Original title: "The Current State of Crypto Insurance"
Original Author: Joo Kian, Encryption Researcher
introduce
introduce
The advent of DeFi has opened up yield-generating opportunities for many protocols. However, as the protocol gains traction and sees more and more deposits in smart contracts, this creates lucrative opportunities for hackers and exploiters.
Hackers find flaws in protocol architectures or smart contracts and find ways to extract value from those flaws. Since the start of the 2020 DeFi summer, the amount of stolen funds has only increased. Already $2.7 billion will be lost to hacking in 2022 alone, a 63% increase from last year.
As cryptocurrency adoption increases, it will be important for protocols and their users to guard against exploitation. Audits and code reviews are the first and most obvious steps (but they don't imply a zero chance of being exploited). How can protocols and users protect themselves against these attacks? As in the case of TradFi, insurance may be the best answer.
The inner workings of crypto insurance
The insurance protocol provides insurance services for selected DeFi protocols. This allows users of these protocols to insure against certain risks. There are two main types of insurance services provided by insurance agreements:
Smart Contract Vulnerabilities: Covers the underlying smart contracts of the protocol. It will allow for claims on covered amounts if a smart contract malfunctions, is hacked, or is exploited, resulting in the loss of users’ funds.
Depeg risk: Stablecoin is covered. It will allow for claims on insured amounts in the event of a certain level of decoupling.
Note: These are broad interpretations to help understand what the insurance covers. For exact insurance specifications, visit the insurance agreement's website and search for their coverage wording.
Now that we understand the types of insurance offered, let's break them down to better understand the process and participants.
Insurance Purchaser (Coverage Purchaser, DeFi user):DeFi users deposit funds into DeFi protocols to earn yield. In order to eliminate their risks in utilizing smart contracts, users can use insurance agreements to purchase insurance services for DeFi agreements. They only pay a small premium for insurance, which is usually less than what they would get from yield farming. When a vulnerability occurs, users can use the relevant proof to make a claim. Once approved, users get insurance payouts.
Insurance issuer (Coverage Issuer, insurance agreement):Insurance protocols provide insurance services for selected protocols or Stablecoins. Users can purchase insurance by paying a premium. Unlike traditional insurance, where the counterparty is an insurance company, an insurance protocol allows other users to underwrite deposits (and these deposits will act as counterparties). Then, the insurer's deposit will earn income from the premium and receive Token rewards at the same time. When a vulnerability occurs and a user files a claim, the claim evaluator will vote to approve or reject the claim. Anyone can become a claim assessor by pledging the original Token of the insurance agreement. Once approved, insurance claims are paid to the buyer. If rejected, there will be no payout. Claims assessors are also rewarded with fees or token rewards for voting after claims are settled.
Unattractive key product
While DeFi’s TVL is growing and hacking incidents are hitting new highs, the insurance industry is not growing. At its peak, only 1.2% of all DeFi TVL was covered by insurance protocols, and in recent months it has been between 0.7% and 1% of total TVL. Up to now, only 235 million US dollars of TVL is in the insurance agreement, while the entire market has a total of 40.8 billion US dollars. Even with a coverage rate of 200% (Total Covered Value/TVL), it can only provide coverage for 1.15% of the total TVL.
Note: Losses for Terra and UST are calculated using the difference in UST market capitalization from the day before the decoupling to the date of the first insurance claim on May 17, 2022.
Furthermore, when the study looked at the top five events by claim value, the average loss covered by insurance was only 6.47%. This means that for every $1 million lost, only $64,700 was covered by insurance. The two graphs below show that DeFi users are underinsured for the risks involved, which can be attributed to the current insurance model struggling to find product-market fit.
Insurance is a tough sell in crypto
Insurance is still a tough sell to the crypto crowd. Let's break it down from a behavioral and motivational perspective. First, let’s see what are the core reasons why DeFi insurance is developing so slowly:
1. Risk-loving people:Risk-loving crypto investors have become accustomed to the high volatility and risks of the crypto space. Buying insurance to manage risk is also not second nature to people.
2. "Battle-tested" protocol:Proven protocols are often considered "safer" because their code has been running smoothly for a long time. Since the protocols are believed to be "battle-tested" and therefore have a "low" risk of a bug, users feel that using these protocols to insure their deposits is a waste of money.
3. The cost of insurance hurts profitability:Insurance purchased affects profitability by introducing a cost carrier. This is even more evident in the case of declining yields in DeFi. So someone earning 15% APR is more willing to pay for insurance than someone earning 5% APR.
4. Capital rotation cycle:Mercenary capital is rotated from protocol to protocol to maximize yield. This makes buying insurance for a short period of time less attractive.
An insurance agreement represents the agreement itself and the deposit it insures. There are several problems among them, which make the enthusiasm of underwriting decline:
1. High risk, low reward:Underwriting low yields is risky; potential tail events could not only rob the insurer of returns but even reduce the principal deposited.
