Disruptions to the financial underwriting norm are nothing new.
Several significant trends and changes have surfaced relatively quickly over the years – from business valuation of dotcoms in the late 1990s to non-recourse loan premium financing and Stranger Owned Life Insurance (STOLI) in the mid-2000s. The latest novel challenge to establishing a client’s financial insurability has arrived: determining the value of digital assets, including cryptocurrency.
Despite their perceived newness, cryptocurrencies have been around for more than a decade and their usage and acceptance continue to increase. It is therefore important for underwriters to take steps now to understand cryptocurrency – what it is, how it works, key risks and issues – and establish guidelines for adapting financial underwriting to this new asset class.
What are cryptocurrencies?
A cryptocurrency is an encrypted, decentralized digital medium of exchange based on blockchain technology. No central authority such as a government or bank manages and maintains the value of a cryptocurrency (or crypto); instead, this role is distributed broadly among users via the internet. Bitcoin, which was released in 2009, is the best-known, but cryptos in circulation now number over 5,000. While crypto can be used to buy regular goods and services (and in some cases to pay employee salaries), it is not yet a widely accepted payment method. For now, digital currencies remain primarily an investment asset, such as stocks or precious metals.
New units of cryptocurrencies are created, or mined, by completing two general processes requiring significant computing power:
- Validating crypto transactions on a blockchain network and adding them to a distributed ledger, which is achieved through complex computer calculations to find a 64-digit hexadecimal code, or hash.
- The proof-of-work process in which a miner must be the first person to arrive at the correct hash (or closest to the correct hash).
Crypto wallets, which can be an app or something resembling a USB stick, are the key to storing, sending, and receiving cryptocurrencies. A crypto wallet doesn’t hold any actual cryptocurrency but instead contains the owner’s public and private key information; the assets themselves are stored in the blockchain for the specific currency.
Although once obscure and primarily associated with financing illegal activities, cryptos have begun moving into the mainstream. Nevertheless, crypto is not accepted in several countries, some of which have banned it outright and others implicitly through severe restrictions, such as prohibiting financial institutions from dealing in crypto or banning crypto exchanges.
Regulatory approaches to cryptocurrency can also include the application of taxation laws or money laundering and terror financing laws.
Like everything else with crypto, the regulatory environment is changing rapidly and frequently.
The U.S. is now working on a plan to regulate cryptocurrencies in response to the explosive growth in digital assets and the increasing number of countries exploring central bank digital currencies.
Central Bank Digital Currency (CBDC)
With the growth in cryptocurrencies, the world’s banks are working to provide alternatives lest the “future of money” pass them by. A CBDC is virtual money backed and issued by a central bank that is developed as direct competition to cryptocurrency so that the banks maintain control. The value of these CBDCs corresponds to the value of the traditional, physical monetary equivalent.
Eighty-nine countries are in the process of either researching, developing, or piloting CDBC. Currently, nine countries have launched CBDCs: the Bahamas, Antigua, Barbuda, Grenada, Saint Kitts, Nevis, Saint Lucia, Dominica, and Montserrat. The Bahamas launched the first central bank-issued digital currency, the Sand Dollar, in October 2020, and authorities there want to eliminate the use of checks in the country by 2024 because they believe mobile wallet payments and the Sand Dollar provide better alternatives for consumers.
China has had a CBDC in development since 2014 through The People’s Bank of China. The bank has been trying to increase adoption by giving away tens of millions of the tokens and recently released a pilot version of a digital wallet for the digital yuan in 10 areas in China, including Beijing and Shanghai. This digital currency is also now compatible with WeChat, the most popular super-app in China.
To attract and recruit talent amid the “Great Resignation,” some employers have added paying in bitcoin or other cryptocurrencies to their growing list of incentives, especially in U.S. markets. Younger workers in particular see certain advantages to being paid in cryptocurrency:
- A YOLO (you only live once) opportunity to get rich quickly
- A way to potentially get ahead financially given heavy tuition-related debt, exorbitant housing costs, and increasing inflation rates
Payment in digital currency, either in full or in part, has also started to become more frequent with high-profile individuals, including celebrities, pro athletes, and even the mayors of some U.S. cities, as a means to promote digital currency.
Given crypto’s ongoing volatility, remuneration through digital currency comes with significant upside and downside considerations:
- Potential gains from increasing crypto value
- Immediate payments without a bank as a middleman, requiring no pending direct deposits or check-clearing processes
- Perception as cutting-edge and “trendy”
- Volatility of cryptocurrency making value of the payments susceptible to change without warning
- Vulnerability to crypto crime, hacking, and scams
- Learning curve with setting up and operating a digital wallet
- More complicated taxation
Factors to consider in financial underwriting
Despite increased usage and acceptance of cryptocurrencies, persistent volatility and many unknowns remain. How then can insurers best determine the value of crypto in assessing an applicant’s net worth and appropriate levels of coverage? While the answer to this question will undoubtedly evolve in the years ahead, establishing basic guidelines now will enable insurers to better serve applicants today and be prepared for the digital economy of tomorrow.
Collect appropriate financial details
Most insurance applications currently in use were developed before digital assets such as cryptocurrencies were in widespread use. Financial underwriting questionnaires should be revised to capture details about crypto assets held and whether an applicant is remunerated in cryptocurrency. Due to its extreme volatility at this point, any portion of salary or other remuneration paid through cryptocurrency should be excluded from earned income.
For assets, most financial questionnaires ask about investments as a single entry, lumping together shares, bonds, debentures, managed investments, and more. Adding a line to the assets section of the financial questionnaire to ask specifically about digital assets, including type of asset – cryptocurrencies, non-fungible tokens (NFTs), etc. – and percentage of the total investment assets they make up, can provide valuable insights into an applicant’s net worth.
Evaluate digital assets
With the inherent risks, insurers should only consider crypto as part of a client’s net worth if it makes up a small portion of overall assets, establishing a defined maximum percentage, such as 25%. Anything above that threshold should be excluded from the calculation of assets. In determining the value of crypto, it is best to use the average value over a span of two to three years.
It is also important to assess the relative risk of the specific cryptocurrency in determining asset value. Key questions to ask include:
- Which crypto is it and how many units does the applicant own?
- Has the crypto been established and traded for at least three years?
- Is the crypto a CDBC?
- Is the use of cryptocurrency banned either absolutely or implicitly in the country where the client resides?
- Do laws to prevent money laundering and financing of terrorism apply to cryptocurrency in the country where the client resides?
The value of cryptocurrency is largely based on the strength of belief in the future of the technology. The hype around crypto is fueled by the potential of achieving a more democratic financial system with more inclusion and lower costs. Crypto may also lead to greater democratization of capitalism and cause “Finance” to operate in new ways. If the core function of finance is to move money and risk within the economy, cryptocurrency could transform and decentralize this function.
With the insurance industry’s central role in the global financial system, the implications for insurers are clearly profound. Whether cryptocurrencies even come close to full ubiquity remains in doubt, yet it is undeniable that their influence is already being felt and will change the way financial systems operate to some degree. Preparing now for what lies ahead is the best way to insure future growth.