Nexus Mutual - Covering Consumer Risk

Consumers interact within the ecosystem to either purchase insurance, provide claims assessment, governance, or to be a risk accessor and this page is on the consumers risk purchasing insurance.

Abstract

An objective of this report is to provide an overview of the insurance elements within the Nexus Mutual ecosystem from the consumers perspective. Even though Nexus Mutual says they are “a mutual fund that provides discretionary cover, which is an insurance-like product that involves only a discretion, not a legal obligation, to pay out on the occurrence of a material loss,” [1] they have categorically been labeled an insurance company. This creates a consumer risk for us when we purchase cover from Nexus Mutual believing they may be an “insurance-like” company even though they are not.

Nothing here is meant to discredit Nexus Mutual in any way as they state most-to-all this report on their own, though when it comes to insurance, there are standards and regulations to aid us consumers in more ways than we realize. Because of the lack of current regulation, crossed with the impression that Nexus Mutual is an insurance company, there exists a need for us to understand the insurance elements within Nexus Mutual. To summarize, this report is meant to illustrate the differences between the traditional insurance model and Nexus Mutual from the consumers standpoint on the hopes that it will reduce consumer risk to those attempting to purchase cover believing it is an “insurance-like product.”

A consumer within the Nexus Mutual ecosystem can serve four roles: purchasing coverage, being a claims accessor, governance, or a risk accessor, though to be any of these roles you must be a member of the mutual first, which requires purchasing the native Nexus Mutual token – NXM [2]. This report will only be from the perspective of the consumer who is purchasing coverage and not from the Risk Accessors, Claims Accessors, governance, or from Nexus Mutuals business perspective, though more reports may follow on those topics.

Introduction

From the consumers perspective, the most basic element of insurance is the avoidance of risk. This is accomplished by the consumer when we pay a premium for an insurance policy to transfer our loss or liability to an insurance carrier based on a list of loss events (risks) for a premium. There are more risks out there for the consumer purchasing insurance than listed here, though this report will focus on these three separate risks when purchasing insurance traditionally: a fair insurance premium, the risk that the carrier will reimburse you for covered losses, and the risk that the insurance carrier will have the funds available to pay up to your policy limit for compensable claims. For conversations sake, we’ll call these three risks the Insurance Foundation and we’ll go more in depth on each risk.

In the traditional sense, as consumers we can avoid these three risks because the insurance carrier is legally obligated to offer a fair insurance premium, to pay out in the event of a covered loss up to the occurrence and policy limit, and to remain financially solvent within certain parameters (ie. Iegal, reinsurance, etc). As personal wealth in cryptocurrency increases, so does the need for consumers to protect and preserve our assets, and when used correctly, insurance can be a way of preserving those assets. However, there are risks to consumers who believe Nexus Mutual may operate within the same capacity as traditional insurance and this report is an attempt to elaborate on those ‘insurance risks’ to the consumer.

Insurance Foundation

Fair Insurance Premium

Even though insurance is often considered expensive, if it is put into perspective, then the price of insurance could potentially seem fair in hindsight. For example, let’s consider car insurance where your location may require you to be financially responsible for up to $300,000 in liability. This means, that if you cause bodily injury or property damage to others up to $300,000 for a covered cause of loss, then your insurance company should pay up to the $300,000 limit. Most of our auto insurance policies cost us under 1% of that $300,000 limit in premium, meaning that we are getting a substantial amount of coverage for around 1% or less in premium. And let’s say you want to later on increase your coverage to $600,000, then the chance of a loss surpassing the second $300,000 layer is less likely, so the resulting premium for the second $300,000 in coverage is less than the premium for the first $300,000 in coverage.

There are several variables contributing to what is a fair insurance premium and two of them are the actuarially fair premium, and within scope, the policyholder’s surplus ratio.

i) An actuarially fair premium is the amount of premium that can be equal to the future expected losses of that member of the pool based on the law of large numbers of historical loss data. Essentially, if previous loss data and models suggest you could expect future claims totaling $2,000, then your actuarially fair premium would be $2,000.

