Nexus Mutual: The Next Insurance
In our previous post, we explained the basics of Decentralized Insurance. In this post, we’ll explain an actual application of insurance on the blockchain. Nexus Mutual is a growing insurance model on the Ethereum blockchain. It aims to provide an alternative to the traditional insurance model through a discretionary mutual offering. But first, it would be prudent to reacquaint ourselves with how insurance works.
Where does traditional insurance stand?
Insurance works on the premise of risk management. Not against the liability itself, but against the potential financial loss. Participants periodically pay into a common pool managed by an insurance company. If any of the participants suffer a loss that is covered, they receive a payout from the insurance company.
In this model, the resources are pooled centrally and managed by one participant. Each participant has to rely on the company not only managing their [and everyone else’s] money but also on the insurance company’s ability to eventually provide coverage should any risk arise. Besides the over-reliance on one company, there are also several costs that the participants have to bear for the management of their money by the insurance company.
According to a report by the consulting firm McKinsey, the biggest driver among cost-differences between insurance companies is not the kind insurance policies offered, or the regions serviced, but the management. The four “distinct root causes” which explain cost disparities are, the IT landscape, operating model, business complexity and performance management.
Just to provide an example of how cost optimization on the management side can decrease premiums on the customer side, the report highlights one insurance company which digitized its insurance process and reduced claims-regulation cost by 20% to 30%, processing costs by 50% to 65% and processing time by 50% to 90% and also improved customer service. Let me reiterate, this was just by digitizing the process.
While this is an anecdotal example, it is indicative of what proportion of the premiums-paid go to insurance companies, to eventual coverage and what proportion are simply used to offset their own costs. To this cost-saving point, Nexus Mutual believes that they can remove the inefficiencies of the traditional system.
Of the frictional costs within the traditional system, platforms like Nexus Mutual state they can cut those costs in half. This is achieved by migrating trust away from the inefficient management of an insurance company, to a transparent, decentralized blockchain. Well, how will it work? But more importantly, what do they insure?
Smart contract security
A smart contract is a computer program that operates on a blockchain. Like any other contract, a smart contract’s terms can be determined by the parties to the contract. However, the key difference is a smart contract will automatically execute if any of the terms in it are triggered. Through this automatic execution, payments can be made or received, goods can be dispatched, or information can be shared. Needless to say, such contracts would be essential to the insurance world.
Smart contracts are at the center of the decentralized finance ecosystem, but their strength is also their weakness. Since smart contracts are decentralized, they are vulnerable to hacks, frauds, and third-party changes. These changes can violate the terms of the contract. They also rely on data from other sources to run correctly. This data is required to be accurate, timely and of high quality to ensure there aren’t any bottlenecks. Further, the absence of any central authority decreases the safety of funds, assets, and information.
Ethereum, the most powerful open-source decentralized project is a protocol that allows smart contracts. The native currency of Ethereum, ETH or Ether, is the second-largest cryptocurrency on the market behind Bitcoin. Several companies including major banks have built projects on the Ethereum network. Since Ethereum isn’t operated centrally, they have been and still are vulnerable to external attacks compromising compromise smart contracts security. Security issues include hackers issuing large amounts of tokens, altering the terms of contracts, denying the execution of contracts, etc. Because of these vulnerabilities, there is a need to safeguard smart contracts, and the cryptocurrencies they control. An insurance model serves that need.
Put simply, each breach in the smart contract alters its terms, making it void. Since a smart contract is digitized and executed based on automatic-triggers, a breach, which doesn’t alert the parties, goes unnoticed. This presents a risk and can become a liability for one or both parties, resulting in financial losses. As mentioned earlier, regular insurance is meant to protect against the risk of financial loss. Similarly, insurance models like Nexus Mutual, cover against many possible breaches in smart contracts that lead to financial loss.
An incorrect assumption about the decentralized finance world is that it’s devoid of any sort of human touch. That everything is run on computer programs. Part of the motivation behind building a decentralized finance system is the lack of human inefficiencies. However, there are a few things humans can do better than computer programs. One of those is being driven by incentives. You can’t get a computer to run on incentives!
