How insurers can reap the benefits of Web3.0: Insuring in crypto
By Ben Davis, Team Leader- Digital Assets, Superscript
The insurance industry has not historically been known for its innovation and proclivity for changing with the times; after all, Lloyd’s of London is the last known historical trading floor in the financial services industry. However, there has recently been renewed interest in the denizens of Lloyd’s to look at the digital asset industry in a new light. Historically, not one that has been mired in presumptions and cynicism but one that could bring about an entirely new asset class to insure and a new financial and economic system. And it can’t come too soon; businesses that were once traditional businesses increasingly turn to digital assets and blockchain technology as a form of community engagement, transaction monitoring, and IP monetisation.
With the new tokenisation trend that has been happening in the digital asset community, the once age old debate of how to properly insure digital assets has resurfaced with renewed vigour. That is to say, using crypto to back a contract of insurance rather than traditional fiat currencies (GBP, USD or EUR). The conversation normally centres around three areas:
- Insuring in the same currency to manage volatility
- How to hold cryptocurrencies on an insurer’s balance sheet
- Client’s expectations on paying in cryptocurrency
In order to understand how the conversation is playing out in pubs and boardrooms alike, it’s important to delve into each of these three areas to understand the problems and solutions to conclude how best to approach insuring in cryptocurrencies.
1. Insuring in the same currency to manage volatility
Like all nascent markets, cryptocurrency is volatile. There could be 30% to 40% intraday price swings which obviously make it difficult to insure the loss or theft of this currency from a value pegging perspective. What started out as a policy limit of $1m is now underinsured by 30% due to the appreciation of the asset’s value. This can potentially leave the insured drastically underinsured, while the insurer and broker would be left with a lot of paperwork to change limits depending on the market fluctuations.
The idea then is to insure like for like, crypto for crypto and denominate both the limits and premium in crypto. This allows for the insurer to not worry about underinsurance, limit adequacy, or paperwork frustrations as changes in volatility won’t impact the limits of the policy. Ultimately, volatility is less a problem for insurers as it is for their clients, as insurers will cap their liability at the limit of the policy regardless of volatility. However, this could prove to be a problem in the future when it comes to attracting new business. Currently, the demand far outstrips supply; thus, insurers don’t have to be too innovative in addressing this problem now, meaning that insuring physical private keys in fiat isn’t an issue. In short, it’s a sellers’ market. However, in the future, where more capacity comes to the market and customer demand for policies to be denominated in crypto increases, markets will have to address this to stay relevant. But how? This leads us on to point number two.
2. How to hold cryptocurrencies on an insurer’s balance sheet
Even more so than educating underwriters on digital assets, the problem then becomes how an insurer holds cryptocurrency on their balance sheet. Insurers are heavily regulated companies with strict requirements on allocating their capital and what areas they can invest in. The idea being that they need to make sure they have enough capital to meet liabilities in the event of claims, which means holding cryptocurrency on their balance sheet may pose problems. As rated and publicly traded insurance companies need to disclose their financials to the public, they would need to disclose what cryptocurrency they currently hold and how this is being treated.
While I am neither a lawyer nor an accountant and cannot comment on exactly how it would be treated from either of those perspectives, there would certainly have to be portfolio management where the insurer would hold crypto assets split between risk allocation and only allocate a small percentage of their entire capital to crypto for claims payments. For example, there would have to be a certain percentage held in stable coins to maintain adequate reserves and the rest balanced between Bitcoin and potentially Ether. With these three crypto assets an insurer would not only be able to pay liabilities with a low volatility token but also potentially gain exposure to an alternative asset class to provide investment returns. Not to mention gas fees to interact with smart contracts and pay for onchain services.
In relation to ways, an insurer could hold crypto on their balance sheet, they would most likely have to agree with the regulator on how to ‘mark to market’ the crypto they hold. There would potentially have to be a coupon discount on all Bitcoin or Ether held by the insurer in order to account for volatility, this means that if one Bitcoin was equal to $50k at the time, it was bought the regulator may only view it as if the insurer were holding only $35k. This discounted valuation would be used for calculating reserves and could potentially insulate the insurer from unwanted price volatility.
3. Clients’ expectations on paying with cryptocurrency
Maybe the most interesting part of the evolution of crypto insurance is that it will become more common for clients to want to pay in cryptocurrency over time. As crypto becomes more widely accepted and utilised, insurers will have to set up their own digital asset wallets for them to accept these tokens. Otherwise, they can just use an instant exchange service where the insured sends crypto and the insurer receives the fiat currency (minus a fee). This may seem like an easy answer but would undoubtedly eat away at the insurers’ loss ratios as paying high fees on each transaction would certainly add up over time. It may be more conducive to a longer term investment to operate a multisignature wallet to accept premiums and pay out claims.
Anecdotally, there has been a noted shift toward digital asset companies only speaking in amounts denominated in ETH when interacting with other digital asset companies. These companies are crypto rich and cash poor. So, while quoting a premium of $80,000 may seem quite expensive to the client, if we quote that same price in ETH, the client would likely be more favourably disposed to pay.
The winds of change are certainly blowing and although insurers don’t yet need to hold cryptocurrency on their balance sheet, they’re not far off. Open conversations with regulators, portfolio management and of course, meeting customer expectations are how a once antiquated industry can firmly step into the era of emerging technology and reap the many benefits of Web3.0.