Defi Insurance: Flawed Incentives Shoehorned Onto Blockchain
By: Drew Patel
Tags: Blockchain, Insurance, Ethereum, Decentralized Finance, Defi

The first recorded distribution and transferring of risk, also known as insurance, was in 2000 BCE. Babylonian sailing merchants would insure their leveraged shipments against theft and damage with this early instance of insurance. This early insurance system was one of the 282 rules within Hammurabi’s Code. You know, that Code we all learned about in the 6th grade.

Hammurabi’s Code Paragraph 165

Hammurabi’s Code was the first recorded attempt to unify a collective group of people under an established set of standards and laws. These standards and laws governed both social and commercial interactions between individuals with set fines and punishments for violations. It codified and standardized rules that were previously tentative.

This Code worked because there was a benevolent leader, Hammurabi himself, that enforced it. Modern day insurance works because governments regulate insurers and arbitrates conflicts. However, modern insurance is not perfect.

Edgar Snyder & Associates — Personal Injury Law Ad

Once an insurance company has your money, everything becomes a slow, arduous process, especially claims. Incentives between insurers and insurees are misaligned. Insurers strive to maximize policies sold and minimize the amount of claims paid. On the flip side, insurees want to pay as little possible for insurance while maximizing how much they can get from a claim. This is a classic example of the Prisoner’s Dilemma. Each side has more to gain if they screw over the other.

There’s a reason insurance lawyers are always on tv. It’s because it’s so hard to get an insurance company to pay, especially the full amount that the insuree deserves. That’s why when insurance is brought to web3, it will have to be rebuilt from the ground up to be as simple and objective as possible.

The Critical Flaw in the Status Quo

Governors of the Wine Merchant’s Guild by Ferdinand Bol — 1680

Currently, there are a few protocols that allow you to insure against smart contract bugs and hacks. On the surface, they are well built products with great growth. However, they all suffer from one core flaw. They simply copy-pasted the flawed insurance system from the real-world onto blockchain.

On these protocols, the people that decide whether a claim is legitimate are the same people who underwrite the policies. This leads the protocols to suffer from the Prisoners Dilemma, just like real-world insurance. The only difference is that you can take an insurer to court in the real-world. The incentives of underwriters never aligns with the incentives of insurance buyers. When you give underwriters the power to dictate if claims are legitimate, buyers suffer.

The platform operators argue that claims won’t be denied since underwriters are looking long term. This argument only holds up if an underwriter is diversified across many different pools such that a loss in confidence to the platform as a whole would yield a greater loss than losing their entire stake in a specific pool.

94% of claims have been denied — According to leading DeFi insurance platform’s stats page

Insurance claims should be decided by a smart contract with codified rules instead of anonymous humans with misaligned incentives.

What DeFi Insurance Should Look Like

Claims

A claim should be a fast, simple, and completely objective process with no human involvement. When a contract is hacked, the user is in a state of panic. All they should have to do is press a button and expect their claim to be fully processed within a few blocks time. Moreover, once the initial claim is successful, every insuree of that contract should be paid out immediately too.

Pricing

Pricing should be handled by the market. The market knows what policies should be priced at given the infinite number of quantitative and qualitative data points. The alternative is wiring in tons of oracles into a costly algorithm that would still underperform the free market. The insurance platform should provide a data dashboard similar to Dune Analytics so that underwriters can easily make their underwriting and pricing decisions.

Human Intervention

None.

That’s all.

Follow Trustless.Insure’s progress: https://twitter.com/trustlessinsure

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