Over the last two years, decentralized finance has led to the creation of new market segments, offering capital-efficient alternatives to traditional financial products and services. Users are now more inclined to allocate capital in high-yield generating protocols.
While the newly launched protocols claim to provide higher returns than their traditional counterparts, they also present a completely different risk profile to the investor. The underlying risks are complex in nature, and non-crypto natives find it challenging to identify any type of exploit.
In 2021, the total crypto losses amounted to more than $10 billion, according to Immunify’s recent report.
The lack of historical data and proof of sustainable economic models of these new protocols pose significant risks for investors. The risk element can come in many forms.
It can be related to the centralized structure of the protocol. Rug pulls are taking place through smart contract loopholes. Developers insert a backdoor exit in the code and vanish with all the funds. In the case of hackers, they are intelligently leveraging flash loans from multiple protocols to manipulate the markets.
As crypto is still a nascent industry, DeFi exploits will continue to happen. What we can do is help investors reduce the risk of capital loss. This will give investors confidence about exploring new DeFi opportunities and remove one of the main bottlenecks for widespread DeFi adoption.
So, how can we reduce the risk of capital loss?
Enter DeFi insurance. A growing sector in DeFi that enables market participants to secure their crypto investments against any type of exploit.
Let’s go through the ins-and-outs of the insurance industry in crypto and help you understand what an ideal insurance protocol operates like.
What is DeFi Insurance?
DeFi insurance is a mechanism to protect investors from various types of exploits. An investor purchases insurance cover and pays a premium to guarantee protection, and has the ability to claim lost money in case of an exploit.
For example, let us say you want to safeguard your crypto holdings from smart contract exploits. You go to an insurance service provider and buy a smart contract cover for the protocol you’ve invested in. If this particular protocol is exploited, you, with an insurance cover, will be refunded from the cover supplier’s liquidity pool. People with no insurance will get liquidated. The same applies to hacks, flash crashes, and wallet drains.
How Does DeFi Insurance Work?
DeFi insurance is conducted in a permissionless manner. The first and probably the most important component is tokenized risk pool. For investors to protect their investments, there has to be a locked liquidity pool backing different insurance covers.
These risk pools are usually supplied with liquidity by using an incentive-driven mechanism, where liquidity providers allocate funds after assessing risks associated with a protocol. If the risk is high, they get more premium payments. On the other hand, if the protocol is well known, with a proven track record, then the risk will be low, cutting down incentives for liquidity providers.
Another component in the DeFi insurance model is governance. The governance token holders have the right to verify claims. Users can provide proof and show their losses to prove their legitimacy. The claiming process can be done off-chain as well, depending upon loss adjustment providers.
Why buy Coverage for Your Digital Assets?
The crypto ecosystem is primed for massive growth. And when things move at a fast pace, it is easy to get lost and assess risk. By buying insurance products for your digital assets, you can leverage various DeFi opportunities and hedge against any risk they carry.
Even if you have invested in fundamentally sound projects, you can still be at risk. Your wallet can be compromised. Your keys can get stolen. Hackers can find loopholes in any given system as no code is bug-free.
So, you can never be 100% certain that your investments are protected.
To overcome this uncertainty, you need insurance covers. If we look at the current DeFi insurance protocols, they offer different types of covers helping with all kinds of DeFi risks. But, the problem arises when investors come to claim their guaranteed payout. Most of the DeFi protocols require proof of loss.
While it is not a bad practice to verify, it is a disservice to give special privileges to third parties. When verification is taken off-chain, the community’s claim and decision-making process take a lot of time. So it is equally important to get coverage of your digital assets and pick the right protocol to back those covers.
DeFi Insurance Landscape
- As a risk management for transferring and apportioning risks in traditional financial markets, insurance has developed relatively slowly on blockchain. According to Defillama, as of 11 March, the total lock-up amount in insurance protocols is only $1.01 billion, which covers 0.63% of the total value locked in DeFi (>$200B).
- DeFi insurance TVL is nowhere close to any other sector in DeFi. The existing insurance market is dominated by few players like Nexus Mutual, Armor Protocol, and Unslashed.
Dissecting Nexus Mutual
Insurance is one of the biggest market opportunities in crypto. As every DeFi user is under the security risks of rug pulls and scams, it is important to pick a reliable insurance provider. The market leader in the insurance sector is Nexus Mutual.
While Nexus Mutual managed to grow its cover amount and total locked value steadily over the years, there are still a few loopholes in the inner workings of the protocol, limiting its ability to drive more adoption.
Here are a few downsides to Nexus Mutual:
KYC and Centralization
DeFi was originally envisioned as a place where cryptocurrency could operate truly independently of traditional finance. Contrary to that, Nexus Mutual requires KYC to be submitted by users who wish to swap Nexus Mutual tokens (NPM), buy covers, and earn rewards from staking, governance, and claim assessment.