· Within Nexus Mutual, even though the price of coverage within certain pools will decrease as more Risk Accessors on-board, the cost of coverage can be prohibitively high [3]. For example, coverage for your currency within the MolochDAO pool is currently 71.95% as of February 15th, 2022 [4].

o According to their Profit & Loss Statement, Nexus Mutual ”assumes 80% of active cover costs will be paid in claims” although less than 29% of all cover costs in the past 12 months was paid out as claims [5]. When Nexus Mutual is paying out less than 29% of active premium out as claims in the past 12 months, but charging you based on 80% expected losses, than it means you are not paying an actuarially fair premium.

o Historically, since the beginning of Nexus Mutual, less than 17% of all premium paid has been paid out in claims as well [5].

o If you were to consider insuring your crypto on the Aave V2 protocol, then at the time of this writing, you would be paying a premium of 2.6% of the coverage limit you are seeking on Nexus Mutual [4]. This may seem like a fair price at first glance, though considering that Nexus Mutual has received over $1,420,000 in premium for over 275 policies and had 0 claims, on top of having over $40,000,000 staked for that protocol, then the 2.6% insurance premium is extremely high and not actuarially fair [6, 7, 8].

· Within Nexus Mutual, the premium does not decrease proportionally to the policy limit as you increase your demand for a higher policy limit. For example, if you wanted to increase your coverage later to $600,000 from $300,000, the premium for the second $300,000 layer in coverage is the same as the price for the first $300,000 in coverage.

ii) Traditionally, the policyholder’s surplus is an added layer of financial protection for the insurance company as a whole. Even though the policyholder’s surplus is meant to illustrate financial security, in addition to having the liquidity to pay future claims, it is not directly related to the price of coverage. However, it is an indication of several factors and future premium ratings can be one of them. Nexus Mutual does not have a ‘policyholders surplus’ exactly, though there is the Nexus Mutual token which mimics the policyholders surplus to a degree and is a large part of the Nexus Mutual ecosystem. The price of the NXM token increases as the success of the mutual increases, so as more coverage is purchased and less claims are paid, the price of the token increases.

· Even though the policyholders surplus is not directly reserved to pay future claims, it can be an indicator of the success of the insurance company, or mutual. Although, when the policyholders surplus increases in value, a reduction in premium amounts charged could lead to an increase in policies being purchased, though that is not happening within Nexus Mutual. The price of the NXM token is right under $100 clearly establishing the success of the mutual, though the cover premium prices have not decreased in relation to the NXM token price.

Claims Process

Nexus Mutual offers coverage for your cryptocurrency assets within a designated protocol held by a custodial exchange or wallet against the following, though this is not meant to be an exhaustive list [9]:

· Coding being used in an unintended way

· Economic design failure resulting in the unintended confiscation or seizure of funds

· Severe oracle failure

· Governance attack

· The designated protocol loses the users funds

i) Bias - The above is a list of perils that you would normally be correct to assume that you are insured against when you see them listed on your ‘contract’ with Nexus Mutual, though, it is just a tease. This is because there is no obligation to pay your “genuine losses” or to have enough liquidity to pay future claims, essentially, eroding any comparison with insurance. According to Nexus Mutual “Members can decide to pay claims as they wish, which includes members applying their discretion in a positive way. This might include paying claims that may be declined according to strict terms and conditions but where there is a genuine loss [10]."

· This applies when the amount of people purchasing coverage is greater than the amount of people staking in to the mutual, otherwise, the balance between those motivated to purchase cover and those motivated to deny cover can become skewed and this creates a bias that will surely bring about future studies.

ii) Indemnity - Within Nexus Mutual, if you file a compensable claim and there is no funding in the pool to pay your claim, then the claim doesn’t get paid that day but Nexus Mutual will try again in 24 hours to pay the claim. If there is no funding in the pool 24 hours later to pay the claim, then the system will try again every 24 hours for a total of 60 days and if there is no funding in the pool after 60 days, then the system forgets about your claim and it will not be considered for payment again [10].

