13 Oct, 2023

Self Insurance and the Illusion of Protection

Category: Insight

In his new biography of Sam Bankman-Fried, author Michael Lewis takes the controversial step of painting SBF as more sloppily-dressed, right-place-wrong-time pioneer than deceitful anti-hero, and FTX as more sloppily-run, wrong place-right-time crypto exchange than fraudulent enterprise.

The jury is still out on the former but the latter was settled recently when former FTX CTO Gary Wang admitted in court that the $100 million FTX claimed to have set aside as self insurance to protect account holders in the event of losses due to sudden liquidation events was largely a fiction. Wang admitted that the true value of the FTX Backstop Fund was somewhere between $0 and $5 million, and that the fund’s dynamic value, as displayed on the FTX website, was arrived at via random number generator.

Self insurance is an uncommon commercial risk transfer strategy because it requires deep cash reserves and an equally deep risk assessment expertise. It makes much more sense to outsource that function, as often just a fraction of the funds held as self insurance would cover may years of premiums paid to a third party insurer, spreading out the cost of potential losses while putting the rest of that money to better use.

In the case of Web3 firms, the arguments against self insurance go much farther, and we’ll get to them, by first conceding that sometimes, self insurance does make sense. Businesses with deep financial reserves and robust internal risk management expertise operating in stable, well-understood industries confronting risk profiles with long, actuarially relevant histories, may find some self insurance to be a good option.

Of course, with the rare exception of deep financial reserves, none of those criteria apply to Web3: a sector as unstable, poorly understood and actuarially irrelevant as any can be.

There are several more reasons why self insurance doesn’t make sense in crypto.

Crypto loss events tend to affect masses

An accurate analog of self insurance is the bond a contractor must maintain to compensate a homeowner for damage to their house. It works because a contractor doesn’t damage every client’s home simultaneously, leading to a run on the bond that may quickly exhaust it. In contrast, when a crypto custodian is hacked or a defi platform exploited, losses are usually experienced by a great many users at the same time, likely rendering the self insurance fund insufficient. Of course customers aren’t thinking that way when evaluating the safety of an exchange—they’re looking at $100 million and feeling confident that it’s more than enough to cover their own deposits, without considering that they’ll be one of a great many affected.

Crypto loss events tend to be huge

The $100 million FTX didn’t have backing up its self insurance fund would only have been a drop in the bucket compared to the billions in actual losses. These days, hacks netting less than $100 million are classified as relatively minor and often fail to garner more than passing attention. The chances that a crypto firm’s self insurance fund will be sufficient to reimburse all losses is very low.

Crooked crypto insiders are crooked

Should the loss event occur at the hands of an insider, it’s hard to imagine they’d have any reservations about draining a juicy self insurance fund on the way out as well. In the all-too-common event that the loss is a rug pull or other inside job, self insurance is unlikely to survive the event and be of any help. 

Crypto risks are complex

Successful crypto founders are more likely to get investment because of their vision and charisma than their risk management expertise. Even the most tenured executives cannot have more than 15 years experience managing the complex operational, business and technical risks inherent to crypto. As a result, they will miss the mark when estimating how much to keep in reserve, and always in the wrong way.

This last part is a human nature problem more than a crypto problem. Simply put, humans tend to view their own shortcomings less harshly and those of others more harshly than is deserved. Endogenous risk assessments will always assume things are better than they are and the size of the self insurance fund will be too small as a result. Conversely, if a highly specialized, third party insurer with skin in the game, like Evertas, makes an error assessing risk, it will be one of over-estimation, which is the right kind of error to make in this business.

Related to this, in the event of a covered loss, human nature dictates that insiders will handle claims in favor of the business, not the customer. A third party insurer like Evertas handles claims quickly and dispassionately, according to the terms of an unambiguous policy contract.

The self insurance illusion

All this is to say that in Web3, self insurance is an uneconomical and ineffective risk transfer solution, which nonetheless gives the illusion of protection, arguably making it worse than no coverage at all. Web3 innovators and their customers deserve the true assurance and protection Evertas provides via our A+ rated crypto insurance policies. Reach out to us today to learn more.

Tags: crypto insurance | cryptocurrency insurance | FTX | Hacking | web3