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Question of centralization faces growing crypto insurance industry

Cryptocurrency insurance is expected to be a big business: Will it be centralized or decentralized?

Cryptocurrency markets have been maturing over the last few years, making demand for crypto insurance solutions larger as more advanced players dip their toes into the nascent ecosystem.

Investopedia reports that cryptocurrency insurance is seen as a “big opportunity,” with a spokesman from one of the world’s largest insurers, Allianz, saying that the company has explored product and coverage options in the cryptocurrency space as it becomes “more relevant, important and prevalent on the real economy.”

The cryptocurrency ecosystem is still seen as dangerous and volatile, where funds aren’t completely secure even on leading cryptocurrency exchanges. While some platforms, including Coinbase, have revealed they have hot wallet coverage via specific insurers, most don’t publicly promote whether assets deposited there are insured.

The industry poses specific challenges for insurers. For one, premiums are often defined with the use of historical data, which in the cryptocurrency industry is slim at best and absent in newer areas including nonfungible tokens (NFTs).

Demand for insurance in the space is nevertheless present, as crypto exchange Crypto.com has expanded its insurance program to cover $750 million in 2021, and decentralized solutions based on decentralized autonomous organizations (DAOs) like Nexus Mutual have been created.

Speaking to Cointelegraph, Tony Lees, chief product officer at digital payment platform Wirex, said one of the key blockers for “true mainstream adoption over the last few years” has been the thought that the cryptocurrency space is “untrustworthy and insecure.”

To Lees, most users feel that their funds are unsafe and that an investment in crypto assets is riskier than an investment in the traditional stock market. Industry-standard compliance and other regulations, Lees added, have helped platforms showcase how users’ funds are safe. Lees said:

“Corporate-level insurance coverage with custodial platforms such as Fireblocks has enabled companies like Wirex to demonstrate that robust systems and controls are in place in order to give the user peace of mind.” 

Michael Vogel, CEO of Coinstream and founder of Canadian crypto exchange Netcoins, echoed Lees’ thoughts, telling Cointelegraph that crypto represents a “very different risk paradigm” than what investors are used to, as no consumers ever worry “about their shares in Tesla going missing from an online brokerage account.”

Many users, Vogel said, aren’t comfortable with the responsibility of handling the security of their coins themselves. As a result, the market has been developing “custody-type solutions, where a trusted company acts as a form of crypto bank.”

Insurers could provide clear guidelines that custodians need to follow to qualify for insurance here, he said. The move could provide familiarity to investors in the space. As Lees said, most are aware of the Financial Services Compensation Scheme of up to $104,000, or 85,000 Great British pounds in the United Kingdom, or the Federal Deposit Insurance Corporation’s coverage of up to $100,000 in the United States.

These schemes, Lees said, help investors feel comfortable leaving their funds in banks. Crypto insurance covering users’ holdings in a centralized platform would provide “that familiar, traditional coverage against hacks or cyber-attacks.”

Centralized entities like Allianz entering the space would only further support the notion of familiarity. Johnny Lyu, CEO of cryptocurrency exchange KuCoin, told Cointelegraph that while the crypto ecosystem needs insurance, in its early stage of development most participation will come from centralized institutions.

As the industry develops, Lyu said that decentralized alternatives are gradually improving. Whether these platforms can be truly decentralized, he said, will “depend on the development and improvement of the crypto environment at large.” For now, both centralized and decentralized entities have challenges to overcome.

Fire insurance contract of 1796.
Confidence to operate with crypto

Overcoming these challenges could give more investors the confidence to invest in cryptocurrencies and gain exposure to the nascent asset class.

According to Vogel, fraud is a major challenge for insurers in the cryptocurrency space. Using house insurance as an example, Vogel noted that the “tangible benefit to insurance is that your house can be rebuilt if it burns down.” The net result, he said, is that at the end of the day, people will still have a house.

