Captives’ cryptic future with cryptocurrencies

The rise of cryptocurrencies into the mainstream psyche in recent years will not have escaped the notice of most captives practitioners. Many sectors are mulling what these once obscure but increasingly mainstream currencies will mean; they are increasingly a talking point at conferences in almost every sector.

Probably the biggest reason they made headlines originally was their soaring value, especially of the most mainstream cryptocurrency: Bitcoin. On December 17, 2017, the value of one Bitcoin soared temporarily to more than $20,000; the market capitalisation of Bitcoin was at more than $330 billion at that point. But prices remain very volatile. The price subsequently collapsed and the value of one Bitcoin halved to around $10,000.

It’s not just Bitcoin creating such a buzz. Specialist website coinmarketcap.com lists almost 1,500 virtual means of payment with a total market value of around $530 billion. There are many types of cryptocurrencies directly comparable to Bitcoin but also others that are complementary. There is Ether, the digital currency based on the blockchain network Ethereum; IOTA, which does not use blockchain technology but a related protocol; and Litecoin, which is technically almost identical to Bitcoin.

Most, but not all, use blockchain technology as the platform they operate on. Blockchain is, of course, increasingly being embraced by many parts of the insurance industry. The distributed ledger concept has vast potential for the way the industry manages and records information and it is almost impossible to hack.

Because cryptocurrencies are only possible because of blockchain technology, the two terms have become inextricably linked in the heads of many. They are separate technologies with distinct advantages and disadvantages, but they both have the potential to transform parts of the industry.

Most offshore domiciles seem to understand this. The Cayman Islands has a taskforce working towards a system that would allow hedge funds to accept payments in cryptocurrencies; Bermuda recently implemented a legislative framework for initial coin offerings (ICOs). Both are seeking to become what might be called centres of excellence for blockchain and cryptocurrencies.

Captive International has been exploring what impact blockchain and cryptocurrency may have on the captive insurance industry. This article looks at the what some of the benefits are and where such technologies have been embraced, and the following article by Tatjana Winter, head of research at BlockART Institute, looks at some of the approaches the re/insurance markets are incorporating into their business models.

Domiciles move on cryptocurrencies

There are a number of reasons cryptocurrencies should be on the radar of the captive industry.

First, in theory, captives could receive payments using cryptocurrencies in the same way some hedge funds are exploring this possibility. While possible in theory, the volatile nature of the value of these currencies makes this unrealistic for now. Equally, many are designed to make the identity of the payee virtually untraceable—something that would not sit well with a sector keen to protect its reputation and be transparent.

Second, a captive, as part of its asset management programme, could invest in cryptocurrencies. Again, their volatile nature would be the biggest deterrent to this happening yet—although that does not mean they could not become a legitimate asset class at some point in the future.

The third area of interest, however, could be around companies that are formed using cryptocurrencies to raise funds. These companies, which will generally operate in the technology sector, could represent a good source of new business and economic activity for domiciles—both onshore and offshore. As a result, some are considering legislation to give them a competitive edge over other domiciles.

The Companies and Limited Liability Company (Initial Coin Offering) Amendment Act 2018—also known as the ICO Act—is the latest move on the part of Bermuda’s government to expand the range of businesses that operate on the Island, as well as to encourage more technology-related companies to open on Bermuda. ICOs can be used to raise funds for re/insurers but in many places are not regulated.

This new legislation affects those who are interested in creating, promoting, investing in and using ICOs and digital assets, as well as companies who are seeking to raise capital through ICOs.

Once the ICO Act receives the approval of the Senate and Royal Assent, it will become operative by notice of the Minister of Finance (Minister), which is expected to occur during May 2018.

The point here is that new companies will ultimately need insurance—a captive solution could be a good one for companies managing relatively unusual risks and operating with funding secured in this way.

Equally, in Vermont legislature is being introduced, exploring cryptocurrency and blockchain.

Senate Bill 269, introduced in January 2018, proposes action on blockchain, cryptocurrency, and other fintech initiatives, as recommended in a report produced by the Center for Legal Innovation (CLI) at Vermont Law School.

Highlighted in the CLI report are provisions for formal structuring options for cryptocurrency limited liability companies (LLCs), personal data/identity trust companies, and autonomous agency corporations.

David Provost, deputy commissioner of the captive insurance division of the Vermont Department of Financial Regulation (DFR), explains that the DFR has been working with companies to get training and education on the subject for its staff, and that some cryptocurrency and blockchain businesses have approached the regulator about forming captives.

Internal studies carried out by the DFR determined that cryptocurrencies qualify as securities and can be regulated as such.

While Provost suggests that a captive could invest some of its assets into cryptocurrencies, it would not be without risk. There may be potential gains to be made, but a clear drawback in his eyes were the potential losses from such a volatile currency.

“I don’t yet see a big opening for cryptocurrency in the captives industry,” Provost says. “Certainly some crypto-related businesses may form captives for various reasons, and some may even pay claims or collect premiums in crypto, but I don’t see the ‘next big thing’ here.”

