There's a lot wrong with this argument. First of all, a primary concern when buying insurance is proof of the solvency of the insurer. That means the insurer has to hold the capital covering their outstanding risks. So any insurer that can prove solvency also has to sit on a ton of capital instead of using it productively, which means the minimal insurance cost of a contract is going to be value * (risk + r * time), where r is the expected rate of return on capital.

Adding on N redundant insurance contracts increases the total cost of insurance by N * value * r * time, assuming that the risk of insuring another insurance contract is extremely low. That number explodes extremely fast, and there's no obvious way to solve the problem apart from buying insurance without blockchain-based proof of solvency. But if you're doing that, why do it on the blockchain at all?

I think blockchain-based proof of solvency is one of the most compelling use cases of cryptocurrency, fwiw.

Your argument is valid, but consider that most contracts execute very quickly and so the scope of the insurance is quite limited. For more elaborate contracts, or for a set of inter-related contracts, insurance will be available for highly demanded combinations.

Also, since much of the insurance is against fraud, as parties became more trusted the price of insuring against their bad behavior would decrease.

Insurance is and has always been a profitable business simply because pooled risk is desirable in many circumstances. Blockchains don't alter this basic reality, and they make it far cheaper to offer proof of solvency and other meaningful transparency measures that benefit consumers.

Consider, for example, if employees could do a solvency audit of the PBGC at the click of a button.