Does Crypto Need Captives? Why This Risk Transfer Method Could Just Be the Answer
Captives have long been seen as a potential insurance solution for companies confronted by a lack of capacity and high pricing due to a marketplace that may not adequately understand their risk.
So it is no surprise that amid an already hardening marketplace exacerbated by COVID-19, and with a complex technological underpinning and a dearth of historical loss data, entities in the cryptocurrency space are turning to captives to find the capacity and pricing unavailable elsewhere.
“The captive has been a traditional tool that emerging risk markets have used, or emerging risk individuals have used, to first of all understand the nature of their risk, generate the data around underwriting, begin the underwriting process, teach the marketplace how to underwrite the specific risks and eventually build capacity,” said Ward Ching, managing director of captive and insurance management for Aon’s Western Region.
Together with Marsh, Ching and Aon collaborated with the cryptocurrency custodian Gemini to create one such new captive, Nakamoto. Domiciled in Bermuda, Nakamoto came online in January.
“We’ve got $200 million in aggregate coverage currently available for the custody platform,” said Yusuf Hussain, head of risk of Gemini, who is also working to make additional coverage available to individual clients.
“The market across the board is hard,” said Ching.
“There are certain lines of coverage that are a little softer than others, but if you’re talking property program or excess casualty or fiduciary coverages, including crime programs, the market is still restricted and relatively tight, so capacity is scarce and pricing for that capacity is expensive.”
The current pandemic is making matters even worse.
“We already had a hardening market due to poor results in the P&C space,” said Thomas Keist, global head of captives at Swiss Re Corporate Solutions.
“With COVID-19, we now have an even higher uncertainty of the traditional insurance market about the claims that will come out of this and the losses that will actually have to be paid. Therefore the cautiousness of moving into new areas with even more capacity has increased tremendously.”
Can Crypto Be Understood?
Another challenge is the technical complexity of the cryptocurrency space. Hussain thinks he is in the right place at the right time to address that complexity in risk transfer/retention.
“We understand crypto custody,” said Hussain.
“Who better than the crypto industry to underwrite this industry, right? So we come from an understanding that we can help evaluate other crypto exchange and custodian infrastructure. We can help educate other reinsurers and commercial insurers,” Hussain said hopefully.
It remains to be seen, though, what breadth of impact captives will have in cryptocurrency.
As in any stage of attempting to address the risk and insurance requirements of an emerging/new type of asset, opinions will differ.
“It’s simply not enough,” said Raymond Zenkich, President and COO of Evertas, formerly known as BlockRe before rebranding in February 2020 as a crypto-asset insurance company, said of using captives for crypto-asset risk.
“Even if you accept that it’s the right vehicle or the right option for them which, obviously, they’ve decided it is. There are 100s of millions of dollars being held by these institutions. These coverages or these captives are really quite small,” he opined.
But Hussain sees a broader impact. “It’s capacity that Gemini could be getting from commercial markets that may be taking away from other crypto exchanges that may need it,” said Hussain.
“It’s kind of like cyber coverage was 10 years ago. No one fully understood it at first, now 10-plus years later you can buy a $100 million policy fairly easily.” — Mike Woytowicz, director of business development, Artex Risk Solutions
“This is the first step in many steps that we’re taking in the insurance space. And we think it’s one of the last few areas to unlock that may help broader adoption.”
“There is a beachhead around understanding frequency and severity and maximum foreseeable loss,” said Ching of the cryptocurrency insurance market development overall. Ching is optimistic the markets will get a handle on cryptocurrency underwriting and do it profitably.
“There is an understanding as to what the program design, the crime program should look like. There is a clear understanding as to what the policy form should look like. And again, as the cryptocurrency market continues to grow, in other words there’s demand for capacity, there will be a continued paying of attention by the carriers that are in the space now that have an appetite for this to grow capacity. Because this should be, if it’s run correctly, priced correctly, it should be profitable business for the carrier.”
Changing the Carrier Mindset
Mike Woytowicz, Director of Business Development for Artex Risk Solutions, which serves as insurance manager and principle representative in Bermuda for Evertas, sees that proof of concept as essential to attracting more capacity.
“I think the goal is to change the mindset of the more traditional insurance companies,” said Mike Woytowicz, Director-Business Development for Artex in Bermuda.
“Right now digital asset insurance is a bit of the unknown. The evolution will hopefully come from the success of the initial captives in this space; proving to others that have been in the market forever that this is something that can be insured, and is something that they should be offering more capacity on.”
One needn’t look far to find a relevant example.
“It’s kind of like cyber coverage was 10 years ago,” Woytowicz said. “No one fully understood it at first, now 10 plus years later you can buy a $100 million cyber policy fairly easily.”
Part of what makes insurance so critical in the cryptocurrency space is the message it sends to potential participants in the space, that risks are understood, quantifiable and tolerable. But it is unclear whether a captive sends that same message.
J. Gdanski, Evertas CEO and founder, has his doubts. “I’m sure it means a lot more to a sophisticated institutional investor to see that a Lloyd Syndicate or an MGA backed by Lloyd’s paper issued a policy then someone who has created a captive for their own purposes,” Gdanski said.
Hussain disagrees with Gdanski.
“With a captive there’s a higher level of scrutiny,” he said.
“Not only do we have to meet the commercial insurer underwriting requirements, not only do we have to meet the reinsurance underwriting comfort, we also have to undergo regular regulatory examinations for the Bermuda Monetary Authority. So it’s an even higher level of scrutiny and regulation that’s being applied when you’ve got a captive insurance company.”
Hussain also points out that a majority of the $200 million in coverage in this Bermuda crypto-captive arrangement is being provided by commercial insurance, and less than half is being provided by Nakamoto.
Over time, one of the benefits of captives can be an accumulation of capital, and that is part of Nakamoto’s long term plans.
“In all of the business plans that we have built, there is downstream expansion of expectation, yes,” said Ching. He declined to discuss details about the shape or timing of such expansions, but added, “There is a strong willingness to curate that market, a strong willingness to expand the offering, and a strong willingness to grow beyond the classic trader into servicing the under-banked. There are hundreds of millions of people out there that potentially could be customers.”
Hussain sees room for expansion with his new captive outside the cryptocurrency space. “The expectation is to build up a track record with minimal losses, and to build up the capital so that we can expand, even beyond crypto,” said Hussain.
Keist points out that it may take some time before the cryptocurrency captives achieve the level of maturity and capital accumulation to expand into other areas. But he does see companies in cryptocurrency-adjacent industries like banking and telecom using their captives to move into the cryptocurrency space.
“The companies within that industries who have captives will certainly start to look into using the capital they have for that,” said Keist.
Ching agrees. “I’m expecting to see institutions that have a cryptocurrency custodial ambition, banks for example, venturing into the space,” said Ching.
And the move to captives may be more than a short-term solution. Keist sees the firming of the marketplace to persist longer than previous hard markets.
“Whilst in the past, hard markets tend to last for a year, maybe two, and then the market was truly soft again, I believe now we have entered the phase where the hard market will stay longer,” said Keist.
“And a hard market means relatively high prices for insurance coverage, as well this limited capacity.”
Keist attributes this to a number of factors, including the interest environment and return on investment environment, plus the consolidation of the commercial insurance industry, among others.
“But it will be prolonged, the hard market, and therefore it will be enough time for captives to really start to bloom,” he said. &