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DE.FI. PROTOCOLS IN THE INSURANCE INDUSTRY BUSINESS MODELS, AND VALUATION ANDREA CESARETTI & ROBERTO MORO-VISCONTI

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Abstract and Figures

The insurance industry can benefit from the introduction of blockchain, smart contract and decentralized finance (De.fi.). The De.fi. introduced a new paradigm of insurance however it respects, in any case, the fundamental principle of insurance that is the community of risks and the common contribution to the reserves. The automation inherent in smart contracts reduces conflicts, the need for trusted intermediaries, execution costs, the risk of fraud and defaults and litigation. Moreover, the De.fi. protocols for insurances solve the information asymmetry and allow access to these investments to the general public who participate in risk pools by buying tokens. Tokens in De.fi. insurance protocols are fungible and hybrid, and their nature as utility, security or governance tokens depends on their use. In the De.fi., the replacement of intermediaries with programmable smart contracts does not allow the application of traditional theories of risk management and it is necessary to use a totally different approach. The challenges for De.fi. insurance companies are to offer easy access to the public, and at the same time, safeguarding jobs in traditional insurance in order to breach the barriers at the entrance. Business modelling is a prerequisite of business planning and consequent corporate valuation.
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BSTRACT
The insurance industry can benefit from the introduction of blockchain, smart contracts, and decentralized
finance (De.fi.). The De.fi. introduced a new paradigm of insurance however it respects, in any case, the fundamental
principle of insurance which is the community of risks and the common contribution to the reserves. The automation
inherent in smart contracts reduces conflicts, the need for trusted intermediaries, execution costs, the risk of fraud and
defaults, and litigation. Moreover, the De.fi. protocols for insurances solve the information asymmetry and allow access
to these investments to the general public who participate in risk pools by buying tokens. Tokens in De.fi. insurance
protocols are fungible and hybrid, and their nature as utility, security, or governance tokens depends on their use. In the
De.fi., the replacement of intermediaries with programmable smart contracts does not allow the application of traditional
theories of risk management and it is necessary to use a different approach. The challenges for De.fi. insurance companies
are to offer easy access to the public and at the same time, safeguard jobs in traditional insurance to breach the barriers at
the entrance. Business modeling is a prerequisite of business planning and consequent corporate valuation.
Keywords: #insurance #blockchain #de.fi. #smartcontract #oracles #augmented business planning
CONTENTS: 1. Introduction - 2. Decentralized finance (De.fi.) - 3. Blockchain - 4. Smart contracts
- 5. Oracles - 6. Tokens - 7. Features of the De.fi. insurances - 8. Parametric policies - 9. Positive
effects of disintermediation in the insurance industry - 10. Business Model - 11. Risks of the De.fi.
protocols – 12. From business planning to valuation patterns - 13. Conclusions.
1. Introduction - Insurance is the transfer of a feared risk from an individual to a community
upon payment of a premium the amount of which is determined in advance
1
. At the heart of the
insurance contract is therefore the community of risks. The insurer acts as an intermediary between a
community that shares the risk contributing, with its own funds, to the constitution of the reserves.
1
https://www.golinucci.it/storia-delle-assicurazioni
2
Protection from risks is a need that has ancient roots. The first insurance company was
founded in the port city of Genoa, in 1424, and is called Tam mari quam terra, but already in 2.700
b.C. established in ancient Egypt a mutual fund for funeral expenses of stonecutters
2
.
Today, the global insurance industry has reached $7 trillion (by mid-2022
3
). The number of
people employed in the industry in 2020 amounted to 2.86 million in the United States
4
and more
than 1.7 million in Europe
5
.
One of the latest technological innovations that the insurance industry can benefit from is the
introduction of blockchain, smart contracts, and decentralized finance.
Business models developed in the fully decentralized finance system concern, for the moment,
the parametric policy sector, but it is not excluded that, thanks to artificial intelligence, they can
extend to more complex policies.
Blockchain, smart contracts, and decentralized finance are important innovations, but they
respect, in any case, the fundamental principle of insurance which is the community of risks and the
common contribution to the reserves.
