Crypto technologies are beginning to be used in the traditional insurance industry to improve their products, while decentralized insurance protocols in
DeFi create a new class of insurance products on the blockchain. Blockchain-based insurance provides increased efficiency and transparency compared to traditional insurance systems. This article examines how blockchain-based insurance improves insurance in traditional finance and how it applies to DeFi.
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How does insurance work?
Insurance is necessary for the prosperity of the economy, because it softens the blow of financial difficulties by spreading the risk. The basic idea of insurance is to transfer risk from individuals who may not be able to cope with unforeseen financial difficulties to the collective. In the insurance industry, the process of evenly distributing risk among a group of depositors is called “risk pooling.” People get peace of mind by paying premiums that are much lower than catastrophic losses. The groups, usually represented by insurance companies, make a profit and provide support to individuals, provided that over time premiums exceed claims payouts.
Problems can arise when the number of insurance claims or the cost of payments increases. This can lead to the bankruptcy of insurance companies. On the other hand, commercial insurance companies can exploit people by raising prices, knowing that people will continue to pay for risk protection.
Blockchain is used in insurance in two main ways. First, it is used by traditional insurance companies to improve efficiency and transparency. Second, it is used in DeFi to eliminate the need for a trusted third party, such as traditional insurance companies, whose interests often conflict with those of their customers.
Cryptocurrency in traditional insurance
Blockchain-based technology is already being used by traditional insurance companies to address efficiency and transparency issues. Here are some examples of insurance companies using blockchain technology:
- State Farm and USAAuse the blockchain system for automatic settlementregression requirementsbetween the two companies
- Anthem, the second largest insurance company in the US, has started using blockchain technology to allow patients to securely access and share their medical data. Secure and granular access to medical data is a key challenge in the insurance and healthcare industries.
- An insurance company from Hong KongBlue Crosshas been using blockchain since April 2019 forspeeding up the processing of insurance medical claimsand fraud prevention. Processing and verifying claims has always been a long and expensive process.
Insurance in DeFi
Insurance in DeFi allows people to protect their assets using smart contracts that pool funds from multiple participants to cover potential losses. Paid premiums are used to create a fund from which insurance compensation can be paid in the event of a covered loss. All of this happens transparently on a blockchain such as Ethereum .
Currently, insurance in DeFi is mainly used to protect against risks such as smart contract errors, protocol failures, devaluation stablecoins and other events that may lead to financial losses in the DeFi ecosystem. Projects are now expanding the use of insurance in DeFi to new cases such as air travel insurance (delays, cancellations, etc.), drought and hurricane insurance.
Over time, traditional insurance companies and DeFi newcomers are likely to cover more of the same areas. Traditional insurance companies will move more into the realm of cryptocurrencies and DeFi protocols will expand their coverage into areas normally covered by traditional insurance companies.
Benefits of insurance in DeFi
Blockchain is already being used by large traditional insurance companies to improve efficiency and transparency. Blockchain increases efficiency by reducing the high costs and long processing times associated with traditional insurance companies.
Decentralized Applications (DApps) can further increase efficiency and transparency compared to traditional insurance companies. They are more cost-effective because they require less overhead in labor, materials, and real estate. DApps run faster due to greater automation through smart contracts, non-stop operations (there are no business hours or holidays in DeFi), and the use of a wider range of people to assess risks. They are more transparent because the valuations are done by the participants of the insurance protocol in DeFi on the blockchain and are taken into account by the community. In contrast, traditional insurance claims are still handled in-house and without any transparency in the decision-making process.
Among other things, unlike many traditional insurance companies, insurance protocols in DeFi have interests that coincide with those of the insured. Take, for example, the highly inefficient US insurance industry, which spends considerable effort delaying or denying insurance claims, knowing that every minute delayed or every dollar denied is profit for the insurance company. Since all insurance companies do this, there is no downside to denying customers benefits because they have no other choice. These for-profit companies choose the profits of their shareholders with the help of their customers. This is a distorted incentive structure that makes claimants antagonistic to the insurance company. DeFi turns this on its head by aligning the interests of the protocol with the interests of the insurance holders.
How does insurance work in DeFi?
Insurance in DeFi works by replacing a trusted third party with a cooperative (coop). Unlike traditional insurance companies, each person who pays the premium is also an owner of the insurance “company” and thus can have a say in the payment of insurance claims in the DeFi protocol. In order to buy insurance coverage, a person must purchase a share in the coop, a share in the protocol.
Co-op members can vote as they wish on the requirements, but if the co-op starts to reject legitimate requirements, people will lose confidence in the effectiveness of the platform and stop using it. Back is correct for fair voting. People will see that the co-op effectively protects against risks and will use the protocol more, increasing the rewards received and the growth of the platform. Therefore, coop members are very interested in fair voting to maintain a flawless reputation. To prevent co-op members from seeking short-term gain, it is usually necessary to lock in their share.
Examples of using insurance in DeFi
As mentioned above, the most common use cases for insurance in DeFi are aimed at protecting against blockchain risks. The reason for this is that they are the easiest insurance products to verify and verify claims.
Errors in smart contracts : Errors in smart contracts can result in the loss of funds that users have contributed to the DApp.
Protocol failures : DeFi protocols can lose funds due to technical vulnerabilities, such as the aforementioned errors in smart contracts, as well as security breaches and fraud.
Deviation of the value of stablecoins from the peg : Stablecoins are designed to maintain a fixed value against a specific asset or currency, usually the US dollar. However, there are a number of factors that can cause stablecoins to lose their fixed value.
Crashes on centralized exchanges : As 2022 has shown, centralized exchanges are prone to a myriad of failures that can be caused by everything from security breaches to outright bankruptcy.
Flight delay or cancellation : This is not a DeFi use case! Using oracles with access to flight data, a smart contract can automatically pay out if a flight is delayed for a certain amount of time (for example, more than 45 minutes) or canceled.
