The traditional insurance industry has a long history of development, and its core modules such as risk control and pricing have mature models, which are lacking in decentralized insurance. This also means that products at this stage can only focus on smart contract security and financial derivatives. field, it is still too early for many people to expect "out of the circle".
In the current situation where the entire DeFi market is hot, both the amount locked in smart contracts and the market value of DeFi tokens have exploded within a few months. And at this stage, we haven't seen enough innovation on these tracks. Whether it is mutual insurance Nexus Mutual, financial insurance Opyn, or Upshot, which wants to use the prediction market but still has many problems to be solved, it is the continuous attempt of the decentralized insurance industry. Blockchain, decentralized finance It is a product of youth itself, and we should think about how to deal with the huge risks behind it in a state of market frenzy.
This report will conduct a fundamental analysis of the Nexus Mutual project and the decentralized insurance industry from the following dimensions:
1. What are the problems with traditional insurance?
2. Introduction to Nexus Mutual Project
3. Nexus Mutual Technical Highlights
4. Nexus Mutual Token Economy
5. Analysis of decentralized insurance industry
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insurance company agent
In the sense of law and economics, insurance is a risk management method, and its essence is to allocate and transfer the risk of potential loss of a specific entity. Human beings' natural aversion to natural disasters and accidents made primitive insurance ideas and practices appear in the early stages of civilization. People come together by forming communities, pooling resources to share risks rather than suffer disasters alone.
With the development of modern civilization, the embryonic form of the modern insurance system based on the ship mortgage loan system has emerged. This form of loan stipulates that the borrower can borrow money from the lender with the ship as collateral. If the ship arrives safely at the port, the borrower will repay the principal and interest to the lender; if the ship encounters an accident, the debt of the borrower will be forgiven. The continuous expansion of people's demand for insurance and the development of modern commerce have given birth to insurance companies specializing in insurance business. Based on the strict supervision of the government and the constraints of complex legal frameworks, the insurance industry has experienced long-term development and spawned many large-scale companies. .
However, in recent years, the outbreak of multiple financial crises has led to the loss of people's confidence and trust in the financial system, and the natural "Agency Problem" of insurance companies has become increasingly prominent. The current challenges facing the insurance industry are mainly manifested in two points:
The insurance industry is extremely information asymmetric. Insurance companies decide how to manage customers' funds, including investment methods and compensation methods for policyholders. It is difficult for customers to evaluate the safety of insurance companies;
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High "friction costs"
For the above-mentioned "trust" issues between customers and insurance agencies, the mainstream solutions are legal constraints and prudential supervision. The specific contents include: defining minimum capital levels, standardizing governance processes, regularly reviewing and submitting financial reports that meet standards, etc. This centralized supervision method is undoubtedly effective, but it also brings huge additional costs. According to historical statistics, about 35% of the premiums paid by policyholders are handed over to "friction costs", while reducing the industry's flexibility and efficiency.
Blockchain technology proposes an efficient solution for the insurance industry. Smart contracts developed based on blockchain technology not only eliminate the inefficiency of traditional insurance industry management, but also eliminate most of the costs associated with governance and supervision. Provide trust in a more cost-effective way (trust has moved from institutions and regulations to transparent code).
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Concerns of Blockchain Institutional Investors
The "decentralized insurance" developed based on blockchain technology and smart contracts can dispel some of the concerns of blockchain institutional investors when making decisions.
For example: When institutional investors consider putting idle funds into Compound—the most basic and lowest-level lending agreement in finance—to generate interest, they will face the following two problems:
Compliance: If the organization wants to move the money, how the company's legal affairs should write compliance documents is a big problem;
The DeFi industry lacks stable and safe insurance business, and institutional investors with abundant cash flow are afraid to enter the market. The existence of decentralized insurance business will greatly increase the number of players entering the DeFi field.
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About the Nexus Mutual Project
Nexus Mutual's first product is the Smart Contract Cover. This product provides insurance services for the security risks of smart contracts (such as being hacked), so as to ensure that policyholders can get compensation after suffering financial losses. Users who purchase Smart Contract Cover (Nexus Mutual members first) choose a fixed amount, the "Cover Amount", which will be paid if the claim application is approved through the evaluation process.
