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What every insurance professional should know about Bitcoin

Investments|Insurance Consulting and Technology

By Ravi Sharma, FCAS | July 6, 2022

As Bitcoin and other digital currencies come into fruition, understanding the attributes of digital assets and how to interact with them is vital for insurance professionals.

Bitcoin adoption is growing across the globe and has the potential to create new opportunities for the insurance industry. In order to take advantage of those opportunities, we must understand the technology, risks as well as the myths surrounding Bitcoin. The technology is not well understood by the public creating many misconceptions. With a deeper understanding of Bitcoin, such technology could play a crucial role in facilitating the future of the insurance industry.

However, many in the insurance industry continue to doubt the relevancy of cryptocurrency. But we cannot look past the potential of the technology especially when the U.S. Federal Reserve has acknowledged the need for an evolution of currency.

On June 17, the Fed Chairman Jerome Powell gave opening remarks to a research conference in which he said, “Looking forward, rapid changes are taking place in the global monetary system that may affect the international role of the dollar in the future.” Powell went on to add that the Fed and most major economies are in the process of developing their own 24/7 payment platforms and that the FedNow service from the U.S. Federal Reserve will be available in 2023.

The potential of digital currencies

The Fed’s announcement shows the potential that digital currencies like cryptocurrencies have to revolutionize business in the same way that the Internet changed commerce and even society over the last 25 years. For example, the digitization of the telephone system occurred seamlessly behind the scenes. When customers picked up a phone, they still heard that familiar ringtone and still dialed the same 10 digits. And while consumers initially didn’t notice the changes, the digitization allowed for a faster Internet that gave rise to the Web and whole new industries like digital media and e-commerce.

Similarly, the evolution of our monetary system will likely first happen behind the scenes, utilizing cutting edge technology found in cryptocurrencies to conduct business faster and more efficiently. Eventually the digitization of currencies like the revolution in communications will similarly give rise to new opportunities for businesses.

For the insurance industry, our interaction with money will change before our customers interaction with money does. For that reason, it is imperative to gain knowledge and understanding of cryptocurrencies and know what differentiates them from one another. The gold standard of cryptocurrencies is widely accepted to be Bitcoin, and this article will provide a foundation to which emerging assets and policies can be measured up against.

Bitcoin is the amalgamation of years of development within cryptography, computer science, and economics. While the technology is relatively new to many, Bitcoin was created in 2009 with the underlying principles of slow, steady, and stable evolution.

Bitcoin primer

Prior to discussing the potential insurance uses of Bitcoin, lets address a few important terms associated with cryptocurrency and what makes Bitcoin different than other cryptocurrencies:

  • Mining – In the context of cryptocurrency, and specifically Bitcoin, mining is the process by which computers work to solve complex mathematical equations. Vast amounts of computers race each other to submit solutions to the equation as fast as possible, with each submitted solution acting like a lottery ticket with a chance to solve the block. The miner who submits the winning solution will receive what is known as the block reward, or block subsidy. The block subsidy is paid in Bitcoin to reward the miner for devoting computational resources to solve these complex equations. Attached to this complex mathematical problem is a series of transactions that will be validated through the miner’s work. This concept of mining to verify transactions is known as proof of work and is at the core of what enables a peer-to-peer, decentralized network like Bitcoin.
  • Block – A block is a collection of transactions, verified through mining, to be recorded into a longer stream of transactions on a ledger. The miners have consensus for all transactions on the ledger from the very beginning of the ledger up through the latest block, prior to moving onto the next block.
  • Blockchain – This is the digital ledger that records every transaction. The transaction history recorded in the ledger is composed of a chain of blocks, hence the term blockchain. As more blocks are added to the chain, older blocks having increasing levels of verification. Each block that is added requires network agreement of all prior blocks up to and through the current block. The blockchain grows longer with time as blocks are added in chronological order.
  • Stock to flow ratio – Measuring the amount of newly issued resources to an existing pool of resources, the stock to flow ratio is commonly used in commodity markets to quantify abundance/scarcity. A high stock to flow ratio would indicate that while there are several units of a resource in circulation/reserves, new units coming to market will be limited, causing the underlying asset to have a strong propensity to retain its value.

The economics of Bitcoin

In economics, there is a core list of desirable traits for a currency to have. By design, Bitcoin possesses these traits.

