Introduction to Risk Pool Tokens on the Etherisc Protocol

This blog post investigates how insureds, investors, and developers may benefit from using risk pool tokens on the Etherisc protocol.

How users can create tokens that generate passive income

A member of the Etherisc Community Chat on Telegram asked an important question earlier this year:

Providing a satisfactory answer is critical for investors to gain trust in risk pool tokens. To provide this answer, we can first illustrate how the Etherisc protocol enables collaborative development of insurance products, and where risk pools come from. Once we see, where the risk pools originate from, we can delve into the mechanics of tokenized risk pools — how users will create risk pool tokens, and what generates passive reinsurance income for holders of such tokens.

Below, you will find a visual representation of the money flow behind insurance products.

Revenue model for protocol users and crypto investors

The diagram above shows how all three types of Etherisc protocol users benefit without having to trust one another, and without having to rely on rent-seeking middlemen. It works the following way.

Insureds. Pay insurance premiums (for example, insuring their flights from delays).

Workers. Developers, data scientists, actuaries, license providers, and entrepreneurs make money by collaboratively developing and distributing insurance products. For example, a 20-year-old developer from China may choose to deploy a copy of Flight Delay (or any other insurance product template) and configure a fee to be sent to his/her Ethereum address as a payment for his/her work. Perhaps, there is a different language in the UI, different distribution channel, or a more accurate risk model. Such a copy of Flight Delay (or any other insurance product template) becomes their own, autonomous insurance business. Each such product comes with a risk pool, holding premiums from insureds.

As a result of collaborative development and operation of insurance products, a number of risk pools will operate on the network. Risk pools can be generally split into three categories — unleveraged, reinsured, and collateralized with risk pool tokens.

That is, some of the risk pools will never be tokenized for various reasons. Some insurance products do not need leverage at all (i.e., when insureds are comfortable just sharing risk with each other). Insurance products with risk pools without leverage is effectively a P2P insurance.

Many risk pools will need to use leverage. For some, there will be plenty of reinsurance capital available at very small premiums.

What if reinsurance is not available for a risk pool? For many risk pools that need leverage, reinsurance capital may be too expensive or not available at all. Some product builders will choose not to work with traditional reinsurers due to lack of experience, or for other reasons. Instead, they may choose to tokenize one or more of the risk pools and make them available to any investor seeking opportunities to earn passive income on their crypto assets.

Investors. This model assumes that investors are willing to accept a force majeure or catastrophe risk, such as a hurricane that might disrupt flights for a few days or something more grave like the Icelandic volcano eruption in 2010 that closed down numerous European airports for several days. Investors who purchase tokenized risk pool tokens effectively become owners of their own part-time reinsurance business. Investors do not sell their crypto into fiat. This brings them passive income on their existing crypto assets with a risk profile that does not correlate to crypto, debt, or equity markets (i.e., volcano eruptions don’t correlate with financial market risks).

In this scenario, users of the Etherisc protocol will thus be able to create “insurance-linked securities” risk pool tokens, where a portion of the premium originally paid by the insured is paid to investors as interest in exchange for accepting a catastrophe risk.

In accepting this risk, risk pool token holders will be aware that they may lose some or all of the staked principal (i.e., the original amount they paid for the tokens). This would happen if and when an unusually high number of payments had to be made to insureds, depleting the operating risk pool as the collateral staked behind the smart contracts of the risk pool token is being deployed.

Turning back to the upside in this scenario, we can look at two types of risk pool tokens: fixed rate bonds and zero-coupon bonds.

Option 1: Fixed rate bonds

Step 1: Create a risk pool token. For example, protocol user John chooses to tokenize risk of a Flight Delay risk pool contract (created by any other user of the protocol).

John opens a web interface (a client to the protocol) and creates the DELAY1 token, which represents a flight delay risk in North America and Europe, QUAKE4 for earthquakes in California, and WALLET3 to represent the risk of 100% loss of funds held by users of crypto wallet ABC.

Risk pool tokens are effectively bonds that pay certain annual/monthly interest and have a date of issuance, as well as a date of maturity (expiration). For example, DELAY1 is denominated in ETH, has a 6-month maturity and pays 24% interest. A total of 150 DELAY1 tokens are issued, costing 1 ETH each. If John wants to market these to US investors, a form 506(d) is filed online by the smart contract through an oracle service or by John himself.

Step 2: Purchase risk pool token. Investor Kate decides to buy 10 DELAY1 tokens on February 15th, 2018 and receives them by paying 10 ETH to the DELAY1 smart contract.

Step 3: Generate passive income. A portion of all premiums paid by insureds is transferred by the DELAY1 smart contract to holders of the DELAY1 token. This means that on March 15th, 2018, Kate receives 0.2 ETH for her 10 DELAY1 tokens, calculated in this case as follows:

1 ETH / 12 × 24% × 10 DELAY1

If there is no gigantic volcano eruption in Iceland before August 15, 2018, Kate will be receiving her interest every month. If there is a catastrophe, Kate may lose some or all of her principal (10 ETH).

In the absence of a catastrophe, Kate will receive a total of 1.2 ETH by August 15, 2018, as compensation for her “reinsuring” the risk of catastrophe, and on the maturity date of the sDELAY1 token (August 16th, 2018), the DELAY1 smart contract returns the original investment of 10 ETH to Kate’s wallet. As a result, Kate keeps 1.2 ETH “reinsurance compensation” and 10 ETH — a total of 11.2 ETH. Hodl!

Option 2: Zero-coupon bonds

The same Hodl! result can be achieved without the smart contract having to pay interest every month, through a vehicle known as a zero-coupon bond. The holder of a coupon paying bond receives the face value of the bond at maturity but is also paid coupons over the life of the bond.

Zero-coupon bonds are priced at a deep discount. Holders gain on the difference between what they pay for the bond, and the amount they will receive at maturity. A coupon-paying bond will initially trade near the price of its face value. In other words, a zero-coupon bond gains from the difference between the purchase price and the face value, while the coupon bond gains from the regular distribution of interest. The steps are the same as in Option 1, as the underlying assumptions are the same (i.e., investors seek passive income through bonds while accepting a catastrophe risk).

Note: Both types of bonds are created by a smart contract native to the Etherisc protocol. This smart contract manages the lifecycle of the insurance-linked security — including issuance, distribution, and the end-of-life of a risk pool token.

References

The fundamentals of insurance-linked securities

Zero-coupon bond value

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