Cryptocurrency’s Influence on Insurance
The insurance industry as we know it is losing credibility. The image of traditional insurance is flailing under the weight of technology - those who won’t be able to catch up will disappear. Why? Because tech offers solutions to problems insurance hasn’t been able to fix. In 2015, Anthem Insurance suffered a data breach that exposed the sensitive data of 78.8 million customers - as a result; the entire industry lost $375 million. Blockchain, the operating system that holds cryptocurrency, has the potential to build trust thanks to its public ledgers and fortified cybersecurity protocols. Blockchain, combined with the forces of Artificial Intelligence and big data, has the power to completely transform the insurance industry and render traditional firms utterly obsolete.
Recent reports have highlighted important changes taking place in the digital asset market, which could lead to many implications for the insurance industry. One of these implications is the influence cryptocurrencies are in the process of generating on insurance. In this article, we will be discussing how the use of cryptocurrencies has been modifying the market of insurance worldwide and what perspectives it has to offer.
The beginnings of cryptocurrency
In 2008, the worldwide financial crisis, also known as GFC (Global Financial Crisis), struck the planet. Considered by many economists as the worst financial crisis to happen since the Great Depression, it started when housing prices began to decline in 2006. There is great debate around the causes of this decline; some blame the Community Reinvestment Act, which enticed banks to make investments in subprime areas of the United States for the deregulation of the financial system. Banks were encouraged to invest in housing derivatives and lend to borrowers less and less capable of honoring their mortgages. This rapidly led to instability and the so-called ‘subprimes’ crisis.
Banks began to panic in 2007 once they realized they would have to absorb the losses brought about, so they stopped lending to each other. Interbank borrowing costs rose. The previously created housing bubble burst and financial institutions were left carrying trillions of dollars worth of worthless investments in subprime mortgages. Homeowners owed more on their mortgages than their houses were worth. In March 2008, the crisis officially started when the situation on Wall Street started to deteriorate. The Great Recession that followed would come to have a humongous impact on the economy worldwide and cost many their jobs, savings, and homes.
To put things simply, those to blame for the 2008 crisis are banks, and therefore traditional currencies around the world that were so reliant on banking systems that they failed the people. As a reaction to this, an individual going by the name of Satoshi Nakamoto, whose real identity remains unknown to this day, published a paper in 2008 that kickstarted the first crypto-currency ever: the Bitcoin. His paper, Bitcoin: A Peer-to-Peer Electronic Cash System, illustrated the peer-to-peer network as a solution to double-spending.
The idea was revolutionary: a digital currency or token could be duplicated in as many transactions as decided by the buyer— unlike a traditional coin or bill that can only exist in one place at a single time. Digital currencies have no physical space, so to use them in a transaction doesn’t mean removing them from someone’s possession. Nakamoto outlined a decentralized approach to transactions, which would eventually lead to the creation of blockchains.
The first Bitcoin transaction supposedly happened when someone used 10,000 Bitcoin to purchase pizza. Today, 10,000 Bitcoin is worth $321 658 000. 13 years later, it would be a very, very expensive pizza… Nevertheless, Bitcoin has remained the most popular and lucrative cryptocurrency ever since Nakamoto’s paper.
The new generation of crypto
In the early days of Bitcoin, many alternative cryptocurrencies arose, operating along the same lines. None were as successful. In 2015, Ethereum was created, whose blockchain is fueled by its native coin, Ether. Blockchain is a digital ledger of transactions duplicated and distributed across the sum of computer systems that make up the blockchain. Each of the chains’ blocks contains several transactions, and whenever a new transaction happens, a record of that transaction is included in every participant’s ledger. This is known as Distributed Ledger Technology (DLT). Ethereum’s blockchain is different from Bitcoin’s by way of how it can execute smart contracts that can be written between two parties and go into effect as soon as terms are met. The creators of Ethereum were able to maintain control over the system by creating dApps, decentralized applications similar to applications one can find on a cell phone or internet network, though not controlled by a third party.
