By: Dipti Mishra, Specialist – Business Analysis

Till recently, cryptocurrency was receiving a stink eye from finance analysts. But now, many banking giants like Barclays, HSBC, Credit Suisse, etc., are entering the playing field and investing in the crypto industry. Undoubtedly, many of these names felt the pulse of these digital coins and sensed that they are here to stay. New possibilities related to digital currencies are also emerging in the insurance industry.

Although the economic recession of 2008 proved how fatal our heavy reliance on the traditional finance system can be, the pandemic accelerated the acceptance of alternatives to the former. Decentralized Finance (DeFi) is a competent financial system running and regulating independently without any central authority. In 2008, right after the Lehman Brothers went bankrupt, Bitcoin emerged through a whitepaper with the idea of relying on cryptographic proofs instead of massive reliance on traditional finance systems that keep a big chunk of profit to themselves.

Cryptocurrency is a derivative of the same system and uses blockchain, smart contracts, and cryptography. Intending to democratize finance by challenging traditional financial practices, it enables developers to create decentralized financial products, promotes peer-to-peer financial transactions and contracts without the involvement of any third party, e.g., banks, courts, or authorities, and thereby eliminates the need for any intermediaries such as banks, payment processors, payment gateways, etc.

The increasing acceptance of the cryptocurrency industry also creates an excellent possibility for the crypto insurance market. The reasons behind this can be attributed to:

1. Growth in the DeFi industry: Following the surge in Bitcoin’s popularity, many corporate investors have started to take an interest, e.g., Tesla, which acquired $1.5 billion of Bitcoin (BTC) in January 2021, or business-intelligence software company MicroStrategy, which holds an aggregate of $2.2 billion of BTC.The recent advancement in the crypto industry has been brought forward by Non-Fungible Tokens (NFTs), which can be both physical and digital assets, that act as non-interchangeable unique assets meant for certified ownership. Unlike cryptocurrencies, these tokens are distinct from each other. On March 3^rd, 22 insurance brokers and wealth managers at IMA Financial stated that they are investing in an R&D facility to figure out ways to assess risk and underwrite coverage of NFTs.

   Apart from that, the usability of NFTs in the Metaverse (i.e., virtual tokens in a virtual universe) has been on the rise for quite some time. Some examples of the use cases are owning virtual real estate (like Decentral), collecting in-game items (like Axie in Axie Infinity, whom the owner can train and breed, representing ownership of virtual characters and avatars), having passes via NFTs to virtual events and experiences, and so much more. Even Nike has stepped into the Metaverse with its own virtual “Nikeland” and has now acquired a studio (RTFKT) known for making NFTs of products. The possibilities in the DeFi industry seem limitless now.

2. Instability of cryptocurrencies: The volatility of the crypto market has been the moot point. While the alluring peak of profit draws many, the extreme troughs create panic among consumers. Add the threat of online thefts and fraud, and insurance becomes the only feasible solution. Even though the insurance industry has traditionally had a conservative approach towards risk profiling, the issues in the crypto industry can be a potential source of revenue for it.

3. Increasing need for insurance: As with the theft of physical cash, there have been many incidents of theft and malicious hacks of digital currencies. While in the case of physical or electronic cash, security systems are in place to track the theft, the hacker of a digital currency account can quickly go missing into thin air of anonymity on the web. In fact, around $16.7 billion in cryptocurrencies have been stolen between January 2011 and February 2023.
4. Increased focus on regulatory compliance: In an interview with the Financial Times last year, the US Securities and Exchange Commission (SEC) chairperson Gary Gensler said that crypto platforms need regulation to survive. The Financial Action Task Force (FATF) recently defined virtual asset service providers as cryptocurrency exchanges, stable coin issuers, DeFi protocols, and NFT marketplaces. Apart from that, in the United States, crypto assets are now considered legal and fall under the Bank Secrecy Act (BSA) jurisdiction.With many regulatory compliances defining and redefining the increasing boundaries of the crypto industry, reluctant industries such as insurance are slowly willing to test the waters.

As blockchain is the building block of these currencies, it embeds new information at every step, making it easy to assess the authenticity of claims while decreasing administrative costs. And it is only one of the many benefits that insurers can reap from the skyrocketing crypto market.

