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, written by Hugh Karp, founder of Nexus Mutual, compiled by Perry Wang, published with permission.

I'm often asked questions like, can prediction markets replace insurance? Alternatively, financial derivatives and

How does what's done compare?

The truth is, every product here has its pros and cons, and is often used for different purposes by itself. So let's refer to this in-depth comparison table.

Please note that the author is the founder of Nexus Mutual, so I try to use a neutral tone throughout the text, and it is still impossible for me to avoid a little bias.Funding Pools and LiquidityThe main feature of similar insurance agreements is the public pool of funds. Allows for the sharing of risk across insureds and, crucially, allows for collateralized pools to be undercollateralized (holding assets that are less than 100% of the sum of all potential claims). In fact, this is the fundamental reason for the existence of insurance companies, they can take many times the risk with much lower capital.

Financial derivatives

flexibility

Compared with the public asset pool structure of the insurance contract, the risk is covered more effectively, because each prediction market or option needs to be able to pay itself, so it needs to be fully collateralized.

In addition, the pooling approach makes it easier to direct liquidity between various risks. Instead of a two-way liquidity market for every risk, a pool of funds acts as one side of the market. The fund pool provides liquidity for all risks at one time, and the main limitation is to limit the size of each risk (related to the size of the fund pool).

flexibility

Derivatives can also be listed quickly, as long as the risk is within the general criteria and constraints of the platform (for example, the concept of financial options with a strike price must be met).

Oracle

Insurance products, by contrast, are much slower to market and require extensive research into pricing and underwriting to ensure asset pools have the confidence to take on new risks.
The types of risks that can be covered, i.e. the flexibility of risk coverage, also need to consider some other factors. Prediction markets, and insurance pools (to a lesser extent) are only limited by your imagination. For financial derivatives, there are more restrictions because one financial asset needs to be exchanged for another at some point in the future, so it is limited by the existing financial assets.

Oracle

Oracles are another thing worth discussing. Nexus has voting methods and thus is largely similar to Augur oracles. However, other insurance-like methods such as

, the external oracle machine is used as the data source to determine the compensation payment.

The main point of interest in this type of comparison is not external data streams vs voting, which itself is a hot topic of discussion, but actually the method of financial derivatives without oracles. If option buyers want to exercise, to execute the right to buy/sell at a pre-agreed price, they just have to do so. This actually has a very neat advantage over the oracle approach.

If we look at extreme events or "deep out of the money" events alone, the insurance fund pool method has obvious advantages over the prediction market method or derivatives.

summary

Assume that the probability of an event occurring is very small, 1% per year. If you want to bet on an agreement going wrong, the most you can earn is 1% of your capital since you have to lock in the entire value of your potential claim. If full collateral is required, the cost of capital becomes a serious limiting factor that can seriously affect "deep out-of-the-money" events. This is the primary use case of the insurance pool approach and the benefit of undercollateralization.

• It is commendable that there is "at-the-money option risk at the money risks", or a reasonable probability of paying off. Here the cost of capital is much smaller relative to the cost of risk, and the flexibility (and other benefits) of forecasting markets and derivatives clearly stand out. If you want to hedge risk to smooth returns, or limit losses in volatile markets, then prediction markets and derivatives are your best friends.

• summary

Each method works better in specific situations, the key is to understand which method is best for the problem you want to solve. You can get a better idea of ​​what to do if you break down the risk into two parts: