On Decentralized Insurance’s Development and Value-Capture

Insurance, one of the earliest envisioned use-cases in the DeFi sector, has yet to gain the same momentum as decentralized exchanges: $230 million to $2.7 billion is the difference in market cap, according to Delphi Digital. Concurring that the insurance sector is underdeveloped, the Cambridge Center for Alternative Finance’s (CCAF’s) latest benchmark survey notes that less than 0.5% of the insurance market goes to cryptoasset coverage, and finds that 46% of surveyed cryptoasset service providers were not insured against any category of risk, with ‘cybercrime’, ‘professional service error’, and ‘loss or theft of private keys’ the risks covered by providers with insurance. 

Whereas the CCAF frames the insurance sector’s underdevelopment as a security issue—“The safety of cryptoasset storage should not be left to well-designed IT security systems alone. The insurance of funds is a key component of a sound service offering.”— Delphi suggests there may also be investment opportunities. In particular, Delphi Digital’s Jose Macedo argues that projects in the insurance sector are better positioned to capture value than decentralized exchanges. 

While observing that liquidity functions as a ‘moat’ in both DEXs and insurance, making it difficult for newer entrants to attract incumbents’ users, Macedo highlights some key differences in how insurance platforms and DEXs benefit from liquidity. Insurance platforms, with greater liquidity and capital, can underwrite different types of risks altogether, whereas greater liquidity only allows DEXs to offer better pricing; incumbent insurance platforms are likely to benefit from more diverse offerings. Likewise, in contrast with DEXs, expanding liquidity alone will not enable new entrants to compete with incumbent insurance platforms on price, since price in insurance is a function of leverage—new entrants would need to also underwrite a diverse set of risks to compete. Finally, whereas liquidity provision for automated market makers is passive, in insurance, supply-side liquidity providers “…have skin in the game and must accurately assess claims to ensure the long-term growth of the platform.”

Despite offering reasons to believe that insurance platforms are better positioned to capture value than exchanges, Macedo acknowledges that value capture is only one factor in assessing projects for investment, with market fit, and, distinctive to the crypto industry, the token’s ability to accrue value being two other important considerations. A deeper dive into the types of cryptoeconomic models typically utilized by DEXs and insurance would offer additional context on whether and how the value captured by a particular project will accrue to a project’s token. In addition, the prospect of offering insurance in a DeFi context necessarily involves the assumption of a wide range of risks related to the underlying functioning of the projects and protocols in question, and without some certainty regarding the nature and scope of the underlying risks being assumed—prospects that are considerably different then the knowledge traditional life or auto insurers bring to the markets they insure—one cannot help but wonder if short term entrants into the DeFi insurance markets may be assuming more risk and liability than they are able to quantify or appreciate.