, Author: Lucius Fang, Compiler: Alyson, reproduced by Odaily with authorization.

Recently, CoinGecko analyst Lucius Fang wrote an article about the DeFi insurance market, introducing in detail the main players in the market, their operating mechanism, and future market prospects. Chain Catcher translated the original text and made adjustments that do not affect willingness.

With the continuous innovation of DeFi projects, we see more and more hacking incidents and losses. Since the second half of 2019, there have been 21 publicly reported DeFi security incidents, resulting in losses of more than $165 million.

If this field only welcomes those who can bear high risks, the development of DeFi will stagnate, and having insurance is the key to attracting more users.

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Meaning and Mechanism of Insurance

The insurance industry is a huge market, with global written premiums totaling $6.3 trillion in 2019. The world is complex and we are always at risk of some kind of accident. Below is a simple risk management framework illustrating what we should do to address different types of risk.

Individuals should shift away from high-impact but low-frequency risks, such as natural disasters and cancer, and use insurance to deal with this type of risk.

Insurance operates on two main assumptions:

The second is the risk sharing mechanism. Loss events have the characteristics of low frequency and high impact, so the insurance premium paid by a large number of people subsidizes the loss of a small number of large claims.

Essentially, insurance is a tool for pooling capital and socializing large losses so that participants do not go bankrupt in a catastrophic event.

Insurance socializes the cost of experiencing catastrophic events, thereby enabling individuals to take risks. It is a risk management tool that encourages more user participation, and it is crucial for the DeFi industry to go beyond existing audience segments. The DeFi industry needs insurance products to convince institutional players with large capital to join.

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Detailed analysis of the three major insurance items

Two major insurance projects currently dominate the DeFi insurance market — Nexus Mutual and Cover Protocol. We'll examine how they work in detail below. We'll also delve into the Armor protocol, as it plays a key role in the development of Nexus Mutual.

1. Nexus Mutual

Nexus Mutual is the largest insurance program in the crypto market. It has a total value locked (TVL) of $288 million and was founded by Hugh Karp, the former CFO of Munich Re in the UK.

Nexus Mutual is registered as a mutual company in the UK. Unlike a company of shareholders, a mutual company is managed by its members, who are the only ones allowed to transact with the company. Nexus Mutual is like a company run by members, for members.

Currently Nexus Mutual offers two types of insurance:

One is smart contract insurance, which is mainly for DeFi protocols that host user funds, because these protocols may be hacked due to errors in smart contracts. The insurance covers major DeFi protocols such as Uniswap, MakerDAO, Aave, Synthetix, and YearnFinance.

The second is custody fund insurance, which is mainly aimed at the risk of funds being stolen by hackers or suspension of withdrawals. Nexus Mutual provides services covering centralized exchanges such as Binance, Coinbase, Kraken, Gemini, as well as lending companies such as BlockFi, Nexo and Celcius.

Users can purchase a total of 72 different types of insurance, covering smart contract agreements, centralized exchanges, lending services, and custody services.

How to buy insurance:

To purchase insurance from Nexus, users must go through the KYC process to register as a member and pay a one-time fee of 0.002 ETH, and can then use ETH or DAI to purchase insurance.

Nexus Mutual will convert the payment into NXM tokens, representing rights to the mutual capital. 90% of NXM is burned as cover cost. 10% of NXM will be kept in user's wallet. It will be used as a deposit when a claim is submitted and will be refunded if no claim is made.

Claims Assessment Mechanism:

Users may make a claim at any time during the warranty period or up to 35 days after the end of the warranty period. When a user submits a claim, a 5% premium must be locked in. Users are allowed a maximum of two claims per policy.

Unlike traditional insurance companies, claims outcomes are determined by member votes. Members vote to have complete discretion as to whether a claim is valid or not. Members can use NXM to participate as claim assessors, subject to a 7-day lock-in period.

When members vote in line with the overall vote, 20% of the premium is shared proportionally with those members. However, if the vote does not match the result, the member will not receive any rewards and the lock-up period will be extended for another 7 days.

• In order to qualify for a claim, users must prove that they have lost funds, with smart contract insurance requiring a loss of at least 20% of funds and custody insurance requiring a loss of at least 10% of funds.

• Risk assessment mechanism:

Pricing for insurance depends on the amount of funds staked on a particular protocol. Users can stake NXM on these protocols to become risk assessors. The pricing formula is as follows:

Risk cost = 1-(pledged NXM amount / low risk cost limit)^(1/7)

Underwriting Price = Risk Cost x (1 + Surplus Profit Margin) x Underwriting Period/365.25 x Underwriting Amount

The low-risk cost limit is the minimum staking standard required to reach 2% of the minimum pricing, and the limit is set at 50,000 NXM. Surplus profits are used to cover costs and generate surplus for the mutual fund, and the surplus profit margin is set at 30%. Therefore, the minimum insurance cost is 2.6%.

When a claim occurs, the risk assessor bears the loss. To cover this risk, 50% of the insurance premium is shared by the risk assessor.

The pie chart below shows where premiums go:

CS: The fee paid by the user for submitting a claim

CA: Fees earned by Assessor if a claim is filed

If the user does not file a claim when the insurance policy expires, 10% of the insurance premium will be returned to the insured buyer, while 40% of the insurance premium will go into the fund pool.

The assumption here is that simultaneous attacks on multiple protocols are rare, and this practice is consistent with how the insurance industry operates on the basis of the law of large numbers and risk sharing.

Token Economics:

If the claim amount is greater than the funds owned by the risk assessor, the mutual fund's capital pool will pay the remaining amount.

A = 0.01028

C = 5,800,000

To ensure that there is always sufficient capital to cover claims, the mutual needs of both parties must result in capital above the Minimum Capital Requirement (MCR). Typically, the MCR is calculated based on the risk of the insurance being sold. But due to a lack of claims data, both sides followed manual parameters decided by the team.

Token Economics:

NXM token economics is an important factor in attracting and retaining capital. It uses the bonding curve model to determine the price of NXM. Calculated as follows:

MCR (ETH) = minimum capital required

wNXM：

MCR% = available capital / MCR (ETH)

MCR% is a key factor in determining the price of NXM because it has the fourth power in the price formula. When people buy NXM based on the Bonding Curve Model, the available capital will increase, causing the MCR% to grow, resulting in an exponential increase in the price of NXM.

The thing to note here is that when the MCR% falls below 100%, exits from the Bonding Curve model are halted to ensure that there are sufficient funds to cover claims.

Nexus Mutual has released wrapped NXM (wNXM) to allow investors to gain exposure to NXM without KYC. Users can wrap NXM into wNXM and then sell it through secondary markets such as Uniswap and Binance.

wNXM has many disadvantages, it cannot be used for risk assessment, claims assessment and governance voting. The launch of the Armor protocol helps solve the problem by converting wNXM to arNXM.

Shield Mining (till farming):

In order to encourage more risk assessors to stake their NXM, Nexus Mutual released the Shield Mining program, which plans to use native tokens to reward staking users. Shield Mining helps increase the amount of NXM staked and increases the insurance available.

Agreement income:

The NXM token is different from other governance tokens in that its token price is controlled by a formula. Therefore, mutual benefit will help increase the available capital and increase the price of NXM. There are two sources of profit:

1) Premiums Collected - Claims Paid - Expenditures.

2) The price difference when users sell NXM from the binding curve is 2.5%

arNXM：

2. Armor protocol

In order to overcome the limitations of KYC, Yearn Finance created yInsure, users can purchase Nexus Mutual insurance without KYC. yInsure was supposed to be managed by Safe Protocol, but the project was canceled due to some infighting between the founder, Alan, and Azeem, a well-known member of the community. Alan went on to release the Cover protocol, while Azeem took over the yInsure product and released the Armor protocol.

The Armor Protocol has four main products: arNXM, arNFT, arCORE, and arSHIELD.