On the other hand, obfuscation on the blockchain could lead to specific types of fraud. Vogel added:

“A crypto-insurance fraudster could double dip, hide or obfuscate their coins plus an insurance payout.”

To Lees, the biggest challenge the cryptocurrency industry has faced so far is “providing traditional services to a new unknown sector, especially regarding the technology.” Lees echoed Vogel’s sentiment, saying that funds being hard to trace on the blockchain have “created a nervousness for insurance firms.”

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In recent years, he added, robust Know Your Customer (KYC) checks have been “paramount to crypto providers,” whose work with blockchain forensics firms like Chainalysis and Elliptic has meant “that transactions made between crypto addresses have been much easier to track.”

Lees now expects the overall risks within the industry to further be reduced, ensuring “it is much easier for insurers to understand and underwrite.” Ultimately, he said, insurers will “play an important role in realising a fully digital economy in the future, by giving both consumers and businesses the confidence to operate in the space.”

This type of confidence would, at first, come from centralized players in the insurance space, as decentralized solutions aren’t still widespread and may have to improve further before going mainstream.

Smart contract risks

Decentralized insurance solutions have been active over the last few months. Popular decentralized insurance provider Nexus Mutual, for example, currently covers over $400 million in Ether (ETH) across a number of projects, while rival protocol InsurAce claims to have covered over $340 million.

Speaking to Cointelegraph, Lior Lamesh, CEO and co-founder of blockchain security firm GK8, said the crypto ecosystem needs insurance for decentralized protocols and end-users. Wile Lamesh noted that “automatic, decentralized insurance tools could indeed come in handy,” he suggested they themselves could need insurance.

As decentralized insurance tools are part of the protocol layer and rely on smart contracts, which could fail over human error, they could have “vulnerabilities open for hackers to exploit.”

Lamesh suggested a potential flaw could be in the protocol covering its own failure after it causes losses for users, “making for a lucrative selling point for potential users.” He added:

“Hypothetically, we could still end up in a loop of smart contracts insuring other smart contracts, but I would expect that centralized insurers would likely get involved at some point.”

As a result, the crypto CEO expects more centralized insurers to enter the market as they better grasp blockchain technology and remain in the lead “while decentralized insurance solutions will likely take some time to evolve and figure out the best approaches for the industry.

He added that, currently, hacks in the decentralized finance (DeFi) space occur “every week, if not every day” and, as such, it’s hard for decentralized insurance protocols to operate, as these protocols themselves can become lucrative targets for hackers.

Once the industry matures, he said, decentralized insurance “will take off.”

A growing industry

The cryptocurrency insurance industry has been growing over time. To Lamesh, its current challenge is for experts to “wrap their heads around the technology involved,” as blockchain “can be confusing enough for its own people without degrees in computer science.”

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Crypto insurance deals with DeFi protocols, which require “a lot of specialist knowledge.” Lamesh noted, however, that the crypto insurance industry may have a bright future ahead, saying:

“The future may be stunning, of course, with blockchain entering mainstream insurance, and decentralized protocols tapping AI-driven data oracles to offer us tailored insurance plans and packages for anything we need.”

Lees noted the crypto insurance industry has “become more established over the last 12-18 months,” with traditional firms entering the space and offering coverage on “certain digital assets based on how they are stored and the compliance levels of wallet providers.”

As the overall crypto industry grows, he said, Lees can “only see the crypto-insurance industry following suit, given the sheer volume of new crypto wallets being opened every month.” To Lees, the standards crypto firms meet will have a “traditional feel, giving insurers peace of mind that they can underwrite holdings.”

The challenges crypto insurers face could be a significant source of revenue for the insurance industry, as centralized providers may move in with products that exclude specific types of common risks in the space such as hacks or smart contract failures.

While these risks are likely what most users are after, the peace of mind of a centralized platform offering them insurance they can rely on may be enough to persuade them into entering the crypto market.