Unlocking Opportunities

The Place for Insurance in Decentralised Finance

Date
March 2024

Author
Charlie Kellaway

Reading Time
11 minutes

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Introduction

Blockchain technology has emerged as a disruptive force across various industries, including finance, supply chain management and healthcare. One area in which its potential impact is increasingly recognised is insurance. This report delves into the ways in which insurance can leverage blockchain technology on existing processes, discusses new products for DeFi activities and presents real-world innovations in the industry.

Insurance Within the Blockchain Ecosystem

Insurance is a financial product sold to safeguard you and/or your property against the risk of loss, damage or theft [1]. Most people are well-acquainted with motor insurance or home insurance, in which one pays regular fees (called premiums) to an insurance company for protection. If you are involved in a car accident, the insurance company will cover costs for damage, subject to the claim meeting the circumstances stipulated in your insurance contract. The products available in insurance are diverse, and DeFi insurance, or decentralised insurance, is a natural avenue for innovation.

Decentralised Finance (DeFi) is a nascent industry stimulated by the advent of blockchain: a distributed system in which transactions and records can be signed, exchanged and verified without the control of a central party. This distinguishes it from traditional centralised systems, in which third parties (or other intermediaries) are typically required to bridge trust between market participants and are compensated for their work, increasing the cost of a given transaction. Rather, blockchain is decentralised, meaning records of transactions are distributed across participants (known as nodes) in the network. Decentralisation provides security, trust and transparency in transactional flow and creates a “distributed ledger”, in which each participant has access to one shared copy of the ledger. As more transactions are recorded, they are bundled into new blocks of information and chained to the previous one in a permanent, immutable sequence. Before new blocks can be added to the ledger, they must first be confirmed by nodes across the network, giving blockchain its decentralised nature [2]. No central authority controls the ledger, no central authority controls the legitimacy of transactions and, if a bad actor tries to tamper with information in the chain, the network detects this, rejecting the attempt.

Blockchain is poised to revolutionise business operations in multiple sectors and insurance is no exception. Consider, for one, that blockchain can ease interactions between stakeholders such as brokers, vendors and reinsurers, creating a more connected ecosystem founded on security and trust. As insurers seek to harness the potential of blockchain, key areas have emerged, namely the application of blockchain to replace traditional processes and coverage for DeFi activity and assets. This report examines both areas in detail, providing an overview of the current landscape and exploring prospects.

Blockchain-based Insurance to Replace Traditional Policies

Within the insurance industry, risk is pooled, meaning premiums paid by multiple clients are combined. This allows each client to pay a far smaller premium than if an insurer was solely covering their risk, and premiums are a fraction of the cost required to recover a position if damage is incurred. Insurance companies calculate that the amount they collect from clients will be less than what they will need to pay out for claims [3].

Just as the pooling of risk is done through a centralised entity, so too is the payment of claims. Following a loss, clients must raise a claim and prove that it is justified. Insurance companies use claims adjusters to verify claims, whilst settlement requires reconciliation with external parties and the exchange of money, typically performed as an electronic transaction. The whole process is one of significant expense.

This is where blockchain can step in. Smart contracts – a major feature of blockchain networks – are coded contracts that self-execute when terms are met. They were first defined as [4]:

A set of promises, including protocols within which the parties perform on the other promises. The protocols are usually implemented with programs on a computer network, or in other forms of digital electronics, thus these contracts are ‘smarter’ than their paper-based ancestors.

Nick Szabo – The Idea of Smart Contracts

Smart contracts seek to empower peer-to-peer, disintermediated agreements automatically with code, contributing greatly to a trust-less network in which two parties can interact without knowing each other. This coded logic could be applied to an insurance contract.

For example, smart contracts could automate claims on life insurance policies. When a policyholder passes away, the smart contract can verify the death certificate and automatically release funds to the designated beneficiary. The process would reduce the cost of settlement to insurers and reduce the time taken for beneficiaries to receive payment [5].

