What the crypto crisis may mean for insurers

In the wake of the collapse of FTX, which wiped out billions of dollars from digital assets, insurers and other financial institutions, that had a strong fundamental understanding of digital assets and utilized that information in their business operations, were able to rest peacefully, while those that lacked this fundamental understanding were left exposed to an unbelievable financial collapse. As the insurance industry looks to innovate and modernize, understanding the technology that may underlie some of the financial systems is something to consider for both the insurance industry and those who wish to work within it. 

Some in the industry continue to doubt the relevancy of cryptocurrency and digital assets, especially following major events like the multibillion-dollar FTX insolvency. Despite doubts, major financial systems are moving forward with the inevitable as several world economies have already undertaken major steps to pilot and plan implementations of their own Central Bank Digital Currency (CDBC). 

The potential for digital currencies to revolutionize financial transactions in the same way that the internet changed commerce and society over the last 30 years is palpable. For example, the digitization of the telephone system occurred seamlessly behind the scenes. When customers picked up a phone, they still heard that familiar ringtone and still dialed the same 10 digits. While consumers initially didn’t notice the changes, the digitization allowed for faster, higher quality phone calls at a lower cost that ultimately fueled the development of web infrastructure leading to the development of new industries like digital media and e-commerce. 

Similarly, the evolution of our monetary system will likely start behind the scenes, utilizing cutting edge technology found in cryptocurrencies to conduct business faster and more efficiently. Eventually the digitization of currencies, like the revolution in communications, will give rise to new opportunities for businesses and individuals. 

For insurance, the interaction with money will likely change before it does for customers. For that reason, it is imperative to gain knowledge and understanding of cryptocurrencies and what differentiates them from one another. The gold standard of cryptocurrencies is widely accepted to be bitcoin –an amalgamation of years of development within cryptography, computer science, and economics. While the technology is relatively new to many, bitcoin was created in 2009.

In economics, there is a core list of desirable traits for a currency to have including durability, portability, divisibility, uniformity, scarcity and acceptability.   With the impending rise of CBDCs and the increasingly common failure of multiple global financial institutions, the durability of a currency is becoming increasingly desirable. 

A common misconception in the FTX collapse is that bitcoin was lost or destroyed. bitcoin can never be destroyed as each transaction is enshrined on the blockchain, auditable by anyone with a computer. Institutions that wish to assure their investors and depositors of their liquidity can safely and securely publish what is referred to as proof of reserves. Providing proof of reserves would enable interested parties to verify the underlying assets exist to secure the deposits with an institution. 

Although bitcoin cannot be destroyed, it can certainly be lost, as has happened several times in the past. 

But the question arises, how do we insure these assets? Individuals looking to store their assets at an exchange or with another digital asset institution are taking on an additional exposure to risk. Counter-party risk amongst digital assets is very real as several institutions practice fractional reserve banking with these deposits and have found themselves facing liquidity issues on multiple occasions in recent history. Insurers have an opportunity to help unsophisticated consumers evaluate the credit worthiness of these organizations and provide insurance products to help offset some of the risk that coincides with storing digital assets with a third party.

Self-custody of digital assets is the preferred way by most in the crypto industry to eliminate counter-party risk, however, as with possession of all real property, risks of theft and damage still exist. According to Chainanalysis, roughly $3.2 billion worth of cryptocurrency was stolen in 2021 — a 516% increase compared to 2020.  While crypto owners who practice self-custody are typically concerned with privacy, there may be an opportunity for insurers to provide coverage in the space.

Also, insuring businesses that are mining bitcoin. An emerging field to consider is smart contracts. A smart contract is a digital agreement which is automatically executed and based on predefined criteria. Smart contracts can be extremely complex and include multiple conditional criteria, or they can be as simple as requiring a digital signature to spend money. There is also the risk that a user’s funds will get lost or stolen by hackers. As developments take place around digital assets, revolutions outside of currency could take place. Smart contracts create interesting use cases around peer-to-peer insurance and contracts that could execute automatically based on objective measures or triggers.

We also must be mindful of the losses indemnified in cryptocurrencies. With the expanding dependence on technology, cyber-attacks are more expensive for victims than ever before. Many ransomware attacks request payment in cryptocurrency to release a victim’s technological resources, placing insurers in a position to pay losses in cryptocurrencies. This exposure necessitates insurers increase their competency with cryptocurrencies and how to responsibly interact with a variety of digital assets. 

There continues to be demand for cryptocurrency insurance. The primary concern for insurers is underwriting and pricing the risk because of the lack of understanding and price volatility. Despite it being a multi-trillion-dollar industry, it remains mostly uninsured. That is shifting, particularly with new insurance players entering the field. 

As this field emerges, it will become increasingly important for the insurance industry to possess this fundamental knowledge and experience, so that we can make wise business decisions, avoiding the expense of precious resources on solutions looking for a problem.