Nexus Mutual created WrappedNXM (wNXM) to allow investors to invest in NXM without KYC. However, as more wNXM are created, the amount of NXM available for internal interaction functions such as staking, claim evaluation, and governance voting decreases.

Armor created arNXM to solve this problem, allowing investors to participate in the operation of Nexus Mutual without KYC.

arNFT：

To obtain arNXM, users can stake wNXM in Armor. Armor opens wNXM and then stakes NXM tokens on Nexus Mutual. By staking on Nexus Mutual, stakers signal that the smart contract is secure, opening up more channels for insurance sales.

Armor will keep a reserve of 10,000 wNXM to ensure sufficient liquidity between arNXM and wNXM for transactions. Armor replenishes its reserves every ten days.

arCORE：

arNXM can be called the wNXM fund pool, users can deposit wNXM into the fund pool, and it is expected to get more wNXM in the future.

arNFT is a tokenized form of insurance purchased on Nexus Mutual. arNFT allows users to purchase insurance without KYC. Since these insurance objects are tokenized, users can now transfer them to other users or sell them on secondary markets. These tokenized insurances will also further explore DeFi composability.

All Nexus Mutual insurance can use arNFT.

arSHIELD：

arCORE is a pay-as-you-go insurance product. Armor tracks the exact amount of user funds through a liquid payment system as they can dynamically span different protocols. The underlying technology of arCORE integrates arnft, which are sold at a premium after being decomposed. arCORE allows for more innovative product designs and demonstrates the composability of the DeFi ecosystem.

arCORE’s products charge higher insurance premiums to compensate arNFT stakers for the risk of not being able to fully sell insurance. Currently, arCORE's premium multiplier is 161.8%, which means the price will be 61.8% higher than buying it directly from Nexus Mutual.

For the additional insurance premium, 90% will be returned to arNFT supporters and 10% will be collected by Armor as a management fee. Based on a premium multiplier of 1.618 and a revenue share of 90%, the utilization rate must be greater than 69% to make arNFT investors profitable. If the amount of insurance sold is less than 69% of the amount staked in the pool, then those stakers will have to pay for the insurance themselves.

arSHIELD is an insurance repository for Liquidity Market Maker (LP) tokens, where insurance premiums are automatically deducted from earned LP fees. arSHIELD essentially creates LP tokens with insurance and no upfront payment from users.

arSHIELD only covers protocol risk for liquidity pools. For example, insured Uniswap Lp tokens only cover the risk of Uniswap’s smart contracts being compromised, but not the risks of the underlying assets (such as the underlying asset protocol being hacked).

arSHIELD is just a repackaged version of arCore with two different risk levels.

Shield + Vault is the most secure version and guarantees payouts. It is fully mortgaged but has limited coverage. It has a high multiplier of 200%, making it twice as expensive as Shield Vault.

Shield Vault is the riskier version and the claim payout may not be fully repaid as it depends on the funds available in the pool during the hack. To compensate for the extra risk, it only has a 100% premium multiplier, meaning it costs the same as buying it directly from Nexus Mutual itself. The insurance capacity is designed to be unlimited, so it is difficult for users not to be satisfied with the mortgage rate, because it may not be fully mortgaged.

Claim mechanism:

After the user files a claim, the review process will be triggered and submitted to Nexus Mutual for consideration. Armor token holders will also participate in Nexus Mutual's claims approval and payment process. If a payment is confirmed, the amount will be sent to Armor's payment treasury, which will then be distributed to affected users.

Agreement income:

Below is the program's updated profit-sharing fee schedule as of February 2021.

Something to note is that for every policy purchased from Nexus Mutual, the program sets aside 10% of the premium for claims, and claims cost 5% of the premium. Each user can apply twice for the same reason, and if no claim is made by the end of the policy period, 10% of the premium will be refunded. This is where the arNFT profits come from.

3. Cover agreement

As mentioned earlier, the Cover protocol was incubated by Yearn Finance and was originally a Safe protocol that provided yInsure. In November 2020, Yearn Finance announced the merger with the Cover agreement to insure its yvaults, but Yearn Finance chose to terminate the partnership on March 5, 2021.

