Digital assets, often referred to as cryptocurrencies, represent a groundbreaking shift in the way financial transactions occur globally. Unlike traditional banking systems that rely on infrastructure from the 1970s, digital assets offer a borderless, secure, and faster means of exchange. Notable cryptocurrencies like Bitcoin have gained popularity due to their transparency and ease of conducting transactions via blockchain.

In the evolving landscape of digital assets, it’s crucial that businesses understand how to navigate the insurance space. Over the past several years, this industry has seen significant growth and transformation, with various challenges and opportunities coming to the forefront. After unprecedented bankruptcies and hacks in 2022, the digital asset world faces the major challenge of insuring against such incidents. While traditional bank accounts often come with government sponsored FDIC cover against events like bankruptcy, digital asset platforms provide few shields, a reality underscored by the November 2022 collapse of the FTX exchange.³

WHAT WE’VE LEARNED OVER THE LAST YEAR

The past year offered many insights into the digital asset industry. The crypto ecosystem has undergone a cleansing, revealing that good risks do exist, even as the sector continues to build. From a legal perspective, it has become clear that the traditional securities framework does not adequately consider digital assets. The definition of securities, originally established in 1946, is outdated for the new digital asset era.5 In addition, the U.S. Securities and Exchange Commission (SEC) has been actively pursuing enforcement actions, creating uncertainty in the court system. The lack of definitive guidance on regulatory compliance for digital asset companies poses challenges for businesses operating in this space. Companies must make every effort to operate within existing rules while advocating for clearer regulatory guidelines.

Many stakeholders remain anxious because navigating a regulatory framework not designed for digital assets is difficult. The uncertainty has driven many businesses offshore, where comprehensive digital asset frameworks are emerging. The exclusion of the U.S. from many initial offerings due to regulatory concerns harms the American market and hampers innovation. Ultimately, there will likely come a breaking point where regulatory agencies must act to prevent the U.S. from falling behind in the global digital asset marketplace.

UNDERSTANDING DIGITAL ASSET COMPANY INSURANCE NEEDS

Companies operating in the growing digital asset arena must understand and manage key exposures as they work to grow and innovate, which makes finding the right insurance protection even more important to long-term business success.

Professional Liability. This coverage can help protect against errors and omissions associated with a digital asset company’s delivery of professional services, such as client advisement. Professional liability can help pay to defend the claim or the cost of a settlement or judgment. Liability insurance is also often required to satisfy contracts with clients, business partners, or vendors.

Employment Practices Liability (EPL). Companies across all industries, including digital assets, should proactively manage exposure around employment-related discrimination, retaliation, or sexual harassment. EPL coverage can help manage exposures by insuring against various allegations of wrongful employment conduct. Crime Coverage. Due to the known risk of hacks and/or the theft of digital assets, crime coverage is a wise choice. It provides insurance for direct financial losses due to the theft or destruction of covered property.

Directors & Officers. Given the rapidly changing regulatory landscape of the digital asset sector, there’s a heightened risk for a company’s directors and officers (D&O). These executives are vulnerable to claims from shareholders, investors, or regulatory authorities, citing breaches of securities laws, fiduciary duties, or regulatory mandates. This underscores the importance of Side A D&O liability insurance, especially if a company is hesitant or incapable of indemnifying its directors and officers. D&O insurance becomes even more significant when a company initiates offerings (like an IPO) and faces lawsuits for potential misrepresentations or failure to properly register its assets. Such insurance can defray defense expenses and might even cover settlements or judgments, safeguarding directors and officers from allegations of mishandling managerial responsibilities. Additionally, it provides a shield for businesses against claims of corporate malfeasance.

Cyber. Because digital assets can involve the gathering and storage of customers’ personal identifiable information (PPI), companies in this sector are also at risk of a cyber breach or privacy incident, incurring significant notification and business interruption costs if the organization is unable to operate while the incident is addressed. Cyber insurance can cover first-party and third-party losses as well as regulatory liability associated with data privacy, system failure, or network security events.

Tech E&O. A company operating in the digital asset space may also face liability if a client is hit with a financial loss due to a technology-related error or omission in a provided service or product. Technology E&O works to transfer that exposure off the company’s balance sheet.

Having the right insurance in place can make digital asset companies more attractive to lenders or investors, helping a business stand out as a better investment and making it easier to secure the capital required to keep pace within the industry.