Nexus Mutual uses this individual motivation to build a pool of independent assessors. These independent assessors take on a particular role in the insurance process and execute it for an incentive. In a traditional insurance system, right from receiving insurance premiums from individual insurance-seekers to paying insurance to them when the liability arises, there are several roles. However, these are occupied by humans within one company. Nexus Mutual is changing that.
Under the traditional insurance system, the workflow is broadly divided into four departments – investment management, claims assessment, risk assessment and governance.
- Investment or capital management involves investing the money received through insurance premiums so that their value will increase over time.
- Claims assessment involves assessing how much claim or coverage is paid out to an individual for an insured asset when they suffer a financial cost. In the example of a home’s roof is damaged by a hailstorm, the insurance company will determine the amount of coverage the individual will receive per the home insurance they have taken out on the house.
- Underwriting involves determining the degree of risk the insurance company is taking when it insures an asset
- Governance involves the internal administrative work within an insurance company.
These functions will broadly be done by what Nexus Mutual refers to as the “mutual,” [which simply means the collection of individuals on the platform] rather than a single company. Here, the mutual is not a third party company, or Nexus itself, but it is the individuals within the platform. Those individuals are driven by a series of incentives to act in a beneficial manner.
The NXM token
Like most projects, Nexus Mutual has a token NXM which is used, among other things, to vote, stake, provide coverage etc. According to the whitepaper, the token is a “internal incentive mechanism to bind the mutual together.”
The supply of the token is not fixed or periodic. This means that the token does not have a supply cap. Unlike an initial coin offering, there is no set number of coins created and auctioned off right from the get-go. Tokens can be purchased like any other token [at the time of writing one NXM token is $52.1], or they can be earned through participating in the insurance process. However, its price will vary.
Without getting too much into the formula, or its derivation, put simply, the price of the NXM token will depend on how much capital is in the pool and if there are any existing covers which could decrease that level of capital. But what is the use of the NXM token? Well, like any other system, the token or the currency is to get stuff done. In the insurance world, the ‘stuff’ is – get insurance and asses it.
Once purchased, the tokens can be used as any currency would be in paying insurance premiums. Individuals who intend to insure their smart contracts can use their tokens to purchase cover. This cover would kick-in if the risk is realized. Then the ‘coverage’ has to be paid out, similar to a traditional insurance contract.
The key difference between a traditional system and the Nexus Mutual model is how the tokens are used once the insurance is purchased. In a traditional system, the premiums directly go to the insurance companies. These companies decide to store them, invest them, or use them for various expenses. In the Nexus Mutual model, 90% of the tokens are burnt, 10% of the tokens are locked for the period-of-coverage plus an additional 35 days.
The coverage provided does not directly come from the actual cover paid by the individual but from a combination of the assessment processes. Here, the impetus is not on the individual securing the coverage for their smart contract. The impetus is on individual assessors assessing risks involved and eventual claims paid out. This is where the coverage amount is disseminated.
Within the Nexus model, the NXM tokens can be earned through assessments. These assessments are primarily in three forms:
- Risk assessment
- Claims assessment
- Governance assessment
The primary focus of an insurance operation is to identify insurable risks. These risks once identified are expressed in quantifiable terms. Insurance agents calculate the financial cost of the risk, probability, and other metrics. This calculation determines the premiums individuals have to pay in their policies. In the traditional insurance contract, this would be carried out by an actuary acting on behalf of the company. In the Nexus Mutual model, this is done through the mutual.
Individuals in the mutual can participate in assessing the potential risks involved in insuring a smart contract. Anyone can “assess”, but how do assessors put their money where their mouth is? Simple, through the NXM tokens. If an individual is of the opinion that a smart contract insured is well made and the threat of it being hacked [risk] is low, they can stake some amount of NXM tokens to back their assessment. Conversely, they can also stake their tokens if they are of the opinion that the risk is high.
This creates a feedback loop between two sets of parties – the individuals entering into smart contracts and the risk assessors. If a large number of risk assessors have staked their NXM tokens arguing the risk is low, individuals on the smart contract platform see this community trust and are more likely to enter into the contract. Similarly, if a large number of tokens are staked with assessors arguing the risk is high, then individuals on the smart contract platform are less likely to enter into the contract. These risk assessors act like independent third party auditors for smart contracts. They have no stake in either the smart contract, or the platform itself, and only assess the risk within it.
