Innovative Solutions: First Cryptocurrency Captive in Bermuda
The flexibility and control offered by captives continues to play an important role in addressing cryptocurrency and tokenized asset risks. As the use of these digital assets grow, organizations need a place to store them. Much in the way a bank holds savings and investment accounts for individuals, there are now financial institutions that serve as storage firms for digital assets. Similar to the theft risks faced by a bank, these storage firms must protect digital assets against loss or theft.
Potential customers are aware of these risks and are increasingly looking for guarantees that they will be protected in the event of theft. Storage firms have found this guarantee in the commercial insurance market.
However, the insurance market cannot always offer the capacity or satisfactory pricing needed for emerging digital risks. Rather than buying an insurance policy from the commercial market, some storage firms have recently decided to provide evidence of insurance coverage by insuring their risk through a captive.
Understanding the Nature of Cryptocurrency Risk
There are different forms of storage used for digital assets, each with unique insurance coverage. The main stages of storage are:
- Cold storage: Cryptocurrency is stored offline, away from any Internet access.
- Warm storage: The period in which a cold storage asset is transitioned/transacted to hot storage.
- Hot storage: Cryptocurrency is stored online, and connected in some way to the Internet.
From an insurance perspective, cold storage is the better risk as it is not connected to the internet and has very few and very secure access points. Hot storage is connected to the internet and is more susceptible to traditional cyber hacking/theft perils, such as social engineering. In turn, this makes hot storage the more difficult coverage to obtain in the insurance marketplace.
Using a captive, it is possible to write a first-party policy for the theft of digital assets, from both cold storage and hot storage, for which the owner is responsible. If digital assets were to be stolen or lost from their digital vault, the losses would be covered by this policy.
Challenges and Key Considerations
As with all captives, there are capitalization requirements and some drawbacks to consider during the formation process. Any form of self-insurance requires the ability to fund for future losses. In a new industry, predicting future losses is very difficult as there is no history to make assumptions on, which in turn makes underwriting a challenge.
Our actuarial team built a model that used data from a variety of sources to work out the likelihood of losses in cold and hot storage scenarios for a client. After determining the risk, the client put US$5 million of capital into the vehicle, which while not an issue for this firm could be tough for a startup with limited capital.
An additional challenge was making sure that the domicile regulator, in this case the Bermuda Monetary Authority (BMA), was comfortable that the captive’s financial performance could be credibly supported. To do this, we established the captive’s premium charge and modeled the risk and loss pattern going forward so the captive would have enough money set aside to survive any claims.
Looking into the Cryptocurrency Captive’s Future
As a new company in an industry with limited history, the captive owner found it a challenge to purchase traditional coverage. The captive is now looking into setting the vehicle up as a digital asset insurer in its own right to offer coverage for traditional lines, such as directors and officers (D&O) and errors and omissions (E&O) liabilities, as well as other financial lines.
The BMA was excited to see this first digital asset captive established and was flexible in its approach and understanding of the nature of the risk. Through the use of a captive, the owner was able to meet the local insurance requirements put forth by Bermuda’s Digital Asset Business Act in a more economical way that could work for other businesses in this space.