DeFi Insurance & Nexus Mutual

DeFi is one of the fastest-growing areas of the crypto ecosystem because it does not rely on a central intermediary for traditional financial services, such as trading, borrowing, and insurance.

The current centralized institutional insurance model is inefficient as it leads to large frictional costs borne by customers. However, blockchain DeFi technology has the potential to optimize the transactional process by allowing individuals to transact directly with one another enabling the possibility to replace core insurance entities as we know them.

Evolution of the Current Insurance Industry

Insurance has evolved from a community-based model into an adversarial model where centralized institutions dominate the industry. Before the mega-insurance conglomerate era, communities would pool their resources to protect each other from common risks. All funds were raised in hopes of benefiting members of the greater community at large. The senior members, or leaders of a community, would decide whether the communities’ resources would assist or not. The objective of the structure was to provide transparent and dependable insurance coverage, although not yet established as a financial tool, to communities with no profit-seeking component. In the 17th century in England, the mutual insurance concept was more formally developed to cover property losses from fire. The first example of a mutual achieving significant scale was in 1752 when Benjamin Franklin founded the Philadelphia Contributionship for the Insurance of Houses, the oldest property and casualty insurer in the United States.

Since then, the profit-seeking “shareholder model” has become far more prevalent as insurance exposures have become more difficult to underwrite and because it provides a far more efficient business model — benefiting from economies of scale. Mutuals in the 20th century had trouble managing governance and fundraising at scale so would become insolvent much quicker than stock companies.

Solutions that Blockchain Offers the Current Insurance Model

Blockchain technology has the potential to reverse this trend, which has been to the detriment of policyholders, allowing decentralized mutual companies to profit and their members to benefit from a more transparent and cost-efficient model.

The traditional insurance landscape is flawed with administrative inefficiencies and sunk costs. McKinsey reports that in the traditional insurance model, 35% of insurance premiums are lost due to frictional costs in the system and only 65% of premiums are returned to customers via claims. With Nexus Mutual, the cost for a shareholder to join the pool is significantly lower and the added-value benefit is significantly higher. Reducing administrative costs by up to 18%.

Fortunately, the peer-to-peer insurance mutual model made possible by blockchain technology recreates the cost-effective community-based model with the same economies of scale as the mega-insurance company model. In essence, blockchain technology and smart contract can rid the insurance industry of administrative inefficiencies and large portions of governance and regulatory costs because it regains a cooperative ethos while preserving the benefits of diversification. The most apparent solutions brought on by the blockchain-backed insurance model include the following areas: Claims assessment, membership participation, pricing, governance, distribution, legal, product development, capital requirements and funding — More on this soon in the context of Nexus Mutual.

Reasons for DeFi Insurance

As institutional capital continues to flow into DeFi, the risk and reward for hackings grow exponentially. Most importantly, the anonymity of the ecosystem allows hackers to easily get away with hacks when they see the opportunity to strike.

User security and fund recovery continue to plague the crypto industry confidence. Today, many smart contracts that store Ether are vulnerable to hacks and other loopholes. Traditionally, central authorities, such as banks or credit card companies, are responsible for an individual’s lost funds in the case of a robbery or hack. However, in the crypto ecosystem, the power and advantage of the decentralized framework result in no central company protecting one’s funds.

Consumer confidence and mitigation of losses from these sorts of attacks are vital for crypto to become mainstream. Currently, those that are ‘self-custodians’ for their funds have no protection on their holdings. Additionally, a significant number of smart contracts are unaudited and subsequently vulnerable to security breaches. As the sector continues to mature, the need for DeFi will continue to expand its range of products.

As the DeFi sector matures, DeFi insurance will expand its product range. For now, the rise of DeFi and smart contract insurance will likely come to the forefront in the minds of crypto investors as DeFi applications continue to accrue value in the underlying smart contracts.

Nexus Mutual Overview

Nexus Mutual is a UK headquartered decentralized insurer operating under a mutual structure. Founded in 2017 by Hugh Karp, the company launched its first product in May 2019 and has raised from VC firms including Kenetic, Block0, Blockchain Capital, and others over three stages of funding.

Nexus is an open platform on Ethereum where members pool and share risks. The mutual is 100% owned by its members who are entitled to dividend payments as the mutual generates underwriting profits. Its native token, NXM, can only be purchased and held by members of the network. Membership is available to anyone purchasing coverage in ETH or NXM through the Nexus platform and there is no minimum premium required to participate.

Nexus currently provides a single product, Smart Contract Coverage, which protects against “unintended code usage” resulting in a financial loss. The coverage is flexible where buyers choose their smart contract — any Etherscan-verifiable contract or related contracts for more complex Apps — the duration, and the coverage amount.

How it Works:

Purchasing Coverage

To purchase cover, interested parties can simply sign up on the Metamask platform, declare the smart contract address they would like to cover, and declare the cover amount in either ETH or DAI currencies. Once the signup is complete, members may become decision-makers by staking a portion of their tokens. Those decision-makers are granted the power to accept or reject a claim (the only options to vote are yes or no), with a majority of 70% vote, almost instantly. While non-blockchain-backed insurance companies often try to find flaws and loopholes to avoid hefty claim payouts, the Nexus Mutual model is designed to incentivize assessors to make an honest judgment and to increase the number of participants, yielding rewards in NXM for consensus outcomes.

