The advent of DeFi created yield-generating possibilities across a wide range of protocols. However, as protocols gained popularity and deposits to smart contracts increased, this presented attractive possibilities for hackers and exploiters.Hackers identify holes in protocol design or smart contracts and discover methods to profit from them. The quantity of stolen funds has steadily increased since the commencement of DeFi summer of 2020. Hackers stole $2.7 billion in 2022 alone, a 63% rise from the previous year.As crypto usage grows, it is critical for protocols and their users to protect against vulnerabilities. Audits and code reviews are the first and most evident steps, but they do not guarantee that vulnerabilities will not be exploited. How can protocols and users safeguard against these exploits? Insurance, like in the case of TradFi, might be the solution.<h2>What is a Crypto Insurance?</h2>A policy of insurance is a contract that protects a person, family, or company against specified risks. It is a legally binding agreement between a policyholder and a provider that protects the holder financially against particular risks.People often want to safeguard their homes, automobiles, crops, and personal health from the unknown. To achieve this purpose, a person will get an insurance policy to protect themselves against expected and unforeseen hazards. Insurance firms such as State Farm, AIG, and UnitedHealth Group Inc. underwrite such plans.Policies meant to safeguard cryptocurrencies are one of the newer and more exotic types of insurance. These contracts, known as crypto insurance, provide crypto traders and investors with a layer of protection against a variety of distinct hazards.Crypto insurance is a coverage that protects against damages caused by cryptocurrency theft. These regulations may be implemented at the exchange, wallet, or personal level. Each is unique and is intended to satisfy the demands of the bearer.<h2>The mechanisms of crypto insurance</h2>Select DeFi protocols are covered by insurance procedures. This enables users of certain protocols to insure against specific risks. Insurance protocols provide two major forms of coverage:<ul><li>Smart Contract Vulnerabilities: This addresses the protocols' underlying smart contracts. In the case of a smart contract failure, hack, or exploit that causes a user to lose money, it will allow for a claim for the insured amount.</li><li>Depeg Risk: This applies to stablecoins. It will authorize a claim for the insured amount if there is a depeg to a specific degree.</li></ul>Please keep in mind that these are general descriptions to help you understand what insurance covers. Please visit the insurance protocol's website and seek their cover wording for the actual coverage detail.Now that we've established the sort of coverage provided let's break it down further to better understand the flow and participants.Coverage Purchaser (DeFi User): A DeFi user invests money in a DeFi protocol in order to earn interest. To eliminate the danger of smart contract exploitation, the user goes to an insurance protocol and obtains DeFi protocol coverage. They pay a little premium, which is generally less than the yield from yield farming. When an exploit occurs, the user may register a claim with supporting proof. After approval, the user receives the covered amount.Coverage Issuer (Insurance Protocol): A coverage issuer provides coverage for certain protocols or stablecoins. Users may get coverage by paying a fee. In contrast to conventional insurance, where the counterparty is the insurance company, insurance protocols enable other users to underwrite deposits, which operate as the counterparty. The underwriter deposits will then receive premium returns as well as token incentives. When an exploit occurs, and a user submits a claim, the claim assessors vote on whether the claim should be approved or rejected. By staking the insurance protocol's native token, anybody may become a claim assessor. Once authorized, the buyer receives the coverage payment. There will be no payment if the application is refused. Claim assessors are also compensated for voting on fees or token incentives after the claim has been settled.<h2>A key market that lacks traction</h2>Despite the increase in TVL in DeFi and hacks reaching new highs, the insurance business has not risen much. At its height, just 1.2% of all DeFi TVL was in insurance protocols, with subsequent months seeing a range of 0.7% to 1% of total TVL. Only $235 million of TVL is now in insurance protocols, compared to $40.8 billion in the whole market. It can only ensure 1.15% of the whole TVL, even with a 200% cover ratio (total cover amount / TVL).