Claims and settlement can potentially be completely automated by applying smart contracts within a blockchain ecosystem, triggering automatic settlement when well-defined terms and conditions are met by a claim. Contracts that settle so efficiently would greatly enhance customer service and reduce expenses demanded of insurers. Other areas in which blockchain help insurers win quickly are [6]:

  • Transparency in claims processes
  • Supporting efficient payments between insurers and third parties (claims, brokerage fees etc.)
  • Streamlined subrogation
  • Enhanced underwriting and risk assessment by applying shared information chains to obtain data-driven insights on prospective clients
  • Self-insurance
  • Policies that adjust mid-term based on changing circumstances

One area that stands out from the above is the sharing of information to derive more meaningful insights on prospective clients. Risk modelling benefits from improved depth and accuracy of data. Blockchain networks can facilitate the secure sharing of data among insurers, reinsurers, brokers and other stakeholders across the industry. If all stakeholders joined together, data such as claims information and policy history could be distributed across all in an efficient and secure manner. Leveraging distributed ledger technology in this way can advance analytical capabilities: insurers would gain deeper insights into customer behaviour, understand updates in real-time and be able to assess risk more accurately. This is critical for calculating a client’s insurance policy, but also vital in tackling fraud.

As discussed above, claims depend on arduous processes involving many parties, spanning multiple insurers, brokers and claims adjusters. The process has gaps in visibility and is greatly exposed to fraud [7]. Insurance fraud has a major impact on insurance companies’ profit and, consequently, increases the cost that clients pay for a policy.

One of the most common types of fraud perpetrated in the US is against Federal healthcare programs, with perpetrators filing false claims for reimbursement. A recent case saw Francisco Patino, M.D., convicted of fraud and money laundering for his role in running a scheme that submitted over US$250 million in false and fraudulent claims to Medicare, Medicaid and other health insurance programs for unnecessary medical treatment [8]. In the UK, false claims cost the industry £1.1 billion, with an average claim of £15,000 [9].

Exposure to false claims is far reaching and tackling it in the current environment presents a huge challenge. Though public data can be used to identify patterns of fraudulent behaviour from previous transactions, it is often inconsistent due to constraints on sharing personally identifiable information or other sensitive information between organisations.

On a distributed ledger, however, insurers could record permanent transactions, whilst network access controls protect data security. Storing claims information on a shared ledger would help insurers collaborate and identify suspicious behaviour across the ecosystem.

Consider the following proposition. The process of insurance can remain largely the same – the broker brings a client’s portfolio to an insurer, who reviews the risk and quotes their price and terms. But, after the client accepts the terms, the broker submits the contract onto the blockchain and a smart contract is activated. This smart contract verifies if the client or their assets already have an active insurance policy in place with another company to prevent a future double claim. If no insurance policy is found, the new policy is concluded and the information becomes available to all companies participating in the blockchain network [10].

Though insurance products using smart contracts are not yet a necessity, they offer a route to streamline processes and prevent fraud. Research by Accenture found that 33 percent of insurers are planning to use blockchain in the next two years and further 36 percent have it on their agendas for consideration [11]. For companies intent on innovation, the opportunity exists to defend against fraud and win market share by focusing on client service and transparency. Application of blockchain, by reimagining and redefining current processes, promises long-term benefits for the industry.

Insurance Products for DeFi activities

Beyond applying to traditional processes, blockchain has the potential to form its own niche within the industry. DeFi has spawned a wave of new projects that could benefit from innovative solutions.

To participate in DeFi, one relies on the smooth and accurate execution of smart contracts. But code is vulnerable to hacks, as evidenced by two high profile attacks on a DeFi application called bZx [12]. Across two days – 15th and 18th February 2020 – 3,649 Ether (ETH) was lost in a complex hack involving multiple DeFi applications. The following year, bZx was again hacked after a developer fell for a phishing scam, resulting in losses of US$55 million [13].

In 2022 alone, the collapse of Terra/Luna and bankruptcy of cryptocurrency exchange FTX took US$650 billion from the market [14]. Users of exchanges are exposed to risk, with many venues falling foul to major thefts. Crypto exchanges take responsibility to centrally store customers’ crypto keys, but centralisation increases responsibility for all parties involved to store cryptoassets safely. Storing crypto is costly and risky, so businesses turn to companies that specialise in storage to store it for them. Cyber and physical security may be outsourced to contracted security firms, increasing the size of operations and introducing vulnerabilities. Billions of dollars’ worth of cryptoassets are stolen each year, evident in over 650 hacks between 2021-2023 and US$8.5 billion stolen [15].

The industry is susceptible to large losses, highlighting inherent risks within the ecosystem. Insurance is the only way to ensure that the assets the original customers placed in custody can be replaced if something happens. As a product suite, it is becoming critical.

