Insurance#
The cryptocurrency field is a domain where risk events frequently occur, such as exchange theft and contract vulnerabilities. A series of projects have emerged to address these insurance issues.
Insurance is a typical industry that relies on the "law of large numbers" to make money. The conditions for insurance business to be profitable include the following:
- There must be a large number of insured individuals for the same type of insurance. The cost of insurance claims is calculated based on historical data, and a small number of insured individuals can greatly deviate from the claim ratio due to randomness.
- Individual insured individuals are willing to pay higher premiums. Insurance covers events with a low probability of occurrence, and it is difficult for ordinary people to perceive the probability of such events through experience. Therefore, the average person does not know the reasonable pricing of insurance. Furthermore, by describing the severity of such events after they occur, insured individuals are willing to pay insurance premiums far higher than the equilibrium price. For example, the probability of an event covered by accident insurance is one in a hundred thousand, and the insured individual is willing to pay a premium of five in a hundred thousand. In this case, the premium paid is five times the equilibrium price.
Risk events in the blockchain field have their own characteristics, lack support from a large amount of data, and have a decentralized nature. The following introduces some insurance-related protocols to see how insurance works in the industry.
Nexus Mutual - Compliance Insurance Protocol#
Nexus Mutual was launched in May 2019. It is an insurance protocol developed by a British company, and its founding team has many years of experience in the insurance industry. The protocol was not developed primarily by programmers, so it can be seen that this project has had a strong compliance focus from the beginning.
The protocol currently provides three types of insurance:
- Protocol risks, such as hacker attacks, economic system vulnerabilities, oracle errors, etc.
- Yield token risks, such as yUSDC, yCRV, etc., where the price cannot maintain a 1:1 ratio with the underlying assets due to certain risks.
- Custodial risks, mainly referring to the risk of decentralized exchanges being hacked or unable to withdraw funds.
On Nexus Mutual, both becoming an insured party and providing insurance require membership. To become a member, one must complete a full KYC (Know Your Customer) process and pay a membership fee. Additionally, citizens of certain countries cannot use its products. Nexus Mutual ensures that all participants are identified, which ensures compliance while also blocking many potential participants.
In the entire mechanism of Nexus Mutual, the protocol token NXM plays a central role. It affects all aspects, including risk assessment, insurance coverage, claims, and claims assessment.
For each insurance coverage, there is an NXM pool where members can freely deposit NXM. All NXM in the pool serves as insurance funds for policyholders and can be referred to as the insurance fund pool. The pricing of each insurance coverage, which is the annual premium-to-insured amount ratio, is determined by the amount of NXM in the pool. The more NXM there is, the smaller the perceived risk of the insurance coverage, and thus the cheaper the premium. This determines the risk pricing for each insurance coverage. For example, if the NXM quantity in the insurance fund pool for the protocol risk of Uniswap is high, the annual premium for coverage of $1000 may be $30, or 3%. On the other hand, a small CEX with a low NXM quantity may have an annual premium that reaches 6%.
Furthermore, considering capital utilization, Nexus Mutual supports using the same NXM funds to provide insurance coverage for multiple underlying assets, supporting up to 20 different insurance coverages. This allows NXM to receive insurance claims from up to 20 insurance coverages, but it also increases the risk of payouts because any risk event can lead to a loss of this insurance fund.
When purchasing insurance, the insured person's premium is used to repurchase NXM, of which 90% is burned, and the remaining 10% is kept as collateral for future claims. This means that most repurchased NXM is destroyed, which is the intrinsic value of NXM, supported by the premiums of policyholders.
During the insurance coverage period and up to 35 days after the coverage expires, policyholders can initiate claims. The 10% reserved funds from the premium serve as collateral for the claim application, with 5% consumed each time. If the claim application is rejected, the collateral will be forfeited. This mechanism is used to prevent excessive false claim applications.
After a claim is initiated, there can be up to two rounds of voting to decide whether to accept the claim application. The first round of voting is conducted by "claim assessors." The claim result is determined when the value of participating NXM reaches at least five times the claim amount. If it exceeds 70%, the claim is accepted; otherwise, it is rejected. The claim assessment process has a reward and punishment mechanism, where assessors whose votes match the final conclusion receive NXM rewards, while those whose votes do not match the conclusion have their NXM locked for a longer period or even forfeited.
If the claim is rejected, there is a second voting opportunity open to all members. A claim is paid out if the voting result of all members is above 50%.
Although members of the NXM pool that have experienced a risk event tend to reject any related claims, the entire voting process is open to all NXM holders. If genuine risk events cannot be effectively compensated, it will lower the credibility of the protocol and subsequently reduce the price of NXM. For their own interests, the entire voting community still tends to make fair judgments. The claim assessment process of Nexus Mutual is based on collective decision-making, which is different from traditional insurance determination methods. Here, it relies on an economic incentive game mechanism to drive the community to make truthful judgments on claim results.
Once a claim is confirmed, a portion of the NXM in the insurance pool will be used as compensation funds, and NXM holders in the pool will bear the compensation costs.
It can be seen that both the admission and claim assessment of Nexus Mutual involve centralized elements. Other insurance protocols may have achieved decentralization in the admission process, but due to the inability to standardize risk event determinations and the possibility of adverse selection (attackers taking out a large number of policies before an attack), insurance protocols still find it difficult to achieve complete decentralization in the claims process.