Blockchain, a system built on trust - or the absence of it
There have been many attempts at creating virtual currencies in the past, all of which failed to take off. Why? Because of trust issues. Anyone can proclaim they are creating a currency - let’s say it’s called the C currency - but how can we be sure, upon investing in the C currency for, let’s say, 1 million dollars, that the creator won’t just take the million for themselves and shut the system down? Where Bitcoin succeeded in resolving the problem of trust with its users is by running on Blockchain. Blockchain is run by its users; there’s no one in charge. It’s a system built on mutual trust and complete rejection of traditional monetary systems such as banking.
Actually, let’s take a look at the idea of trust within a business arrangement between a buyer and a seller. It is safe to say that the basis of a transaction is trust: when we purchase a service or a product from a business, we trust that it will be executed within the scope of its description. That sense of trust is defined by a set of external factors, like the seller’s reputation and any previous contacts they may have had with the buyer. Trust fluctuates as a result of these factors - it is difficult to earn, increasingly so as we advance into a profoundly digital age where access to information is boundless. So many choices are out there, so how easy is it to build a trusting relationship with a potential seller or a potential buyer when there are infinitely more other options available? Lastly, how can trust be established after deep fractures in relationships between institutions and individuals, such as the 2008 Global Financial Crisis?
In the paper responsible for the creation of Bitcoin, Satoshi Nakamoto wrote: “We have proposed a system for electronic transaction without relying on trust.” Maybe the answer to trust issues isn’t rebuilding trust but simply removing the need for it in the first place, or more precisely, changing the nature of trust. This can be done thanks to Blockchain, which offers:
The ledger, which is the exact record of everything that happened and in what order
The consensus algorithm, which makes sure that all copies of the ledger are the same
The token, which is the currency (Bitcoin, for example)
Crypto, a booming but uninsured field
A spokesman from Allianz told Bloomberg in July 2018 that they were in the process of exploring cryptocurrencies because they “becoming more relevant, important and prevalent on the real economy.” In April 2021, the cryptocurrency market reached $2.2 trillion. Massive corporate investors have been majorly betting on crypto: Tesla acquired $1.5 billion bitcoin (BTC) in January 2021. The company MicroStrategy holds an amount of $2.2 billion BTC.
However, insurers have been extraordinarily slow in entering the crypto world: it is surprising to know it remains 96% uninsured. Yet, the industry of insurance has been in the past decades, as middle-class populations are growing and a need for insurance is expanding all over the planet. How come most insurers haven’t hopped onto the crypto train? What is stopping them from offering insurance to such a huge new industry - that of cryptocurrency?
Of course, insurance players have got involved in different ways:
As crypto underwriters, by underwriting crypto assets and businesses, providing coverage for crime (theft and hacks) or custody coverage (cold storage), and liability: Lloyd’s, Evertas, Munich RE...
By accepting crypto as payment, allowing policyholders to pay for premiums with crypto: Tesla, Axa, Inguard…
BY holding crypto as a balance sheet item, as an asset class: Nexus Mutual, Nayms, Mass Mutual...
Let’s go through these insurance firms’ involvement in crypto in further detail.
Underwriting crypto-market assets
Insurers can underwrite crypto-related risks in two ways. Firstly, they can cover for the crypto assets themselves in the form of crime and custody policies, in the case of theft, hacks, or cold-storage key loss for example. Great American Insurance Group was the first to do so in 2014 with its crime product, covering bitcoin holders for forgery and computer fraud. Insurers can also provide coverage for crypto businesses. Evertas, “the world’s first cryptoasset insurance company”, offers D&O which is a specific cover for crypto. Not many other firms follow Evertas’ tracks because of the lack of regulatory and legal clarity surrounding this type of coverage.
