The hardening of the insurance markets may have reduced the appetite for certain emerging risks but the increasing prevalence of so-called digital assets, including cryptocurrencies and initial coin offerings, will be hard for insurers to ignore.
The recent announcements that Google and Facebook will be entering the cryptocurrency space, and that a number of major US retailers will be accepting payment in cryptocurrencies, adds much needed credibility and confidence to the digital assets industry. In its infancy the sector experienced high volatility, theft and lost tokens scandals and concern over the use of digital assets to fund and conceal criminal activity. Digital asset businesses also proved attractive to those looking to exploit an undeveloped regulatory environment and to defraud naïve investors, including through implausible, but often unverifiable, claims regarding the existence and value of tangible assets said to back the digital assets.
Several insurers now offer tailored cover for risks relating to digital assets including for cyber and theft (including key theft) as well as fidelity and D&O/E&O coverages. Insurers may also pick up exposure to digital asset risks incidentally through existing accounts. However, many insurers will have a limited understanding of this new asset class and there is little if any historical loss experience to assist underwriters in evaluating potential exposures and pricing.
Much of the growth in the digital assets sector has been in offshore financial centres and this is expected to continue. These jurisdictions are attractive to digital assets businesses for many of the reasons that has previously led to insurers and investment funds setting up offshore. This includes the neutral tax environment (leaving taxes to be assessed in investors' home jurisdictions), the presence of strong but flexible regulation through a single financial services regulator and speed to market.
Onshore legislatures and regulatory bodies continue to agonize over how to regulate crypto-businesses with the UK's Treasury Committee describing the landscape as the "Wild West". By contrast many offshore financial centres have now enacted extensive legislation, regulations and guidance specifically tailored to the digital assets sector. This includes "sandbox" initiatives to encourage start-ups and innovation in a monitored environment.
These jurisdictions are also vying to position themselves as the jurisdiction of first choice for emerging digital assets businesses and the first to attain "critical mass". However, the offshore financial centres cannot afford to incur reputational harm in their push for market dominance, particularly at a time when offshore financial centres are under increasing international scrutiny. This has led to an intense and individualised focus on the risk profiles of prospective licensees and an approach to assessing risk that is in many respects similar that that which an insurer might take when underwriting a digital asset risk.
In recognition of the risks presented by digital assets businesses (including to third parties), offshore financial centres have produced extensive legislation and codes of practice requiring detailed business plans and risk assessments for licensing applications, prospectus filing for offerings, written AML, conflict of interest and outsourcing policies, the presence of non-executive directors (in most cases), enhanced customer due diligence for specified categories, qualified compliance and AML officers.
These protections, and the availability of detailed license-related submissions for insurance underwriting purposes, should provide an additional layer of comfort for insurers looking to insure digital asset businesses domiciled in offshore financial centres. Moreover, it is common for prospective licensees to be required to demonstrate that they have adequate insurance cover in place, thus spurring demand for insurance.
Regulators and insurance underwriters will of course have different perspectives and objectives, but when looking at digital asset start-ups both look for comfort-inducing features such as:
- The identity and track records of the individuals behind the start-up
- The presence of independent directors on the board
- The identity of service providers and auditors
- The presence of qualified compliance and anti-money laundering personnel
- The profile of the investors.
When considering proposals for insurance of digital assets business in offshore financial centres, underwriters should request copies of the prospective insured's regulatory filings. Cautious insurers may wish to limit their exposure to jurisdictions with the most stringent regulations on the premise that the less reputable and higher risk businesses may be drawn to jurisdictions with a light regulatory touch.
Lloyd's has issued guidance in the form of a Market Bulletin on the writing of insurance products for digital assets. This includes requirements for Lloyd's underwriters to consider matters such as:
- The security of private keys.
- The integrity of codes behind the insured risk.
- Cyber-crime, hacking risk and underlying network issues that may impact on the insured risk, including technological failure, malicious (or even unintentional) attacks, forks and loss of interest in a particular blockchain leading to failure to maintain the continued processing of transactions.
- The identity of the insured and the scope of coverage in the context of any transaction involving decentralised and/or anonymous actors.
- The insurability of risks and assets in compliance with applicable financial services laws, given the rapidly changing regulatory framework in this area.
- Exchange rate volatility and exposure to any fluctuations in the value of any underlying crypto asset.
In many respects this guidance highlights risks similar to those that have been identified by offshore regulators and which offshore jurisdictions have sought to identify and manage through bespoke digital assets legislation and regulatory requirements.
With global giants like Facebook and Google embracing virtual currencies, it should not be long before digital assets go mainstream and impact our everyday lives. Insurers will therefore increasingly have to confront the risks presented by digital assets and to develop appropriate expertise. In doing so they might follow the progress in offshore financial centres as they lead the charge in seeking to regulate this challenging but rapidly emerging sector.
This article previously appeared in Insurance Day on 27 June 2019
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. Kennedys operates in Bermuda in association with Kennedys Chudleigh Ltd.