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Making change: Coverage considerations arising from advancements in national digital currency

Part 2

Financial, Executive and Professional Risks (FINEX)
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By Miguel Cano and John M. Orr | June 2, 2022

In Part 2 of this series, we discuss insurance coverage issues in connection with CBDC risks with respect to professional liability and directors and officers liability.

In Part 1 of our 2-part series, we explored development by national governments of sovereign digital currencies known as Central Bank Digital Currencies, or CBDCs. We also addressed risk issues arising from CBDCs potentially impacting financial institutions. In Part 2, below, we discuss insurance coverage issues in connection with CBDC risks with respect to professional liability and directors and officers liability.

Professional liability

Professional liability, or Errors & Omissions (E&O) policies generally provide coverage for any act, error, misstatement, or breach of duty in the rendering of professional services. There are many different types of E&O policies, each of which typically align with the services of a broader industry. Some examples include Professional Liability insurance for commercial banks, insurance companies, mortgage lenders/servicers, broker/dealers, employed lawyers, and investment advisors. This wide variety of solutions exist because there are many different types of exposures. The same thought process should be applied to digital asset companies.

Digital asset companies come in many different shapes and sizes so there will never be a one size fits all E&O insurance policy solution. Firms in this space can range from being like a “traditional” asset manager, insurance company, or non-bank lender to more bespoke risks such as NFT platforms, cloud computing services, video game companies, miners, validators, peer-to-peer marketplaces, social media platforms and likely many other use cases that have yet to be developed. Because of this fruitful variety, professional liability insurance solutions will look different depending on the type of risk.

For some digital asset companies, insurance solutions already exist in the market (it’s just a matter of carrier appetite and price). For example, it would make sense for a digital asset hedge fund to use the already existing Asset Management Protect form which includes Directors and Officers alongside Investment Advisor Professional Liability coverage. In contrast, a Proof-of-Stake Validator (a company that uses their own money and accepts customer funds to help secure blockchains) would need to find a niche solution for their professional services exposure. A validator gets paid for securing blockchains and in turn passes on the rewards to their delegators (individuals who give the validator their funds). If a validator is inactive or performs a banned action, a percentage of all the funds with the validator (including delegator funds) get “slashed” or “burned”.

It is the validator's responsibility to provide a service to the blockchain on behalf of their delegators or they could risk losing a percentage of their funds. Blockchain Validator Professional Liability Insurance or “Slashing Insurance” is not something that is widely available in the market. There are a handful of carriers who understand the exposure and even less that underwrite to the risk (but the policy does exist). Hence, when it comes to professional liability the most important and at times difficult aspect is understanding the underlying digital asset business and being able to educate the underwriters on the exposure.

Professional Liability insurance has traditionally been a loss leader for carriers. When adding crypto or digital assets to the mix it would be no surprise that there is a hesitation from the insurers to write the coverage. As this space continues to grow, education alongside regulatory clarity is going to continue to be the key catalyst in creating innovative insurance solutions for our digital asset clients.

Directors & Officers (D&O) liability

D&O liability policies cover the indemnified and non-indemnified management liability exposures of directors and officers, as well as certain corporate liabilities. Risks include liability to shareholders/investors, as well as regulators and others. Claims can take the form of, among other things, investor litigation (shareholder class actions and derivative litigation), regulatory investigations and proceedings, alternative dispute resolution matters, and even criminal proceedings.

In Part 1 of our series, we identified risks to financial institutions arising from the development of CDBCs. As just one example, we discussed the potential that, if the U.S. Federal Reserve were to issue a retail CBDC, it might carry the benefit of interest payments, paying a higher rate than that offered by commercial banks to depositors. Banks could experience an outflow of funds from accounts into the CBDC and might also be commercially pressured to raise the rates they themselves pay. Relatedly, the ability of consumers to convert money (such as a bank deposit) into a CBDC might give rise to significant account withdrawals, fewer customers, decreased revenues, and even longer term liquidity concerns.

For these and other exposures, investor claims against directors and officers may arise in the context of alleged breaches of fiduciary duty, including the duty of oversight, which itself entails the duty to monitor corporate affairs, to make informed decisions, and for directors to avail themselves of material information. It is possible the duty of oversight could be highly scrutinized by shareholders and activists to the extent CDBCs and cryptocurrency more broadly are considered new, emerging risks, with potentially severe exposures – exposures including, but certainly not limited to, significant cryptocurrency market volatility, even around algorithmic “stablecoins”.

Directors and officers may also foresee the potential for regulatory investigations and proceedings. For most organizations, entity coverage for government investigations is not contemplated in a D&O policy; however, a measure of coverage may be afforded to individual directors and officers for investigations and other enforcement body “pre-claim inquiries,” including interview requests, sworn testimony, and production of documents.

Anticipated coverage limitations may arise where an individual’s conduct is proven – typically by a final, non-appealable adjudication – to be deliberate. Coverage can be challenging for most civil fines or penalties, as well as taxes. Coverage is generally not available at all for criminal fines or penalties, not even on a Side A (non-indemnifiable loss) basis, or for sums that are legally uninsurable.

It should be emphasized that D&O coverage for cryptocurrency organizations, in general, is difficult to secure. Top of mind for insurers are concerns over volatility and tax issues, consistent cases of fraud, adequacy of security controls and procedures, and a regulatory landscape that, although developing, remains highly uncertain. Thus, at least in the near term, for financial institutions formulating services and technology around the adoption and implementation of CBDCs, it is possible, if not likely, that D&O insurers will limit CBDC and digital currency exposures more broadly, either in the form of increased retentions and premium, or specific policy wording limitations.

Disclaimer

Willis Towers Watson hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us. In North America, Willis Towers Watson offers insurance products through licensed entities, including Willis Towers Watson Northeast, Inc. (in the United States) and Willis Canada Inc. (in Canada).

Authors

Associate Broker, Middle Market Financial Institutions
FINEX Global

D&O Liability Product Leader
FINEX North America

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