Can DeFi Disrupt The Insurance Industry? Part 1
Decentralized Finance (DeFi if you are one of the cool kids), is looking to disrupt the Financial World. Smart contracts written on the blockchain have already shown the ability to replicate the central functions of banks. Hence known as "Banks are Zeros".
What about other areas of traditional finance (TradFi)?
Insurance is one area thrown around as ripe for DeFi disruption. Total insurance premiums across Life and P&C insurance was $1.3 Trillion in the US in 2019. DeFi is currently estimated to be in the $10s of billion. Additionally there are already inroads to using DeFi for some types of insurance. Could insurance companies be the next zero?
Quick Summary
DeFi is poised to turn Banks into zeros
P&C and Life Insurance industries are over 25x the current DeFi industry
DeFi Insurance is already being sold
Oracles allow for bringing any off-chain events onto the chain and smart contracts can execute most functions of insurance contracts
Is the insurance industry the next zero?
What is DeFi?
Decentralized Finance (DeFi) is the general term for any financial applications built on crypto or blockchain technology. You may see decentralized financial applications referred to as dApps.
Whereas in the traditional financial space (TradFi) you have a centralized entity being the gatekeeper, DeFi relies on its many users to track all transactions and keep a history of all transactions. These users are willing to track all transactions due to being rewarded by the protocol for doing so. This way there is no single centralized middleman. By cutting out the middleman, you end up with faster, cheaper, and more transparent transactions.
What is Benefits of Decentralization?
For example, if you want to transfer money today, you need to ask your bank and it usually takes 2-3 business days plus comes with a fee.
Why?
Since there is only one source of data, the bank needs to ensure the money is there, wait for settlement times, and has a ton of overhead it needs to cover through fees.
However, with decentralization you control your coins, since you know better than to hold coins on a centralized exchange and therefore have them in cold stor.....
wait....
You do have your coins on a hardware wallet right? They aren't sitting out on Clownbase? A sagely Bull reminds us all "Not your keys, not your coins" - go buy a hardware wallet now.
Did you purchase a hardware wallet?
“Not Your Keys, Not Your Coins”
- A Wise Bull
Since we got that cleared up, and you ordered yourself a wallet... when you go to transfer your coins from your wallet to any other wallet, it only takes a long as the protocol takes to confirm a certain number of blocks with your transaction. The cost of the transaction should be significantly less than an expedited money transfer from the bank. Lastly, since the transaction is recorded on the public chain, you have full transparency to view it vs. the endless bureaucracy of trying to get information from a bank.
Examples of Benefits of DeFi?
DeFi has the same benefits of faster, cheaper, and transparent but applied to all sorts of financial transactions.
You can lend out crypto for a return or you can put up collateral and take out a loan on your crypto holdings. This is done directly between you and a decentralized exchanged completely removing any intermediary. Some protocols even allow for you to earn tokens in exchange for using the protocol. For instance, when compound was growing, it rewarded users compound tokens for lend and taking out loans. In many cases the tokens earned were higher than the interest on the loan, meaning you got paid to borrow!!!
Lottos are also being run on DeFi protocols. For example, staking a coin gives you 1 ticket in an online raffle and every period one person wins a large pot of money. The protocol takes the staked coins and lends them out to grow the pot. The only cost to the user is the opportunity cost of using your money elsewhere. But imagine if instead of costing money to pay the lotto, you got ‘free’ tickets based on having money in your bank account.
Prediction markets? Yup, you can gamble with DeFi as well and cut out any middlemen. This is handled automatically through the use of oracles (more on oracles later)
Investing? You can yield farm, stake, or provide liquidity and earn high yields on your tokens. There are option markets to trade around crypto coins as well.
Is the price of crypto too volatile? There are stable coins that are pegged to the US dollar (aka US Trash Token).
Since there is no centralized intermediary, all the above actions can be done for lower frictional costs.
You may note that investing, lending, and borrowing are some major revenue items of banks.
What is insurance?
Insurance is nothing more than pooling of risks among many people.
For example, there may be a small chance that your house burns down, but if it happens it'd be catastrophic. You enter into a risk sharing agreement with many others. Each of you pay money into a pool each year and if anyone in the pools house burns down, they get to take money out to pay for it.
Example of Insurance
If there is a 1% chance your house will burn down in a year and it costs you $100,000 to replace your house. You enter a pool with 100 people. Let's say every year you each pay $2,000 into the pool. A couple things should be immediately clear.
Your expected loss in any given year is only $1,000 = 1% chance of fire x $100k loss
If you live in a house for 50 years, you have roughly a 50/50 chance of ever seeing your house burnt down.
You are paying $2,000 into the pool every year though. Why?
First, even though you expect to lose money every year by risk pooling, you can afford a $2,000 a year cost without being bankrupted. Therefore, entering the pool removes some of your tail risk ($100k loss), but locks in a smaller affordable cost ($2k premium).
