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Crypto Economy Presents Novel Challenges for Insurers

Insurance Law360
August 3, 2018

By Thomas B. Caswell and Dennis C. Anderson
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To cryptocurrency insiders, the name Satoshi Nakamoto is synonymous with mystery. In 2008, Nakamoto published a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” explaining the “cryptographic hash function” that makes bitcoin possible. And in 2009, it was Nakamoto who released the software that launched the bitcoin network, and it was Nakamoto who “mined” the first 50 cryptocurrency units, or “bitcoins.” Since then, Nakamoto has assumed mythical status among cryptocurrency enthusiasts.

When bitcoin burst on the scene, imitators and innovators followed, creating new cryptocurrencies customized for niche interests, each with its own unique cryptographic hash function. In the nine years since the bitcoin launch, the number of digital currencies has exploded to more than 1600. Currency exchanges — the crypto equivalent of stock exchanges — have proliferated, and tech-savvy entrepreneurs have rushed in to compete for cryptocurrency riches.

The first wave of brick-and-mortar businesses to develop around cryptocurrencies have been so-called “mining” operations. Each cryptocurrency transaction must be verified by using the correct cryptographic hash function to solve a complicated math problem that authenticates the transaction. Cryptocurrency miners compete to crunch those numbers, and the first to verify a transaction is rewarded with units of the same cryptocurrency. Vigorous competition among miners has led to a modern-day gold rush, as investors pool resources to set up and operate server farms, which are called “mines” (of course). Other types of businesses have followed as entrepreneurs find creative ways to cash in on the crypto gold rush, and several major companies now accept bitcoin, including Overstock.com, Expedia, Dish Network and Microsoft.

Despite the explosive growth of the crypto economy, the origins of cryptocurrencies remain shrouded in mystery. Indeed, 10 years have passed since the Nakamoto white paper and no one really knows who Satoshi Nakamoto is — or if he is. Several people have claimed to be Nakamoto, but proof is rare and theories abound. But however they started, cryptocurrencies seem to be here to stay, and insurance markets are beginning to respond to the novel risks, challenges and opportunities they present.

The Word of the Day (and the Decade) is Volatility

Hardly a day passes without a news story about cryptocurrency, and almost every one — whatever its primary focus — reminds us that cryptocurrencies can be volatile. That should come as no surprise considering bitcoin’s remarkable ride. In December of 2016 bitcoin was trading under $1,000 per coin. A year later, one bitcoin was worth over $19,000. As of this writing, a major index lists bitcoin just above $7,000, and that could change dramatically by the time this article is published. Despite these dramatic swings, some consider bitcoin among the least volatile cryptocurrencies.[1] If you’re looking for a real roller coaster ride, they say, consider currencies such as TRON, Verge and Nano.[2]

The volatility of digital currencies creates obvious risk. But wherever risk leads, insurers follow, and the cryptocurrency sector is no exception. Several major insurers have responded to the highest profile risk — theft — by providing theft policies specific to cryptocurrency assets. Some are beginning to offer other lines of commercial insurance, including business interruption for mining operations and other businesses unique to the crypto economy. Still others are offering unprecedented insurance products[3] as hedges against loss of value, using “smart” contracts built on blockchain code that execute contractual duties automatically, transferring assets immediately when an agreed-upon triggering event occurs.

These opportunities present unique challenges, as every new insurance product will. But in cryptocurrency insurance, volatility disproportionately affects every stage of an insurance policy’s life cycle from underwriting to adjustment of losses. As insurance offerings diversify, so will the number and type of challenges to be addressed.

At the underwriting stage, the volatility of cryptocurrencies and their relative novelty makes risk very difficult to assess. An underwriter assessing the risk of a robbery at a jewelry store has, by comparison, a straightforward task and many tools to use. She might consider the crime rate in the surrounding neighborhood, the insured’s security precautions and loss history, and other familiar, quantifiable factors. But an underwriter assessing the risk of a cryptocurrency heist may have none of those tools. The relevant neighborhood is likely the entire globe, the insured’s security measures may be simple (like keeping cryptocurrency in a “cold” wallet not connected to the internet) or highly technical (like customized encryption protecting a “hot” wallet stored in the cloud), and the insured might be a startup with no business history (much less loss history) to assess.