LEGAL & UNDERWRITING INSIGHTS

As the crypto ecosystem evolves, a growing emphasis on risk management and compliance has become more important. Due to the enforcement nature of the SEC and the fact that money transmission laws have not truly contemplated digital assets, it is important for companies to be thoughtful about risk mitigation strategy, moving toward decentralization efficiently, or bifurcating development to mitigate risk. While digital asset founders may be tempted to leap at social media or other publicity opportunities, caution is wise when publicizing digital asset projects. Information shared online remains accessible indefinitely, making it imperative for founders and organizations to be prudent in their communications.

Well-run companies exhibit strong legal systems, effective controls, and adherence to industry regulations, regardless of the industry they operate in. When assessing a digital asset risk, underwriters focus on the nature of the organization itself, seeking answers to key questions, including:

• Are appropriate legal systems and controls in place?
• Is the company working in compliance with current rules and regulatory guidelines?
• How is revenue generated?
• How does the company communicate with customers, regulators, investors, and other stakeholders?
• What is the company’s motivation for purchasing insurance - checking a box or proactive risk management?

Whether a company is centralized or decentralized, the structure behind the business is the most important consideration from both a legal and underwriting perspective. Some digital asset companies are also seeing an influx of professionals with a background in traditional finance and banking that provide valuable insights in the digital asset space. Their experience navigating regulations and risk management can be beneficial, especially because handling significant amounts of capital requires greater caution and risk mitigation.

LOOKING AHEAD

The digital asset space has matured significantly, and there is growing global energy around blockchain. The sector’s initial emergence saw a surge of investment into various projects, akin to the boom of the dot-com era. However, this led to oversaturation and a lack of funding for more promising projects. Achieving equilibrium between funding and project quality will be crucial for the industry’s sustainable growth.

Digital asset companies will also need to keep navigating a regulatory framework not necessarily made for digital assets, making it difficult to obtain guidance. Walking that tightrope means doing everything possible to operate within the rules as they are. However, because of the current regulatory environment, the U.S. is blocked from most initial offerings. All of the launch and governance of the community happens offshore. When it comes to technology, Artificial Intelligence (AI) and its potential intersection with digital assets is a hot topic that will likely result in more investment in those areas. It may make the world of investment easier to be involved in, which comes with risks as well. It’s also important to keep an eye on the development of Central Bank Digital Currencies (CBDC) as their development will potentially challenge the digital asset space from a regulatory perspective.

BOTTOM LINE

Digital assets are a constantly evolving class facing an uncertain regulatory future. Organizations operating with digital assets should make every effort to understand and manage key exposures. Assisting clients in the digital asset space involves promoting adaptability and a holistic approach. Understanding the risk spectrum and advising on risk mitigation strategies are essential components of the process. Agents can help by encouraging insureds to understand the scope of the risk spectrum, helping guide them toward less risk, and advising on the consequences of various choices. The more feedback provided through the broking community about what makes a risk preferable helps businesses better mitigate risk.

While regulatory uncertainty persists, insurance can help to safeguard businesses. As the landscape changes, embracing best practices, including obtaining the right insurance, can play a role in building a more resilient ecosystem. Reach out to your local CRC Group producer to learn more about how we can help protect your digital asset clients.

CONTRIBUTORS

Drew Taylor is a Vice President & Broker with CRC Group’s San Francisco office where he focuses on helping clients find solutions in new and emerging sectors like digital assets, cannabis, and fintech.

GUEST CONTRIBUTORS

END NOTES

1. Digital Asset Management Market Size, Fortune Business Insights, July 2023. https://www.fortunebusinessinsights.com/digital-asset-management-dam-market-104914
2. One in Five Adults Has Invested In, Traded or Used Cryptocurrency, NBC News Poll Shows, CNBC News, March 31, 2022. https://www.cnbc.com/2022/03/31/cryptocurrency-news-21percent-of-adults-have-traded-or-used-crypto-nbc-poll-shows.html
3. FTX’s Crash Exposes Insurance Black Hole That Risks Impeding Crypto Sector Recovery, Insurance Journal, March 7, 2023. https://www.insurancejournal.com/news/international/2023/03/07/710857.htm
4. Cryptocurrency Hacks Shot Up in 2022, Amounting to Almost $4 Billion in Losses, Cyberscoop, January 2023. https://cyberscoop.com/cryptocurrency-hacks-2022/#:~:text=The%20firm’s%20analysis%20found%20that,from%20104%20hacks%20 in%202021
5. Howey Test Definition: What It Means and Implications for Cryptocurrency, Investopedia, July 31, 2023. https://www.investopedia.com/terms/h/howey-test.asp#:~:text=The%20Howey%20Test%20determines%20what,from%20the%20 efforts%20of%20others.%22