Since the system is based on incentives, the risk assessors will receive a payout if the risk has been realized. For instance, if the smart contract has not been hacked, those who staked their tokens arguing low risk will benefit. Similarly, if the smart contract is hacked, those who staked their tokens on high risk will earn a commission from the tokens sold to provide coverage.
Claims assessment measures how much should be paid from the insurance provider to the individual. To assess claims in the decentralized insurance space, as we’ve mentioned before, oracles are used. Put simply, an oracle is a data provider. In the insurance space, the oracle could be anything triggered if a risk to an asset is realized. For crop insurance, it could be a rain gauge indicating the decrease or absence of rainfall, for car insurance it could be something measuring impact on the car, for life insurance, it could be the death certificate. You get the point. However, Nexus Mutual does not use a computerized oracle, instead, they use a human one, the mutual members.
In the Nexus Mutual model, individuals in the mutual can choose to become claims assessors by staking their NXM tokens to a pool for a fixed period. The model is made so that the assessors have an incentive if the pool succeeds and a disincentive or deterrent to acting in a fraudulent manner. Once the claims are assessed in a transparent manner, the tokens are returned. But wait, what are the incentives given to the assessors?
The staking of the NXM tokens is based on a vote, which depends on an outcome. Well, every insurance contract is at its bare minimum, a bet on an outcome. Claims assessors take part in this bet, by staking their NXM tokens, voting to predict the outcome of the insured smart asset. If the voted outcome is proved correct, the assessors are entitled to a share of the fees. If the voted outcome is proved incorrect, the tokens are locked for a longer period. During this entire voting and assessment process, an ‘Advisory Board’ [more on this later] will check for any concerning behavior, like high stakes on single bets, multiple stakes on different bets, etc.
Every insurance system has a method of governance, of internal control and procedures. In the traditional space, this internal governance is not known to insurance seekers. Because of this information asymmetry, the costs to the insurance process can be increased without reason, and because of a lack of alternatives, this has to be accepted without reprieve.
In the decentralized model, governance is not only transparent but also community-driven. Nexus Mutual allows individuals within the mutual to take part in the governance of the model by fine-tuning various aspects of the process. Beyond the mere code of the blockchain, for the sake of internal governance, Nexus Mutual has created an ‘Advisory Board.’
This board will be composed of individuals who have a specific skill set required for an insurance model like this. Individuals educated in “insurance, mutual governance, and blockchain development” will occupy the board. The board will oversee decision making with the individuals in the mutual. They also ensure that their functions are based on specific roles. Further, the board will also determine if any individual has acted in a fraudulent manner and will punish them for it, and create a disincentive for the same. The board cannot hold any NXM tokens, or forcefully take tokens staked by individuals in the mutual. However, the board can burn tokens if they deem an individual has acted dishonestly.
Individuals not on the board can develop proposals for the board to consider and thereby “white-list” to take forward. The board is also subject to change with each member subject to replacement at any time through a voting process. Individuals who wish to join the board can submit proposals that will be put to vote, with board members not having the right to veto. This governance system is wholly internal, transparent, and non-monopolistic, preventing excess power in few hands. Needless to say, individuals participating in governance procedures will receive tokens for their expertise.
Insurance and outsourcing
A simple theme presents itself in the Nexus Mutual model, the theme of outsourcing of centralized function. In a traditional insurance company, each assessment is done by an agent of the company, leading to all sorts of expenses that do not directly contribute to the coverage received. Through the Nexus Mutual model, a large amount of these centralized functions are branched into the “mutual” or the insurance community. In this community, different individuals can take part in different insurance roles, risk assessment claims assessment, governance, or more, and can stake their claim through the NXM tokens. Their assessment has weight, is incentivized, and provides a great deal of information to those taking out insurance policies for their smart contracts.
Coverage of the future
Think about what this can eventually develop into. An insurance model where specialization is best used. Those who are good at measuring and calculating risk can become risk assessors. Those who are good at quantifying claims against insurance can become claim assessors. Those who are good at internal administrative procedures can take part in governance. Each of these functions will not come at a cost to the insurance model and neither will it come at a cost to the insurance seekers. The cost will be continuously transferred from those who assess correctly to those who don’t. Isn’t that the whole point of insurance?
Check out our video on Nexus Mutual here.