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Bitcoin offers insurers untapped opportunities

By Ravi Sharma, FCAS | August 16, 2022

Bitcoin adoption offers insurers new opportunities. Gaining knowledge and experience now will help insurance professionals prepare for the future.
Insurance Consulting and Technology
Insurer Solutions|

In the first article in the series, I explained the basic technical and economic principles behind Bitcoin. With an insight that looks beyond the headlines, we can develop a better understanding of how adoption of Bitcoin can solve real world problems.

Bitcoin adoption is growing. While buying a pizza with it was a novelty in 2009, today Bitcoin is widely used across the globe.

Bitcoin adoption offers insurers new opportunities. Gaining knowledge and experience now will help insurance professionals prepare for the future.

Global economy

With an increasingly globalized economy, conducting business across international borders is becoming less niche, and more of the status quo. However, moving money from one country to another has historically been an expensive endeavor from both a cost and logistical perspective.

Foreign exchange fees stand in the way with expensive spreads imposed by organizations facilitating inter-currency transactions. For less developed nations, even if the foreign exchange process isn’t cost prohibitive, often, individuals don’t have bank accounts to receive an electronic payment. Globally, 31% of adults are unbanked, while just 21% of adults do not have access to mobile phones in developing economies, according to a 2017 World Bank study.

Bitcoin provides an opportunity for parties anywhere in the world to conduct business directly with each other. The transaction costs and execution times are low, and all that is needed to participate is a smart phone. Individuals can send and receive payments directly on their smart phone in minutes, without the need for a bank. This opportunity to provide banking services to many of the worlds unbanked population could have material impacts on quality of life and economic development in traditionally underserved economic areas.

As the world’s unbanked population adopts Bitcoin, insurers have an opportunity to offer insurance products globally, serving the far reaches of the earth.

El Salvador was the first country to recognize Bitcoins as legal tender in September 2021. Now, if an insurer wishes to write a product in El Salvador, it could use Bitcoin to collect premium and pay claims without relying on existing banking infrastructure. Additionally, exchange rate risk is reduced to fluctuation in Bitcoin’s value, rather than including risks imposed by a third party.

As an example, there is a risk that a foreign government will ban monetary exports when they experience economic turbulence (à la Argentina’s dividend and profit payout ban). This reduction in counterparty risk would benefit both the policyholder and the insurer, by removing an element of uncertainty from the insurance process.

Regulation and the strength of the Bitcoin network

A hot topic surrounding the use of Bitcoin is regulation. It is often claimed that Bitcoin isn’t safe for use without proper safety nets and regulation. An important consideration is that Bitcoin and its blockchain are valuable because they are resistant to change, including changes that may be proposed by a regulatory body.

To implement a change, the majority of the network must agree to adopt the proposal. There are groups and consortiums that work together to develop Bitcoin, but there are no governing authorities. Major changes, like implementing regulation or centralized control are extremely improbable.

Bitcoin is a truly decentralized network. This independence and self-governance is the main attribute that separates Bitcoin from other currencies, including most other cryptocurrencies. No central bank, government, or organization exists that can directly manipulate the Bitcoin network and its policies, ensuring that the positive currency characteristics of this asset will likely remain unchanged.

Rather than changing Bitcoin, regulation will most likely take the form of imposing rules on companies that interact with Bitcoin. A good analogy comes from a 1933 U.S. regulation of gold. Amid the Great Depression, President Franklin D. Roosevelt issued Executive Order 6102, which required the deposit of all gold coin, gold bullion, and gold certificates to the U.S. Federal Reserve in exchange for a set amount of U.S. dollars. This is analogous because the regulation enacted rules for the way companies and private citizens could interact with gold, but gold itself was unchanged.

Today, governments could set rules and limits on the way individuals and businesses interact with Bitcoin. For example, major companies, like Coinbase, would have to adhere to those limitations, but Bitcoin and its network would still exist outside of direct government regulation.

Additionally, the economic impacts of major regulation surrounding Bitcoin would likely surpass its $1 trillion market capitalization. The potential costliness provides incentive for regulation to be nuanced, as opposed to overreaching.

The decentralized nature of Bitcoin is a premier example of risk mitigation. Network participants are diversified from a geographic perspective, creating redundancy and durability against

  • Accidents
  • War
  • Natural disasters
  • Government intervention
  • Acts of God

Additionally, the hardware the network runs on is also well diversified, reducing exposure to threats like cyber attacks, malware, and viruses.

As of the writing of this article (July 2022) the Bitcoin network is operating with a computational power of more than 200 exahashes/second. A hash is a mathematical function that converts an input to an encrypted output. An exahash is a quintillion executions of the aforementioned mathematical function. Every second, the Bitcoin network is processing 200 quintillion inputs into encrypted outputs.

Anonymity, criminal activity, and counter party risk

One of the greatest misconceptions about Bitcoin is that it facilitates economic transactions under a veil of anonymity, leading to an increase in criminal activity. While it is true that the owner of a wallet doesn’t have to be linked to a verified real identity, all Bitcoin transactions are public record and can be traced back to their genesis since the blockchain ledger is auditable by anyone with a computer. The entire history of every Bitcoin transaction is stored on just over 450 gigabytes as of April 2022.

