Protect Ya Crypto Assets: What Is DeFi Insurance and How Do I Get Coverage?

Despite only being a few years old, Decentralized Finance (DeFi) has grown into a massive industry with nearly $250 billion in total value locked at the peak of 2021. 

This is largely due to DeFi offering a more efficient and inclusive financial system with less reliance on third parties. Not to mention, it enables investors to earn double-digit yields on their crypto holdings.

Say hello to DeFi insurance. We’re going to explore what it is, how it works, and which DApps you can use to get coverage. But first, let’s recap what the traditional insurance landscape looks like.

Nowadays, insurance companies operate as trustworthy counterparties that help consumers, business owners, and investors shield themselves from risk. A policyholder pays a regular (monthly, yearly, etc) premium to cover a specific set of risks to their property, business, or life. And in the event of damage, loss, or death, the insurance company pays out a claim to the policyholder or their beneficiary. 

The problem that most people have with the insurance industry, though, is that it has morphed into a $1.28 trillion cash cow that profits off of premiums while trying to minimize claims payouts. And due to large capital requirements, regulation, and consumer inertia, it’s also extremely difficult for startups to disrupt the old guard. How, then, does DeFi insurance improve upon the current state of affairs?

Ever since the birth of crypto over 14 years ago, we’ve seen numerous hacks, rug pulls, and bugs that have resulted in the loss of billions of dollars. Just last March, we saw the single largest crypto hack of all time on the Ronin Network for over $600 million. 

The primary purpose of DeFi insurance, then, is to provide crypto investors with protection and peace of mind in this digital Wild Wild West. By being trustless and transparent, DeFi insurance protocols can democratize access to insurance for both policyholders and coverage providers. What’s more, these protocols can incentivize claims assessors to behave more honestly than traditional insurers.

Do note, however, that nothing in life is free. The premium you pay for this insurance varies widely depending on the risk you’re covering. The types of risks you can buy DeFi insurance for include: 

• Smart contract code exploits
• Oracle failures
• Centralized exchange hacks
• Stablecoin de-pegging
• Rug pulls
• Token theft

To get a better understanding of DeFi Insurance, let’s walk through the whole process, from buying a policy all the way to getting a payout. 

First things first, you have to choose a protocol. Here’s a quick rundown of 3 popular DeFi insurance providers.

Sources: Defi Lama, project websites & documentation

As you can see, each DeFi insurance protocol has its own peculiarities. Still, they work more or less the same. The three main actors within a DeFi insurance protocol are capital providers, policyholders, and claims assessors.

Buying an insurance policy

To purchase an insurance policy, investors have to log onto a DeFi insurance app, connect their wallet, and specify:

• The asset or application to cover
• The value they want to cover
• The length of the coverage

Finally, the investor needs to pay an upfront premium, which depending on the coverage can be lower than 1% or even higher than 10%. 

The decentralized nature of DeFi insurance simply means that policyholders buy insurance from a distributed group of coverage providers, as opposed to a centralized company. 

Providing coverage

In most cases, anyone can become a coverage provider by locking up their money in a capital pool (also called a vault) that protects against a certain event (e.g. stablecoin de-pegging). 

If a loss event were to occur, then the funds in the capital pool could be used to cover up to 90% of policyholders’ damages—"could" being the operative word. We’ll explore claims assessment in a minute.

Now, why would any capital provider risk having their money liquidated to pay out claims? Well, because in exchange for taking on that risk, DeFi insurance protocols reward capital providers with tokens that generate yield, much like crypto staking. In many cases, this yield comes from the insurance premiums and profits made from investing the protocol’s idle funds. 

What’s more, the tokens awarded to capital providers can be used to vote on decisions within the protocol’s DAO (Decentralized Autonomous Organization), which sometimes includes claims assessment. 

Filing and verifying claims

Every protocol has a different claims process. In some cases, claims are automatically verified on-chain with the help of oracles like Chainlink. But when that isn’t possible, then at least two things are required for a claims payout to occur. 

The policyholders need to submit a proof of loss for the claims assessors to verify. And a majority of claims assessors need to vote in favor of the claim. But who are these claims assessors exactly? Oftentimes the capital providers themselves. Some protocols also feature a committee of experts that finalize decisions.

If the policyholder is unsatisfied with the decision, they can file a dispute. But at the end of the day, the claims assessors have the final say in accepting or denying your claim.

Although DeFi insurance represents a giant step forward in managing crypto-related risks, these protocols aren’t without fault either. For starters, DeFi insurance apps can be vulnerable to the same risks they're protecting against (e.g. code exploits). 

The way some of these protocols are set up can also unintentionally lead to dishonest behavior. For example, if the coverage providers are the same people who assess claims, then they might be tempted to reject most payouts from their capital pools. However, some protocols do have measures in place to avoid this. For instance, they may burn a claim assessor’s tokens if they vote against the majority.