In the De.fi. field, there are fully decentralized models and other hybrids that need human
intervention. In this paper, we analyze the business model of a fully decentralized system.
2. Decentralized finance (De.fi.) - Decentralized finance (De.fi.) is a financial infrastructure
based on distributed ledgers like those used by cryptocurrencies. It consists of open and interoperable
protocols that operate based on smart contracts and decentralized applications (DApps) deposited in
public (permissionless) blockchains that are open networks available to all. Contractual agreements
are executed by the code and transactions are made in a safe and verifiable manner.
Its main purpose is to remove the control of financial intermediaries over money, products,
and financial services. Therefore, the De.fi. architecture can create an immutable, interoperable and
transparent financial system with equal access rights and no need for custodians, central clearing
houses, or escrow services as most of these roles can be assumed by smart contracts.
3. Blockchain - The blockchain is based on a network of computers and, from a functional
point of view, allows to manage a database in a distributed way. From an operational point of view,
it is an alternative to centralized archives and allows the updating of data with the collaboration of
network participants and the possibility of having data shared, accessible, and distributed among all
participants. It allows data management in terms of verification and authorization without the need
for a central authority. Its features are the digitization of data, decentralization, disintermediation,
traceability of transfers, transparency/verifiability, and immutability.
De.fi. uses public blockchains and, in particular, Ethereum for its ability to manage smart
contracts
6
. The main features of public blockchains are full transaction transparency, open-source
2
https://www.assicurazione.it/storia-delle-assicurazioni.html
3
https://www.insurancebusinessmag.com/us/news/breaking-news/global-insurance-industry-could-hit-new-record-in-
2022-317017.aspx
4
https://www.statista.com/statistics/194233/aggregate-number-of-insurance-employees-in-the-us/
5
https://brokersireland.ie/wp-content/uploads/2020/01/BIPAR-report-Figures-on-insurance-intermediaries-Dec2019.pdf
https://www.statista.com/statistics/441430/insurance-sector-number-of-workers-europe/
6
Buterin, V. (2013). Ethereum Whitepaper
3
development, pseudo-anonymity
7
, lack of a central authority, and massive use of tokens and other
digital resources as rewards for participation.
4. Smart contracts - Smart contracts are computer protocols that facilitate, verify, or enforce
the negotiation or execution of a contract. It is not, in reality, a contract understood in the traditional
sense of the term, but functions if this ... then do that” made possible thanks to the operation of
software capable of making automatic the execution of a contractual clause to the occurrence of a
given condition. This feature allows the reduction of the need for trusted intermediaries, the reduction
of execution costs, and the elimination of fraud and defaults with the consequent reduction of legal
actions.
5. Oracles - Blockchain oracles are computer codes that allow blockchain to interact with the
physical world. Blockchain protocols and smart contracts can only process information and data that
are located within the same network. Through oracles, smart contracts can draw on real-world data
and trigger a specific reaction based on the contractual rules encoded within them (e.g. flight
delay/compensation payment).
6. Tokens - A token is a digital asset that can only be used in blockchains, confers powers and
rights to the possessor, and can be transferred between two entities without the need for
intermediaries. Cryptocurrencies are themselves tokens, but the term is used by all cryptocurrencies
and, more generally, all digital assets other than bitcoin and Ethereum.
Tokens can be used in many different ways: they can give the right to receive a service or
good from the issuer (Utility Token), and they may represent the right to participate in an activity
with or without the right to receive dividends or other types of returns and with or without the right
to vote (Security Token). At the same time, all these types of tokens can be traded and held like any
other cryptocurrency.
Previous tokens are fungible or interchangeable and are therefore important for their value
rather than the token itself. Another category of tokens consists of Non-Fungible-Tokens (NFTs)
whose main function is to allow the certification of an asset, digital or physical. NFTs are unique or
not substitutable with each other and this characteristic is the guarantee and proof of ownership of the
digital or physical asset connected to them. The related smart contracts (as the NFT are smart
contracts) also contain the rights attached to that asset.