Accordingly, the proliferation of cryptoassets has been accompanied by insurance products to protect against theft, hacks and other risks associated with digital assets. Several insurers have introduced policies tailored to cryptoasset holders, offering coverage for losses due to cyberattacks, exchange failures and unauthorised access. For example, Atrium, a Lloyd’s of London insurance syndicate, launched a cryptoasset insurance policy in partnership with CoinCover to protect both individuals and businesses against losses to their online wallets arising from cryptoasset theft [16]. Similarly, companies like Coinbase offer insurance coverage for users’ digital assets held on their platforms.

Hacks and bankruptcies are not the only risks, and investors are not the only participants at risk. There are many different types of insurance that businesses in decentralised finance need to think about, a number of which are covered below:

  • Professional indemnity / technology liability / errors and omissions: protects a business owner from allegations by a third party that they suffered financial loss due to the business owner’s professional services.
    • This could be due to software errors, professional negligence during trading, unintentional copyright infringement or breaches of contract.
  • Cyber: cyber will not cover hacking of private keys, but will cover data hacks, ransomware attacks and cyber business interruption.
    • This product is critical for companies that store data, to insure against hacks and data leakage.
  • Directors’ and Officers’ liability (D&O): for directors of a company, personal assets are often at risk for the decisions they make on behalf of the company.
    • D&O offers senior employees protection, which could be particularly important as DeFi’s regulatory landscape changes the scope of business operations.
  • Crime/Specie: The protection of private keys that enable access to digital wallets containing cryptoassets.
    • Holding private keys incurs significant risk and insurance solutions exist to protect against the loss of wallet access.
  • Operational or Technological failure: shielding assets from infrastructure vulnerabilities and guarding businesses against operational risks.
  • Mining Property: addresses the unique risks faced by industrial cryptoasset miners, co-location and hosting providers and retail miners.

These products represent an important step in addressing the unique risks faced by cryptoasset investors and fostering trust in the emerging asset class. Tracking the maturity of decentralised finance and, with it, decentralised insurance, we can expect to see more comprehensive and innovative products emerge.

Decentralised Insurance in Practice

Several companies already operating in the Decentralised Insurance space. We provide a brief overview of a few below.

Nexus Mutual

Nexus Mutual is a decentralised insurance protocol built on Ethereum that offers cover on smart contracts on the Ethereum blockchain [12]. This covers clients against contract failure and wider coverage products include hacks, oracle failure, governance attacks and liquidation failure [17]. So far, members of the network have paid over US$10 million to cover holders who suffered a loss due to past exploits and technical failures. Nexus Mutual also cover validators against slashing penalties. Validators contribute Ethereum’s native token, ETH, to the network to be considered for validating new blocks in the chain and receive yield in return. Penalties for behaviour as a validator can be incurred, leading to deposit loss. Validating as an activity is outside the scope of this commentary.

Chainlink

Chainlink are developing decentralised oracle networks that provide reliable data feeds for insurance smart contracts, enabling more accurate pricing and faster claims settlement. Blockchain oracles are entities that connect blockchains to external systems, thereby enabling smart contracts to execute based upon inputs and outputs from the real world [18]. Entities can build new products by leveraging Chainlink’s oracle infrastructure; for example, capitalising on blockchain-based identity verification of policyholders to reduce or eliminate fraud. These innovations underscore the transformative potential of blockchain in reshaping the insurance landscape and improving outcomes for insurers and policyholders alike.

Etherisc

Etherisc provide an open source blockchain platform marketed to customers, insurance providers and investors. Their Generic Insurance Framework (GIF) sits at the core of their decentralised insurance platform, delivering open-source smart contracts that implement generic insurance products and policy lifecycle functions across the chain, with oracles to feed data into the contracts (e.g., flight or weather data). Etherisc offers insurance providers:

  • ready-to-use modules to easily design fully compliant and licensed insurance products;
  • a transparent, real-time, structured overview of all building blocks, events and transactions available in a GIF instance;
  • a legal model which removes most legal and financial requirements by exchanging a claim for a technical guarantee.

Their product range currently includes crop protection, train delay protection, carbon credit protection, flight delay, health insurance, natural disaster insurance and life insurance, with more on the way. The initiative demonstrates blockchain’s potential to transform traditional insurance models and increase accessibility for consumers.

