25 September 2023

Why and how blockchain-based protocols may participate in insurance-linked securities

As of June 30, 2023, the value of the treasuries of all blockchain-based digital organizations ("Digital Organizations"), often referred to as 'digital autonomous organizations' or 'DAOs', was approximately $20 billion.  The overwhelming majority of these treasuries are held in crypto assets, assets like bitcoin, ether and stablecoins (digital assets pegged to the value of another asset, typically the US dollar). Recently, however, Digital Organizations have begun investing in 'real-world assets,' assets like US treasuries, mortgages and other assets that are commonplace within the traditional financial system. As more and more real-world assets are brought on-chain, it may be inevitable that insurance premium and risks will flow to blockchain-based protocols and organizations. In this article we present an overview of: (i) why both traditional insurers and Digital Organizations may want to create insurance-linked securities on-chain; (ii) how those assets can be moved from the traditional financial system onto the blockchain; and (iii) some challenges to the adoption of on-chain insurance-linked securities.


Why go on-chain?

Generally, insurers issue insurance-linked securities ("ILS") – securities whose value is dependent upon insurance-related outcomes, like catastrophe bonds and equity interests in a reinsurance sidecar  – in order to reduce the capital the insurer is required to maintain, thus freeing up capital for other parts of the insurer’s business. Instead, the capital is provided by private investors, who, in exchange, participate in the premiums received in connection with the particular risk linked to the ILS. In addition to the potentially high-yields generated by ILS, private investors have been attracted to the lack of correlation between those yields and the yields available in traditional debt and equity markets.

Like traditional private investors, Digital Organizations can also benefit from the uncorrelated risk and yield offered by ILS. The vast majority of the assets held by Digital Organizations are digital assets. And digital assets are generally highly positively correlated with each other relative to traditional assets. Diversifying this risk has motivated some Digital Organizations to invest in or otherwise incorporate real-world assets into their project (see MakerDAO below). Traditional institutions may find Digital Organizations attractive capital providers as Digital Organizations may be willing to accept a lower return than traditional private investors, given the unique diversification benefit that Digital Organizations can derive from real-world assets as well as the added complexity (and, therefore, cost) of transacting with a Digital Organization.

How to go on-chain