• Coverage category:

• The Cover protocol only provides smart contract insurance. Let's look at an example of how insurance can be sold:

Market makers can deposit 1 DAI and they will be able to generate 1 NOCLAIM token and 1 CLAIM token. These two tokens only represent the risk of a single agreement. Tokens are only valid for a fixed timeframe (e.g. half a year). After half a year, two situations may occur:

If no valid claim event occurs, NOCLAIM token holders can claim 1 DAI while the CLAIM token is worth zero.

If a valid claim event occurs, CLAIM token holders can claim 1 DAI, while NOCLAIM tokens are worth zero.

This is similar to a prediction market, where users bet on whether the protocol will be hacked within a time frame.

The Cover protocol introduces a partial claim mechanism, so that in the event of a valid claim, the payout of CLAIM token holders will be determined by the Claim Validity Committee (CVC).

How to buy insurance:

One is Balancer Swap (old), users need to trade in Balancer and buy CLAIM tokens from the Balancer fund pool.

The second is Flash Swap (new), users only need to conduct one Ethereum transaction to purchase insurance from the web page of the Cover agreement.

Claims Assessment Mechanism:

One is a regular claim, which costs 10 DAI. COVER token holders will first vote on the validity of the claim. It will then move to the Claims Validity Committee (CVC) for a final decision.

The second is to force a claim, which costs 500 DAI and is sent directly to the CVC for a decision.

• The CVC is composed of external smart contract auditors. If the claim is approved, Cover Agreement will refund the claim filing fee.

• Risk assessment mechanism:

Balancer Swap (old): As mentioned above, the Cover protocol relies heavily on market makers to expand coverage. After minting NOCLAIM and CLAIM tokens, they will have to provide liquidity in the Balancer pool against DAI. Here are the detailed instructions:

• NOCLAIM/DAI pool ratio 98%/2%, overdue fee 3%

CLAIM/DAI pool with a ratio of 80%/20% and an overdue fee of 5%

Flash Swap (new): Relies on only one pool instead of two different pools to bootstrap NOCLAIM and CLAIM tokens.

NOCLAIM/DAI pool ratio 50%/50%, overdue fee 0.2%

The income of the market maker mainly comes from the overdue fees generated by the Balancer fund pool.

The new Flash Swap system has some advantages:

First, insurance costs are expected to be reduced since there is only one Balancer pool of funds for tillage farming. Under the incentive, market makers will buy more NOCLAIM tokens in exchange for farming rewards or earning transaction fees, driving up the price of NOCLAIM tokens. Therefore, the price of CLAIM tokens will be reduced to CLAIM = 1-NOCLAIM.

Second, market makers are expected to earn more fees because every purchase of insurance requires the sale of NOCLAIM tokens to the Balancer pool. And unlike the old system, market makers only need to provide liquidity to one pool of funds.

Since every purchase involves CLAIM/NOCLAIM tokens, with a 0.1% fee payable during the redemption process, the Cover Protocol promises higher platform revenue.

The insurance price is determined by the supply and demand relationship of the Balancer fund pool.

The Cover protocol does yield farming for NOCLAIM/DAI pools and CLAIM/DAI pools simultaneously in the old BalancerSwap system. In the new Flash Swap system, only the NOCLAIM/DAI pool is incentivized.

Agreement income:

There will be a 0.1% fee for exchanging CLAIM and NOCLAIM tokens. COVER token holders are entitled to vote on how the vault is used. Earnings in COVER tokens are currently being discussed, but details have not yet been finalized.

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A comparison of the two insurance programs

1. Investment efficiency

Nexus Mutual allows funding providers to exert 10x leverage on the funds they own, which results in higher premium income for stakeholders. Investors do have to take on more risk, but this approach is more in line with how traditional insurance spreads risk across different products.

At the same time, since each pool is isolated, investors in the Cover protocol cannot leverage their capital. While it has plans to bundle different risks together for V2, few details have been revealed so far.