2. Pricing issues:If insurance is priced too high, no one will buy it. If the pricing is too low, the insurer has no incentive to take the risk.
3. Different risk exposures:Different insurance agreement designs make it difficult for underwriters to manage their risks. Insurance protocols with isolated protocol pools allow underwriters to choose their preferred protocol to deposit. Insurance protocols with aggregation pools take on more agreements and also increase the probability of tail events.
4. Lack of seamless integration:Insurance and DeFi protocols operate as two separate units and do not provide seamless integration for users to use.
Insurance remains an important product that should be offered and adopted in high-stakes crypto environments, but we need to see changes to the current insurance model to cater to the current subset of users.
The way forward: adopting the idea of insurance
As we learn about how general DeFi users operate, we also look for innovative ways to improve or create a different way to provide insurance services to different groups of people.
automatic insurance
This relies on a so-called "State deviation(status quo bias), which refers to the human tendency to leave things as they are rather than change them.
Automated insurance can be implemented in various DeFi protocols, allowing users to opt out themselves. When yield farming, users may be required to pay a deposit fee or a small percentage of earnings to purchase insurance for users.
In addition, the agreement can direct Token emissions to the insurance agreement to motivate the underwriter and ensure that there is sufficient liquidity to purchase insurance for users.
Early termination
Some traditional insurance providers have clauses that allow for early termination. One example is a one-year global travel insurance policy. If you want to end your trip early and no longer need the insurance, you can terminate the insurance to pay back part of the premium.
Applying the same logic to DeFi insurance, if you decide to terminate your insurance early, you should be able to recover some of the premium you paid. This solves the problem of redundant insurance for agreements that the buyer no longer touches.
Insurance agreements and underwriters also benefit because they can charge for early termination. This frees up underwriting liquidity for other users to purchase, making it more capital efficient.
Insurance purchased by agreement
The insurance purchased by the agreement makes the user's operation simple by providing protection for the entire agreement. Users won't experience any difference in UI or user experience, and won't have to pay for insurance.
While this is good for the end user, it would be very costly for the protocol. Using Nexus Mutual's cheapest 2.6% APR policy, $250,000 only covers $9.6 million in deposits. This means that the protocol must generate an equal amount of protocol revenue in order to break even on its covered costs.
Protocols without a profit model are unlikely to adopt this model. Protocols can also use raised funds or token protocols to fund this insurance.
Continuous innovation in the insurance industry
Sherlock and Y 2 K Finance are two protocols that are innovating by offering different insurance methods.
Sherlock
Sherlock is an audit marketplace and smart contract insurance protocol with a unique model. This model is to combine auditors and insurance companies to work together,As covered in our report last year. Also, instead of targeting DeFi users, they chose to target protocols.
Below is their audit and insurance process:
1. The protocol paid for the public audit contest with Sherlock.
2. Following the audit, the protocol will receive a high and medium severity finding. They will have 72 hours to confirm these investigations and indicate a fix, as well as schedule a fix review within 3 weeks.
3. Once the code is fixed and reviewed, they can work with Sherlock to provide TVL insurance for their protocol at 2% APR.
4. The protocol will pay the premium per second.
5. Sherlock has opened up guaranteed deposits, which can be deposited by anyone to obtain a rate of return.
6. Idle capital will generate income for depositors on other DeFi protocols.
This model provides agreements with cheap insurance services, while allowing underwriters to increase yields through other agreements.
Y 2 K Finance
Y 2 K Finance's structured product design for exotic pegged derivatives. Their first product is “Earthquake,” which brings traditional disaster bonds to DeFi. Earthquake is centered around three stablecoins (USDC, USDT, and MIM) with different strike prices and weekly or monthly maturities. It works by providing a “Hedge Vault” for insurance buyers and a “Risk Vault” for insurance sellers.
Hedge Vault
Not decoupled
Hedge Vault depositors lose insurance premiums paid to Risk Vault depositors.
decoupling
Hedge Vault depositors lose insurance premiums paid to Risk Vault depositors.
Hedge Vault depositors receive a proportional amount of Risk Vault deposits.
Risk Vault
Not decoupled
Risk Vault depositors earn a percentage of the insurance premium paid by Hedge Vault depositors.
decoupling
Risk Vault depositors earn a percentage of the insurance premium paid by Hedge Vault depositors.
Risk Vault depositors lose principal to Hedge Vault depositors.
in conclusion
in conclusion
In a space where "code is law", there is almost no possibility of recourse for those hacked funds, and only insurance can be your shield. With breaches and hacks on the rise, the insurance space has yet to gain the massive traction it so desperately needs to protect users, most of whom are underserved by insurance.
As mentioned earlier, current offerings are not built around a uniquely behaving crypto-native crowd. There needs to be more innovative solutions around unique demographics that make insurance easy for users, whether they realize it or not.
Fortunately, there will be unlimited potential here, as protocols like Sherlock and Y 2 K bring innovative solutions to the masses, helping users get insurance or simplify the steps to get insurance.
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