Smart contract security is a well-known issue in the Ethereum community, and a lot of technical work is devoted to improving the situation. But even with formal security verification, there is always a risk that a particular smart contract will be insecure. Nexus Mutual believes that providing further safeguards against the consequences of coding errors for groups concerned about the security of smart contracts will be of great benefit to the Ethereum ecosystem.
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Decentralized risk assessment mechanism
Nexus Mutual has introduced a "decentralized risk assessment" mechanism, allowing a group of smart contract security audit experts to participate in the assessment of specific risks by pledging tokens, so they can obtain token rewards from the system. These audit specialists are known as risk assessors at Nexus Mutual.
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Source: Nexus Mutual Medium
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The first round: vote in the Claim Assessor (the NXM token is pledged), if more than 70% of the people reach a consensus, the result will be issued directly, if less than 70%, the second round will be conducted. (If the minimum number of votes is not reached, all members will participate in the vote)
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claim assessment
Unlike traditional insurers who approve or deny claims based on the terms of the insurance contract, Nexus Mutual decides whether to pay or not based on the results of member votes. Nexus Mutual provides a platform, and everyone who buys insurance on the platform will become a member. Members on the platform can pledge a part of NXM tokens to become claim assessors and vote on claims submitted by others. The voting result has the highest decision-making power, that is, to determine whether the final compensation will be paid or not. Nexus Mutual believes that this will allow people who cannot get compensation due to strict terms under the traditional insurance model, but actually suffered losses, to get due compensation.
For the system to work fully, people need to be incentivized to vote on claims, and there need to be severe penalties in place to prevent fraud. Nexus Mutual does this by rewarding claim assessors whose assessments agree with the consensus vote and penalizing those who disagree.
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Source: Nexus Mutual
The first round: vote among the claim assessors, if more than 70% of the people reach a consensus, the result will be issued directly, if less than 70%, the second round will be carried out. (If the minimum number of votes is not reached, all members will participate in the vote)
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price setting policy
Nexus Mutual considers the following two questions when formulating its pricing mechanism:
Due to the lack of historical data on smart contract hacking, Nexus Mutual used information about code security to assist pricing;
Insuring a new smart contract will be very expensive (or not even available) at first since it has not been tested for hacking. Only after multiple rounds of testing will insurance costs drop, but this will take a lot of time. Most users cannot bear to wait for a long time and want to insure their smart contracts immediately. The solution proposed by Nexus Mutual is: introduce a decentralized risk assessment mechanism, and reduce insurance pricing to a reasonable price level by incentivizing risk assessors to endorse the security performance of smart contracts.
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risk control
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Nexus Mutual Token Economy
From a conceptual design point of view, Nexus Mutual's shared fund pool is very similar to Uniswap:
Members of Nexus Mutual provide liquidity (in ETH) to the pool and receive NXM tokens in return. Similarly, Uniswap's liquidity providers contribute ETH and other asset pairs to the liquidity pool and receive corresponding tokens in return;
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Source: Medium
Although the two models of Nexus Mutual and Uniswap are similar from the basic model, Nexus Mutual adds some other elements on the basis of this shared fund pool:
The remaining premium of the smart insurance contract Smart Contract Cover is expected to have a surplus of 30%. This value is only an expected value, and the actual claim amount may be larger or smaller than the project party estimated. But no matter how it changes, all Nexus Mutual members will share the risk;
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Analysis of Decentralized Insurance Industry
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Analysis of Decentralized Insurance Segmentation
According to Figure 5, we divide the subdivisions of the decentralized insurance industry into: shared fund pool (Nexus Mutual), prediction market (Augur), financial derivatives (Convexity), decentralized insurance agreement (Etherisc), There are five categories of insurance endorsed by social proof (VouchForMe). Among them, the Upshot project is particularly noteworthy, which combines a shared fund pool and a prediction market, aiming to launch a better insurance solution than Nexus Mutual and Augur.