Limited Cover Options
The value of the cover claimants is received through DeFi insurers. Most only pay-out for technical glitches with smart contracts, which is only on a discretionary basis. Typically, insurance protocols do not provide cover for the numerous things that could go wrong in the various layers of the DeFi protocol.
Discretionary Claim Assessment Process
Nexus Mutual has a pure discretionary model where the payout is paid at the discretion of the members in NXM mutual. Every claim is assessed separately, which could take weeks time or more. In times of crisis, when protocols with thousands of wallets get affected. This model becomes a bottleneck and inefficient. The payout is not guaranteed and is completely dependent on discretion.
Neptune Mutual : The Need for Parametric Covers
- The Neptune Mutual protocol uses the parametric model (also known as index-based insurance), a new and innovative alternative to traditional DeFi insurance. A parametric coverage protects policyholders against financial loss resulting from a set event (also known as cover incident).
- The policyholders pay a premium (also known as cover fee) to get coverage for a fixed duration and desired amount. Not only the parameters of any given cover pool can be independently verified, but they are also transparent and consistent.
- There is no need for the users to submit proof of loss and loss adjusters to perform verification and/or assessment of claims. The claims payout is a quick and extremely easy process as it does not require a case to case assessment as in Nexus Mutual.
- The parametric model plays a significant role in the traditional insurance industry to protect policyholders from DeFi attacks. In addition, this coverage model has gained interest because of the ease and rapidness of getting payouts because it does not require the services of claims assessor for settlements.
Scaling DeFi Insurance With Guaranteed Payouts
Neptune Mutual provides stablecoin liquidity with a fast and immediate claim process. Users can report how they were exploited and claim their lost money without requiring to show proof.
The insurance protocol has adopted a parametric cover instead of a discretionary cover to provide faster claims. When an incident is reported and parameters are triggered, then users can immediately claim their insured assets. And the guaranteed payouts are automatically given for every user who bought the cover. This is why Neptune Mutual is more scalable than any other insurance protocol.
NPM Token Design
Unlike most insurance protocols, Neptune Mutual uses a deflationary token mechanism.
Neptune Mutual Token, $NPM, is used for governance and staking purposes. Users can stake $NPM tokens to create new covers. A minimum of 4000 $NPM tokens are currently required to create a coverage pool. The money received in coverage fees is used to pay the cover creators in commissions and liquidity providers in premium payments.
In addition, Neptune Mutual removes 6.5% of the total fees from the coverage pool and uses the money to buy more $NPM tokens. The purchased tokens are then burnt, creating a deflationary network effect.
Neptune Mutual understands that crypto is fast-paced, and few risks may not come to light. So it provides DeFi users with a platform to create their covers for protocols that may put users at risk. For example, the metaverse is booming right now, and there are many uninformed investors. You can create a cover to protect investors from any kind of meta-crimes.
The covers can be created by staking NPM tokens. After creating, the tokens will be burned. If creators want to redeem their cover fee, they can easily apply for it and claim a full refund after getting governance approval.
Liquidity Provider Benefits
It is important to have an incentive system that attracts more liquidity providers to create covers for different markets and protocols. For this purpose, Neptune Mutual provides multiple LP benefits, such as cover fee incomes, shield mining rewards, flash loan income, and lending income.
To increase LP rewards and to ensure utilization of pools, Neptune Mutual automates different farming strategies. If the utilization ratio is less than one, the LP pools have more idle or uncovered assets. These can be put to work by giving out flash loans and staking for high-interest rates. The protocol also generates lending incomes using platforms like Aave and Venus.
Progress Made So Far
The team has been building the core protocol over the last year. In March 2022, the team announced a public testnet launch that would enable users to test and interact with the protocol.
Users can use the testnet to purchase a policy, provide liquidity, report an incident, and claim covers. You can perform each action by following the steps given here. The team also announced a test-to-earn approach that incentivizes users to interact with the testnet and give feedback.
Outside of the testnet launch, the Neptune Mutual team revealed their brand new website and incorporated multi-language support with up to nine different languages available.
Our Investment Thesis
We truly believe the insurance sector to become one of the biggest industries in crypto. With the more widespread adoption of crypto and DeFi, the need for insurance products is going to increase multifold. The total locked value will only increase in the coming years, which means the number of hackers trying to find vulnerabilities in the DeFi landscape will also increase. So, it is paramount to have platforms like Neptune Mutual.
Neptune Mutual is solving the most challenging part of DeFi insurance by incorporating an easy claim process and guaranteed stablecoins liquidity. We believe this will find a good product-market fit, as more investors want to increase their capital efficiency on a risk-adjusted basis. Its uniqueness also comes from its ability to create new income streams for liquidity providers with flash loans and lending incomes.
Our long-term belief in Neptune Mutual comes from their ability to democratize insurance and their vision to create a series of security products that would protect investors from any type of crypto hack or exploit.