The Economics of Insurance (NXM Part 1)

General Conclusion

Insurance is inefficient. Insurance has a ton of opportunities. Get the economics of insurance right by incentivising the right people, and BAM, jackpot!

It is something that's still relatively quite new in the crypto, yet insurance is one of the oldest industries in the world today. We're going to deep dive into the insurance industry and split it into two parts because it is actually quite long.

This is a two-part episode.

The first part is going to be on the economics of insurance, and the second part we're going to do a deep dive into Nexus Mutual, one of the insurance providers in crypto today.

Inefficiencies in Insurance

• Current market size of insurance industry: US$ 5 trillion
• Online insurance in this segment: US $ 31 billion
• Crypto insurance (via NXM US$ 213 million

It just shows that there is a huge room for growth because online insurance allows us to aggregate more data, get more information, underwrite different types of risks, or have a better understanding of the different risks available to be providing the insurance coverage. This is just online in general and crypto and blockchain which is an even smaller niche that's another big untapped opportunity.

• Lack of trust - insurance companies are meant to act in your best interest, but they don't always do.
• Opaque information - this industry exists because of the unknown, and people try to avoid this unknown danger by using an insurance agency. But typically their opaque information is difficult to access. It is hard to assess how safe an insurer is, if they are going to go bankrupt, if they have bad debts, if they invest wisely, and so on
• Expensive overheads - If you put in $100 in premiums, you can expect only about 60 or 70 of that to go into the fund’s pool. The rest is covering costs for admins, regulations, and other boring things that COULD be automated in today’s world. We have machines, smart contracts, business logic that can be turned to code, and so on.

How to reduce inefficiency

• Solution: Rules & Regulations
• Law and prudential regulation
• Minimum capital levels, governance processes, reviews and regular financial reporting

Economics of Insurance

Economics is about risk and managing it.

• Economics of Signalling - Signaling is where we use different kinds of actions to share or hint hidden information. Compare it to poker. Signaling is similar in the fact that in poker, you are trying to share the information of how strong your hand is by the actions you make. In the insurance space, pricing is a signal, a way to show and share information. As we said, there is a lot of opaque information when it comes to insurance, so we use pricing as a signal to figure out what info needs to be subtly shared.
• Economics of moral hazard - Unlike hidden information, this is all about the problems caused by hidden actions. Moral hazard is the actions after a hidden action happens.
• Principle-Agent relationship - back to moral hazards, the solution is to align incentive of both parties. We want both parties aligned. If both parties are benefiting from each other it helps them grow. In the crypto world, it is difficult to define the PA Relationship because we have anonymity. With smart contracts and data, it’s easier to rely on code to underwrite different risks available.
• Law of Large Numbers - The economics of the entire insurance industry is all about numbers. It’s about aggregating different kinds of risk profiles of people because some people are riskier than others. This is where crypto can perhaps become a breakthrough because we are talking about a distributed data set that cannot be modified, edited, or changed so you can aggregate this trustworthy data once it is verified. Crypto has a lot of potential in insurance and as we learn more it can become an even bigger option.

Risks in DeFi/Crypto (hence Insurance)

Examples of risks

• DAO hack
• Polkadot parity multi-sig freeze
• YAM finance governance token rebase contract
• Liquidation in Maker’s vaults
• bZx smart contract exploit

3 Main Risk Profiles in Crypto

• Internal technical risk - Internal technical risk includes things like smart contracts and code on solidity, as well as potential hacks. This is something you can quantify and put a price on said risk.
• External technical risk - Next, external risk. This is a bit more difficult to define and judge. It is a bit more out of your control. It can still be written on code, but it's a bit outside the scope of your jurisdiction. Things like governance attacks, oracle failure, and other things that are on-chain but external to your primary ecosystem. These risks are currently hard to analyze as there is a lot of information to process that we aren’t familiar with yet.
• Economic incentive risk - Lastly, economic incentive risk. Things like how votes can be manipulated, the concentration of power, how does this economic incentive affect people’s behaviors, and so on. It is a long chain and difficult to quantify the risk but is important to consider. These economic systems in place are new. Right now we are using tokens as a way of incentivization. If we are using incentives that can affect people’s behaviors surely there is a risk, but it proves hard to quantify said risk.

P2P Risk Sharing Model

In traditional insurance, you have two parties. The first party is the principal (like you and me), and the agent that sells the insurance.

In DeFi we are looking at decentralisation, so we have three different parties: the principal, the risk assessor, and a claim assessor. The claim assessor will be the person that comes in and decides if a person deserves a payout or not. The three parties will be working hand in hand to distribute the risk available in the entire system.

Economics of Nexus Mutual (High Level)

High level summary: It is a decentralized insurance protocol that is on the Ethereum platform. They pull all the different assets together. For example, you have your DAI and your Ether and it's pulled together to be governed by the three types of users we mentioned before.

NXM Token

So what does the NXM token do? The entire purpose of the NXM token is to be traded in the primary internal economy. The bonding curve balances the token prices with the collaterals that are available. NXM is not fixed but rather changes based on the number of collaterals, with the amount of funds it covers changing.

So, if you think about it, the NXM price is a signal to the information on how much people trust NXM and how many people are willing to use it. As mentioned earlier, we need signals in this industry, and this is exactly what NXM is providing to those looking to purchase or sell. The foundational principles never change, but how we use signaling in a new technology stack is mind-blowing!

The price of the token becomes a different kind of signal. It is signaling the adoption rate of DeFi protocols. In DeFi you have the total locked value and prices of the tokens. You have this different matrix to understand the growth, which is good. But, to really understand how the mass population is adopting DeFi you don’t look at the total locked value, because there is going to be a lot of double counting. Instead, you should be looking at the risk profile of people.

If more people are purchasing insurance then you know they are making riskier investments, and they have faith in the system. BUT, they are also a bit afraid of the risk, so they are buying insurance. Also, it most likely means more people are coming into the space, and want to protect themselves in their new journey. More people coming in is a much better tool to evaluate than the total locked value, as one purchase by a whale can change the number drastically but doesn’t paint the entire picture.

Conclusion

Decentralised insurance is basically going back to where insurance first started - it was decentralised. We are now looking at reducing the inefficiencies by having various incentives to motivate the right behaviours. Right now, we are getting the low hanging fruits of risks in smart contracts. There are more risks in DeFi, of course. Especially since we are designing various incentive mechanisms! We are still in the early days.

Get smart: Insurance in crypto is still nascent. There is a lot of growth. But to be the winner is to understand how to define and value the risks.

Get smarter: We are nowhere near where we want to be yet. Lots of opportunities, but a huge risk too. NXM is a good base level, and we will see more products built upon NXM instead of building a "new" NXM. With NXM's protocol staking system, we are likely to see more allocation of new incentive models appearing too.