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prediction market
In addition to the original insurance agreement, as well as the model of financial products such as derivatives transactions and option agreements, the prediction market can actually be used as an insurance mechanism. For example, on Augur, you can build a prediction market to hedge the risks you may suffer, but this model requires you to have enough people willing to participate in the prediction market betting.
Decentralized Insurance Protocol
The idea of Etherisc is very similar to Aragon in the DAO field - to build a general decentralized insurance application platform first, so that developers can use this platform to quickly develop new insurance products.
The Etherisc core team has developed some insurance common infrastructure, product templates, and insurance licensing as a service, allowing anyone to create their own insurance products. At present, the Etherisc community has designed a set of basic insurance products, ranging from flight delay insurance, hurricane insurance to encrypted wallet and loan mortgage insurance.
Insurance Backed by Social Proof
Financial derivatives
Financial derivatives
There are two representative projects in the direction of using financial derivatives as DeFi insurance: CDx and Convexity.
CDx：
CDx is a trading platform for tokenized insurance, and its essence is a credit default swap agreement. Credit default swap contract is the most common credit derivative product in the foreign bond market. It refers to a contract in which buyers and sellers exchange risks on specified credit events within a certain period of time. The buyer of the contract regularly pays the contract seller for the credit event of a reference entity during the contract period or before the credit event occurs, in exchange for compensation after the credit event occurs.
The risk conversion contract on CDx is called Swap. Sellers can mint a Token corresponding to the Swap type. Swap sellers need to set the total amount of assets they need to insure and the amount of compensation they want to get; buyers can decide whether to buy through the Swap terms. The Swap contracts on CDx are matched by service providers and finally traded on the chain. In addition, the Swap contract itself can also be traded in the secondary market like ordinary Token. If there is a breach of contract, the person holding Swap can exchange the corresponding compensation through Swap.
Convexity：
Convexity Protocol (the product is OPYN) is an option agreement based on ERC20 homogeneous tokens. In this OPYN, oTokens (option token) can be used as an insurance tool, and its operation mechanism is close to financial derivatives and options transactions. Through With this product, users can protect their assets by purchasing put options.
Let me give a simple example to illustrate how put options provide asset protection for its holders: Xiao Ming is not optimistic about the stock of company A and expects it to fall in the next month, so he bought it from Xiao Hong by paying an option fee of 1 yuan. A put option. The two parties agree that after one month, Xiao Ming has the right (but not the obligation) to sell a share of company A stock to Xiao Hong at a price of 20 yuan. One month later, if the stock of company A falls to 10 yuan, Xiao Ming will choose to execute the option contract, buy the stock of company A at 10 yuan in the market, and immediately sell it to Xiaohong at the price of 20 yuan, earning 10 yuan. Yuan price difference. Regardless of the time cost, Xiao Ming can still earn a net income of 9 yuan after deducting the 1 yuan option fee paid one month ago; Contract not enforced. At this time, Xiao Ming's net loss was 1 yuan when he bought the option. At the same time, Xiao Ming also enjoyed the benefits brought about by the rising stock and was compensated. Xiao Ming obtained a kind of insurance protection in a disguised form by purchasing put options, that is, a certain net income can still be guaranteed when the stock falls. As for the seller of the option, Xiaohong, she can get an option fee (1 yuan) paid by Xiaoming at the beginning of the contract.
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Comparison of Insurance Solutions in the DeFi Field
The following views and content come from our conference call with Nexus Mutual founder Hugh Karp, the conference call with Upshot founder Nick Emmons, and the "Comparing Insurance Like Solutions in DeFi" written by Hugh Karp himself on his blog on November 15 Organize and summarize.
Currently, the most mainstream solutions for decentralized insurance are: Common Capital Pool/Insurance Pool, Prediction Market, and Financial Derivative. Projects like Ethersic, an insurance protocol, focus on providing a platform at the protocol layer to facilitate insurance developers. Therefore, this article does not directly compare Ethersic with the above three directions (all focus on the application layer).
