Governance Tokens Undermine Insurance Pool Stability

Governance tokens turn risk capital into speculative assets, creating a conflict of interest between pool security and token price. This leads to:

• Vote dilution where large token holders prioritize short-term gains over long-term solvency.
• Misaligned incentives where governance decisions (e.g., coverage parameters) are gamed for token utility, not pool health.
• Capital flight risk during market downturns, as token holders exit to cut losses, directly draining the pool's backing.

A pioneer in on-chain insurance, Nexus demonstrates the governance-stability tension. Its NXM token's price is tied to capital pool size, creating a reflexive feedback loop.

• Price-Solvency Link: NXM price formula includes Cover Capacity, making token value hostage to underwriting performance.
• Staking Dilemma: Stakers must lock NXM to underwrite risk, but are exposed to both protocol claims and token market volatility.
• Result: Capital efficiency suffers as the system must over-collateralize to buffer against token price swings.

Decouple governance from the economic backing of the insurance pool. Follow the lead of Euler Finance's rehabilitation or Maker's Endgame Plan.

• Dual-Token Systems: Separate non-transferable 'stake' tokens for governance/underwriting from liquid 'reward' tokens.
• Actuarial-Backed Reserves: Capital pools should be funded by stablecoins or diversified assets, not the governance token itself.
• Skin-in-the-Game via Slashing: Enforce alignment by slashing staked assets (not tradable tokens) for poor underwriting decisions.

Governance token collateral requires massive over-collateralization (often >150%) to account for volatility. Stable-asset pools can operate near 100% collateralization.

• Opportunity Cost: Capital locked as volatile collateral yields zero productive return and amplifies systemic risk.
• Risk Modeling Impossibility: Pricing coverage is chaotic when the collateral's value is driven by sentiment, not actuarial tables.
• The Fix: Use yield-bearing stablecoins (e.g., DAI, USDC) in pools, turning idle collateral into a revenue stream that enhances pool solvency.

Governance tokens decouple voting power from capital-at-risk, allowing token-holders with minimal stake to dictate pool parameters. This creates a principal-agent problem where the interests of voters and capital providers diverge.

• Key Risk: Token holders vote for higher risk/reward strategies to boost token value, while LPs bear the downside.
• Example: A governance proposal to lower collateral ratios or expand coverage to riskier protocols passes, increasing pool insolvency risk.

Insurance pool tokens become yield-bearing speculative assets, not pure risk instruments. Their price volatility introduces a secondary failure mode independent of underlying claims.

• Key Risk: A token price crash can trigger a death spiral: LPs exit → pool capital shrinks → confidence falls → token falls further.
• Data Point: Look at the correlation between Nexus Mutual's NXM price and its capacity for new coverage during bear markets.

The fix is to hard-code core risk parameters (collateral ratios, claim assessment rules) and automate adjustments via on-chain oracles and predefined logic. Remove human governance from critical safety functions.

• Builder Action: Design pools like Euler's insolvency fund or Maker's PSM, where rules are immutable or only changeable via ultra-long timelocks.
• Investor Lens: Favor protocols where capital efficiency is derived from superior risk models, not governance token speculation.

If governance is necessary, directly tie voting power to capital actively deposited in the insurance pool. This realigns incentives by ensuring voters are the first to suffer losses.

• Mechanism: Implement a ve-token model (inspired by Curve/Convex) but where locked tokens represent insured deposits, not a separate governance asset.
• Outcome: Proposals that increase risk must be approved by those whose capital is on the line, creating natural conservatism.

Governance tokens are often marketed as a tool to bootstrap liquidity and improve capital efficiency. In reality, they often subsidize risk with unsustainable token emissions, masking the true cost of capital.

• Result: Pools appear well-capitalized during bull markets but face rapid depeg during stress when mercenary capital flees.
• Investor Takeaway: Scrutinize real yield vs. token inflation. A pool with $10M TVL paying 5% in tokens is less secure than one with $5M TVL paying 2% in real premiums.

The endgame separates capital provision from risk assessment. Specialized Actuarial DAOs (like Sherlock, Uno Re) underwrite and price risk, while passive LPs provide capital to a diversified basket of their approved policies.

• Architecture: This mirrors traditional reinsurance, creating a clear market for risk expertise.
• Opportunity: Build capital-efficient, non-governance middle-layer pools that aggregate underwriting from these expert DAOs.