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Decentralized Insurance: From Babylon to Web3 ⚖️🖥️
Even industries with roots in Babylon are not safe from the cleansing destruction of DeFi.
Table of Contents 🕹️
A Brief History of Insurance ⚖️
Etherisc: Smart Contracts and Parametric Insurance 🖥️
Nexus Mutual: Rebirth of the Mutual 🤝
Community and Contract 🌐
Further Down the Rabbit Hole 🕳️
“You don’t need to pray to God any more when there are storms in the sky, but you do have to be insured.”
― Bertolt Brecht
I. Introduction 👾
Insurance is a form of risk management. It enables the ability to hedge against uncertainty. The basic formula for insurance is simple: the insured pays a small, known sum in exchange for compensation in the event of a covered loss. Since insurers pool funds from multiple insured entities to pay out individual claims, total risk can be offset using the law of large numbers.
In the Web3 era, our money is programmable and our contracts are executed autonomously on-chain. Since insurance is by definition a quantifiable contract for monetary exchange with parametric inputs, we can program it. Any risk that can be quantified can be insured and any logical program that involves money can be captured in a smart contract.
In this issue, we will briefly explore the history of insurance to contextualize the progression to Web3 parametric and mutual insurance models. There are two major themes to highlight:
Historically, insurance was driven by community. Mutual insurance, such as the ancient Greek and Roman “benevolent societies” and the seventeenth century “friendly societies” of England, was a way for communities to help each other in our darkest hours. Modern insurance is plagued with a principal-agency problem and oftentimes devolves into a tactical economic game between participants in the contract. The Web3 era is seeing a return to the earlier community-driven model.
When insurance companies are gutted in favor of programmatic smart contracts, costs decline, payouts are quicker, and more people are able to access the insurance they need. Parametric insurance on-chain will grow as oracles become increasingly sophisticated in the data they can provide and insurance protocols expand on their contract logic.
II. A Brief History of Insurance 👾
Insurance dates back to prehistory.
The Babylonians had developed an insurance system for early Mediterranean sailing merchants that was outlined in the Code of Hammurabi, c. 1750 BCE. A common practice at the time was for the merchant of a funded voyage to pay an additional sum above the cost in exchange for the lender’s guarantee that the loan would be cancelled if the shipment was lost or stolen at sea. This and other early versions of insurance were codified in the Code of Hammurabi. Here are some of the laws that pertain to insurance in the codex:
Law 100: Repayment by a debtor of a loan would follow a payment schedule with a maturity date in the form of a written contract.
Law 101 and 102: A shipping agent, factor, or ship charterer was only required to repay the principal of a loan back to the creditor in the event of loss due to an Act of God.
Law 105: Loss claims were only valid with receipts.
Law 126: Filing a false claim was punishable by law.
Law 240: The owner of a cargo ship that destroyed a passenger ship in a collision was liable for the cost of the ship and any cargo it held.
Elsewhere in ancient Persia, various ethnic groups would pay tribute annually to Acaemenian monarchs. These gifts would officially bind the monarch to the protection of the group, which was essentially a form of political insurance.
The Greeks and Romans had a variety of insurance-like contracts as well. Similar to the Babylonians, the Athenians utilized a maritime loan insurance schema to enforce certain repayment conditions. Interestingly, these maritime laws had rates that would vary with perceived risk, implying an intuitive pricing of risk similarly to modern-day insurance.
Athenians also had a form of insurance on their slaves. During the Peloponnesian Wars, it was common for Athenian slave-owners to volunteer their slaves as oarsmen on warships. The slave-owners would pay a small yearly premium to the Athenian state that would insure the value of their slave in the event of they were killed in action.
By 600 BCE, Greeks and Romans had established “benevolent societies”. These guilds would insure members by assisting with funeral expenses and helping the families of the deceased. This form of mutual insurance aid was prevalent throughout the Middle Ages to as late as 17th century England (“friendly societies”) before modern-style insurance was established.
Ancient era sea loans developed into more traditional marine insurance during the fourteenth century. As noted above, investors would lend money to traveling merchants that would be repayable if the ship returned back safely. These loans were typically associated with high interest rates given the heightened risks involved, resulting in a ban on the practice as usury in 1236 by Pope Gregory IX.
