There are many risks in the cyber world. Having a safety net on your digital funding is necessary when you are saving a huge amount or running a business with it. With decentralized finance (DeFi) gaining popularity, new kinds of threats emerge, from protocol exploits to stablecoin crashes, making digital asset protection more relevant than ever.
This article will elaborate on what DeFi insurance is, why it is important, what differentiates it from traditional insurance, what the types are, and how to decide the suitable coverage for your conditions.
What is DeFi Insurance?
DeFi insurance, short for Decentralized Finance Insurance, is a digital service that protects your funds on the blockchain from unexpected risks such as hacks, bugs in smart contracts, and even sudden value drops. It functions similarly to traditional insurance, but with a faster, more transparent process, and best of all, without the hassle of intermediaries or bureaucratic drama.
Unlike traditional insurance, DeFi insurance isn’t managed by a third party or reliant on human involvement. Instead, it’s powered by smart contracts, making claims more efficient, automated, and objective. Compensation can be triggered automatically based on pre-set conditions when something goes wrong. In short, DeFi insurance provides a safety net for users engaging in decentralized finance activities, giving them peace of mind in an otherwise high-risk environment.
Why Is DeFi Insurance Important?
As mentioned earlier, sometimes misfortunes happen, and when they do, all you can do is find a way to minimize the damage. For instance, a hidden bug in your smart contract might go unnoticed, only to be exploited by cybercriminals, resulting in a significant financial loss.
Much like conventional insurance offers safety against unforeseen events, DeFi insurance provides a similar safety net. Whether the loss is caused by a bug, a hack, a sudden drop in asset value, or even unstable interest rates, DeFi insurance is designed to reduce your risk and give you peace of mind in the ever-volatile world of decentralized finance.
Traditional Insurance Vs DeFi Insurance
As previously mentioned, there are several resemblances and distinctions between DeFi insurance and traditional insurance. Both serve the same core purpose: protecting users from unexpected events that could result in financial loss, such as incidents, damages, system failures, or fraud. However, despite their shared goal, they operate in significantly different ways.
In traditional insurance, like house or car insurance, users pay regular premiums in exchange for protection. When an unfortunate event occurs, a claim can be submitted for review. If the claim is approved, the insurance company compensates the user based on the policy.
Similarly, DeFi insurance also requires users to pay premiums, but instead of covering physical items like cars or homes, it protects digital assets stored in blockchain systems or cryptocurrency platforms. The difference is that DeFi insurance is powered by smart contracts and often doesn’t involve a human middleman, making the claims process faster and more automated.
Even so, the main difference lies in how claims and administration are handled. Traditional insurance relies on a third party, usually the insurance company, to process claims and carry out verification. This process can take a long time due to the many administrative procedures involved. And even after completing all the steps, there’s still no guarantee that the claim will be approved.
In contrast, DeFi insurance does not involve any third party to process claims or verification. Instead, everything is handled in a decentralized manner through smart contracts or community governance. This makes the claim process faster and more transparent, as it doesn’t depend on human administrators or centralized decision-making.
Moreover, conventional insurance usually comes with set policies and limited coverage. For instance, a health insurance policy might cover physical illnesses that require prescribed medication but exclude mental health treatments or rare conditions. In contrast, DeFi insurance offers more flexible coverage options because it is designed to address a wide range of risks specific to the blockchain ecosystem, including known and emerging threats. This flexibility allows users to seek coverage for more complex or unconventional scenarios that traditional insurance might not accommodate.
Types of DeFi Insurance
As mentioned earlier, decentralized finance (DeFi) offers a broader and more flexible approach to financial protection compared to traditional insurance. Due to the complex and technical nature of DeFi, several specialized types of coverage have been developed to address specific risks. There are four primary types of DeFi insurance, each with its scope of protection and claim process.
Protocol Cover
Also known as Smart Contract Cover, this type of insurance protects users against losses caused by technical failures or attacks on a specific DeFi protocol. A DeFi protocol is a blockchain-based application that allows users to conduct financial activities without intermediaries.
Protocol Cover typically protects against smart contract bugs or hacks, economic design failures, governance attacks (where the voting system is compromised), oracle failures (incorrect external data inputs), re-entry attacks, proxy manipulation, math-related errors, and Trojan tokens. Essentially, it safeguards users from the inherent technological vulnerabilities of using decentralized applications.
Stablecoin Depeg Cover
Stablecoin Depeg Cover is designed to protect users from losses caused when a stablecoin, a cryptocurrency pegged to a traditional asset like the US dollar or gold, loses its intended value. This depeg event may occur due to market disruptions, technical failures, or declining user confidence.