Accepting crypto as payment
A small but increasing amount of insurers are accepting crypto as a payment form. Benefits include verification transparency and payment tracking. Accepting a premium in the risk currency eliminates FX volatility: Premier Shield Insurance and InGuard now accept BTC as payment. AXA Switzerland announced in April that BTC payments would be accepted for nearly all products.
Holding crypto as a balance sheet item
Crypto assets are incredibly volatile, so it’s not surprising that only very few insurers have been directly investing in them. The only major example is MassMutual: in 2020, it invested $100m into Bitcoin and $5m into NYDIG, a crypto custody provider.
Crypto could be huge for insurance
Despite the risks interpreted, crypto could be huge for the insurance industry. Its intangible nature makes for a difficult practice to regulate and understand, but it also has immense potential for attention and returns. Crypto users too need insurance! A report from Marsh called “5 Reasons Why the Crypto Insurance Market Could Reach New Heights in 2021” talks about trends in the global digital asset market. It considers five factors in the potential development of insurance in the crypto world:
More regulatory clarity
The scarcity of regulation surrounded the crypto-currency market has been considered as the main obstacle to the wider adoption of digital assets. The Marsh report cites recent advancements by the Office of the Comptroller of the Currency (OCC) and the Securities and Exchange Commission (SEC) that have created more regulatory clarity in the field. “This regulatory progress enables traditional financial institutions to adopt digital currencies and is expected to pave the way for even greater investment in the digital asset space”.
Increased adoption
The coming regulatory clarity could directly contribute to the increased adoption of cryptocurrency, which in turn could spur greater clarity. “Because there’s a little bit more regulatory clarity, more financial institutions are now more comfortable in the space,” former Marsh executive Sarah Downey asserts. “Because more financial institutions are more comfortable in the space and there’s a greater demand on them from their customer base, that’s Bitcoin and others, the regulators have to respond, too.”
The Marsh report warns that “as the regulatory environment continues to evolve, the heightened risk of regulatory activity makes it incredibly important for companies and their directors and officers to understand what, if any, risk transfer options are available to help mitigate potential exposure.”
Downey cites D&O coverage in particular. “A lot of people think of D&O insurance as something that kicks in when there’s some type of litigation, but …whether it’s a regulatory investigation or a regulatory proceeding, assuming there’s coverage, D&O insurance really kicks in and helps fund the defense costs for those types of activities.” That may not always be the case though, Downey also warns:
“A lot of the D&O insurers who work with cryptocurrency companies are actually adding regulatory exclusions or trying to limit that coverage,” Downey said. “Companies in this space should be aware of things that might be added to a traditional policy that they should try to negotiate out.”
Growth of decentralized finance
The Marsh report cites an “explosion” in 2020 of “decentralized finance” (DeFi), or “financial applications operating on smart contracts and without centralized governmental or company control.” Decentralized finance is a system by which financial products become public through a decentralized blockchain network, making them open to use rather than through a traditional middleman bank. Unlike a bank, a government-issued ID, Social Security number, or proof of address are not necessary to use decentralized finance. Decentralized finance aims to employ technology to get rid of intermediaries between parties within a financial transaction.
“In DeFi, the company really tends to be a technology company, that DeFi company creates the smart contracts or the technology, or the protocols that are used to run a platform, but that platform itself is not governed by the company that created the technology behind it,” Downey said. “Instead, that platform is governed most often by individuals who buy tokens associated with the platform itself, and then they can vote on how the platform itself is run.”
A surge in Bitcoin value
The value of Bitcoin quadrupled in 2020, which is contributing to increased adoption, and in turn, greater demand for insurance. More people are using crypto, so more people are in need of insurance linked to their crypto activity.
“As the value of digital assets goes up, those holding the assets — whether institutions or individuals — tend to feel an increased need for insurance protection,” the report says. The supposed volatility of crypto doesn’t seem to remain a major problem as its popularity increases at a fast pace.