· If you file a claim there needs to be at least 10x of your claim amount in the pool itself [10]. But, if the protocol you were insured on gets exploited and other members of the mutual file a claim and get paid before you, there could potentially be no funds remaining in that individual pool for you to be indemnified, or to be financially made-whole as if you did not experience the financial loss.

Also, being reimbursed for a successful claim should not cost you anything additional, though within Nexus Mutual, when you purchase your policy, 10% of what you paid is held for you to act as a deposit when you file a claim [10]. Essentially, when you file a claim, you must deposit 5% of your premium to be staked while your claim is being voted on, and if the claim is accepted, then you paid 5% of your own premium into paying out your own claim, but if the claim is denied, then your 5% deposit is burned [10]. This could be considered a deductible in some perspectives, although a deductible applies to successful claims unlike at Nexus Mutual where your claim can be denied even though it is a genuine claim. This means, that if paying your claim is of less priority to the other members of the mutual, then your claim can be denied, and it will have cost you 5% of your premium. As well, Nexus Mutual only allows you to file two claims during your cover period which is not realistically fair if you purchased a policy with a longer duration of cover [10].

Solvency - Insurance Mechanisms

Broadly speaking, the pooling, spreading, and transferring of risks are fundamental to insurance, and if utilized efficiently, can become factors in determining available/reserve liquidity and financial solvency of the insurance company.

i) Risk Pooling - A fundamental mechanism of insurance, mutual or otherwise, is to spread the liability the mutual assumed in a pool and any remaining funds in the pool can likely be considered underwriting profit. Within Nexus Mutual, there are two factors that limit the “available cover” that Nexus Mutual is able to insure and that is the Specific Risk Limit and the Global Capacity Limit, with the lower of the two limits applying [11]. The Specific Risk Limit is the ‘capacity factor’ multiplied by the total staked NXM tokens for that specific pool, with all platforms having a capacity factor of 2 except for the notable protocols that have a capacity factor of 4, like Aave, Curve, and Compound to name a few. The Global Capacity Limit is 20% of the Minimum Capital Requirement of Nexus Mutual valued in Ethereum [11].

· The pools are treated individually and not as a whole, which means that protocols like Aave V2 is charging the same premium as Yearn.Finance when Yearn.Finance has successful claims equating to 93% of all claims paid out within Nexus Mutual, while Aave V2 has over $40,000,000 staked historically and has not had any claims against its protocol [6, 7].

· The Global Capacity Limit, if the lower of the two limits, means that individual pools can represent up to 20% of the Minimum Capital Requirement [11]. If this is the case, this means that if given certain circumstances, multiple pools can each equate up to 20% of the Minimum Capital Requirement. If there are only 5 or less pools being insured, this makes sense, though there are over 100 pools available for you to insure your crypto on, which poses a solvency risk under certain conditions [4].

ii) Risk Spreading is an opportunity to diversify your portfolio so that correlation factors are at a minimum and can be practiced at multiple levels within insurance.

· Spreading of risk can be practiced by diversifying the pooling of a shared risk in varying pools and not within one pool. For example, within Nexus Mutual, all the risks being insured for Aave are pooled into one pool by themselves which creates a systemic risk within the Nexus Mutual ecosystem [4]. If the Aave protocol experiences a compensable claim and the capacity with this Aave pool was able to be 20% of the Minimum Capital Requirement, then this presents a solvency risk, especially if many different protocols are able to insure capacity up to 20% of the Minimum Capital Requirement [11].

iii) Risk Transfer - When purchasing insurance, it is traditionally a guarantee that you have transferred your risk to the insurance carrier, or mutual, for your predetermined liabilities or material losses.

· Nexus Mutual states they do not have any legal obligations to accept your legitimate claim, so there is no guarantee when purchasing coverage that you are transferring your risk to Nexus Mutual [10]. In their favor, Nexus Mutual does state that by paying a premium you are purchasing “discretionary cover” but in the same sentence also declare it is an “insurance-like product,” however, for the consumer from the claims perspective, there is little correlation with insurance, if any [12].