<img src="https://lh3.googleusercontent.com/-mmx4ao070qjmb6lxFkRM7KJxGn1MFzDXmZZTycGaFcGC7Fjon-7gP4aRDlFU-DScnGFxu_dh0JvxUedNGUMkwXWb4I-gS7OLE9C5oraggdf_edSEFRUBYC0VhT9oa2crg9Zj4kjabWCCnmonDUwTO0WYpQ7BI8JgENU6RkHSRwWCCwtMsQiQchgh6OpGw" width="624" height="316">Source: Delphi DigitalFurthermore, when the top five incidents by claim amount were examined, the average damages covered by insurance were just 6.47%. This indicates that just $64.7k was insured for every $1M lost. The graph demonstrates that DeFi users are underfunded for the risks involved, which may be linked to the present insurance model's inability to achieve product-market fit.<h2>The barriers to crypto insurance</h2>Insurance is still a difficult product to pitch to the crypto population. Let's look at it from a behavioral and motivational standpoint. First, consider the primary reasons why DeFi insurance has expanded so slowly:<ul><li>Risk-Taking Crowd: Risk-taking crypto investors are aware of the significant volatility and hazards associated with cryptocurrency. Purchasing insurance to mitigate risk is not automatic.</li><li>"Battle-Tested" Protocols: Proven protocols are regarded as "safer" since their code has been operating smoothly for a long period. With the assumption that protocols have been "battle-tested," and hence the risks of exploits are "reduced," consumers consider protecting their deposits with these protocols to be a waste of money.</li><li>Insurance Cost Reduces Yields: Purchasing insurance reduces yields by adding a cost vector. This is especially true now that DeFi yields have declined. A 15% APR earner is more inclined to pay for insurance than a 5% APR earner.</li><li>Capital Rotation Cycles: To optimize profits, mercenary capital rotates from protocol to protocol. This makes purchasing coverage for a limited time period unappealing.</li></ul>Insurance protocols include both the protocols and their underwriting deposits. There are various drawbacks to this that make underwriting less appealing:<ul><li>High Risk, Low Reward: Underwriting for low yields is dangerous; possible tail events might rob not only underwriters of their income but also reduce the principal invested.</li></ul><ul><li>Pricing Issues: If insurance prices are excessively high, no one will purchase coverage. Underwriters are not encouraged to take risks if the price is too low.</li><li>Different Risk Exposures: Because insurance standards are designed differently, it is difficult for underwriters to control their exposure. Protocols with segregated protocol pools let underwriters choose which one to deposit into. Insurance protocols that use aggregated pools accept more protocols, increasing the likelihood of tail occurrences.</li><li>Lack of integrations: Insurance and DeFi protocols function as two independent entities and are not completely integrated for users to access.</li><li>Insurance is still an essential product that should be provided and used in a high-risk crypto ecosystem, but adjustments to the present insurance model are required to suit the current user base.</li></ul><h2>How can crypto insurance be widely adopted?</h2>We seek inventive approaches to better or build a different technique for ensuring a challenging crowd after we learn how the average DeFi customer behaves.<h3>Insurance Automation</h3>This is based on a cognitive bias known as "status quo bias," which refers to humans' preference for keeping things instead of altering them.Automated insurance may be included in a variety of DeFi protocols, enabling users to opt out at their discretion. When yield farming, a user may be required to pay a deposit fee or a small proportion of the yields generated in order to get insurance coverage.A protocol may also route token emissions toward an insurance protocol to reward underwriters and provide adequate liquidity to purchase coverage for its consumers.<h3>Early Termination</h3>Some conventional insurance carriers feature early termination provisions. A year's worth of worldwide travel insurance is one example. If you return home early and no longer need the insurance, you may cancel it to recoup part of your costs.If you apply the same rationale to DeFi insurance, you should be able to recoup part of your payments if you decide to cancel the coverage early. This eliminates the need for duplicate coverage for a protocol that the buyer is no longer exposed to.Insurance companies and underwriters gain as well since they may charge a premium for early cancellation. This frees up underwriting liquidity for other users to purchase, increasing capital efficiency.