To date, the solutions to these uncertainties have generally involved charging higher premiums to paper over the uncertainties of cryptocurrency risks. For example, Reuters reported earlier this year[4] that for a theft policy issued to a traditional financial client the premium could be less than 1 percent of the policy limit, while a similar policy covering cryptocurrency could cost more than twice as much. For the meantime, insureds faced with limited options may grudgingly accept heftier premiums. But as more insurers enter this new market, those who quickly develop the expertise to assess novel cryptocurrency risks will have an advantage that enables them to offer lower premiums than their competitors.

The Compound Challenge of Business Interruption

Some of the challenges involved in assessing the risk of theft in this cryptocurrency area will also affect risk assessment for business interruption losses. For example, a hacker could attack a cryptocurrency mining operation with the objective of stealing currency from its virtual wallet, and in the process, cause damage that interrupts the mining operations. An underwriter anticipating both risks — theft and business interruption — would have the challenge of assessing the likelihood of such an attack in the first place. But the challenge is compounded by the fact that the theft loss might be adjusted in dollars based on the value of the digital currency as of the date of loss, while the business interruption loss might be measured in a volatile cryptocurrency that could fluctuate dramatically over the course of the adjustment process.

For the same reason, adjusting a business interruption loss sustained by a cryptocurrency business may pose challenges that are not present in other types of businesses. Consider this example: storm damage shuts down a production line in a U.S. widget factory. The market value of the widgets not produced during the business interruption will be relatively stable during the time necessary to adjust the loss, repair the damage and resume production. And the loss will be measured in dollars, which will also remain relatively stable during the process.

But if the same storm destroyed servers in a cryptocurrency mining operation down the street, the lost production could be measured as the number of cryptocurrency units that could have been mined during the business interruption, but were not. The adjustment might also consider the rise (or fall) in the value of those units during the months it takes to adjust the claim, repair the building, replace the servers and resume mining.

Depending on the cryptocurrency involved, there may have been little to no historical value data available when the policy was underwritten. Or historical data might have been available — but it might have been a poor indicator of future changes in value. For instance, suppose the mining business mines bitcoin, and the underwriter considered the following graph tracking the history of bitcoin values over the last eight years:[5]

Suppose that in late 2016, an underwriter assessed the risk of a business interruption loss by looking at the previous six years of slow growth (among other things) and assumed the trend would continue over the life of a one-year policy. If a business interruption loss occurred in late 2017 — after the price of one bitcoin had rocketed from $900 to more than $19,000 — the loss could eclipse the insurer’s expectation of the risk.

As with the case of theft insurance, the challenge facing writers of business interruption coverage will be to assess the risk, limit exposure and offer competitive premiums. Clear and unambiguous specification of how losses will be quantified will likely play a key role, as will policy limits carefully tailored to the unique characteristics of cryptocurrencies and cryptocurrency businesses.

Pay No (More) Attention to that Man Behind the Curtain

Satoshi Nakamoto might exist (or might not) and might be the parent of cryptocurrencies (or might not). Whoever answers those questions will have lifetime bragging rights. But innovators in the fast-growing crypto economy have little interest in pondering the sector’s origin stories, and a great deal of interest in new opportunities to create and protect wealth. As the crypto economy continues to grow, those innovators and their investors will need to manage novel risks, and the insurance industry will respond to those needs with novel products. The seemingly inherent volatility of cryptocurrencies creates real challenges, especially when it comes to valuing losses. But for insurers willing to tackle those challenges, the rewards may be substantial.

Thomas B. Caswell is a partner and Dennis C. Anderson is an associate at Zelle LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] www.finder.com.au/least-volatile-cryptocurrencies

[2] https://www.finder.com.au/most-volatile-cryptocurrencies

[3] https://www.newsbtc.com/2018/03/06/introducing-bitrust-first-crypto-currency-insurance-platform/

[4] https://www.reuters.com/article/us-markets-bitcoin-insurance-insight/insurers-gingerly-test-bitcoin-business-with-heist-policies-idUSKBN1FL406

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