DeFi Insurance Explained: Shield Your Crypto Investments

Decentralized Finance is coming up as the future of finance. However, the higher the DeFi industry grows, the higher it will be associated with risks. Therefore, adopting safety means to protect your digital assets is crucial to prevent any losses. 

In this blog, we will discover about DeFi Insurance, the ultimate solution to scams and frauds in the crypto world and discover how it enhances the investor’s trust and security. 

What is DeFi? 

Decentralized finance is the digital finance which operates on the blockchain network. Unlike traditional finance systems, which had a middleman (banks) to do transactions, decentralized finance allows people to deal with their finances directly, which in turn reduces the extra fees. 

However, as the field of DeFi is constantly evolving, it is raising concerns regarding the management of associated risks with cryptocurrencies; let us understand these risks first: 

Risks associated with DeFi

Price Fluctuations 

Crypto assets undergo extreme price swings in short periods of time. Their prices are affected by various factors like market sentiments, regulatory news, technological advancements, and trends. 

Scams & Fraudulent Schemes 

Scams and fraudulent practices are very common in the crypto world. Promising high returns with little risks is how fraudsters attract a high number of investors. 

Security Risks 

The DeFi ecosystem is vulnerable to cyber-attacks and data breaches. Also, there might be flaws in the code of smart contracts that also cause security risks and operational disruptions. 

Thus, to control all these risks, certain protection and security are required to retain people’s trust in DeFi and let them invest their money trustfully and safely. 

What is DeFi Insurance?

DeFi insurance is the solution that safeguards the investor’s money in different types of crypto assets. Similar to traditional insurance, investors pay a certain amount of fees periodically (monthly, annually), and they get protection for their investments for various types of risk coverages; DeFi insurance has brought this kind of security to the digital finance world. 

How DeFi Insurance Works? 

DeFi insurance works by collecting pool funds from investors through smart contracts to cover the losses. Investors pay premiums to safeguard their investments and cover their potential risks, which are used by the insurance platform to create a money pool. Whenever any investor suffers a loss of money in a way that the loss is covered in the insurance, they will get paid for their losses using the pool funds. 

In DeFi insurance, a third party is replaced with a cooperative (co-op) model, and any person who is paying the premium has a say in all the claims and operations of the insurance company. To get insurance coverage, any person must purchase a part of the co-op, a stake in the protocol. People paying this premium can actively take part in the decision-making, and they will vote for different cases depicting their opinion on whether the claim should be given for a certain situation or not. However, if the board keeps on denying legitimate claims, people will eventually lose trust, and this will definitely backfire on members of the co-op. 

Types of Defi Insurance 

DeFi insurance does not work in a “one shoe fits all” manner. It ensures that each insurance coverage is tailored to the loss and its impact. Below given are the three categories that cover falls into: 

Protocol Cover: 

It covers the losses that arose from the fault in DeFi’s protocol, like exploitation of smart contracts, data breaches, economic design failure, and governance failure (when evil-intentioned players gain the power to modify contract rules, leading to network failure). 

Stablecoin Depeg Cover:

Stablecoins are supposed to have a stable value against a real-world asset. However, stablecoin depeg cover takes care of the situation when the stablecoin loses its value or its peg against its intended asset. 

Yield Token Cover 

Yield tokens are the tokens that gain interest over time. The interest they are supposed to gain is called their face value. However, sometimes, the price at which they are sold (market value) is a significant drop compared to their face value, and yield token cover protects the investors against this type of loss. 

DeFi insurance is not considered the standard protection policy in finance, which is why it is called out with different names like “cover,” insurance alternatives, or DeFi fund protection. 

Pay Out Systems For Coverage in DeFi Insurance

There are two models which cover the asset losses; let us discuss them in detail: 

Discretionary Insurance Model 

The Discretionary Insurance Model is the non-contractual model in which the claim would be given purely on the basis of the judgment of the provider. This type of model does not guarantee the reimbursement of the claim, even if it falls in the valid category. Moreover, the process of reimbursement is long and complex as a detailed evaluation is done to validate the policy’s scope. 

Parametric Insurance Model 

The parametric insurance model has clear and binary terms (parameters) that are used to trigger payouts. In this type of model, the pre-defined circumstances or events that happened are considered rather than the loss; for example, in the case of an earthquake, the earthquake’s magnitude will be considered rather than the damage it did, which makes the reimbursement process quite quick and simple. The parametric insurance model is beneficial for certain risks in the blockchain space.  

Use Cases of DeFi Insurance 

Now that we have understood the basics of DeFi insurance let us move forward to its use cases. 

Smart Contract Coverage 

For the last eight years, Ethereum smart contracts have been targetted by hackers, due to which investors have lost significant amounts of money. To handle this situation, Ethereum introduced its defense mechanism, Smart Contract Cover, which provides protection to investors against any unintended code use that results in financial loss. Thus, by guaranteeing safety, Ethereum has successfully gained the investor’s and developer’s trust, as the blockchain now has an added layer of security for both parties. 

Collateral Protection Insurance 

This type of insurance provides protection against collateralized crypto loans through an insurance contract. It provides both the lender and the borrower with security in case the collateral against which the loan is sanctioned gets stolen or lost; hence, collateral protection insurance is a great deal for cryptocurrency lending networks, and it benefits in boosting stakeholder’s trust for lending or borrowing in crypto space.  

Crypto Insurance 

It is no surprise that the crypto market is vulnerable to fraud and scams, and many such incidents happen every day. Therefore, crypto insurance is the solution that provides a wholesome security to the whole scenario. With the help of crypto-insurance, the investor can get reimbursement for any type of loss like loss due to exchange hacks, custodian failure, price volatility, and so on.  

Crypto Wallet Protection 

Crypto wallet theft due to security breaches is another challenge that the crypto market experiences. Safeguarding your digital assets is as important as saving your real-world assets. Users should keep strong passwords and should not share any privacy keys. Also, insurance may cover different hacks, depending on the insurance provider’s policies. 

Benefits of DeFi Insurance 

Now let us brief about the benefits of DeFi insurance into three main points: 

Evaluating Risks

In decentralized insurance systems, all the risks and losses are calculated automatedly which reduces human errors and provides reimbursement to the investor for every penny they lose. This system has the edge over the traditional insurance system where risk assessment is done manually, and thus, helps in saving time for both parties. 

Ensuring Security 

Most people make fraud claims which would result in insurance companies providing extra money to these fake claims and fraudsters. Therefore, with the help of decentralized insurance systems, the data and transactions would be kept transparent and automated, which would reduce the chances of fraudulent activities and external manipulation and thus prove beneficial for the claim providers. 

Enhancing Automation 

By using automation for payments, decentralized insurance systems streamline claim procedures and do timely settlements that add the cherry on the cake for people who actively invest in crypto and enhance their trust in the crypto industry, ensuring its wide spread adoption. 

Thus, the crypto industry is growing at a rapid pace, and the only obstacle it has on the way is its vulnerability to frauds and scams, which stop people from freely engaging and investing in crypto-related activities. However, DeFi insurance or crypto insurance is the one wholesome solution that would help the crypto businesses to promote wider adoption of crypto by safeguarding the digital assets of the investors and reimbursing any losses they might face.