In the De.fi. insurance model that is described, the nature of tokens is fungible and hybrid.
The investors in the token are divided into two categories. The ones in the first category take
an active role because they use the protocol. As they put tokens at stake in the pool, investors in the
first category are entitled to rewards and dividends. The investors in the second category take a
passive role by investing in the token only in the expectation of its appreciation without having a real
interest in the project. In consequence, they do not have property rights because they do not entitle to
rewards and dividends from staking.
What is interesting is that the property rights (right to rewards and dividends) do not depend
on the category of tokens, but on their use (in stake or not) at the free choice of the holder. These
7
Pseudo-anonymity is a weaker form of anonymity. In blockchains such as Bitcoin or Ethereum, an alphanumeric code
is the pseudonym of the person holding the corresponding private key. Any transaction made to or from that code can be
traced back to the person whose identity remains unknown.
4
tokens are utility tokens because they contribute to the operation of insurance coverage, but they
assume the character of security tokens when they are put in pools.
For the sake of completeness, however, it should be remembered that some authors argue that
the tokens of decentralized finance do not pass the Howey Test
8
(and, therefore, are not secure)
because their value isn't generated by the efforts of others
9
.
In some De.fi. insurance models, the token also gives the holder (who deposits tokens in the
pool) administrative rights and, in particular, voting rights on matters such as changes in premiums,
authorization for special claims, etc. In this case, the token also assumes the function of a governance
token.
7. Features of the De.fi. insurances - The business model we are considering has the following
characteristics:
- the absence of a person who centralizes all transactions as is the case with traditional insurance
companies. All operations take place within the framework of the blockchain and, therefore, in a
decentralized manner;
risks are taken only through parametric policies;
the identification of events giving the right to compensation takes place through oracles;
compensation payments to parties contributing to the ecosystem (development teams, data
providers/oracles, license providers, distributors, investors) are managed by smart contracts;
also, transfers between risk pools are managed by smart contract;
the financing of risk reserves is open to any person wishing to contribute through the purchase
and subsequent deposit of tokens;
as a further effect of the decentralization and transparency inherent in the blockchain, all data
collected within the protocol, including smart contract codes, are available to the public. The data
of the subjects participating in the ecosystem naturally enjoy the pseudo-anonymity guaranteed
by the blockchain.
8. Parametric policies - Parametric policies are insurance policies that provide for the right to
obtain compensation at the occurrence of an event that has already been established in the policy at
the time of executing the contract regardless of the actual damage that has occurred.
The claim, the occurrence of which causes compensation, is linked to certain well-defined
parameters such as the delay or the cancellation of a flight, a given number of days of drought, the
blocking of computer systems due to anomalies or hacker attacks, etc.
If the event stipulated in the contract occurs, the policyholder has the right to receive a lump
sum compensation regardless of the damage he has suffered.
In traditional insurance, compensation is calculated based on the damage that actually
occurred and documented by an expert report. In parametric insurance, on the other hand, the
insurance company provides a pre-established service based on the probability that that particular
8
In the US to qualify a token as security, it must pass the Howey Test based on 4 points: (a) A party invests money, (b)
In a common enterprise, (c) With the expectation of profiting and (d) Based on the efforts of a third party. The "Howey
Test" is a test created by the Supreme Court for determining whether certain transactions qualify as "investment
contracts." If so, then under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are
considered securities and therefore subject to certain disclosure and registration requirements.
9
Kim, The Howey test: A set of rules that determine if an investment is a security, 2022 in
https://www.businessinsider.com/personal-finance/howey-test?r=US&IR=T.
5
event will happen. For these reasons, in parametric insurance, the premium is calculated based on the
probability of an event, unlike traditional insurance, in which the premium is calculated according to
the characteristics of the insured risk.
9. Positive effects of disintermediation in the insurance industry - The automation inherent in
smart contracts reduces conflicts, the need for trusted intermediaries, the execution costs, the risk of
fraud and defaults, and litigation.
