Bermuda has long been an innovator in insurance and, under the leadership of its crypto believer Premier David Burt, it is now looking to be an innovator in digital assets.
Conversations I had on the island during the Bermuda Tech Summit this week have led me to believe there’s a huge opportunity to combine those two strengths into a powerful use case for crypto. At a time when the industry needs to emphasize real world applications – rather than simply riding the boom-bust cycle of “number go up” speculation – this one’s a doozy.
It’s based on an idea from Joe Ziolkowski, the CEO of crypto-focused insurer Relm. He wants to offer investors in staked token pools the chance to apply those holdings as collateral for special purpose vehicles that underwrite reinsurance contracts. It could be a solution to an alarming multi-billion-dollar shortfall facing the reinsurance industry, a vital sector that exists to absorb the risks taken by insurance companies so the latter can continue to expand their policy issuance.
In our “Money Reimagined” podcast this week, Ziolkowski said that on Jan. 1, $20 billion in reinsurance contracts are due to roll over – meaning they’ll need to be refunded – and that the estimated amount committed is just $2 billion. Other people in the Bermuda insurance industry told me that the full-year 2023 shortfall in reinsurance is as high as $60 billion.
Here’s the problem: Insurance claims triggered by Hurricane Ian’s record-breaking destruction last month – with total losses seen as high as $75 billion – have combined with elevated uncertainty around climate change and with the general investor risk aversion stoked by rising interest rates to leave hedge funds and other entities reluctant to commit capital to the industry.
Many fear a lack of catastrophe risk insurance will tank housing markets in Florida and elsewhere. It's a really big, little-discussed problem. And crypto could contribute to solving it.
Staked tokens as collateral
Ziolkowski is proposing a new version of so-called insurance-linked securities (ILS) that first arose in Bermuda after Hurricane Andrew in 1992 left insurers with a then-unprecedented $15.5 billion bill. Ever since, Bermuda has been the world leader for regulating ILS and one of the top three reinsurance hubs in the world.
These ILS instruments, which include catastrophe bonds (colloquially known as CAT bonds) are issued by special purpose vehicles to external investors whose funding pledges provide the collateral to backstop the reinsurance risk. The ILS market has allowed hedge funds, pension funds and other non-insurance traditional investing institutions to tap an additional source of high, uncorrelated returns. In turn, that has allowed the insurance industry to continue to expand with its risks appropriately underwritten.
Ziolkowski believes an on-chain, smart contract-powered version of ILS could be backed with tokens locked up in the staking pools that run validators on proof-of-stake blockchains. In an interesting application of on-chain programmability to real-world problems, the staked funds could be locked up via a smart contract that would execute a reinsurance payout if one is triggered.
Either way, they would deliver a reliable interest rate-determined, uncorrelated return to crypto investors above the staking returns they already receive. The concept might not close the reinsurance funding gap entirely, but with tens of billions of dollars worth of tokens now being staked it has significant potential.
Insurance as opportunity for crypto
This on-chain reinsurance idea is one way in which insurance could be a key element in driving crypto adoption, thereby providing greater stability and security to decentralized finance (DeFi).
Crypto companies have huge demand for regular off-chain insurance. Traditional insurers have been reluctant to provide directors and officers coverage, liability coverage and cybercrime coverage. Seeing the opportunity, Relm came up with risk assessment techniques for crypto companies, including analyses of software code, reserve practices and audit policies. As a result, it secured an Innovative Insurer General Business (IIGB) license from Bermuda’s regulatory agency.
Relm’s business has boomed over the past three years. And now Ziolkowski has his sights on a world in which anyone adding tokens to their crypto wallet can opt in for insurance, much as travelers can buy coverage when they purchase a flight.
Relm is by no means the only insurer working in this space. Its competitors include Chainproof, a spin-off of smart contract developer shop Quantstamp that recently obtained a Bermuda license. Chainproof, which bills itself as the “world’s first regulated smart contract insurer,” charges DeFi depositors a fee based on a percentage of their deposits and pledges to refund the full exposure for any technical failure of the code.
Read more: Why DeFi Insurance Needs a New Design
Other players, such as Nexus Mutual and InsurAce, are decentralized and therefore not regulated per se. Such projects mutualize the risk across token holders and use smart contracts to automate payouts in the event of a breach or failure. Some, such as Cover Protocol, have come and gone because their own smart contracts were attacked and drained of funds.
Security and standards have improved for such insurers, as has the reliability of many of the smart contracts they cover. Still, Chainalysis says October was the worst month on record for crypto attacks: The blockchain analytics firm tallied up over $718 million lost in just the first 13 days. It’s clear that customers are going to need far more assurances that they’re protected if DeFi adoption is to grow.
Here, insurance can play a key role, not only in providing that financial backstop but in incentivizing best practices that protect customers’ funds – much as auto insurer demands have influenced the adoption of many safety features in cars and have encouraged drivers to drive safely.
With the insurance industry’s help, the DeFI industry will eventually figure out how to better manage risk across the entire ecosystem. Innovative insurance hubs such as Bermuda are ideally placed to lead that effort.
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