He adds: “I do not expect to see existing captives owned by traditional businesses either investing in cryptocurrency or transacting with cryptocurrency any time soon. In the words of Sir Charles Barkley, ‘I may be wrong, but I doubt it’. Blockchain might be another story.”

How does the industry benefit?

Blockchain is a very different animal and one that will undoubtedly transform parts of the industry. The concept of the distributed ledger is one that could being real benefits to captives managers, according to Matthew Queen, chief compliance officer and general counsel at Venture Captive Management.

Distributed ledgers use independent computers—referred to as nodes—to share and synchronise transactions in their respective electronic ledgers. This is opposed to keeping data centralised, as is the case with a traditional ledger.

Distributed ledgers not only allow programmers to create unique digital assets that can’t be counterfeited, they also allow for the transfer of digital assets in a system without the need for third parties to regulate it.

Queen notes that just as there are many cryptocurrencies, there are also a number of different ledgers, such as Tangle or Hashgraph; each has its pros and cons but they share a single fundamental value: digital asset protection. And, while the use of any distributed ledger does not need to be linked to a cryptocurrency, when it comes to organising payment, they often can be.

“Captive insurtech companies need to use distributed ledger systems with versatile code allowing for complex programmes,” says Queen.

“One great ledger is Ethereum. Ethereum, much like Bitcoin, is a decentralised platform running on a blockchain. However, Ethereum differs from Bitcoin in that the ledger is more advanced and allows for smart contracts and distributed applications (DApps).

“DApps (open-source software that leverage on the blockchain technology) and smart contracts are nothing more than computer code that executes functions without a middle man.”

One of the benefits of a smart contract is that it allows for the automatic payment of a claim upon the occurrence of an event. Upon an event occurring, the contract would trigger without any worry of fraud or the need for a human to act.

Queen gives the example of a smart car registering the deployment of an airbag. The driver is informed via email or text to take the car to a number of preferred service providers in the area. The insured tells the insurance company approximately when he or she will arrive at the service provider and an adjuster estimates the damage to the vehicle. The service provider conducts the repairs and bills the insurance company, prompting an instant transfer of a cryptocurrency.

The insured is taken care of, the transaction takes hours or days instead of weeks, and the insured never needs to figure out cryptocurrency or blockchain.

Another example Queen gives is where insurance carriers use parametric insurance policies to pay out predetermined amounts based on the occurrence of weather events.

“An anemometer that registers winds in excess of 75 miles per hour may provide an automatic distribution of funds to an insured who is in a hurricane territory. Currently, these policies are marketed as excess policies for the insured, but the technology is already in place to execute smart insurance companies.

“These companies need a lot of manpower to set up, but only require basic maintenance of the infrastructure and accounting on the back end to continue operations.”

It is through these examples that, Queen says, one can see the true power of distributed ledgers for captives: decentralised autonomous organisations (DAOs).

He explains: “A DAO is a robot company that essentially runs itself. With proper inputs (such as the airbag or anemometer) and infrastructure (such as the payments systems with clients and service providers), there is less need for labour.

“Adjusters and bankers will find new ways of adding value to the insurance transaction, or vanish into the oblivion of automation.”

Adoption

The future of blockchain and cryptocurrencies within the insurance industry remains uncertain.

It is unlikely that many captive managers are using distributed ledger technology, which Queen believes is partly due to its cost.

He suggests that setting up smart contracts requires hiring software engineers with a lexicographic understanding of cryptoprogramming, who command salaries way into six figures in Western countries.

“Engineers have found faster, cheaper distributed ledger technologies that may crowd out blockchain. Or, perhaps Tangle and Hashgraph will go the way of Betamax and CDs. Second, the cost of implementing blockchain solutions into captive insurtech companies exceeds what most mid-market firms are willing to pay.”

He continues: “That said, the mid-market is not the only market. Large firms that pride themselves on early adoption may be interested in implementing distributed ledger solutions in their captive insurance companies.”

Queen recommends that captive managers who are interested in this space should study the current solutions already in place, such as parametric insurance policies.

“Where smart contracts shine are situations where the occurrence of the triggering event is easily recognised by a computer and the record of the event can be stored on the blockchain. If the policy’s payment is easily calculated, or predetermined, then the captive can pay a claim without the need for a claims analyst, bank funding request, or any human involvement.”

Queen concludes by saying the most exciting part of the cryptocurrency areas is not the current technology, but rather innovations already spreading through the industry.

“Could a car in an accident diagnose the costs of repair and automatically distribute funds via blockchain transfer without the filing of a claim? Could there be a transnational insurance coverage for property coverage purchased via Bitcoin? Are there new forms of insurance waiting to be innovated?

“Captive managers are wise to start incorporating blockchain into their operations as soon as is practicable. A practical understanding of this technology in 2018 will pay dividends in 2025 when it reaches ubiquity in the capital markets,” he concludes.