Each policy specifies what qualifies as a depeg (e.g., a drop of 10% from the pegged value) and how long the stablecoin must remain below the peg for a claim to be valid. If these conditions are met, the policyholder may receive partial or full compensation for the loss incurred from holding the depegged asset. Yield Token Cover protects users from losses resulting from the depeg of yield-bearing tokens—tokens generated within a DeFi protocol when users deposit stablecoins or other assets to earn interest. Examples include yDAI (Yearn’s version of DAI) and mUSDC (mStable’s version of USDC).
When users engage in yield-generating activities, their assets are automatically converted into these tokens. If the protocol experiences a failure or hack, or if the underlying stablecoin depegs, the yield token may lose its value. This cover reimburses users for such losses. Unlike Protocol Cover, which is protocol-specific, Yield Token Cover often protects across multiple integrated smart contracts, making it more comprehensive in scenarios where yield farming involves several protocols.
Yield Token Cover
This coverage is designed to protect against financial loss as a result of a decline in the value of yield-bearing tokens. Yield-bearing token is a token that induces interest in DeFi protocols.
Yield token cover is usually considered the internal version of stablecoin, such as yDAI in Years or mUSDC in mStable. When you deposit stablecoin in DeFi protocols to gain revenue, the system will automatically convert it to yield tokens. If technical errors occur that cause the value to drop (depeg), this insurance can cover you for the loss.
Even though this seems similar to protocol cover, there is a significant difference. Protocol cover only protects a loss in one specific protocol, while yield token cover includes protocol chains that are related to the yield process.
Custody Cover
Custody Cover is designed to protect funds stored on centralized finance (CeFi) platforms such as Coinbase, Binance, or other custodial wallets. These platforms manage users’ private keys, meaning users entrust them with full control over their assets.
This type of cover protects against specific events such as hacks, fraud, and the sudden freezing or halting of fund withdrawals without notice. To file a claim, users typically need to demonstrate they lost a minimum of 10% of their assets held with the custodian. Unlike DeFi protocols, where users retain self-custody, CeFi platforms introduce centralized risks that this coverage aims to mitigate.
Overall, DeFi insurance offers tailored protection for various use cases and user needs. Whether interacting with smart contracts, stablecoins, or custodial platforms, users can find specific coverage to reduce the financial impact of unexpected events in the crypto ecosystem.
How to Choose DeFi Insurance
As mentioned earlier, DeFi insurance offers more varied coverage, thus, it is important to determine which type suits the problem you’re facing. Here are things you can consider to selecting the appropriate insurance.
Choose Assets to Protect
Similar to conventional insurance that only covers certain cars, DeFi also covers specific types of assets. Even though DeFi is more flexible and covers complex problems, you are still required to select which assets you want to protect and ensure that the coverage is on target.
Choose the Right Coverage
Connected to the previous point, after choosing which assets you want to protect, you have to identify which insurance suits your assets. Grasping the coverage and what they offer can help you understand the benefits and the rights to get compensated.
Choose the Right DeFi Insurance Providers that Offer Relevant Coverage
Once you’re sure which assets you want to protect and know what insurance you should get, the next step is to look for the DeFi insurance providers. There are some widely known providers, such as Nexus Mutual, InsurAce, Unslashed Finance, and Risk Harbor.
Understand the TnC
Some protocol covers different types, under different conditions. You need to grasp the terms and conditions thoroughly and consider what type of attacks they cover, how much compensation percentage they offer, when the right time to propose the claim if there is a bundling option, and so on.
Understand Claim Procedures
Though DeFi insurance doesn’t have to go through administrative procedures like conventional insurance, you’re still required to understand the claiming methods. There are three methods of claiming insurance, such as community voting, third-party assessment, and parametric.
- Community voting refers to the token holders from the insurance platform. They can discuss and vote regarding your claim.
- Third-party assessment refers to judgments made by experts, panels, or third-party organizations like Kleros.
- Parametric means automatic. If your claim checklists all the boxes, the system will automatically compensate you.
Disclaimer: The information provided by HeLa Labs in this article is intended for general informational purposes and does not reflect the company’s opinion. It is not intended as investment advice or recommendations. Readers are strongly advised to conduct their own thorough research and consult with a qualified financial advisor before making any financial decisions.
Hi, I'm Carina, and I've been captivated by the world of web3 for as long as I can remember. Ever since I first dipped my toes into this innovative technology, I've found myself drawn to exploring and understanding its infinite potential. The complexities of layer 1 solutions particularly intrigue me, as they form the foundation of decentralized networks and pave the way for a more transparent and efficient digital landscape.