Cover insurance is more expensive than Nexus due to lower capital efficiency. For example, in the Cover agreement, the annual cost of purchasing insurance for OriginDollar is 12.91%, while in Nexus Mutual it is only 2.6%.

We can quantitatively calculate investment efficiency by dividing the effective insurance quantity in the capital pool. Nexus Mutual's capital efficiency ratio is as high as 200%. And for the Cover protocol, it is always less than 100% by design.

2. Insurance Coverage

The Cover protocol only covers 22 protocols, while Nexus Mutual covers 74 trading pairs. Nexus Mutual provides greater flexibility in terms of protection, users can decide to start protection on any day, and the protection period is up to one year.

Cover agreements provide predetermined term coverage only. For example, for a specific series, the insurance period is valid until the end of May, and no matter when the user purchases the insurance, the insurance will end in May. Therefore, over time, the value of the CLAIM token will tend to $0 and the value of the NOCLAIM token will tend to $1.

Nexus Mutual covers most major DeFi protocols, and users can find more comprehensive services. It offers wider coverage than Cover Protocol, which is limited by its Total Value Locked (TVL). Even so, many covers were snapped up due to a lack of pledgers. The release of the Armor protocol does alleviate this problem by attracting more wNXM into arNXM, thus putting NXM under threat.

The Cover agreement can be regarded as a competitor of long-tail insurance, because projects can be established faster without having to pass tedious risk assessments. This is because each risk is isolated and contained in a single pool, unlike in NXM where claims from any single agreement can erode the capital pool.

However, new insurance coverage for lesser-known projects is not an easy task. In addition to being constrained by limited capacity, insurance costs are often prohibitively expensive. For example, a newly listed project, Reflexer Finance, has a payment cost of 32.46% per annum.

3. Claim ratio

Yearn Finance suffered an $11 million hack in February 2021. Although ultimately the company decided to cover the losses through its own funds, insurance companies have now decided to pay compensation to prove that their products are indeed working as expected.

Nexus Mutual has accepted 14 claims for $2,410,499 (1,351 ETH + 129,660 DAI). This resulted in a loss of 9.57% for users who staked NXM to Yearn Finance. If claimants can prove that they actually lost at least 20% of their funds, they can be compensated for their losses in full.

At the same time, the Cover protocol decided to only set the payout ratio at 36%, since the losses only accounted for 36% of the affected vaults. If a user holds 1000 CLAIM tokens, they will only receive $360. Yearn Finance owns $409,000 worth of CLAIM tokens. In fact, the market maker only lost $147,000. Insurance buyers should be aware that buying insurance from the Cover protocol does not guarantee full payouts, and the way claims are determined is more akin to a prediction market.

Nexus Mutual currently leads the insurance market with seemingly no competition. However, its penetration rate in DeFi is very low, accounting for only 2% of the total DeFi TVL.

Contenders have plenty of room to catch up. In a field where innovations emerge every day, the king of insurance is always within reach.

Cover Protocol has been innovating rapidly, even during the entire security protocol fiasco. While the product has yet to gain traction, 0-to-1 innovation is never easy. We have to remember that the Cover protocol was released less than a year ago. It's too early to say for sure which is better.

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Other Upcoming Insurance Agreements

1. Unslashed Finance

Currently in test mode. Unslashed Finance provides investors with a bucket-like risk-sharing model. The first product, called Spartan Bucket, covers 24 different risks, covering trading pairs such as custodians, wallets, exchanges, smart contracts, and oracles.

Lido Finance purchased $200 million worth of insurance from Unslashed Finance for its stETH (ETH 2.0 staking) to mitigate the risk of harsh penalties. Penalties are penalties imposed on validators of Proof-of-Stake (PoS) networks when validators are unable to maintain the network on an ongoing basis.

Two, Nsure

Nsure completed a $1.4 million seed round back in September 2020 with funding from Mechanism Capital, Caballeros Capital, 3Commas, AU21, SignalVentures, and Genblock. Currently, Nsure has been deployed on Ethereum’s Kovan testnet.