In addition, the claim assessors typically hold a significant stake in the pool and are tied to the overall success of the fund. Before making an assessment, part of an assessor’s stake is deposited in the form of a membership token. At this time, the assessor cannot access the token until a decision on a claim has been finalized. If the internal Advisory Board (composed of experts from the worlds of insurance, mutual management and smart contract security) deems an assessor to act dishonestly, the reward tokens may be burned. To prove the legitimacy of the model and avoid shareholders cheating the system, honest human judgment and active participation of the membership base are required.

Insurance Products Offered

At present, Nexus Mutual offers two products: Protocol Coverage, protecting against material loss of value resulting from failures in either the protocol code, economic design, governance set-up or oracles, as well as Custody Cover, which protects against material loss of value resulting from centralized exchange hacks and discontinued access to withdrawals beyond 90 days. Claim qualifications and guidelines are clearly outlined in wording, with constraints, such as a 72-hour cooldown period before submitting a claim and deadlines of 35 days of the coverage period ending. The products are sold at a transparent base pricing

The Purpose of NXM Tokens and Tokenization

In the nexus mutual ecosystem, there is a token called NXM (ERC20) which represents the membership, and NXM can be used to purchase coverage as well as participate in claims assessment, risk assessment, and governance. The main purposes of tokenization are as follows:

1. Capital Efficiency — Tokenization enables a scalable way to raise risk capital.

2. Aligned Incentives — Periodical distribution of NXM to contributors of the ecosystem works as incentives for more engagement.

3. Value and Performance — NXM price rises as adoption and performance of the nexus mutual increases.

NXM Token Uses

NXM token is used to achieve four main operations within Nexus Mutual:

1. Purchase Cover — Members can use NXM to purchase cover while 90% of NXM used is burned and 10% of NXM is retained by the member that can be used as a deposit when submitting claims.

2. Governance — Members who participate in voting can earn NXM.

3. Claims Assessment — Members who want to vote on claims will stake NXM, and members who vote with the consensus earn new NXM as a reward.

4. Risk Assessment — Members can stake NXM against any smart contract to lower the price of cover, and when the cover is purchased, the staker earns new NXM.

Staking

The Nexus Mutual team introduced a staking system called “pooled staking;” it is a staking system that determines how much cover can be written on any smart contract. Any participants can become a risk assessor by staking NXM and receive rewards (equivalent to 50% of the cover price of NXM are distributed, see Exhibit V) while they implement risk assessments of the cover. In addition, the deposited NXM will be burned if there is already an accepted claim on that contract. The NXM staking process is outlined as follows:

1. The risk assessors determine that they think a smart contract is secure.

2. The risk assessor stakes NXM (Nexus native token) on that smart contract.

3. Coverage is now available for members to purchase.

4. Member purchases are covered on that smart contract and are protected in the event of a hack.

5. The risk assessor gains rewards based on the cover purchased.

6. If a hack takes place and successful claims are made, the risk assessor’s stake gets burned (which then goes towards paying out claims)

Future Considerations & Opportunities

In the near term, Nexus Mutual plans to design products for the cryptocurrency enthusiast market. By focusing on this market, Nexus can focus on building a product with a clear consumer need that can be handled with current DeFi capabilities. This will also provide the mutual with time to test out its code and search for bugs and potential enhancements before rolling out a more comprehensive product suite to members.

Once the mutual has taken off and is processing claims, the team will naturally move to provide more decentralized insurance products using the protocol. With this in mind, we should expect to see crypto wallet coverage in the short term with more generalized traditional applications including earthquake and flood in the mid-to-long term.

With Ethereum as a technology layer, Nexus has an open API architecture that anyone can integrate with. For example, they can connect with AI or IOT devices to capture real-time data that can provide huge underwriting advantages. In addition, as a fully ‘open API’ insurer, courtesy of Ethereum, they can be a reinsurance capital layer that anyone can use to get underwriting capacity and distribute their product (ie. reinsurance as a service), closely resembling the Lloyds of London syndicate model.

Nexus distributes its products solely through its platform which limits its exposure to future members. In the future, we expect distribution to be embedded with third parties such as Compound whose risks are insured with Nexus.

The nature of accessibility in DeFi provides an intriguing opportunity for insurance applications to reach underserved markets. One example theorized by the Nexus Mutual team is the ability to provide insurance on earthquake damages in developed markets.

Final Thoughts

Nexus Mutual has taken an innovative approach in providing DeFi insurance on the Ethereum ecosystem that is powered by the people. While insurance is not always considered within the crypto ecosystem, it adds tremendous value to the DeFi community in terms of consumer confidence and mitigating against losses. Hence, Nexus Mutual has tremendous potential to grow and provide investor protection, while reinstating confidence to users interacting with value-storing contracts. The accessibility that Nexus Mutual offers the network is key to the continued success and confidence of DeFi as an industry. Additionally, the improved accessibility of decentralized insurance is an intriguing opportunity to reach underserved markets moving forward, which is why Nexus Mutual has the potential to disrupt the multi-trillion-dollar mega-insurance industry as we know it. Moving forward, the Nexus Mutual mission, ethos, technological backing, and potential use cases make it a compelling company with tremendous upside for its members.