The insurance industry can don many hats to gain traction, such as:

• Acting as crypto underwriters: In this role, organizations can invest in the crypto market, and insurers can provide protection from cyber-attacks like theft or hacking.
• Accepting crypto as a mode of payment: Insurers can take premiums in terms of these currencies and, vice-versa, pay in digital currencies when a hazard occurs.

Challenges for insurers:

• Volatility: The premium amount is calculated by the historical data or past performance of the assets, and such data is absent in the case of cryptocurrency because it is still a new industry. While insurtech has undoubtedly pushed the otherwise risk-averse insurance industry out of its heavily regulated environment, many insurance carriers are hesitant to enter the crypto market because of its high volatility and unpredictability.
• Risk profiling: For reasons such as these, it is also difficult for insurers to assess the likelihood of loss and profile risks without actuarial data. The anonymity involved in the crypto industry is also another reason for the difficulty in risk profiling. While the public tracking of a crypto coin is viable, the participants can still maintain an anonymous identity. Without knowing the authenticity of the owner, the insurer can’t provide insurance to the asset. Such factors create a great imbalance between the profound need for insurance in the crypto industry and the immense difficulty in providing the same.
• Regulatory frameworks: One of the most critical questions in the regulatory debate is if a crypto-based instrument is legally eligible to be called a “security”(i.e., an asset with monetary value and able to be traded). Even if a crypto-based offering can come under the umbrella of “securities,” further discussions are needed about whether the trading platforms for these crypto instruments constitute a “marketplace,” as different rules and regulations apply to platforms depending on whether they come under this characterization.In some instances, the SEC has defined crypto assets as securities. In other cases they are recognized as representing or embodying security, and, in other instances, they are recognized as a part of securities transactions.
• Pricing: As NFTs are non-fungible and unique, there is no standard market pricing like cryptocurrencies, as the valuation of NFTs solely depends on the quotation of the owner.

Despite all these roadblocks, cryptocurrency companies and investors need to provide transparency to insurers to better gauge the market and provide appropriate coverage. Some of the elements where transparency will be needed include:

• What is their operating model?
• What steps do they plan to undertake to minimize risks and cyber-crime?
• Is there a need for insurance for their operations?
• What is the insurance needed for an organization?

While cryptocurrency is one of the earliest innovations of blockchain, there are many exciting possibilities looming large around the corner.  To unlock those possibilities, transparency, and collaboration among various stakeholders are key to moving forward, particularly in the insurance industry.

References:

1. SEC Chairman on regulation required for survival of Crypto platforms, Ari Levy, Mackenzie Sigalos, CNBC, Apr 27, 2023: https://www.cnbc.com/2023/04/27/sec-chairman-gary-gensler-says-the-law-is-clear-for-crypto-exchanges.html
2. IMA financial investing in a R&D facility for assessing risk and underwriting coverage for NFTs, PYMNTS, March 3, 2022:https://www.pymnts.com/es/nfts/2022/nft-insurance-is-coming-but-is-there-an-industry-to-support-it

3. Tesla’s and MicroStrategy’s investments in Bitcoins, Emily Mason, Forbes, Aug 2, 2022:https://www.forbes.com/sites/emilymason/2022/08/02/microstrategy-bought-bitcoin-in-2q-as-tesla-was-selling/?sh=6a9ece3a70df

4. Role of NFTs in the Metaverse, Oleg Fonarov, Forbes, March 11, 2022: https://www.forbes.com/sites/forbestechcouncil/2022/03/11/what-is-the-role-of-nfts-in-the-metaverse/?sh=6e7471206bb8
5. Defining Virtual Assets, FATF, 2021: https://www.fatf-gafi.org/en/topics/virtual-assets.html
6. Blockchain and its implications for the insurance industry, Munich Re Life US, July 2020: https://www.munichre.com/us-life/en/perspectives/underwriting/blockchain-implications-insurance-industry.html
7. The adequate laws and regulations of cryptocurrency, Financial Crime Academy, June 25, 2024: https://financialcrimeacademy.org/cryptocurrency-in-the-americas/#:~:text=Cryptocurrency%20exchanges%20are%20legal%20in,and%20report%20to%20the%20authorities