DeFi insurance: navigating decentralized finance’s risks

As the flaws of centrally managed financial companies are once again all over the headlines, decentralized finance, or DeFi, can seem like a promising way to fix them. It’s not. At least for the moment: even as DeFi brings the degree of transparency that makes it impossible to misuse client’s funds, or misplace its reserves (so far the most popular failings of both traditional finance and the CeFi part of crypto), it comes with its own set of issues.

The flaws in smart contract code can lead to hacker exploits or any kind of unintended – and possibly dangerous – situation. According to DeFiLlama, since inception, DeFi users have suffered losses of over $6 billion due to technical and governance exploits. Smart contracts audit firms and generous bug bounties help, but 100% security is unlikely to exist.

Enter DeFi insurance, a sector that has been gaining momentum recently.

OpenCover, an on-chain analytics firm specialized in this sector, has released a report on the state of DeFi insurance, analyzing data from June 2022 to March 2023 across 7 EVM-compatible chains (Ethereum, Polygon, Arbitrum, Optimism, BNB Smart Chain, Astar, and Avalanche) and 9 main insurers.

Key takeaways:

• only $231 million of funds were covered, which is approximately ~0.5% of DeFi TVL (total value locked) across the bulk of underwriting capital – a minuscule share showing much room for growth,
• 2022 marked the DeFi insurance industry’s first stress test with 90% of all-time claim payouts,
• 9 players share 90% of the DeFi insurance market,
• the sector is developing fast, with many companies rolling out upgrades that will allow them to scale and offer new products.

DeFi cover

Traditional insurance providers typically only offer risk protection in one area of the crypto ecosystem: custody. DeFi-native insurance, often called DeFi cover, tackles the problems that have not been insurable by traditional providers due to their novelty and complexity.

It is a rapidly emerging industry with varying approaches to risk management, governance, and claim assessment.

The risks covered by the existing DeFi providers include:

• protocol covers (smart contract exploits, bugs, economic design failure, oracle failures or manipulation, and governance attacks),
• stablecoin and yield token depegs,
• bridges failures,
• audit failures (purchased by developers to cover the vulnerabilities undetected during audit),
• slashing (purchased by PoS blockchain validators).

Some providers even diversify into the CeFi, or centralized crypto finance, offering custody covers.

DeFi insurance market

The DeFi cover market counts at least 23 active players.

The first and biggest DeFi insurance provider, Nexus Mutual, was established in 2017 and steadily growing since. Together with 8 other providers (Unslashed Finance, InsurAce, Chainproof, Sherlock, Neptune Mutual, Risk Harbor, InsureDAO and Ease), they represent over 90% of the industry’s on-chain underwriting capital.

Most DeFi cover providers operate on-chain, with a DAO that governs the protocol facilitating the purchase of cover, assessment of claims, and triggering of payouts. Anyone can join the DAO, and anyone can audit its operations at all times.

There are also several centralized providers (like Etherisc or Chainproof), which operate as regulated entities that keep a significant portion of their operations off-chain, sacrificing transparency for the sake of providing a more familiar customer experience.

The state of DeFi cover

So far, most DeFi cover buyers on Ethereum are institutional users: Nexus Mutual’s median and mean cover amounts purchased in 2022 represent around $100,000 and $750,000 respectively.

The retail adoption is higher on other chains:  over half of InsurAce cover purchases on Polygon and BSC are under $10’000.

In 2022, DeFi insurance companies paid out $34.4 million in claims, with unprecedented events like the UST depeg and the FTX collapse leading to a record amount of respectively $22.5 million and $4.8 million being paid out to cover holders (a total of $34.4 million overall).

The total value of underwriting capital across DeFi cover providers (the amount of liquidity backing active covers) is $290 million. This figure is still very low, and the lack of scalable DeFi cover options is a fundamental bottleneck for both retail and institutional DeFi adoption. 

Many established players are currently focused on protocol upgrades (Nexus Mutual V2, InsurAce V2, Risk Harbor V3), introducing new mechanisms such as marketplaces aiming at scaling capacity and distribution, as well as sharing the risks. Others, like Carapace or Neptune Mutual, are exploring new opportunities such as credit default cover for on-chain undercollateralized lending.

As the DeFi industry evolves, the development of scalable and reliable insurance options will be crucial for its success.

Written by D.Center