If you’re reading this legal update, chances are you’ve heard of decentralized finance (DeFi) before. Simply put, DeFi is a decentralized platform that enables peer-to-peer provision of various types of financial services without the need for a central intermediary (like a bank). DeFi transactions are enabled by public blockchains, such as Ethereum, Solana, Terra, and Avalanche.
The volume of transactions taking place in the DeFi space is huge and continues to grow exponentially, as measured by the overall value of cryptocurrency assets deposited in DeFi protocols (i.e. the “ total value locked” or “TVL”). Given the growth experienced by the DeFi market, it is no surprise that DeFi users have sought to take advantage of risk-spreading schemes similar to those used in other markets and industries. Insurance is one such risk-spreading device. Since DeFi is – by nature – decentralized and its users are accustomed to decentralized financial products, it makes sense that the insurance solutions provided to DeFi users also have decentralized features. Indeed, we have seen a number of providers establish themselves in the emerging decentralized insurance space recently with the aim of offering decentralized insurance solutions. However, insurance coverage of events that affect the DeFi ecosystem (e.g. cybersecurity coverage for DeFi exchanges) need not be decentralized, which provides many opportunities for existing providers of a such insurance coverage to expand their current offerings in the DeFi market.
In both cases, insurers will need to ensure that their operations comply with the regulatory framework for insurance in the United States, which is complex and nuanced. These nuances will be familiar to current players in the insurance industry, but may not be so obvious to new entrants to the market, such as decentralized insurers. Each US state has its own code of insurance laws and its own insurance regulatory authority that enforces and monitors compliance with those laws. This means that offering an insurance product nationwide in the United States, whether the insurance product is decentralized or not, requires an operating model that is compliant with the insurance laws of more than 50 U.S. states. and other jurisdictions. Some considerations that are important in structuring the operations of an insurance provider, including hedging providers for DeFi, are:
1. Operating as an insurance company. U.S. state insurance laws uniformly require a person carrying on insurance business in a U.S. state to be licensed as an insurance company in that state, unless there is a state-specific exemption from these licensing requirements do not apply. The range of activities that constitute the insurance “transaction” is usually very wide. For example, issuing or delivering an insurance contract in a state of the United States would generally be considered to be “carrying on” insurance business in that state and would therefore require the person carrying on such activity is licensed as an insurance company. While we’ve seen arguments that a DeFi insurance solution offered through a smart contract shouldn’t constitute an “insurance contract,” we think state insurance regulators would likely view these arguments with skepticism. . Although the definition of “insurance contract” varies widely from state to state, an insurance regulator would generally consider a contract that meets this definition to be an insurance contract, regardless of form in which it arises (i.e. a smart contract could be an insurance contract even if no insurance policy is issued to the customer as long as the smart contract meets the definition of “contract of ‘insurance’ under the law of the relevant state).
For example, New York insurance law generally defines a “contract of insurance” as any agreement “or other transaction” whereby one party becomes obligated to confer a benefit of monetary value on another party. based on (1) a fortuitous event (i.e., an event that is substantially beyond the control of either party) in which (2) that latter party has a material interest that will be negatively affected by this event. In our view, a smart contract would constitute an agreement “or other transaction” between the insurance provider and a customer, and – so long as the smart contract obligates the provider to indemnify the customer based on the occurrence of a fortuitous event that negatively affects the customer – this type of smart contract would most likely constitute an “insurance contract” under New York insurance law. As a result, an insurance provider issuing a smart contract like this to New York customers would be required to be licensed as an insurance company in New York, unless an exemption from these requirements of license is applicable.
2. Other activities subject to licensing. Depending on specific U.S. state insurance laws, certain licensing requirements may apply to activities such as marketing insurance products, adjusting or settling insurance claims, receiving compensation in the form of a percentage of insurance premiums (i.e. commissions), underwriting insurance products, receiving insurance premiums and a wide variety of other activities related to insurance. These licensing requirements are strictly enforced by state insurance regulators. For example, a cloud-based platform that offered insurance solutions to its customers and was licensed as an insurance agency, but failed to ensure that all of its employees had the appropriate insurance licenses and failed to comply with certain other national insurance laws. was the subject of a multi-state investigation and had to pay millions of dollars in fines.
These licensing requirements may apply to the decentralized insurer itself or to its partners or investors. For example, if a decentralized insurance provider has organized a decentralized autonomous organization (DAO) whose members have the power to vote on whether or not to pay a particular insurance claim, state insurance regulators may view these voting rights as allowing members of the DAO to adjust or settle claims and therefore require them to be licensed as independent adjusters. As another example, a third party engaged by a decentralized insurance provider to market its products may be considered by state insurance regulators to be selling, soliciting, or dealing in insurance – activities that generally require the person who executes is licensed as an insurance producer.
3. Discounts and Incentives. Most U.S. states have enacted insurance laws prohibiting insurance companies, insurance agents, insurance brokers, and other licensees from paying a discount on an insurance premium to an insured or to grant a special benefit or favor to an insured which is not specified in the insurance policy. These laws would generally prohibit a decentralized insurance provider from, for example, offering lower insurance premium rates to holders of its DeFi token or members of its DAO or offering free or priced products or services. reduced (such as “airdrops” of tokens) to its policyholders or to the subscribers of its insurance products.
4. Mandatory reserves. US state insurance laws generally require an insurance company to maintain reserves for purposes such as payment of losses and claims and expenses of adjusting and settling claims. If a decentralized insurance provider uses a liquidity pool model for some or all of its reserves, in which participants in the liquidity pool are compensated with tokens for providing reserve liquidity to the pool, insurance regulators of the State may assert that the pool of cash is not large enough to ensure that the insurer is adequately reserved and/or that the pool of cash does not constitute the assets of the insurer to the extent that cash may be withdrawn from it by participants at any time.
The above list of insurance regulatory considerations is not exhaustive, but represents some key areas that we would expect state insurance regulators to focus on when reviewing a provider’s operations. decentralized insurance.
While these insurance regulatory hurdles can be difficult to overcome, they also present a significant opportunity for a player in the insurance industry that both employs sophisticated underwriters familiar with the DeFi space and understands the US regulatory framework. insurance to capture a significant proportion of the still nascent market. US DeFi insurance market. Additionally, capturing this market could lead to cross-pollination opportunities by offering other types of insurance products (i.e. not just DeFi-related ones) to consumers in the DeFi space. Much like the now-established insurtech market, working within the confines of US insurance laws will likely prove critical for decentralized insurance market players as they seek to expand their operations and scale. the scope of their product offerings.
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This article by Mayer Brown provides information and commentary on interesting legal issues and developments. The foregoing is not a complete treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action regarding the matters discussed here.