What is Cryptocurrency Insurance and Do You Need It?


What is Cryptocurrency Insurance and Do You Need It?

Investors in Japanese cryptocurrency exchange Coincheck took a major hit when it was hacked in early 2018. The hackers made off with $500 million worth of $NEM coins. A similar story unfolded during the collapse of Mt. Gox, another Japan-based cryptocurrency exchange which crashed in 2014, leaving its investors high and dry.

In the volatility that has characterized the ascent of cryptocurrencies, such cases are more the norm than the exception. Indeed, the industry’s technological underpinnings and haphazard growth means that its products and services are more susceptible to online criminals than other industries.

Bolstering defense by adding security layers for access is one way to secure the industry against online criminals. Cryptocurrency insurance may be another.

What is Cryptocurrency Insurance?

Cryptocurrency insurance is a type of insurance that covers operational aspects of cryptocurrency-related products and services. It can be insurance against thefts and hacks at exchanges, or coverage against fraud during initial coin offerings (ICOs). Cryptocurrency custody services also use insurance to safeguard against theft of coins entrusted to them. According to estimates, the higher end of the cryptocurrency insurance market is worth $6 billion.

Currently, crypto investors have limited recourse to claim their funds, if something goes wrong. In the case of Coincheck, government pressure and an investor lawsuit forced the exchange to issue reimbursements to customers, which came from the company’s own profits. More recently, the QuadrigaCX fiasco highlighted the absence of safeguards for a cryptocurrency investor’s funds. In this case, QuadrigaCX’s founder, who had sole knowledge of the private keys used to access the exchange’s funds, died unexpectedly while on a trip to India. The exchange’s creditors have since filed a lawsuit, while investor funds remain caught in limbo.

These instances sharply illustrate the need for insurance against mishaps in the cryptocurrency ecosystem. Apart from the financial damage wreaked on investors, hacks also add to a flood of bad news in an industry already suffering from a bad press problem.

But, insurance is perhaps easier imagined than implemented in cryptocurrency products and services. The ecosystem currently faces several challenges, from the absence of operating standards for exchanges to the presence of dubious characters.

What Are the Challenges for Insurance Players in the Cryptocurrency Industry?

Regulatory uncertainty is still a major hurdle in crypto, and lawmakers around the world are struggling to figure out how to legislate it. The most contentious issue in this regard is the classification of tokens. While crypto entrepreneurs routinely refer to their tokens as utility tokens, the SEC has taken a different view, and accused some companies of issuing securities without following the appropriate protocol.

At the same time, the federal agency has refused to clearly demarcate requirements for utility tokens and security tokens, leaving projects and companies in the industry in a regulatory limbo. The status of smart contracts, a unique selling proposition of Ethereum’s blockchain, also remains unclear across borders. Regulatory uncertainty magnifies risk by orders of magnitude for insurance companies because it increases the possibility of an operation folding up due to legal problems.  

Difficulty in understanding the ecosystem is another major reason why insurers are shying away from cryptocurrencies. Anyone attempting to understand cryptocurrencies must contend with a blizzard of technical terms and novel economic concepts. While it is consistently imagined as a silver bullet fix for several industries, blockchain (and its workings) still remain inscrutable. Some refer to it as simply a database, while others ascribe revolutions to it.

Then there are cryptocurrency markets. Conventional trading methodology is insufficient to explain volatile price swings of coins at exchanges. Multiple hacks have also laid the theory of an impenetrable and secure blockchain to rest. In practical terms, all of this means that it is difficult for underwriters to understand and evaluate the ecosystem — they cannot even determine the layers of security involved in cryptocurrency blockchains to assign risk levels.

Another challenge for cryptocurrencies lies in the absence of precedents for evaluating claims. Past claims are used to benchmark future ones. They are also used to establish a framework to evaluate similar cases. But the absence of insurance in the crypto industry has resulted in a classic chicken-and-egg situation. There are no benchmarking claims because insurance companies have largely stayed away from cryptocurrencies. And there is no data for claims because there are no insurance safeguards in the industry.

Finally, the relatively nascent nature of cryptocurrency markets means that it lacks the business volume for economies of scale required to bring down costs. For the most part, the cryptocurrency market is populated by startups and small firms who cannot afford expensive premiums that insurance companies tack on. The average premium for $10 million theft coverage is two percent of the amount or approximately $200,000. For cryptocurrency startups burning their way through an assortment of expenses with limited capital on hand, that is an expense they can ill afford.   

Insurance in Current Cryptocurrency Markets

While commercial insurers have largely stayed away from cryptocurrency markets, a couple of big names have ventured into the space. Lloyds of London, the world’s biggest insurance marketplace, has reportedly insured two percent of total funds at Coinbase, North America’s biggest cryptocurrency exchange. Gemini, a New York-based exchange launched by the infamous Winklevoss brothers, also claims to have insurance coverage for its online hot wallet.  Cryptocurrency custody service Bitgo recently announced a $100 million insurance policy for its coins with the same company. Great American Insurance, a unit of American Financial Group, offers theft coverage to cryptocurrency firms.

The flow of insurance funds into crypto has come at a steep cost, however. Insurance companies and underwriters charge more than five times their usual fees for coverage against loss or theft to crypto companies.

This is bad news for investors because startups tend to pass these costs on to customers in their products and services. For example, companies that offer Bitcoin trading facilities in IRA accounts include insurance costs in their fee schedules, making the overall transaction expensive for customers interested in profiting off Bitcoin’s volatility.  

Insurance companies have also restricted their coverage to theft at cryptocurrency exchanges and, for the most part, refuse to insure crypto products and services against hacks. The difference in terminology here is critical — theft refers to the stealing of coins in cold wallets or cold storage. These are coins that are disconnected from the Internet. Online hacks, the sort that are prevalent in the crypto industry currently, are not covered.   

Custody firm Bitgo found itself in hot water recently after one of the underwriters for its policy objected to the company’s press release wording that listed “third-party hacks” among the risks covered by its insurance. “Cover is only provided for ‘storage media’ in secure storage. In other words, there is no cover for any loss of sensitive information (private keys) resulting from the generation, transportation or transaction phases of the private keys’ life cycle,” the underwriter told Coindesk.    

Insurance companies are nonetheless making efforts to get to know the market better. Christopher Liu from American International Group Inc.’s North American Cyber Insurance practice for financial institutions, told Insurance Journal he is using examples from similar industries to develop a framework for evaluating risk in cryptocurrencies. “It’s sort of akin to a digital armored car service. If there is a problem – like an accident or a robbery – that’s going to be accumulation of all those exposures,” he said.   

As the cryptocurrency ecosystem evolves to maturity, that list of exposures is expected to become clear. For cryptocurrency and ICO investors, this translates to more safeguards against mishaps in crypto products and services.

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