A Three Tier Architecture for Decentralized Insurance Governance: Capital Backed Parameter Markets and Equilibrium Analysis

Abstract

Insurance governance fundamentally concerns the legitimate authority to price risk, allocate capital, and absorb correlated losses. Traditional models centralize this authority in credentialed institutions, while existing decentralized finance (DeFi) protocols either replicate centralized control or treat critical actuarial parameters as exogenous inputs. This paper resolves the decentralized insurance governance trilemma by proposing the first complete theoretical framework built on a three-tier architecture of capital-backed parameter markets, extending and completing the Risk Coin framework (Yu, 2025). The architecture transforms actuarial assumptions into endogenously discovered economic variables. At the Risk-Pool Tier, insurers commit capital to bid on parameters of an MBBEFD exposure curve. Policyholders signal their private risk assessments by declaring a coverage limit and a total premium payment; from these, an implied retention multiplier is derived after market pricing. At the Catastrophe-Pool Tier, reinsurers likewise commit capital to bid on parameters for pricing optional excess-of-loss reinsurance. The core governance innovation is a recursive design: a Catastrophe Pool operates identically to a Risk Pool, with Risk Pools as its policyholders, thereby unifying the governance logic of primary and reinsurance markets under the same capital-backed mechanism. The ecosystem is anchored by the Risk-Coin-Fund Tier, which centralizes all capital—including the base risk premiums (corresponding to actuarial costs), policyholders’ voluntary supra-actuarial contributions, and professional investment reinsurance capital—and serves as the ultimate residual risk bearer. A core innovation is the consistent application of Risk Coin as a dual-purpose claim on the collective capital pool. RC tokens are issued to participants based on two principles: (1) as compensation for voluntary capital investment (the portion of declared premiums exceeding actuarial cost), and (2) as payment for risk-bearing, with the latter quantified by the market-determined exposure curve 𝐺(⋅). This creates a unified incentive system where capital commitment confers pricing authority, and better risk management preserves RC value. We formalize the mechanism and prove its core properties: incentive-compatible parameter bidding, asymptotic information aggregation, dynamic stability of parameter markets, systemic resilience via an exponential solvency guarantee for diversifiable risks, and regulatory non-intrusiveness. A pivotal theoretical extension is the introduction of a protocol-native capital coverage ratio (ρ), which emerges from the recursive markets. This ratio is governed by a target (𝜌target) and serves as a real-time, transparent solvency signal. It demonstrates how decentralized systems can achieve endogenous stability while providing a direct interface for financial oversight, effectively bridging cryptographic economics with prudential regulatory frameworks. The framework demonstrates that legitimate pricing authority and financial stability can emerge organically from cryptographic economics where tokens serve not as speculative instruments but as verifiable, economically-founded claims on underwriting capacity and capital pool ownership. By solving the governance trilemma through recursive capital-backed parameter markets, a unified RC-based capital accounting system, and a native regulatory interface, this work provides more than a new insurance mechanism—it offers a blueprint for stable, transparent, incentive-aligned, and regulatorily-compatible financial ecosystems that reimagine the foundations of risk-sharing and financial governance.