- Coinbase is exploring plans to set up its own “captive” insurance company, industry sources said.
- At the start of this year, insurance
broker Aon began establishing captive companies in the Cayman Islands,
working with a handful of cryptocurrency firms. - Aon says a captive structure can help firms get access to additional coverage at more reasonable prices.
- Insurance for crypto remains scarce,
and major exchanges Kraken and Huobi say they simply self-insure by
setting aside coins to cover losses from thefts or hacks.
Cryptocurrency exchange Coinbase is
in talks to set up its own regulated insurance company with the help of
insurance broker giant Aon, industry sources told CoinDesk.
Establishing “captive” insurance
subsidiaries, wholly owned by the firm being insured, is a time-honored
way for corporations to reduce costs and improve access to reinsurance
markets (a form of insurance purchased by insurance companies in order
to mitigate risk). Nearly all
Fortune 500 companies and thousands of midsize firms maintain captives,
according to a December 2018 article in trade publication CPA Journal.
Coinbase and Aon see this structure as potentially part of the answer to the shortage
of insurance available to crypto exchanges, the sources said. Often,
such firms just self-insure by setting aside a bunch of coins to cover
losses in the event of a hack or disappearance of customer funds. The
problem with that approach is its lack of a formal structure, creating
the temptation to access the funds for other purposes and ambiguity
about how much coverage a firm actually has.
With a captive, on the other hand,
the funds are segregated and held in a regulated, audited vehicle, which
can help the firm go out and attain more cover from the reinsurance
market.
Neither Aon nor Coinbase would
comment on the latter’s interest in captive insurance. However, Aon did
say that it established the industry’s first crypto captive earlier this
year for an unnamed client. This Caymans Islands-based captive will
write “crime” policies covering hacks of hot (online) wallets and
“specie” coverage for cryptocurrency kept offline in cold storage, the
broker said.
And the two companies have worked together before: in April, Aon helped arrange
about $255 million in coverage for Coinbase’s hot wallets. The
exchange, which keeps only 2% of client funds in hot wallets, held $25
billion of crypto at the height of the 2017 bullrun.
Aon said a handful of its crypto
clients are considering the captive option, adding that Bermuda and some
leading U.S. on-shore domiciles are expected to follow the Caymans
soon.
“There is a lack of capacity and some
are uncomfortable with what is available in the marketplace and are
looking to alternative solutions,” said Jacqueline Quintal, a managing
director and the financial institutions practice leader at Aon. “I think
the path for most will be to buy some amount of traditional insurance
first and then to explore alternative structures, potentially including a
captive — and we are having more and more of these conversations.”
The case for captives
Stepping back, a captive is an
insurance company created and completely owned by another company to
provide coverage for itself. It’s a regulated alternative to
self-insurance which can offer direct access to reinsurance markets and
act as an investment vehicle.
If pricing is too high in the
commercial insurance markets or no underwriters are willing to cover a
firm’s risk, captives are used to formalize self-insurance with
reporting on capital and reserve requirements.
Speaking to the advantages of using a
captive rather than simple self-insurance, Quintal said: “If a firm is
self-insuring, they’ve accepted responsibility for funding 100% of any
loss. Captives, in comparison, provide a means through which firms can
access insurance or reinsurance, while also pre-funding self-insured
loss amounts in a more formal way than simply setting aside capital.”
Taking this more formal and regulated
approach, Quintal added, can help create more capacity in the market,
and “by having more control over a firm’s insurance program, captives
can bring the price of risk financing down over time.”
Even for a crypto firm, a captive
would have to keep most of its claims reserve in fiat, but crypto could
potentially be used for the surplus (additional funds reserved in case
of an unexpected amount of claims), according to Ward Ching, managing
director, Aon Captive Insurance Managers.
There have also been discussions about including crypto in the Caymans captive’s investment activities, said Ching.
“It’s all about doing the math and
showing the domicile regulatory leadership how the inclusion of
cryptocurrency as an asset class both satisfies the regulatory mandate
and provides financial flexibility in a constructive and safe manner,”
he said.
Self-insurance
It’s no secret that many of the largest cryptocurrency exchanges simply self-insure against hacks and losses.
The problem historically has been
that crypto insurance is prohibitively expensive, way too limited and
fiendishly tricky when it comes to actually making a claim. In response,
crypto firms have resigned themselves to holding their own coins in
cold storage (where the private keys are disconnected from the internet,
in a hardware device or piece of paper locked in a safe) to deal with
losses.
San Francisco-based exchange Kraken
has been candid about having its own insurance fund. As Kraken CEO Jesse
Powell told CoinDesk:
“The balance sheet is basically also called the insurance fund.”
Kraken has “well over $100 million”
put aside, said Powell, much of it in bitcoin to save the company from
having to go out and buy coins on the open market in the event clients’
coins need to be replaced.
Similarly, in February 2018,
Singapore-based Huobi put aside 20,000 bitcoin as its fallback
protection mechanism in the event of a security breach, known as “the
Huobi security reserve”. As a further measure, it has hoarded a
“protection fund” by earmarking 20 percent of transaction fees per
quarter to buy back its native tokens.
“If you add our protection fund up
with our reserve fund we are talking well over $400m of protection
there,” Josh Goodbody, head of Europe and the Americas, Huobi global
sales and institutional business told CoinDesk.
Powell, an outspoken critic of
the state of insurance provision offered to crypto firms, said over the
years his firm has been quoted insurance many times at prices which
were “ridiculous and obscene.”
“There’s just not a good deal out
there,” he said, “I’m sure you can get someone to write you a deal for
like 10% a year of the balance and actually have real meaningful
coverage. But I don’t think people are going to pay that.”
Goodbody, likewise, explained that
Huobi had been around the block looking at insurance. Indeed, he
questioned how coverage in the hundreds of millions of dollars touted by
some firms would apply to hot wallets, which he said would be “extremely confusing and full of caveats and fine print.”
Considering alternatives
Exchanges tend to be loose in how they go about self-insuring, according to Powell.
“I think everybody basically has
these funds on their balance sheet and they are investing them or
dipping into them for operations,” he explained. “Nobody, as far as I
know, has provided some sort of audit or an explicit statement about how
these funds are segregated and kept in a different entity as if it were
really like third party insurance provider.”
Nevertheless, Powell said he struggled to see what value it would add setting up a separate captive insurance company.
“I just feel like it’s moving money
between pockets of the same entity, and I don’t really see how this
actually helps the consumer have more protection. It’s all the same
basket of money anyway,” said Powell. “I don’t know why this would be
able to get a better deal than we could get directly with an insurance
broker.”
Huobi’s Goodbody was more optimistic, calling Aon’s plans “extremely interesting and super positive for the market.”
Some innovators in the insurance
space, such as ethereum-based Nexus Mutual, have suggested going further
than setting up individual captive vehicles and rather pooling together
groups of crypto disaster funds into a system of reinsurance.
Powell agreed this idea seemed to have more potential value for the industry, but he questioned the practicalities.
“You could conceivably do a group
insurance deal among the exchanges, like a co-operative kind of thing.
But then you have to have your competitors audit everything and I think
everybody’s too smart for that – and too paranoid,” he said.
Aon’s Ching agreed there was some
“obvious logic” in getting a group of crypto self-insurers together and
aggregating. The problem, he said, is these companies are very different
once you get under the covers:
“They have different risk
tolerances, different capital structures and different security
mechanisms. Until they harmonize that it’ll be hard to put a group
captive together; not saying it’s impossible, just a bumpier ride.”
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