<h3>Insurance Purchased Through Protocol</h3>Protocol-purchased insurance simplifies things for users by covering the whole protocol. Users will not notice any differences in UI or UX, and they will not be required to pay for coverage.While this is advantageous to the end user, it may be incredibly expensive to the protocol. Using the lowest Nexus Mutual coverage of 2.6% APR annual cost, $250k protects just $9.6M of deposits. To break even on its coverage expenses, the protocol must earn an equivalent amount of protocol income.Protocols that lack a profitable model are unlikely to adopt this strategy. Protocols might also support this coverage using funds raised through token agreements.<h2>Insurance companies continue to innovate</h2>Sherlock and Y2K Finance are two protocols that are pioneering new insurance approaches.<h3>Sherlock</h3><img src="https://lh5.googleusercontent.com/wvyaXSNxmzg_rRmd4EkR0CAHigm_j3j1MEjPDk49JTKv2LtUSBwSb1p8xSKebIrcvq_PiJBQcDPX5zuHeE1Eyg-qY7Bl__y0v7ZpNOd2WWFvsg9CIxWVM5ASkicwIyO0pcf3mL2EpxClrcZxC7H0JnUBV5bWrleE2dxe3Lf8KKmvqjoCCIoKUYmvMOSgNw" width="624" height="360">Source: GitcoinSherlock is a one-of-a-kind audit marketplace and smart contract coverage mechanism. T his strategy combines auditors and insurers who collaborate. Furthermore, they opt to target protocols rather than DeFi users.Their audit and coverage procedure is as follows:<ul><li>Protocols fund a public audit competition with Sherlock.</li><li>Following the audit, the protocol will be provided with a list of high and medium-severity results. They will have 72 hours to recognize these findings and propose solutions, as well as arrange a three-week repair review.</li><li>They may work with Sherlock to cover their protocol for 2% APR on TVL after the code has been repaired and approved.</li><li>Insurance will be paid for on a per-second basis under the protocol.</li><li>Sherlock creates underwriting deposits into which anybody may put to earn interest.</li><li>Idle money will produce returns for depositors on other DeFi protocols.</li></ul>This strategy offers low-cost coverage for protocols while enabling underwriters to increase their returns via other protocols.<h3>Y2K Finance</h3>Y2K Finance develops structured solutions for unusual peg derivatives. "Earthquake," their first offering, introduces classic catastrophic ties to DeFi. Earthquake revolves around three stablecoins — USDC, USDT, and MIM — each with a variable strike price and a weekly or monthly expiration date. It operates on the basis of a "hedge vault" for insurance purchasers and a "risk vault" for insurance suppliers.<img src="https://lh6.googleusercontent.com/opZGcc8_ZHo6pcWc3QqiQzgHA-cthWwLL7G5-XPJrWEmEVqQuXKIUWneh0YTI8ddzqzYtHeAGoYcGI8oUjPDm3AFYlBMCrNRmo-uCdQ_pjuOEL1VFZzTe8MONNhkOSSBoA7vyiXJ26sPbAhzU2l1hfJG5CR_yO7R76kdfoloCdjxIhozjRdggSBZgvbR8Q" width="624" height="377">Source: Y2K FinanceThe Hedge Vault<ul><li>No depeg: Hedge vault depositors lose the premiums they pay to risk vault depositors.</li><li>Depeg: Hedge vault depositors lose the premiums they pay to risk vault depositors. Depositors of hedge vaults get a pro-rata portion of risk vault deposits.</li></ul>The Risk Vault<ul><li>No Depeg: Risk vault depositors get a pro-rata part of hedge vault depositors' premiums.</li><li>Depeg: Risk vault depositors get a pro-rata part of hedge vault depositors' premiums. Depositors in risk vaults lose their principal to depositors in hedge vaults.</li></ul>This one-of-a-kind insurance product offers a straightforward binary answer (depeg or not) that does not depend on determining the veracity of a claim, resulting in a simple user lifetime.ConclusionOnly insurance can protect you in a world where code is the law, and there is limited recourse for stolen assets. With vulnerabilities and hacks on the rise, the insurance industry has yet to get the momentum it needs to safeguard users, the majority of whom are underinsured.As previously said, present offers are not based on the distinct habits of the crypto-native community. More inventive solutions are needed to work around the specific demography and make it simple for consumers to become insured, with or without their knowledge.Fortunately, there is an opportunity since protocols such as Sherlock and Y2K introduce creative solutions that aid in onboarding users or simplify coverage.The crypto insurance industry is only getting started, and we'll be on the lookout for additional new solutions that protocols may provide.<div class="pr-block-special">Disclaimer: This article is intended for and only to be used for reference purposes only. No such information provided constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific name.</div>

Crypto insurance offers a protective layer against a range of specific risks to investors and traders in the cryptocurrency market.

Crypto Insurance: Can it be widely adopted?