“The value will fluctuate, undoubtedly, but I think it will always recover,” said Downey. “If the value of Bitcoin were decreased exponentially, it obviously would impact some companies in the space [but] I don’t think it will retract or take away from the insurance capacity supply. Crypto-centric companies are here to stay. Traditional financial institutions are going to continue to work with virtual currency, whether it’s Bitcoin or another type of currency. Decreasing the value of Bitcoin will not impact the insurers or the insurance community’s willingness to participate in it.”
More corporate transactions
The four previously cited factors may all contribute to the fifth, which is an increase in corporate transactions whereby more crypto-focused companies will be going public. “The total value of crypto mergers and acquisitions in the first half of 2020 reached a record $597 million, surpassing the total from 2019, with the average deal size more than doubling,” the report says. That success will most likely bring more on in the near future.
“This is likely to lead to traditional financial firms starting to acquire crypto-focused companies, such as custodians and technology companies, as additions to their portfolio of offerings,” the report states. “This will lead to more investments continuing to flow into the space.”
The report concludes with, “to date, insurance markets’ willingness to freely underwrite this space has not kept up with the demand for insurance. But as the growth continues, we expect a shift in supply over the next few years. Companies working with digital assets should understand their specific risk exposures, how they can be transferred, and the right insurance partners for their business.”
However, crypto is still viewed as volatile
The bitcoin spot rate on cryptocurrency exchanges undergoes constant fluctuations, driven by many factors. In traditional markets, volatility is measured by the Volatility Index, also known as the CBOE Volatility Index (VIX). A volatility index for bitcoin has recently become available: the Bitcoin Volatility Index aims to track the volatility of Bitcoin over various periods of time.
Bitcoin's value has always been volatile. In three months from October 2017 to January 2018, for example, the volatility of the price of bitcoin reached 8%; more than twice the volatility of bitcoin in the 30-day period ending January 15, 2020. Why is bitcoin so volatile?
News events that scare Bitcoin users, like geopolitical events and statements by governments that cryptocurrency is being regulated.
Swaying of the perceived store of value versus the fiat currency.
Uncertainty of Bitcoin’s value in the future
Currency holder risks that render large holdings impossible to liquidate without displacing the market
Security vulnerabilities
High-profile mediatized losses
Countries experiencing high inflation in relation to Bitcoin
Added complexity as a result of tax treatment
Why does crypto need insurance?
The instability of the cryptocurrency field is what builds the very need for insurance. The fluctuation within the valuation mechanisms of Bitcoin and other types of cryptocurrencies has created many instances of theft and exchanges of online wallets. In January 2014, for example, $500 million worth of crypto was stolen from Coincheck, the Japanese cryptocurrency exchange. The outcome of these numerous hacks is a vulnerable environment that the traditional finance territory doesn’t address. Sebastian Higgs, Director at Volt, says: “Any firm can say its security is robust but having insurance in place also demonstrates that insurers are comfortable with the measures that have been taken.” Thus, insurance can be an extra security measure for crypto users to protect them from attacks but also to deter any potential perpetrators from pulling any virtual triggers.
Crypto presents challenges never experienced before for insurance firms. Insurance premiums are typically constructed on past data - there isn’t any for cryptocurrencies. Volatility also affects premiums, and as we have previously mentioned, a lack of regulatory clarity and oversight complicates matters even further for insurers trying to provide services to crypto users or businesses.
In the future, these risks could also be presented as opportunities for insurance firms to invest in the crypto mechanisms that can make for such profitable ventures. By finding new ways of calculating premiums, such as some insurance firms have recently attempted, ways can be found of catering to the immense need crypto users have for insurance. More risk means more possibilities - after all, what is insurance if it isn’t risk pooling?
Blockchain applied to insurance
There are various concrete ways in which insurance could integrate blockchain systems within its core function to cater to a new world of cryptocurrency. Here are a few:
Smart contracts
A smart contract is a contract between two or more parties that can be written and executed automatically and electronically via a tacit blockchain response to events encrypted into the contract. The data required to enforce said contract could be situated outside of the blockchain - a third party known as an “oracle” would place this information onto a position of the blockchain at any given time. The smart contract will function by interpreting the data and execute or not, accordingly. Ledger, a crypto company, has developed an oracle solution that pushes information onto the blockchain in real-time, using a series of sensors to track events. Benefits include:
Process automation and autonomy thanks to data reported by connected devices in order to fulfill the conditions for executing the smart contract.