Nsure is a risk trading market. It relies on the stake in NSURE tokens to represent the risk of the protocol and use it to price it. They are running an underwriting program in the testnet to test how the pricing will work in the mainnet, and participants will be rewarded with NSURE tokens.

They also propose a risk rating scale that rates each project based on multiple criteria, including team and history, visibility, code quality, developer community, and more. In addition to the mortgage component, the risk level will affect the final policy price.

3. InsurAce

InsurAce recently raised $3 million from investors including Alameda Research, DeFiance Capital, ParaFi Capital, Maple Leaf Capital, and others, but has yet to announce a launch date.

InsurAce aims to be the first portfolio-based insurance protocol, offering investment and insurance products for capital efficiency. Unlike current insurance products where users would have to buy multiple policies if they were exposed to different agreements while doing tillage farming, InsurAce offers a portfolio based policy that covers all of the above mentioned investment strategies protocol.

• The project claims to use an actuarial-based pricing model rather than relying on mortgages or markets to price insurance. Given the lack of claim history in the DeFi ecosystem, it is doubtful that they can come up with a reliable model.

• Other insurance protocols include InsureDAO and Insured Finance.

Some derivative agreements also offer interesting insurance products, such as:

Adoption of these insurance products offered by derivative agreements has so far been lacklustre.

in conclusion

Unlike other types of projects such as DEX and lending, insurance projects have received less attention. Aside from being a more capital-intensive business, the awareness of buying insurance is less prevalent in the crypto space. As more insurance agreements will be launched this year, we may see more users use insurance.

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in conclusion

First, insurance only covers around 2% of DeFi’s total locked value (TVL), and has not yet been widely adopted.

Derivatives such as credit default swaps (CDS) and options may reduce the need to buy insurance. But compared to insurance risk pooling, these products typically require more capital to build, making insurance more expensive. Also, derivatives are, of course, more expensive because they have greater price risk.

High-risk users and retail users have the potential to dominate the current DeFi market. They may place less emphasis on risk management and therefore not consider buying insurance. When the time is right, the insurance market will gain more momentum and have more cooperation with institutional capital.

Second, the NXM price has stagnated despite the rapid growth of the business. Nexus Mutual's underlying business is functioning well, with in-force policy volumes growing steadily from $68 million at the start of the year to $730 million in February. This 10x increase is impressive, but the price of NXM has remained stagnant.

MCR% has hit the 100% floor as investors withdraw from Nexus Mutual. Investors have more options when it comes to synthesizing the Ethereum stack. Now NXM is competing with ETH 2.0 pledge service providers (Lido's stETH, Ankr's AETH), Alpha Homora's ibETH and Curve's ETH pool.

Last year, hackers stole $8 million worth of NXM tokens from Nexus Mutual founder Hugh Karp, and dumped NXM through the wNXM market, causing the price of wNXM to plummet. Since the MCR% has reached the lower limit of 100%, NXM holders cannot sell NXM through the bonding curve model. The only way for holders to exit their position is to sell through wNXM, creating a price gap between wNXM and NXM.

As long as the price gap exists, the best way to get NXM is to buy cheap wNXM. Therefore, capital will flow into the mutual aid market only until the price gap narrows. According to the formula, the price of NXM will remain suppressed until new funds flow in.

Nexus Mutual proposed a number of plans to solve this problem: create a community fund to motivate community members to participate more; explore ways to invest in idle fund pools, such as ETH 2.0 mortgages; through the introduction of stacked risk insurance, stablecoins to peg Insurance and oracle insurance to expand the product range.

Third, the launch of the Armor protocol has brought NexusMutual a huge advantage, consolidating its leading position in the DeFi insurance market. As the wNXM fund pool, arNXM intends to replace wNXM. It attracted so much wNXM that arNXM now contributes 47% of the total NXM, which helps more insurance to buy.

The current arNFT has a total effective guarantee of approximately $491 million, while Nexus Mutual has a total active guarantee of $700 million. arNFTs contribute about 70% of effective coverage.

Released only two months ago, the Armor protocol has already made an important contribution to the growth of Nexus Mutual.