Additional Consumer Insurance Risk

Broadly speaking, historical losses used in actuarial models can be categorized as either certain or uncertain in terms of predictability. Certain losses may be based on random loss events, and the law of large numbers, which implies that future losses can be predicted with a high certainty throughout an actuarial process. Uncertain losses may be random events for the insured, however, they may not be random events at all, and this is because within the cryptosphere the cause of our losses for what we are being insured for are basically intentionally orchestrated events. Yes, there have been exploits that were legitimate accidents of unintentional coding failures, though the majority of the exploits seem to be because a particular vulnerability was intentionally pursued and exploited by bad actors. Overall, the risk from losses based on uncertainty are a heightened exposure and consideration should be increased when addressing this from all perspectives.

i) Adverse Selection is a notable factor for consideration within traditional insurance underwriting. In one perspective, there is the risk that the insurance prospect themselves will be the cause of their own loss. And based on the potential degree of anonymity of the clients paying for cover on Nexus Mutual, this is a more heightened factor within cryptocurrency. Basically, a policy holder can either lead to their own loss event because of a moral hazard or a morale hazard.

A morale hazard exists when an insured purchases an insurance policy and has an indifference to a loss event because they have an insurance policy to reimburse them for that loss event. Essentially, morale hazard is still an unintentional loss event from the consumers point of view, for example, leaving the front door unlocked because if something gets stolen then insurance may reimburse you for the stolen goods.

A moral hazard is from an intentional loss event and is more commonly known as insurance fraud. Traditionally within insurance, an insurance carrier has legal backstops that aid the carrier in case of insurance fraud. In traditional insurance, if you file a fraudulent claim, not only will your claim be denied but you can be charged with committing a crime. Based on the level of know-your-client requirements at Nexus Mutual, the moral hazard is increased and becomes a shared liability for everyone in the mutual. According to Operation Wartortle, there is the potential to end the requirement for KYC for new members going forward [13].

Conclusion

Insurance has the ability to be a social mechanism that allows individuals to be compensated for unfavorable economic losses. At the community level, one of the most efficient ways of reducing losses from uncertainty is through a collective pool of funds that distribute losses from one individual of the community among all of those who distributed to the pool, and most of all, should be an opportunity to preserve your assets.

When considering a mutual insurance arrangement, usually all policy holders become owners of the insurance company and are entitled to any underwriting profits. Part of the benefit is that you get a say in the underwriting standards of the mutual, though at Nexus Mutual, it seems that whoever stakes against a pool, does not have any say in the acceptance of others into that pool, eroding part of the benefit of being an owner in your own insurance pool or mutual. The chances of the insurance carrier not earning any underwriting profits is an investment risk for the insurance carrier, not you.

If you are a member of the mutual and you wish to cash out because the mutual has been successful to the point the token is valued near $100, then you might not have the chance to cash out and recoup any benefits of being part of the mutual to begin with. This is because you cannot withdraw any of your NXM value if the Minimum Capital Requirement ratio is below 100%, which is currently sitting at 95% at the time of this writing [14]. In addition, the amount that you are able to withdraw is reduced by 2.5% to discourage people from withdrawing their funds from the mutual [15].

When the Minimum Capital Requirement ratio is below 100% this prevents anyone from cashing out their NXM and withdrawing their funds [16]. At the time of this writing, the MCR is below 100% so NXM token holders may not be able to withdraw their share of the earnings from Nexus Mutual. Interestingly, there has been over 500 policies purchased for known dead wallets in the past year and are still being purchased through February of 2022 [8, 17] This is especially interesting since the coverage for the dead wallets started two months after the Minimum Capital Requirement started dipping below 100% preventing anyone from withdrawing their funds [8]. Spending $1,600,000 in premium for coverage for wallets that no one owns is quite a lot of work to go through to prop up the NXM token and try to keep Nexus Mutual solvent, but it might just be easier to pay a few claims instead, though more on that the next time.