Even when traditional insurance companies are listed on stock exchanges, the number of
investors is limited and, consequently, only a small circle benefits from the relative returns. The De.fi.
protocols allow access to these investments to the general public who participate in risk pools by
buying tokens.
Another problem with traditional insurance is information asymmetry. These companies,
along with others in other industries, store and manage a huge amount of data of people they have
relationships with and use to create insurance services (at worst to create an additional source of
revenue from the sale of the data). In these cases, parties (including clients) outside the company do
not have access to the data and processes by which they are used. The De.fi. protocols, on the contrary,
are open, transactions are traceable and anyone can examine them.
10. Business model - De.fi. has introduced a new paradigm of finance. In the De.fi. world,
there are no companies, but protocols and business models take on different connotations from those
of the traditional economy.
The decentralization and automation inherent in smart contracts allow the remuneration of all
participants in the ecosystem (development team, operating structure, investors) to each event that
provides for such remuneration. In particular, as far as investors are concerned, they are remunerated
according to the rules codified in smart contracts and do not follow the approval of financial
statements with fixed deadlines.
Revenues, net of operating costs, are immediately distributed among the various components
of the system without being temporarily deposited with a central body (in the real economy, the
insurance company) that does not exist.
To be precise, there is a legal entity generally owned by the founders, but its function is to
develop and update the system, hold licenses and legal authorizations, and coordinate the operational
team.
There is therefore no entity to decide whether or not to pay compensation and/or whether or
not to distribute dividends to investors. The execution of these functions is left to smart contracts.
The model we examined can be represented in the following Figure 1:
6
Figure 1 – Business Model of a De.fi. Insurance
The risk pool is fed by the collection of premiums and decreased by the payment of claims.
Although the analysis of the method of calculating premiums is outside the present work, in
summary, by the law of large numbers, the greater the number of policies underwritten, the less likely
the negative event will occur. For this reason, the expectation is that the risk pool will have a
probability of a positive balance between revenues (premiums) and expenditures (claims).
A premium rate of between 5% and 10% is used to cover operating costs.
When a policy expires without a claim, its premium is split between the risk pool itself, the
reinsurance pool, and investors, for example, in percentages of 10%, 20%, and 70% respectively.
Claims are paid automatically upon the occurrence of the negative event.
The smart contract assigned to this function receives information about the event through the
oracle (e.g. delay or cancellation of a flight detected by the ADS-B systems, number of days of
drought detected by the satellite, etc.) and issues the payment of compensation without the need for
human intervention.
The reinsurance pool is financed by the proceeds of the placement of tokens to the public.
Its function is to cover the long-tail-risk that is the risk of catastrophic events so the amount
of funds in the risk pool is not enough to cope with the claims. In this case, the amount of
compensation exceeding the capacity of the risk pool is paid with the funds in the reinsurance pool.
The amount of funds held by the reinsurance pool constrains the number of policies to be
issued because the risk pool does not assume risks greater than this amount.
In this way, each insurance policy is 100% guaranteed and the customer is assured that, in the
event of a claim, also his indemnity is guaranteed.
11. Risks of the De.fi. protocols - Risk management models in traditional finance are based on
factors such as volatility and beta
10
, and on the assumption that regulators, central banks, and other
intermediaries make up a stable infrastructure and play a risk-reducing role.
10
Measure of the systematic riskiness of the stock: the beta coefficient measures the expected variation of the yield of the
stock for each change of a percentage point of the market return
7
In the De.fi., the replacement of intermediaries with programmable smart contracts does not
allow the application of traditional theories of risk management and it is necessary to use a different
approach. Below, is a review of the main risks inherent in the De.fi. protocols.
Smart contracts are sequences of code, they are software and, as such, they can contain
programming errors or, worse, malicious codes that allow intentional malfunctions or currency theft.
Oracles are also subject to the same risks. In addition, there is a risk of disservice to external
providers about data transmitted to the blockchain using oracles.
The codes used in the De.fi. are open source. Since anyone can examine the code, the upside
is that anyone can fix bugs. The downside is that even hackers can analyze the code and identify its
weaknesses.
