How does DeFi Insurance work?

Sep 16, 2022 2 min read
How does DeFi Insurance work?

DeFi is built on top of blockchains allowing for a high level of base-layer security. However, there are still sizeable risks related to usability, hacks and market volatility.

As an industry still in its infancy, many users are technology enthusiasts, early adopters and large financial institutions. These people have a deep understanding of the underlying technology as well as the code running the protocols they use, enabling them to fully quantify some of the more intricate risks they face.

In order to make DeFi more accessible, insurance is key to allowing the average person to place their trust in this new financial system, and provide a backup if things go wrong.

Traditionally, insurance companies operate by collecting premiums from policyholders in exchange for specified coverage, and then paying out on claims if appropriate. As long as more value is collected in premiums than is paid out in claims, the company should be able to operate at a profit. However, these tend to be centralised organisations, with claims ultimately being paid out at the discretion of the company.

DeFi insurance, therefore, must provide a decentralised alternative, and various options have been explored so far. For example, Mutual Insurance works via a pool of funds into which users can deposit, receiving tokens in return. Claims can then be filed (by staking a portion of the deposit token) and voted on by all token holders. Successful claims are paid out from the pool and ineligible claims lose their staked tokens, discouraging fraudulent behaviour. Prediction markets have also been used as a type of insurance, whereby users ‘bet’ on whether a protocol will be hacked or not, and risk is determined via the ‘wisdom of the crowd’. By betting that the project they use will be hacked, users can offset the risk they face by using it.

However, these two approaches both require a deep understanding of the risks related with each protocol, and don’t provide blanket coverage. In order to grow the number of non-expert users in DeFi, a greater level of trust is needed before the general public will risk investing their money in an ecosystem famous for hacks and scams. This can be achieved by offering simple, comprehensive coverage for entire portfolios without a lengthy and technical claims procedure.

Stake DAO partner Solace allows users to buy address-specific coverage directly in the app. Using on-chain monitoring of all exposure across 200+ DeFi protocols, claims are paid automatically in the event of a hack or exploit on any of the address’s positions.

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