Truly anonymous transactions are much more likely to take place with physical money, like cash, where the transaction won’t be chiseled in digital stone for all of eternity.

An advantage that comes from the history of Bitcoin transactions existing on one ledger is a reduction in counter-party risk. Verification of available funds can easily take place prior to entering into an agreement or transaction. Once the transaction is executed, the official transfer of ownership within the ledger is recorded within minutes and minimal expense in comparison to traditional monetary instruments.

A common illustration about the role of the Bitcoin network in economic transactions is to separate activities by frequency and size. Smaller, more frequent payments, like a daily cup of coffee, could take place on a second layer network (Lightning network), taking the place of credit and debit card transactions today. Larger transactions, such as paying a monthly credit card bill from a bank account, could settle on the more robust first layer Bitcoin network.

Using existing financial systems, we rely on third parties (credit/debit cards) to execute quick transactions based on lines of credit for individuals to eliminate counter-party risk. Smaller, faster transactions with Bitcoin are more likely to take place on a second layer network like the Lightning network. The fees on the Lightning network can be so small that microtransactions become economically feasible opening a new world of economic possibilities.

For larger monetary transactions (wire transfer/check writing) we rely on third parties to facilitate the transfer of ownership (clearing houses). These larger monetary transactions can take days and are costly to all parties involved. With Bitcoin, individuals have an opportunity to be their own bank, or, if a higher level of service is required, they can opt to utilize a third party while still maintaining lower cost and greater efficiency than traditional banking systems. Cutting out the additional parties enables Bitcoin to conduct transactions globally with incredible speed and minimal cost.

Money supply

Currently, the U.S. Dollar is the global reserve currency. The world is coming out of a period of unprecedented government expenditure, placing pressure on the purchasing power of the U.S. Dollar. This pressure comes in the form of inflation, largely driven by currency creation.

Looking at the M1 money supply from the U.S. Federal Reserve, a 5x increase in U.S. Dollars can be seen from the beginning of 2020 through April 2022. As the U.S. Federal Reserve continues to print money at an increasing rate, the money supply is multiplied through government spending, fractional reserve banking, and central bank lending. These functions are not present in the Bitcoin system, and the supply is mathematically limited to 21 million coins.

As an industry, the cash we hold as reserves is being diluted and represents a smaller fraction of the money supply with every day that goes by. Utilizing a currency or asset with a fixed or limited supply (high stock to flow ratio) will help to store economic resources over the long haul; the limitations on supply prevents the dilution of value.

While many pose Bitcoin as a speculative investment, it can also be thought of as a reserve currency utilized to store economic units of value due to its high stock to flow ratio. There is a speculative component in that Bitcoin is still early in its adoption curve, but as the level of adoption increases, the price is likely to stabilize, and the store of value overtime will become more apparent.

As an insurer, a relatively minimal investment today could serve as a hedge for future uses of Bitcoin that could be cost prohibitive. Insuring against ransomware, where losses are frequently indemnified in Bitcoins, creates a use case for an insurer to begin holding the asset today.

Additionally, if prices continue to rise relative to the U.S. dollar, establishing a position today would pose a strong value proposition. The lessons learned within an organization about interacting with digital assets and their storage will be a much less expensive lesson to learn now than 10 years from now if the asset continues to appreciate.

Limitations and considerations

The barrier to entry requires individuals and organizations to take it upon themselves to understand the new and emerging technology. Volatility of Bitcoin’s price denominated in existing currencies can understandably create skepticism, and it is up to the purchaser to determine if Bitcoin fits into their risk appetite.

Storage and security of Bitcoin holdings is another major consideration that must be painstakingly evaluated. There are risks and benefits to all storage options, and these should be understood so that an informed decision can be made.

Holding Bitcoins requires complete personal responsibility; if your keys (24 words) are lost, there is no option for recovery. Several of the Bitcoins in existence have already been lost by their owners with next to no chance of recovery. Misplaced thumb drives and forgotten encryption seeds carry increasingly large fortunes. This means the total supply of Bitcoins in circulation will be less than the 21 million that will ultimately exist on the blockchain.

Conclusion

Metcalfe’s law states that the value of a network is proportional to the square of the number of participants in a network. Originally, this law was developed in relation to telecommunications, but as the internet became increasingly mainstream, the application to computer networks became obvious. As Bitcoin continues to evolve and more users join the network, its value is likely to increase. Many individuals view it as a safe haven from inflation, even liberating citizens of war-torn countries from total economic disaster.

Bitcoin adoption is still in its infancy. Gaining knowledge and experience now is a wise investment for any insurance professional looking toward the future. As our industry continues to innovate while maintaining the foundational principles that led to past success, technology like Bitcoin will play a crucial role in facilitating the insurance industry of tomorrow.

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Associate Director – Insurance Consulting and Technology

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