De.fi. protocols depend on the infrastructure of the blockchain that presents vulnerabilities
such as, for example, the compromise of consent mechanisms. In Proof-of-Stake networks,
cryptocurrency owners offer cryptocurrencies as collateral in exchange for the ability to validate
transactions and earn rewards. In such a scenario, several subjects may form a "cartel" to influence
the distribution of rewards and thereby compromise the functionality of the De.fi. protocols.
In the case of De.fi. insurance (but the concept can be generalized for all De.fi. protocols that
are based on staking), the reduction of funds in the reinsurance pool (increasing demand for policies,
claims above the funds of the risk pool, etc.) requires the placement of additional tokens with investors
to restore the correct level of reinsurance pool.
The increase in the mass of tokens can lead to an inflationary effect with a reduction in the
market value of tokens in circulation. This may lead to a lower interest in the token for new investors
and the disposal of tokens from the portfolios of those who already hold them and, in turn, a further
decrease in their value.
This scenario would therefore lead to a reduction in the number of policies that the system can
take out, limits to its scalability, and, once again, a consequent reduction in value and, therefore, less
interest for the tokens that support the entire infrastructure.
Smart contracts, as we have seen, reduce litigation. However, the likelihood of disputes cannot
be ruled out. Many De.fi. protocols provide for the devolution of disputes to arbitrators registered in
blockchain whose probability of being chosen depends on the number of tokens placed in stakes
11
.
Not all disputes, however, can be submitted to arbitration and this circumstance can create difficulties
or even the impossibility to resort to the judicial authority if the company holder of the protocol is
domiciled in particular jurisdictions.
An additional risk lies in the mechanisms of deposits in pools. Platforms through which tokens
can be pooled can suspend the right to put them in staking (and to withdraw them) reducing the
possibility of underwriting policies at times when the market is unstable or hostile as well as for
malfunctions or hacker attacks
12
.
Finally, the traditional insurance industry represents a strong barrier to the entry of new
players. In Europe alone, the insurance industry realized premiums of €1,264 billion in 2020 alone
13
.
It employs more than 900 thousand people
14
, plus more than 800 thousand traditional intermediaries
(agents, brokers, and consultants)
15
. It is therefore obvious that such a strong industry does not give
11
E.g., https://kleros.io/.
12
by way of example: https://thede.fi.ant.io/bancor-suspends-impermanent-loss-protection-in-hostile-market/
13
https://www.insuranceeurope.eu/publications/2570/european-insurance-key-facts-2020-data
14
https://brokersireland.ie/wp-content/uploads/2020/01/BIPAR-report-Figures-on-insurance-intermediaries-
Dec2019.pdf
15
https://www.statista.com/statistics/441430/insurance-sector-number-of-workers-europe/
8
up market shares easily and that suffers strong pressure from intermediaries to maintain the status
quo.
12. From business planning to valuation patterns
Traditional business planning patterns follow a managerial top-down approach where
forecasts are conceived within the insurance firm and occasionally compared with external
market returns.
The increasing availability of timely big data allows receiving continuous feedback that
can be conveniently used to refresh assumptions and forecasts (with a sort of “F5” keyboard
update), using a complementary bottom-up approach. Forecasting accuracy can be substantially
improved by incorporating timely empirical evidence, with consequent mitigation of both
information asymmetries and the risk of facing unexpected events. While risks are intrinsically
embedded in the insurance world, they can hardly be predicted and mitigated.
Network theory may constitute a further interpretation tool, considering the interaction of
nodes (vertices) represented by IoT and big data, mastering digital platforms, and physical
stakeholders that are linked through edging connections. Networked digital ecosystems shape the
InsurTech industry, and digitalization provides an important playground for data optimization,
bringing new products and markets.
Artificial intelligence (machine learning), database interoperability, and data-validating
blockchains are consistent with the networking interpretation of the interaction of physical and
virtual nodes.
The comprehensive interaction of big data within networked ecosystems eventually
brings Augmented Business Planning.