According to Hugh Karp's point of view, the three directions of risk-sharing fund pool, forecasting market, and financial derivatives have their own advantages and disadvantages, so how to use their respective characteristics to launch products that meet the needs of users is the most important. Then we can compare three types of products from the following dimensions, namely: Capital Pool & Liquidity, Flexibility, Claim Assessment & Oracle, Risk Assessment & Oracle Insurance pricing (Risk Assessment & Pricing).
Dimension 1: Fund Pool and Liquidity - Capital Efficiency
The topic of "risk-sharing fund pool" cannot be avoided when comparing decentralized insurance projects. The risk-sharing fund pool can diversify the risk while also allowing the participants of the fund pool (ie policyholders) not to make full mortgages. To give a simple example, if an insured person wants to insure 200 Ethereum in his smart contract, he/she only needs to contribute 1.06 Ethereum to the fund pool without actually going to Mortgage 200 Ethereum.
In contrast, in the prediction market and financial derivatives, 100% of the mortgage funds are required for compensation. Especially when there is a risk with a very low probability of occurrence, such as a 1% probability per year, then obviously, in this case, it is more capital efficient for customers to pledge 100% of their funds for a long-term mortgage on a risk with an extremely low probability of occurrence low. The risk-sharing fund pool model has a much lower cost of capital than prediction markets and financial derivatives.
In terms of liquidity, Hugh Karp believes that risk-sharing fund pools can provide liquidity for various types of risks faster (because as long as one fund pool is formed, various types of risks can be covered). In contrast, prediction markets and financial derivatives are much worse in this regard, because they require the participation of both buyers and sellers, so that every insurance needs to find liquidity (find a counterparty).
Dimension 2: Flexibility
From the perspective of the flexibility of building new products, prediction markets and financial derivatives are faster than risk-sharing fund pools in the innovation speed of insurance contracts. The reason is that before forming a risk-sharing fund pool, it is necessary to do a lot of research work on pricing and underwriting to ensure that the fund pool has sufficient ability to bear risks (simply put, it has enough ability to make compensation).
Dimension 3: Claims Evaluation and Oracle
In terms of claim evaluation, Nexus Mutual uses community member voting and does not involve oracle machines. According to Hugh Karp's explanation, the reason why no oracle machine is needed is because of the claim evaluation of smart contracts, all information about smart contracts is open and transparent on the chain.
Another project we are concerned about, the prediction market project Upshot uses oracle machines in claim evaluation, but Upshot does not seek external information sources for oracle machines, but designs a set of "reputation ranking" mechanisms for the Upshot platform Reputation ranking is done on the oracles (that is, claim evaluators) involved in claim evaluation. According to the design of Upshot, policyholders will tend to evaluate their claims with high-ranking oracle machines. On this point of design, Nick Emmons of Upshot believes that Nexus Mutual's voting mechanism to decide whether to claim or not is flawed.
However, there is no oracle machine for financial derivatives, and users directly use the pre-determined price to pay when exchanging put and call options. This is an advantage of financial derivatives as a means of insurance.
Dimension Four: Risk Assessment and Insurance Pricing
For risk assessment and insurance pricing, Nexus Mutual uses the method of asking community members to pledge tokens to assess the security risk of smart contracts (judging the probability of being hijacked by hackers). The specific way to assess the risk of smart contracts is to run multiple hackers Attack test, run multiple attack tests on a smart contract to provide the policyholder with a low insurance quotation (for example: I want to open a smart contract insurance on Nexus Mutual, then before the contract takes effect, the Nexus Mutual platform The risk assessors on the website will conduct attack tests and security tests on my smart contracts. They will only take effect after ensuring that the security of my smart contracts reaches the target. Of course, it is impossible for every smart contract to do this many times. testing, for smart contracts similar to those previously evaluated on the platform (according to Hugh Karp, there is no need for multiple tedious attack tests)
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New Direction of Decentralized Insurance Industry—Prediction Market Insurance
Many people are concerned about the advantages of decentralized insurance over traditional insurance. In order to understand what problems decentralized insurance can solve, we must first understand what the pain points of the traditional insurance industry are:
1. Risk assessment is costly
Risk assessment usually includes two parts: data integration + data processing (this is usually the work of an actuary). For a centralized entity (traditional insurance company), it is costly to complete data integration, processing and ensure the accuracy of risk assessment (because the data source is centralized, the cost of acquisition is high).
