According to Autonomous Next, a London based fintech research practice, digital asset hedge funds now number 251 as of August 2018; more than double the number in October of 2017. Many are small, buoyed by entrepreneurs who were part of the early days of Bitcoin’s prolific rise, but there are also very large funds with $1 billion plus in assets under management. They have sophisticated management with quality service providers for compliance, audit, fund administration, legal and accounting. These larger funds are helping to shape the regulatory landscape by working with the SEC, CFTC, NFA and FINRA.
According to Crunchbase, through May $1.3 billion of investment has poured into the Blockchain space including ICOs, which is roughly double the investment in 2017. The proliferation of Blockchain focused funds from established private equity and venture investment groups continues to gain momentum in 2018, which will only add to the explosive growth around distributed ledge technology (DLT).
Since 2014, we have seen the industry mature with capital coming from sophisticated investors looking to create a market in this new asset class. Developing regulation has accompanied this maturation. The SEC has now started to issue statements regarding when a token may or may no longer be a security and court rulings have indicated that cryptocurrency may be a commodity, enabling the CFTC to regulate this industry. The National Futures Association requires immediate notification if a member is engaging in cryptocurrency derivatives transaction. Until the regulatory landscape has settled the insurance industry is having a difficult time providing coverage for parts of the industry.
Management Liability (Directors and Officers and Professional Liability) for Crypto Hedge Funds, Private Equity and Venture Capital Firms
London remains the primary market for Directors and Officers/Professional Liability coverage and many of those products have limited regulatory coverage. A few US insurers are taking underwriting meetings in the space, but only to understand more about the industry, their appetite remains limited, particularly for Funds investing in ICO’s. Most US insurers are waiting for clarity from the SEC about how ICOs and Tokens will be regulated and until that happens any funds focused on ICO investment will be challenged to find quality coverage.
Contrary to the private equity funds, there is capacity and interest in coverage for hedge funds trading in crypto assets. Capacity is roughly $50 million and terms and conditions on the primary $5M or $10M can vary, so it is important to review the language of the policies. Many have regulatory and ICO exclusions. One of the broadest policies being used is the hedge fund directors and officers and professional liability policy form developed by Integro. It has no regulatory or ICO exclusions and the insurer involved is A+.
Crime & Kidnap and Ransom for Crypto Funds
For the theft of Crypto Asset, if the assets are in a “hot” environment there is little in the way of coverage solutions, but capacity and product is available for “cold storage” assets. Although coverage is available, it can be costly with premiums ranging $15-25K per million for the first $5M. Potential buyers should expect extensive underwriting diligence to be done on a firm’s “cold storage” processes and without solid controls and procedures, a firm may find themselves uninsurable. We have observed that many firms simply can’t afford the options presented by the market. As more managers buy coverage the spread of risk will allow pricing to come down, but without broad adoption, rates will remain high and coverage will be limited.
Kidnap and Ransom (K&R) policies offer coverage for ransom demands and more importantly provide negotiation and extraction services to deal with a kidnapping. Coverage options are limited, but available and can be done as a stand-alone offering or within a Crime Bond.
“Like any new industry, it takes time for the insurance marketplace to understand the risks, create relevant products and price them within reason.”
– Richard A. Maloy, Jr. CIC, CRM, Managing Principal
Cyber Liability is always a hot button for crypto managers and Blockchain technology firms who have done token offerings or ICOs. Many confuse Cyber Liability as a policy to cover stolen cyber assets, but it does not, that coverage comes from the Crime Bond. This is a liability product providing insurance for claims brought by third parties alleging damages arising from a hack or breach. Cyber liability can also provide First Party coverage to cover the cost of Forensics, Breach Notification Costs, PR Crisis Management Cost, and Business Income.
As an Asset Manager or Blockchain company there are still aspects of running the fund or technology company where having cyber liability coverage is advisable. Managers may face hacks and breaches resulting in stolen investor or employee information; denial of service attacks; forensics and legal costs; potential litigation from those affected; and/or, regulatory investigations. Coverage for these risks is available with a cyber liability policy. Managers should expect cyber liability policy forms to include exclusions around token offerings or ICOS, theft of the assets and litigation around the theft or regulatory investigations around the theft.
Directors and Officers Liability for Invested Blockchain Companies
Directors and Officers coverage options for DLT companies are still bleak. Until there is mature regulation surrounding ICOs and Token Sales very few insurers will offer terms and those that will, offer terms excluding the ICO and any regulatory investigations. For Private Equity and Venture firms investing in the space, they will face a challenge to get coverage at the portfolio company level, so it will be important to have coverage at the fund level that can extend the outside directorship liability for the benefit of their appointed directors or officers at the portfolio company. There are only a select number of insurers that will allow the Outside Directorship extension.
In the past few months, we have seen insurers non-renew Directors and Officers policies for blockchain companies that did ICOs after originally completing traditional equity investments. Coverage was put in place at the time of the traditional equity financing and then canceled on the renewal due to the ICO.
Like any new industry, it takes time for the insurance marketplace to understand the risks, create relevant products and price them within reason. The current solutions are advancing rapidly but are often expensive and with poor coverage language with exclusions around the ICOs and any regulatory coverage. However, as more and more managers purchase coverage and the insurance industry gets a handle on the severity and frequency of claims, you will see more market entrants that will help drive better products and lower costs.
Richard A. Maloy, Jr.
Alternative Asset Management and Cryptocurrency Practice Leader