In response to the Pope’s crackdown, commenda contracts (an early form of limited partnership) were developed. These medieval contracts resolved the main usury complaint of paying for risk by reframing the terms. Under the commenda model, a capitalist provided funds to an entrepreneur in order to carry out a trade as partners in an enterprise, with profit shared between partners and risks borne by the capitalist.
Mediterranean traders spread their knowledge and use of insurance further into Europe, and by the fifteenth century, wording for insurance contracts became standardized. By the seventeenth century, insurance spread beyond native countries, allowing traders to insure goods outside of their homelands. The laws governing insurance became more universal, and third party arbiters became a staple for settling claim disputes.
Modern insurance grew out of Enlightenment era Europe, as specialized varieties of insurance began to form. Here are some major advents of the Modern era:
Property Insurance - Following the Great Fire of London in 1666 when over 13,000 homes were destroyed, property insurance became of national concern. Shortly thereafter in 1681, the first fire insurance mutual was formed. Property insurance today has grown to protect against fire, theft, floods, earthquakes, and more.
Life Insurance - In 1706, William Talbot and Sir Thomas Allen created the first company to offer life insurance: the Amicable Society for Perpetual Assurance Office. The first life insurance contracts required each member to pay a fixed annual payment. At the end of the year a portion of the "amicable contribution" was divided among the family members of the deceased members in proportion to the amount of shares the heirs owned.
Accident Insurance - Accident insurance developed out of the railway industry. The first company to offer accident insurance was the Railway Passengers Assurance Company in 1848. Their intent was to insure against the rising number of deaths and injuries in the industry. Interestingly, the company charged higher premiums for second and third class travel due to the amplified risk of the roofless carriages.
Traditional insurance models are plagued with high operating costs, lack of transparency, information asymmetries, and a major principal-agency problem. In the 21st century, the advent of blockchain technology, smart contracts, and decentralized autonomous organizations (DAOs) have enabled a new way of transferring risk.
What follows is a brief overview of two insurance protocols in DeFi working to modify the insurance experience by upgrading it for the 21st century.
III. Etherisc: Smart Contracts and Parametric Insurance 👾
Etherisc is an open-source, open-access platform for a wide range of decentralized insurance applications. The goal is to provide the technical and application layers so that insurance companies, fintech startups, license holders, risk modelers, reinsurance financiers, and more can easily begin building on-chain.
Etherisc provides a platform for creating parametric insurance contracts. Parametric insurance relies on data sources and algorithms to programmatically underwrite and make payout decisions. This form of insurance is the most ideal for porting to blockchains since smart contracts can manage the entire claims process. When the specified event occurs, payment is automatically doled out to the insured.
The Flight Delay DApp was the first parametric insurance application built on top of Etherisc. It aims to solve some of the current issues of the flight delay insurance model—inefficiencies and operational costs that lead to delayed claims processing times and a culture of mistrust between insurers and policyholders.
Using a combination of Ethereum and Chainlink, Etherisc’s Flight Delay DApp codifies the terms of the insurance agreement into a smart contract that automatically executes when conditions are met. This execution `strips away the entire claims process and ensures that no informational asymmetry sours the terms.
Chainlink uses independent, Sybil-resitant oracles to verify flight status data on a trusted web API, such as Flightstats API. Each node submits their response, and these responses are aggregated and transformed into an outcome for the contract.
Etherisc has since expanded into other insurance products as well. Crop insurance is one such development.
Accessible and affordable crop insurance is essential for smallholder farmers in Sub-Saharan Africa, yet only 3% of farmers use agricultural insurance to protect their income. This discrepancy implies a disconnect between the products offered by traditional insurers and the end users in the region. The current offerings are typically expensive, and a distrust in insurers stemming from delayed or absent claims payouts makes many individuals skeptical of insurance providers.
Etherisc has partnered with Chainlink to provide parametric crop insurance that relies on local weather parameters to determine and automate payouts related to extreme weather events. The model was successfully piloted in 2019 by providing drought insurance to farmers in Sri Lanka in partnership with Oxfam and Aon.
A study from the Global Innovation Lab for Climate Finance found that Etherisc’s smart contract technology reduced costs for policyholders by 41%. The claims cycle was also reduced from 3 months or longer down to automatic payouts executed immediately following the event.
Now, Etherisc has begun scaling the program in hopes of reaching the 1.2 million farmers in Sub-Saharan Africa. Etherisc has partnered with ACRE Africa, one of the largest insurance providers in the area, to provide 250,000 farmers in East Africa with insurance with premiums as low as $0.50.