2. Insurance claim verification is centralized and opaque
Claim verification is a matter that only a small number of people or institutions are allowed to complete in the traditional insurance industry. If it can be decentralized and better incentives are used to allow more people (or even anyone) to participate in claim verification, it will be huge. Reducing the cost of insurance companies and customers can also bring more diversified insurance products.
3. It is difficult to coordinate the three core modules of insurance
The three core modules of the insurance industry include: Actuarial Accounting, Solvency, and Claims. For a centralized entity (insurance company), it is not easy to coordinate these three resources at the same time, and it also brings high costs. According to statistics, more than 50% of insurance costs in the traditional insurance industry come from this. Now there are new directions (such as the insurance project Upshot on Near) that want to replace the traditional insurance field with the prediction market model, but we think that this kind of solution will be more difficult when it is actually implemented. The difficulty is that it is difficult for the prediction market to recognize the insurance Risk assessment is done based on personal information (including: policyholder history, credit records, etc.).
For the above three pain points, both Nexus Mutual and Upshot are trying to solve them with blockchain technology and decentralized governance models, but there are still problems:
1. Claim Assessment:
Regarding the claim evaluation, Nexus Mutual uses community members to pledge native tokens (NXM) and then vote on the claim application (Claim Submission) to decide whether to pay the policyholder in the end; while Upshot tries to use a decentralized oracle network to Playing the role of a claim assessor (Claim Assessor) to complete the assessment work, Upshot is designed to allow anyone who wants to do claim assessment work to participate, but in theory, you need to equip yourself with an oracle machine, and the information source of the oracle machine (that is, who is your oracle's information provider) Regardless of the Upshot platform, there will be a reputation ranking list about the oracle on the Upshot platform. Upshot wants to use this method to constrain the oracle.
For DeFi products, or in simple terms, policyholders open an insurance policy for their smart contracts on Maker, Compound, and Uniswap platforms (considering that smart contracts will be hijacked by hackers and cause economic losses), then the status of smart contracts The information is actually on-chain (that is, the information on the chain), so the necessity of the oracle as a channel for obtaining off-chain information is actually not enough here.
2. Risk Assessment & Pricing:
Since Upshot wants to make insurance in the prediction market, the risk assessment & insurance pricing has become what the market needs to complete. To put it simply, behind the use of the prediction market to complete the work of risk assessment is the belief in the power of "group wisdom". Will it be stolen” event contract, then the policyholder’s counterparty will do a risk assessment to determine the probability of this event happening.
3. The counterparty’s mortgage problem:
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The concern of traditional financial investors about the lack of stable and safe insurance business in the DeFi field has become one of the important reasons why they dare not enter the market. Due to the high volatility of digital asset prices and the security of smart contracts, the conservative business model of traditional insurance companies makes them unlikely to meet market demand and provide business for the DeFi or digital currency industry in the short term. Therefore, decentralized insurance such as Nexus Mutual, OPYN has become the first to eat crabs.
Although blockchain technology and smart contracts can theoretically eliminate traditional insurance industry management inefficiencies and most of the high costs associated with governance and regulation. However, the design of insurance pricing, risk assessment, and post-event compensation is still early. The core risk lies in the possibility of using community voting for compensation assessment (but at the same time, voters are stakeholders of the fund pool). In addition, in addition to the risk of smart contracts being attacked, it is difficult for some real-world insurance categories to be completely replaced by decentralized products (because it involves a large number of policyholder evaluations, guarantee risk assessments, product pricing, etc.). I want to use the wisdom of the crowd to solve these things by predicting the market, but it is too idealistic and difficult to actually implement.
Therefore, taking a comprehensive look at the track of decentralized insurance, although it is valuable, it must be viewed dialectically to understand which problems can be solved and which cannot currently be solved.