B3i

Unfortunately, not all initiatives succeed. B3i, which stands for the Blockchain Insurance Industry Initiative, started in 2016 as a project between five insurers and reinsurers (Aegon, Allianz, Munich Re, Swiss RE and Zurich) [19]. B3i aimed to improve end-to-end efficiency, focusing on trust through common standards, quality of data and efficiency of operations. Beyond this, B3i did succeed in placing the first Excess of Loss reinsurance contract using distributed ledger technology. However, despite a further 30 companies joining the initiative, volumes of demand did not reach the heights that investment had hoped for. In 2022, B3i filed for insolvency [20].

Closing remarks

Blockchain technology holds immense potential to revolutionise the insurance industry, offering opportunities for enhanced efficiency, transparency and customer engagement. From specialised insurance products for cryptoasset accounts to decentralised insurance platforms and innovative applications of blockchain in risk management, insurers are increasingly exploring ways to leverage blockchain to stay competitive in a rapidly evolving landscape. Investment and innovation in decentralised insurance are poised to drive significant advancements in the industry, ultimately benefiting insurers, stakeholders and consumers.

[1] Association of British Insurers. (2008). Insurance In The UK: The Benefits of Pricing Risk. abi-insurance-in-the-uk_the-benefits-of-pricing-risk.pdf.

[2] Hayes, A. (2023). Blockchain Facts: What Is It, How It Works, and How It Can Be Used. Available at: Investopedia (Accessed: 22 February 2024).

[3] Lloyd’s. How insurance works. Available at: Lloyd’s (Accessed: 22 February 2024).

[4] Szabo, N. (1997). The Idea of Smart Contracts. Nick Szabo’s Papers and Concise Tutorials, 6.

[5] Saini, H. (2023). Secure, Transparent, and Efficient: How Smart Contracts are Reshaping Life Insurance. Available at: LinkedIn (Accessed: 22 February 2024).

[6] Bramblet, J. (2020). Ultimate Guide to Blockchain in Insurance. Accenture.

[7] CBInsights. (2022). How Blockchain Is Disrupting Insurance. Insurance Disruption Using Blockchain Tech l CB Insights.

[8] Department of the Treasury. (2024). National Money Laundering Risk Assessment (NMLRA).

[9] ABI. (2023). Conning big – crackdown on insurance cheats delivering results, but average scam up to nearly £15,000. Available at: ABI (Accessed: 22 February 2024).

[10] Roriz, R., & Pereira, J. L. (2019). Avoiding Insurance Fraud: A Blockchain-based Solution for the Vehicle Sector. Procedia Computer Science, 164, 211-218.

[11] Rangwala, A. (2018). Insurers are unblocking blockchain, preparing for the future. Accenture.

[12] Lau, D., Lau, D., Jin, T. S., Kho, K., Azmi, E., Lee, T. M., & Ong, B. (2020). How to DeFi. CoinGecko.

[13] Shalvey, K. (2021). A hacker stole more than $55 million in crypto after a bZx developer fell for a phishing attack. Available at: Business Insider (Accessed: 19 February 2024).

[14] Cornelli, G., Doerr, S., Frost, J., & Gambacorta, L. (2023). Crypto shocks and retail losses. BIS Bulletin.

[15] Chainalysis. (2024). Funds Stolen from Crypto Platforms Fall More Than 50% in 2023, but Hacking Remains a Significant Threat as Number of Incidents Rises. Stolen Crypto Falls in 2023, but Hacking Remains a Threat (chainalysis.com).

[16] Lloyd’s. (2020). Lloyd’s launches new cryptocurrency wallet insurance solution for Coincover. Lloyd’s Launches New Cryptocurrency Wallet Insurance Solution For Coincover – Lloyd’s (lloyds.com).

[17] Nexus Mutual. Protocol Cover. Available at: Nexus Mutual (Accessed: 22 February 2024).

[18] Chainlink. (2024). What Is a Blockchain Oracle? Available at: Chainlink (Accessed: 22 February 2024).

[19] Howard, L. S. (2022). Industry’s Blockchain Project, B3i, Ceases to Trade After Filing for Insolvency. Available at: Insurance Journal (Accessed: 20 February 2024).

[20] GlobalDataFinancialServices. (2022). B3i insolvency leaves an uncertain future for blockchain in insurance. Available at: Life Insurance International (Accessed: 20 February 2024).