Etherisc is also developing the following insurance products on their platform:
Hurricane Insurance - Designed for low-income individuals and small business owners. Instant payouts are triggered by wind speed registered by weather-stations within 30 mile radius from insured’s permanent location.
Crypto Wallet Insurance - Protection against risk of theft and attacks of hackers on wallet smart contracts. Target coverage up to $1M.
Collateral Protection for Crypto-backed Loans - Policy pays up to 100% of the issued loan amount if value of collateral provided by the borrower (i.e. ETH, or tokenized car) drops by 90% or more.
Social Insurance - Affordable, accessible protection against risk of death or heavy illness of a community member. Immediate emergency payment which helps to get through critical times.
IV. Nexus Mutual: Rebirth of the Mutual 👾
Nexus Mutual is a decentralized insurance protocol that utilizes a peer-to-peer framework similar to traditional mutual insurance models. The protocol runs on Ethereum, using cryptoeconomics to create on-chain risk-sharing pools. Anyone can become a member and purchase cover.
Nexus Mutual is wholly owned and managed by its community with economic incentives provided for participants actively engaged in risk assessment, claims assessment, and governance. The entire Nexus Mutual ecosystem is bound together by the $NXM ERC-20 token. Members of the mutual can stake their $NXM in different risk pools in exchange for a percentage of premiums generated by individuals purchasing cover. If a covered event occurs, staked $NXM is slashed to make the payment. This model requires members of the DAO to remain vigilant with their risk assessments, but it also creates an economic game that reduces the principal-agency problem: members are incentivized to pay claims following a covered event or risk devaluing their $NXM.
Everyone’s greatest fear in DeFi is malicious exploitation of a protocol they have deposited funds into. Protocol cover from Nexus Mutual covers:
Code being used in an unintended way
Economic design failure
Severe oracle failure
Protection for assets on Layer 2 solutions
Protection for non-Ethereum smart contracts
Protection for a protocol across multiple chains
Members of Nexus Mutual stake their $NXM tokens into risk pools representing specific protocols. Every time cover is purchased, 50% of the cover price is distributed proportionally to stakers. In the event of a covered hack, the Risk Assessor’s stake is proportionally burned to payout the claim amount.
Yield Token Cover
Yield Token Cover protects the insured against the risk of a yield-bearing token de-pegging. If the token de-pegs by 10% or more for a span of at least four hours, the claimant can claim up to 90% of the losses by swapping the yield-bearing token for its underlying. This is particularly useful for participants in various vault strategies, such as Yearn’s yVaults or Curve’s 3pool.
The risk pool model used to pay claimants is the same as the Protocol Cover model above.
Crypto has a vibrant history replete with legendary scandals and hacks, but known come close to the notorious Mt. Gox hack from early in Bitcoin’s history. Custody Cover from Nexus Mutual provides coverage for these types of scenarios, protecting purchasers from a custodian getting hacked resulting in a loss of more than 10% of their funds or in the event a custodian halts withdrawals for more than 90 days.
What’s particularly exciting about this coverage is that the risk is written by a decentralized provider and covers the risk of a centralized failure. Again, this uses the same risk pool model as above to incentivize liquidity for claims.
V. Community and Contract 👾
Etherisc and Nexus Mutual are just two of the protocols in the DeFi space looking to transform insurance with cryptoeconomics and smart contracts. As highlighted in the introduction, there seem to be two major themes at work: a return to the mutual model through peer-to-peer risk transfer and the stripping away of unnecessary bureaucratic burdens.
The use of blockchain technology within the insurance vertical is reducing costs and improving the end-user experience. Nexus Mutual identifies in their whitepaper that roughly 35% of insurance premiums are due to frictional costs in the system and only 65% of premiums are returned to customers via claims with the remainder being lost in distribution and operational expenses. Of the 35% of frictional costs, blockchain technology is expected to cut out approximately 18% due to administrative savings and reduced regulatory costs.
DeFi is stripping out inefficiency in all forms while driving a return to community-based organizational structures. Even traditional industries with roots in Babylon are not safe from this cleansing destruction.
VI. Further Down the Rabbit Hole 🕳️
Decentralized Autonomous Risk Transfer on the Blockchain by Braun, Haeusle, and Karpischek
Whitepaper by Nexus Mutual
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