Second, if everyone in the pool has a 1% chance of a fire, that means around 3/4 of the time there will be 0 or 1 fires in a year. However, 1/4 of the time there will be greater than 1 fire. If everyone paid in $1,000 in year one the pool would have $100k in it. But there is a 25% chance you would need to pay out at least $200k bankrupting the pool. (See Binomial probability distribution if you want to do the calculation out yourself).
Note, the above is very simplified view and leaves out a lot of pieces like partial loss, underwriting, customer differences, different home values, yearly renewable contracts with updated pricing, etc etc.
If you want more info on insurance basics for life insurance you can check out the post here.
Can DeFi Replicate Insurance Contracts?
The short answer, Yes.
Every part of what is described above can be done through smart contracts today. You pay into a smart contract and if an oracle is able to determine your house burnt, you get paid.
What are Oracles?
If you aren't familiar with oracles, they are decentralized nodes that report back on off-chain events into the protocol. To be an oracle, a user needs to stake some tokens. When the oracle reports correct event and is verified by other oracles, they are rewarded with token payment. However, if a bad actor oracle is found to report incorrect information, they are punished by losing some of their staked coins. Therefore, there is incentive to report accurately.
You can learn more here as Chainlink is currently the leader in the space.
Also, do you really not know about $LINK?
It literally is bringing any real-world event and putting it onto the blockchain. It is revolutionary. Not knowing about $LINK is almost as bad as not owning a Ledger. You, Ser, have a lot to catch up to do. You should immediately go and purchase $LINK, even if it means selling a child or 3. If $Link ends up where people are speculating, you could easily buy back 10x as many kids in a few years. (Note - This is not financial advice nor is it parenting advice, as always DYOR on any investment or child slave labor contract).
Benefits of Insurance on DeFi
As long as off-chain real-world events can be validated into the blockchain, there is no reason DeFi can't offer insurance contracts & at significantly lower costs. DeFi insurance would get the benefit of:
1) Very little overhead - Insurance companies have huge buildings, legacy systems that need to be maintained from the 70s, 100s and 1,000s of employees, and huge c-suite salaries. Additionally, most corporations spend money lobbying, and donating to 'charity' which is little more than the CEOs personal pet interests. All that overhead is a huge cost.
2) High yields - DeFi offers extremely high-yields relative what can be purchased in insurance companies. Insurers are largely restricted to investment grade fixed income securities which currently are yield in the 3% range. You can stake stable coins for much more than 3% right now. The more money that can be made while holding the pool of premiums, the lower the required premiums will be.
3) Faster payouts - Granted, insurance companies have been trying to improve, but a smart contract could transfer money to your wallet in the time it takes to validate a few additional blocks on the chain. The oracles don't need the insured/beneficiary to contact the company and provide proof that a human employee at a insurance company needs to confirm.
4) Lower acquisition costs - Currently insurance products are largely sold through an agent who earns a commission. Commissions vary from 20% to over 100% of the premium depending on the product (ie 20% for single year P&C contracts and 100%+ for multi-year life insurance contracts)
All 4 of the items drive to significantly cheaper pricing in a DeFi world.
Can DeFi REPLACE Insurance Companies?
DeFi can certainly replicate the workings of an insurance contract.
There is already some decentralized insurance products being sold. Etherisc has a platform for creators to use to build new DeFi Insurance. They already have 6 types of insurance on the site: 1) Flight Delay insurance, 2) Crypto wallet insurance, 3) Hurrican protection, 4) Collateral loan protection, 5) Crop insurance, 6) Social Insurance (life, health, etc).
Crop insurance was used to pay thousands of Kenyan farmers for flood damages. So the proof of concept is there.
(Side note - it sounds like there is plenty of room for further refinement. The oracles were set up to look at a given area and pay out under certain flood conditions in the area. However, 1) not all farms in an area may have sustained flood damage (think top of hill vs in a valley of same area), and 2) some bordering farms that were technically in a different area may have been flooded but not compensated. Therefore, some of the granularity needs improving).
So it is true? DeFi is going to make it so all 'Insurance Companies are Zeros'? (Not the same ring as 'Banks are Zeros").
Not so fast. We still have a ways to go.
When creating crop insurance in Kenya, Etherisc had to team up with a local insurer. Why?
You will have to wait for Part 2 where you will find out more about insurance regulation and pricing in order to understand some of the challenges faced.
Concluding Remarks
I have worked as an actuary for over 15 years at various large and small companies. Therefore, my background knowledge base is much more about insurance products. There is very little attention being paid to this topic. DeFi could be a black swan event to many large insurance companies. This series aims to educate people with TradFi background to learn a bit about DeFi as well as those with DeFi backgrounds to learn a bit about TradFi Insurance.
Please leave a comment with any thoughts or questions you want addressed in future posts.
Some links in the above post may be affiliate links. There is no impact to you, but if you purchase through my site I may get a small commission that will immediately go into purchasing more $LINK and/or buying my children back from their labor camp…I mean summer camp. And by that I mean 100% to buying more $LINK.