanding of each of their offerings.

How is DeFi disrupting them?

Of the four career paths I’ve outlined in this article, I’ve seen the fewest developments in Web3.0 technology meant to replace insurance broker functions. This is probably due to most DeFi Insurance projects paralleling a direct-to-consumer model, where potential policyholders must interact directly with the project to purchase cover. This is somewhat ironic – arguably, brokers are ‘decentralized’ in that they allow for consumers to interact with many insurers at once.

In the future, there may be brokers that specialize in Web3.0/DeFi specific technologies. Perhaps you have a portfolio of cryptocurrencies that you’d like to insure against loss – these brokers would direct you towards a DeFi protocol that best suits your personal mix of digital assets and blockchain usage. Or, if you’re looking to purchase more traditional products such as homeowners insurance, they could help you navigate the landscape of retail-backed insurance liquidity pools as a potential alternative to traditional insurers.

How successful will it be?

Insurance brokers exist to find the optimal insurance solution (not necessarily cheapest) for those looking to purchase a policy. Like a doctor, lawyer or dentist, they are experts and advisors. in their field that provide services to consumers who are not expected to have a deep understanding of the product offerings. For these reasons, I believe there are limitations in how much of a broker’s role can be replaced by decentralization.

Instead, I expect existing brokers or newcomers to the career to adapt to changing technology, as described above. Much like cyber-specializing brokers that have emerged in the past few years, where there is a new LOB, there will be demand for experts. I can also imagine some applications of Web3.0 technology that would augment some of a broker’s responsibilities – for example, Smart Contracts already allow users to get quotes from on-chain insurance protocols. Policyholders could also grant their broker authority to bind, renew and pay premiums directly from their crypto wallets using signed transactions similar to the ERC20 ‘allowance’ standard.

Actuaries

What do they do?

Actuaries run the math behind insurance. Usually, an Actuary’s role will fall under one of two categories, ‘pricing’ or ‘reserving’. Pricing actuaries are responsible for determining the premiums to charge for insurance policies. Reserving actuaries (sometimes called valuation actuaries) make estimates for how much capital an insurer has to hold to pay future claims on policies written in the past. Actuaries are also often involved in other risk management and modeling heavy work within an insurance company.

How is DeFi disrupting them?

In some cases, ratemaking is being replaced by market forces to determine premiums. The more people that are willing to provide capital to back a certain risk (say Uniswap, Curve, etc.), the less risky it is assumed to be, and thus premiums are less expensive. The mathematical formulae behind these premiums are relatively simple; they are agnostic to the specific risk itself, instead being a sliding scale based on the amount of existing coverage and locked in capital.

On the reserving side, many DeFi Insurance protocols are actually over-reserving for their capacity. That is, the total limit on exposed policies is always less than or equal to the capital supporting those policies. Most insurance professionals will recognize the inefficiencies this may introduce, which I will discuss below. The argument for doing so is that any fractional reserving model will require some level of ‘trust’, and therefore centralization, which is antithetical to DeFi. The guarantee supply of locked-in capital is the only true way to guarantee claims can be paid out in a completely decentralized, trustless manner.

How successful will it be?

For DeFi insurance to be scalable, it will need to offer returns to investors that outpace alternatives that don’t require taking on underwriting risk. For this reason, I don’t expect the 1:1 reserving to policy limits model to win out, as it’s much too capital inefficient. Currently these models are largely supported by DeFi enthusiasts who are excited about the technology, and not necessarily ‘rational’ investors.

A semi-centralized fractional reserve model (i.e. the traditional model) will require actuaries behind it to monitor reserve adequacy. This support provides two functions – policyholders (and regulators) can be reasonably certain that claims can be paid out, and capital providers can expect to be compensated for the additional risk they are taking on.

Actuaries need to become educated on the specific risks associated with DeFi insurance to be able to sufficiently price for it. Smart contract errors, loss of keys and depegging events are all examples of risks unique to the DeFi world for which actuaries could provide insight on loss magnitudes and frequencies.

Claims Adjusters

What do they do?

When a policyholder makes a claim, they will likely be assigned a claims adjuster. This is often true even for the modern “AI driven” claims handling, there still might be a human in the middle inputting information into the system or verifying its accuracy.

Claims adjusters play an important role in ensuring claims are paid out accurately and fairly. They collect information about the claim and determine coverage based on policy wording. They. often work with third parties (lawyers, health professionals) to determine accurate remediation costs.

How is DeFi disrupting them?

Similar to the underwriting discussion, DeFi insurance protocols are attempting to replace traditional claims adjusters with decentralized voting communities or automated parametric based claims triggers.

How do these voting communities work? Typically, a member of a DeFi Insurance project will purchase a governance token from the project, representing their membership in the collective. These governance tokens give holders the right to vote on approval or denial of claims. The amount of weight an individual’s vote has usually scales with the amount of tokens they hold, though the function behind this weighting isn’t necessarily 1:1.

Parametric claims triggers are much easier to explain and understand. A Smart Contract representing the policy will contain a ‘check claim’ function. When this function is called, the Smart Contract will retrieve a datapoint from an external API via a Blockchain Oracle, which will determine if the parametric claim trigger has been met. This is theoretically possible to do with zero human interaction, with claims payments automatically distributed.

For examples of each model, check out Nexus Mutual’s claim tracking page, and Etherisc’s Flight Delay product.

How successful will it be?

The main issue needing to be solved by DeFi Insurance projects using the collective model is the alignment of incentives. Existing models typically include incentivizing token holders to vote on claims with rewards, and additional incentives for voting with the majority, or potentially penalties for voting against legitimate claims payouts. These models have yet to be proven by a true catastrophic event. In the event that capital providers are asked to select between paying out legitimate large claims using their own funds, or denying claims and withdrawing their contributions, I’m not convinced there are sufficient controls in place to ensure these claims will be paid.

Parametric claims triggers on the other hand, especially those backed with a guaranteed pool of funds, are probably one of the most talked about and most viable applications of DeFi to the insurance world. Since these types of claims are objective (payment happens based on an independent, known value), by automating the claims process insurers can reduce expense loads and therefore offer more competitive premiums. Examples of possible triggers include weather events, stock market indices or power outages in the insured’s location.

Final Thoughts

DeFi is going through a lot of the growing pains already figured out by the industries it attempts to emulate. The insurance world has seen this many times before – despite newlines saying that asbestos, hurricanes, earthquakes or the internet would render the industry obsolete, it has shown an ability to adapt to changing landscapes. DeFi will be no different, and in fact will require the expertise of those in the insurance world to navigate the industry. Our jobs are all safe, for now.