Data history based on a ledger with records of all date, acting as guaranteed transparency.
Peer to peer insurance
Peer-to-peer (P2P) insurance has existed for quite some time, yet practices have greatly evolved in the last decade. Blockchain technology has brought new opportunities thanks to the Decentralized Autonomous Organization (DAO). Smart contracts, which we have previously talked about, are the first level of the application and they usually require human input, increasingly so as the number of parties involved grows. An Open Network Enterprise (ONE) is employed when one smart contract interacts with other smart contracts. When programs that run without human input and ONEs are combined, a DAO is created. DAO allows P2P insurance to unfold on a very large scale because of its capacity to administer a complex set of rules between stakeholders, often many. P2P is simply a new vision of risk pooling, which is the core idea of insurance.
Index-based insurance
Index-based insurance is linked to an index like rainfall, temperature, humidity, or crop yield.
Cryptocurrency: the redesign of risk pooling, the main function of insurance
The term "risk pooling" refers to the even fanning out of financial risks among contributors to a program. Insurance is the transmission of risks from individuals or businesses who would not be able to endure a potentially adverse financial event to the capital markets, which could support the load. The capital markets take on risk from these individuals and corporations in exchange for a sufficient premium, considered the right amount proportionate to the risk.
Within the systems of cryptocurrency, though, based on blockchain, there is no need for risk pooling, or at least in the traditional sense of it. Cryptocurrency funds are governed by a protocol that doesn’t require human intervention, and with the help of smart contracts, insurance subscribers can pool their resources by agreeing to the protocol. The insurable interest is specified by the smart contract (property for example), as well as the terms of the insurance. If a loss is claimed, it would be resolved by referring to the protocols specified in the smart contract, according to the data on the blockchain.
The keys players of crypto
The first cryptocurrency was only born around 10 years ago, yet nowadays an overwhelming amount of digital coins are on the market. However, many coins don’t last long. Some fail due to a lack of originality; others collapse faced with overwhelming competition. The cryptocurrency ecosystem is constantly fluctuating, and developments happen on the daily. Two generations of cryptocurrencies can be differentiated, though it has recently been analyzed that two more can be added to the list as a result of new blockchain advancements:
First-generation coins
Bitcoin
Bitcoin Cash
Litecoin
Dash
Tether
Second-generation coins
Ethereum
EOS
Complex but real perspectives on the horizon
We have discussed to what extent cryptocurrencies, though presenting deep technological advancements, are still in a developmental phase. It is difficult to assess the impact they will have on mainstream industries in the long run. They were designed to cut out the middle man - if that isn’t fully possible, how will the innovative technologies that make up the concept of cryptocurrencies adapt to the world? And most importantly, how will the world adapt to these technologies?
A small but fierce number of promising applications of crypto-currency concepts and blockchain systems show us that there is great potential for change within the insurance industry. What is certain is that there is a need from both parties: crypto users lack insurance perspectives, and insurers could benefit greatly from opening up their services to these users and/or businesses.
There is a lot yet to unfold though before crypto can make a durable impact on the insurance industry. Companies have yet to figure out how to adapt to the standards and processes of blockchain technology, though it can provide insurers with more effective tools for the treatment of data.
It is also clear that the technology available nowadays must be developed further before it can be made accessible to the insurance industry. Public blockchains would be impossible for insurance firms to use, as it raises privacy and security concerns. Private blockchains are still under development.
Lastly, the insurance industry is regulated to the greatest extent; in order to protect all parties involved - regulatory and legal insurance frameworks will need to evolve and provide thorough guidance in order to see blockchain technology succeed within the industry.