  • Durability – Enshrined within code on the Bitcoin blockchain, every single transaction is perfectly accounted for, and no units can be mined or transferred without the blockchain network accepting the transaction. This causes Bitcoin to be durable against fire, flood, nuclear, chemical biological, radiological, fraud, theft, and any other peril that even the most creative enterprise risk management (ERM) team could dream up.
  • Portability – Anywhere you can take a thumb drive, you can carry Bitcoin with you. For instances where you cannot take a thumb drive, Bitcoin can be stored in a digital wallet which can be recalled by providing a seed, usually 24 words, to an encryption algorithm. Anyone can carry Bitcoin worth billions of U.S. dollars around with them by memorizing these words. As Bitcoin becomes more valuable versus U.S. dollar denomination, that figure will scale with the Bitcoin market capitalization.
  • Divisibility – Like dollars and other currencies, Bitcoin are made up of smaller denominations. Each Bitcoin is composed of 100 million satoshi (colloquially known as sats), named after the pseudonym of its creator(s), Satoshi Nakamoto. One satoshi to a Bitcoin is analogous to one penny to a dollar, in that a penny is the smallest unit of a dollar.
  • Uniformity – Bitcoin is perfectly uniform due to its mathematical nature. All Bitcoins hold equal value, regardless of when or where it was mined, and by whom.
  • Scarcity – In total, there will only ever be 21 million Bitcoins issued. Currently, there are just over 19 million Bitcoins in circulation, with 6.25 coins added every 10 minutes. The remaining 2 million Bitcoins will be mined between now and around 2140. As computational power advances, the mining algorithm has a difficulty adjustment built in to maintain the designed flow of Bitcoin into circulation. This difficulty adjustment serves to maintain an average block time of around 10 minutes. The block subsidy, currently 6.25 coins per block, halves every 210,000 blocks, which ends up occurring approximately every four years. The decreasing block subsidy will result in an increasing stock to flow ratio, further increasing the scarcity and value of each Bitcoin.
  • Acceptability – Bitcoin experienced its first economic transaction back in 2010 when an early adopter spent 10,000 Bitcoins to purchase two large pizzas from a Papa John’s – as of June 2022, that transaction would have been worth more than $200 million. Today, Bitcoin is becoming increasingly accepted as a form of payment and a store of value. Everything from homes and cars to everyday items are purchased using Bitcoins. Investment firms and major corporations are offering Bitcoins to their customers and even employees, as well as allocating a portion of their assets to Bitcoins.

While Bitcoin possesses these positive traits of a solid currency, a common critique is its volatility, and rightly so. The lack of common knowledge about Bitcoin and relatively high barrier to entry due to that lack of knowledge has created a speculative component to buying and holding Bitcoin and other cryptocurrencies. The speculation hinges on the widespread adoption of the underlying asset. While this creates volatility in the price of Bitcoin denominated in U.S. Dollars, it also provides a potential reward for earlier adopters.

As consumers and insurance companies grow more comfortable with their knowledge of Bitcoin, it may make sense for insurers to start holding Bitcoin to further diversify their asset allocation and potentially indemnify losses that are already paid in cryptocurrency, like cyber insurance ransomware losses.

The fact that Bitcoin’s market capitalization has exceeded $300 billion since late 2020 and has broken $1 trillion on multiple occasions provides a strong case for insurers and others to take this asset seriously. For comparison, gold has an estimated market capitalization between $12 trillion and $13 trillion, Apple between $2 trillion and $3 trillion, and silver between $1 trillion and $2 trillion as of June 2022.

Final thoughts

While there are several technical aspects of Bitcoin to be discussed, the practical application as a solution to many existing problems explains the increasing adoption rate. The expanse of opinions and headlines surrounding Bitcoin is too great to cover in one article. With the knowledge and definitions established in this article, critical thought based on a fundamental understanding of the properties of Bitcoin will allow for the separation of hyperbole from fact. As this field emerges, it will become increasingly important for us in the insurance industry to possess this fundamental knowledge so that we can make wise business decisions, avoiding the expense of precious resources on solutions looking for a problem.

In the next article in the series, I will address the growing adoption of Bitcoin and practical applications for the insurance industry.

Author

Associate Director – Insurance Consulting and Technology

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