Charles A Cowan is counsel in the Insurance Practice Team within the Corporate & Securities Practice Group at Drinker Biddle & Reath. He previously managed a team responsible for the investigation of internal and external financial crime and regulatory non-compliance at Lloyd’s of London.
In this article he discusses the risks that influence an insurer's decision to work with companies in bitcoin, and how they might be overcome.
In 1904, Lloyd’s of London was still largely a marine market. And so, when approached in that year to issue the world’s first automobile policy, underwriters did so while describing the car as a "ship navigating on land". Just as in 1904, insurance and innovation have often been inextricably – if, at times, awkwardly – interlinked.
Those who invest time, energy and financial resources into developing and distributing an innovative product or process are often keenly aware of the vital role that insurance can play in supporting and protecting their ventures. And so, as virtual currency businesses (or 'bitcoin businesses' for purposes of this article) increasingly establish themselves as 'mainstream' enterprises, the logical question arises: what role, if any, should or must insurance play in the process and how should insurers and innovators navigate this space?
Insurance is about risk: assessing, understanding, valuing and sharing risk. Insurers tend to be conservative when it comes to assessing and accepting risk, preferring to focus upon concrete data, loss histories and actuarial models rather than pure instinct. This is why insurers spend a great deal of time, energy and money discussing and analysing 'emerging risks' such as bitcoin.
A heavily regulated space
The fact that an innovative product or process has captured the imagination of venture capitalists, academics and inventors does not mean that it has yet reached a level of maturity necessary to be deemed an 'insurable risk'. To the extent that underwriters have been slow or unwilling to insure risks associated with bitcoin business, what may explain this and what, if anything, can be done to bridge any perceived gap between insurers and innovators?
Insurers operate in a heavily regulated space. From rates to contract wordings; lines of business to reserving practices: there are few aspects of insurance that are not subject to some form of regulation. Depending upon the markets that an insurer serves, moreover, they may answer to numerous regulators at once. In addition, insurers – like many large businesses – must answer to their investors for decisions that they make.
When approached with a new, 'cutting edge' type of risk, then, insurers must often first address the important questions of:
- Whether they can legally write the risk in the way proposed.
- What, if any, reputational issues might be implicated.
- Whether enough information is available appropriately to assess and value the risk.
(There are many more factors, but time and space are limited here.) Each of these considerations is central to an understanding of how bitcoin is often viewed by underwriters.
I will discuss each briefly below and then propose some possible ways that underwriters and bitcoin entrepreneurs can improve dialogue with respect to them.
With respect to regulation, a critical area of concern for underwriters is that of financial crime controls. (The question of the extent to which regulation can or should 'legitimize' bitcoin is fodder for another article.) In an era in which nine- or 10-figure fines have been imposed by US federal and state regulators against banks that have been deemed to run afoul of Anti-Money Laundering or sanctions laws, insurers are keenly aware of the need to ensure that sufficient controls are in place with respect to risks that they accept.
Bitcoin, for obvious reasons, presents a challenge in this regard, not the least of which reason is its association with the Dark Web. Legitimate bitcoin businesses are right to challenge this view as outdated and to point to efforts by both industry and regulators to improve transparency and accountability in the exchange of bitcoins.
But the fact is that news reports persist of a resilient Dark Web marketplace and of the involvement of bitcoin in crimes (either as the target or as the medium of payment). This can be enough to discourage conservative underwriters from considering the risk.
Closely aligned with the regulatory risk that is exemplified by financial crime controls is reputational risk. Insurance is not merely a transfer of risk, it is a relationship based upon mutual trust. Consumers must be able to trust that insurers will protect them in times of need and, as a result, insurers have very practical incentives for placing a premium (pun intended) on reputation.
Again, while legitimate bitcoin entrepreneurs may protest that there should no longer be a perceived reputational risk associated with bitcoin, for reasons discussed above, many underwriters remain wary of being too closely aligned with bitcoin’s inescapable notoriety.
The availability of information – both generally with respect to an industry and specifically with regard to a proposed risk – are essential in the underwriting process.
Emerging risks such as bitcoin present unique challenges to underwriters in this regard. Bitcoin start-ups, for example, will have no loss history, thereby making it more difficult for even the brightest of actuaries to assess the likelihood of future losses. And loss projections form a central part of risk pricing.
What makes innovations such as bitcoin even more challenging is that there are few analogous industries or products. Insurance has for some time provided cover for businesses engaged in the exchange and storage of digital assets such as copyrighted material, films and the like. And the electronic exchange of 'value' is certainly nothing unique, as witnessed by the fact that consumers worldwide can manage and exchange value between their own insured bank accounts.
But it is the very decentralized, community-based nature of bitcoin that makes it difficult to compare with risks that, while 'virtual' in some sense, are nevertheless subject to transparent and tested procedures, protocols, regulation and the like that make the assessment and valuation of such risks more acceptable.
Bear in mind that, at most large insurers, underwriting is subject to strict peer review and that, in order to accept an admittedly 'novel' risk such as bitcoin, an underwriter will have to answer to his peers (and managers) questions such as:
- What does a proof of loss look like?
- How can underwriters or insureds 'know' the quantity of bitcoins that were held or 'lost' at the time an incident occurred?
- How can we be sure that we are not insuring the fluctuating value of bitcoin?
- Cold storage, as described, seems all but fool-proof – so why do they need insurance? What do they know about their risk that we do not?
- Are there 'macro risks', meaning those that exist apart from this particular insured’s profile, that nevertheless have a bearing upon this risk (here, the focus is generally upon whether the bitcoin protocol is vulnerable in ways that could lead to an unanticipated exposure at the level of each exchange)?
- In paying claims, how do we address financial crime risk such as those posed by sanctions regimes?
What should happen next?
Given the points outlined above, what can be done, if anything, to bridge perceived gaps between what bitcoin businesses want and insurers (as an industry) have thus far been willing to offer? The key is transparency and openness. Unless and until insurers are satisfied with respect to regulatory or reputational risk, they may be constrained from acting (even if some of their competitors are willing to do so).
Bitcoin businesses must recognize that these are genuine concerns and be willing, at the proposal stage, to address them in a detailed and thorough manner. More importantly, there must be a full and frank discussion of the vulnerabilities that arise from the business proposed.
While the insurance industry is making strides in terms of bringing technological expertise into the industry, at present there is often a significant gap between bitcoin entrepeneurs and underwriters in terms of the technology and any vulnerabilities of which underwriters should be aware. In the long run, both parties are best served by that level of transparency because far too many business disputes are created by a lack of mutual understanding at the outset.
I realize that this article poses more questions than it could hope to answer, but if it serves to foster future dialogue, then it has served its purpose. I can only hope that it serves to foster further exchange (again, pun intended).
Gap image via Shutterstock