In this series of blogposts, we explore some of the main types of decentralised finance (DeFi) applications (dApps), and key areas of legal risk that may be of particular relevance for that type of application or product.

In this second blogpost in the series, we consider the nature of tokenised insurance or alternative risk coverage dApps

What is it?

Tokenised insurance, or alternative risk coverage dApps, enable placement and claims handling-like processes, in addition to management of the capital model, to be conducted on a decentralised basis.

Examples of risk coverage offered include:

  • Crypto-denominated risk exposures, such as coverage for bad actors exploiting smart contract code vulnerabilities or collateral protection for crypto-backed loans (e.g. where the price of a USD stablecoin locked as collateral in DeFi lending platforms falls below USD 1).

Analogue world risk exposures, often linked to parametric triggers (e.g. wind speed for hurricane coverage or rainfall for crop protection) or simple loss triggers (e.g. flight cancellation).

The traditional insurance market has to date been cautious about underwriting risks relating to the blockchain sector, especially where the loss is denominated in crypto.

DeFi insurance and alternative risk coverage platforms therefore have the potential to fill the crypto-protection gap and to facilitate much needed management of risk exposures faced by businesses operating in the decentralised economy.

Key features

An illustrative example of a DeFI insurance, or an alternative risk solution model, is as follows:

Risk coverage diagram

* Examples of reinsurance or tokenised ILS structures that may be put in place

1) Tokenised risk pool: managed by smart contracts using token incentive mechanisms to attract funding through premium payments and / or third party liquidity providers (in exchange for tokens issued by the dApp).

2) Placement: premium may be set automatically (for example, parametric product pricing calculated based on the probability of a predefined event happening instead of indemnifying actual loss incurred) or through dApp token incentive mechanisms encouraging token holders participate in pricing of risk by reference to risk profile.

3) Claims payments/Loss adjustment: automatically triggered by oracle data (calls on publically available data feeds), determined through loss adjustment by other dApp token holders (using token incentive mechanisms to encourage accurate voting) or off-chain loss adjustment providers.

4) Governance: decentralised governance of the dApp controlled by dApp token holders.

5) ILS investors: earn interest on staked cryptoassets locked within the ILS smart contact without selling the staked cryptoassets.

Legal considerations

Perhaps unsurprisingly, given their decentralised nature and potential global reach, DeFi insurance and alternative risk coverage dApps pose a number of interesting legal and regulatory challenges that need to be considered on a jurisdictional basis:

  • Analysis will be required to confirm if the structure will fall within the scope of the insurance regulatory perimeter of relevant jurisdictions. If it does, further consideration will be required as to requirements for regulatory authorisations and ensuring that the operation of the dApp and insurance product provided comply with applicable regulatory requirements.
  • Risk coverage provided in relation parametric-type products with index-based loss payments also has the potential to push the boundaries of how an insurance contract can operate within existing regulatory frameworks – in particular, the extent to which certain of these products can arguably be seen to constitute derivative contracts.
  • Analysis will also be required to confirm the status of any tokens issued by the dApp from a regulatory and securities perspective in relevant jurisdictions.

For further information on the key legal risk areas that are likely to be relevant for all DeFi projects, please see our introductory blog DeFi: What is DeFi?