The model is graphically described in Figures 2, 3, and 4 (taken from Moro-Visconti, 2022,
Augmented Corporate Valuation. From Digital Networking to ESG Compliance, Palgrave
Macmillan, Cham).
9
Figure 2 – From Big Data-Driven Forecasting to Augmented Business Planning
2.
Big Data / IoT
1.
Networked (digital )
ecosystems
3.
Leveraging Data wit h:
* Cloud computing
* Interoperable Databases
* Artificial Intelligence
* Blockchains
* Digital Platforms
4.
Real Opti on-driven Incremental Cash Flows
5.
Flexibility / Risk Reduction of Cost of Capital
6.
Deterministic forecasts
7.
Stochastic planning
Business planning can become more valuable - augmented - if it incorporates big data’s
informative contents, validated by blockchains, and interpreted through artificial intelligence
predictive patterns.
Figure 2 can be further developed, as shown in Figure 3, to express the added value incorporated
in augmented business planning.
Figure 3 – Value Creation, from Traditional to Augmented Business Planning
Ecosystem
Extraction of
(past) data
Extraction of real-
time big data /IoT
Natural
intelligence
estimates
Artificial Intelligence
predictive analytics
Traditional
business
planning
- DCF
Augmented
Business
Planning
- DCF*
Stochastic
modeling
Blockchain
validation
Deterministic
forecasts
Value
creation
Top-down & Bottom-up simultaneously integrated approach
Top-down traditional approach
Networks
/ Digital
platforms
The interaction of top-down and bottom-up strategies can be synthesized in Figure 4.
10
Figure 4 – Interaction of top-down and bottom-up strategies
Market Ecosystem
Digital Supply Chain
augmented
Business Model
Business Plan /
Accounting Metrics
Valuation Metrics
Stock Market Prices
d
e
d
u
c
t
i
v
e
t
o
p
d
o
w
n
Firm
Intermedi
ari es Client
i
n
d
u
c
t
i
v
e
b
o
t
t
o
m
u
p
Big Data / IoT /
validating Blockchains /
Artificial Intelligence
The business model is a prerequisite of the formal metrics of the business plan that contains
data and parameters for the valuation (discounted cash flows, EBITDA for market comparability,
etc.), as shown in Figure 5.
Figure 5 – From business models to business plans and valuation
This theoretical background for valuation should consider the impact of blockchains that are
used for data validation, smart contracts, and oracles.
With De.fi. models, value can be created without centralized intermediaries, smoothing the
supply & value chain. Disintermediation brings marginal savings that improve the traditional
valuation parameters (DCF, EBITDA, etc.).
De.fi. structures reshape the networked ecosystem and its architecture, with an absence of hub
(pivoting) nodes, and more “democratic” access to information.
13. Conclusions - The entry of insurance in the De.fi. has advantages such as the elimination
of intermediaries, reduction of the cost of premiums, greater transparency, reduction of fraud and
2. 3.
business
plan
business
model corporate
valuation
1.
11
conflicts, and consequently of the litigations. The future introduction of artificial intelligence will
bring even more benefits.
De.fi. is still young and has witnessed a surge in overall value and a subsequent contraction.
It is possible, however, that the latter phenomenon is like that of Dotcoms that, after the bubble at the
turn of the two centuries, has cleaned up, stabilized, and developed offering the market the many
applications that we all use.
The challenges for De.fi. insurance companies to follow the same path are to offer easy access
to the general public, most of which is not yet used to the use of tokens and wallets, and at the same
time, safeguarding jobs in traditional insurance to breach the barriers at the entrance.
Even though it might seem like a contradiction since we’re talking about decentralized
finance, this could be possible through the active participation of traditional companies that could
enter the sector to cover those risks that are not economically attractive for their intermediaries
supporting and developing, at the same time, the sector with their considerable financial resources.
Si non potes inimicum tuum vincere, habeas eum amicum(If you can’t defeat your enemy, befriend
him)
16
.
16
aphorism attributed to Caius Iulius Caesar.
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ResearchGate has not been able to resolve any references for this publication.