3 Jun, 2022

NFT Insurance Types

Category: Insight
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There’s a lot of interest in NFTs, and Evertas gets a lot of inquiries about NFT insurance.  With that in mind we spent a lot of time developing the definitions and framework needed to create NFT insurance policies.  If you’re interested in such policies please have your broker contact us.

Broadly NFTs can be broken up into Off-Line and On-Line NFTs.

Off-Line NFTs would represent ownership of assets that exist disconnected from the Internet, this could be art, wine, gold, jewelry, or even a digital file that’s stored off-line (think archival copies of things like the gold record on Voyager). This would be like a deed, title, or ownership registry. It is important to note that Off-Line NFTs do not include synthetic assets designed to track the value of an off-chain assets.

On-Line NFTs would represent ownerships of assets that exist on the Internet, this could be purely blockchain based items (e.g., stored on IPFS) or on a normal server (could be a specific URL or file location).

Off-Line NFTs

For Off-Line NFTs, the asset of value is off-chain, and thus the NFTs act more as a record of ownership/title than as something with endogenous value.  Whatever entity that controls the off-chain asset has care, custody, and control of the asset and not the Off-Line NFT (i.e. the Off-Line NFT does not ultimately control the underlying asset). This means the Off-Line NFTs mainly need to be insured against losses resulting from some failure of their record keeping.

Other considerations to keep in mind (to prevent or limit losses) would be for the Off-Line NFT to clarify where the underlying asset is, how it is protected/insured, and what would happen if a Hard Fork were to occur (see Hard Fork considerations below).

Valuation and Loss

Off-Line NFTs are valued based on the ownership percentage of an underlying asset as represented by an NFT, thus there is implicit trust in a central authority which is overseeing the care custody and control of the asset.  This authority should have an ability to reset the ledger, freeze NFTs, and issue replacement NFTs if needed (for an analogy think of how USDT and USDC can be “frozen”).  When some sort of failure occurs, it should be fairly straight forward to restore things to their proper state.  Losses are likely only to occur when a failure of an Off-Line NFT system causes some monetary damage (such as opportunity cost/loss) or causes some sort of irrevocable loss of the underlying asset (e.g., if someone can acquire enough of the Off-Line NFTs to order a sale of the underlying asset and that asset cannot be recovered).

Hard Fork Considerations

In the event of a hard fork, there has to be clarity built into the Off-Line NFT as to what chain will be considered the chain of record.  If this is not the case any insurance policy would have to clearly and unambiguously lay out which is the chain of record (and what would happen if it is not clear).

On-Line NFTs

For On-Line NFTs, the asset of value is the NFT and sits on-chain: whoever has the On-Line NFT owns/controls the asset. Fundamentally, as these are purely on-chain assets, the custody and control considerations are identical to those of any other digital asset or token.

Valuation and Loss

The biggest issue with On-Line NFTs is determining the value of the On-Line NFTs.  Given the transparency afforded by blockchain transactions, recreating the conventional appraisal approach—with all its opacity, gladhanding, subjectivity, and conflicts of interest—is insanity.  To this end there are a number of ways to determine the value of an NFT.

Some of the variables that we can use for price determination are:

  • The floor price (i.e. the lowest price for an NFT in a collection) would give an idea of the minimum value for an NFT
  • The rarity score can be used to determine how rare an NFT is relative to other NFTs in a collection; there are many methods, however the most straightforward method would be just to multiply the probability of all traits together for an NFT (this assumes that each trait is independent from every other trait), let’s call it PNFT; we can convert this into a Rarity Score for the NFT (RSNFT) just by using the complement of PNFT, thus RSNFT=P’NFT=1- PNFT
  • The purchase price of the NFT

Using these we can formulate several different approaches to valuing an NFT.

  • Assume that the pricing distribution roughly follows the rarity distribution, you can than use the floor price and the rarity score to create a normalized price per rarity.  If you have a Floor Price (FP), which is held by an NFT (NFTFP) with a Rarity Score (RSNFT). Remember the Rarity Score we are using you could calculate the probability of an NFT in a collection c (Pic ) occurring by Pic=1- P’ic=1- RSic. This means that the Value Per Rarity for an NFT Collection C (VPRc) could be calculated: VPRc =FP/RSFP (n.b., that RSFP is the Rarity Scores for the NFT corresponding to the floor price, this can be expanded to multiple NFTs that have the same floor price—or are very close to it—by using an average Rarity Score and average Floor Price to calculate VPRc).  Once you have VPRc you can calculate the value of an NFT i (Vi) with Vi=RSi*VPRi
  • In cases where you have a large amount of information on pricing you could interpolate the pricing distribution across the rarity scores and determine the value of the NFT that way; you may have to estimate a pricing distribution when there is a dearth of pricing information or trading activity.
  • Using the purchase price of an NFT may be very helpful if it was recently purchased, however over time it may be less helpful (though it may give a sense of relative value of an NFT which can be used with purchase prices of those NFTs to help determine valuation)

It should be noted that there are companies that have their own proprietary tools for valuing NFTs, assuming those tools are vetted and the pricing mechanism makes sense, they could be used to asses price on their own or as a supplement to any other mechanism.  We also want to highlight that even after an asset is stolen we can use trades of the stolen NFT to help determine the value (this is not possible with conventional art), and, should all other valuation methods and tools fail one can fall back to valuations as done in the traditional art world.

Regardless of the method used the price must account, and adjust for, any wash trading,  or other activity that would artificially inflate the price; the transparency afforded by NFTs allows for this to be done…something nearly impossible in the conventional art world.

Hard Fork Considerations

These are the same as with any other token or pure digital asset.  Both assets after have value which needs to be determined (see above).  For insurance coverage, one would need to look at their policy form.

Hybrid NFTs

Hybrid NFTs have attributes of both Off-Line and On-Line NFTs.  An example would be an NFT representing ownership of a physical object, but where you add some additional functionality to the NFT (e.g., some artwork representing the object).  Another example would be an on-line NFT, that grants you access to an actual club or events (interestingly you could have a situation where an On-Line NFT becomes an Off-Line NFT if the membership benefits afforded by then On-Line NFT turn into its main value).

Valuation and Loss

Here the value of the NFT will be determined by looking up the value of the underlying physical asset and using the On-Line NFT analysis above.

Hard Fork Considerations

In the event of a hard fork, there has to be clarity built into the Hybrid NFT as to what chain will be considered the chain of record.  If this is not the case any insurance policy would have to clearly and unambiguously lay out which is the chain of record (and what would happen if it is not clear).  It is conceivable that the On-Line portion of the Hybrid NFT could still have value on the secondary chain and could be covered after a fork, but that would have to be dealt with in your specific insurance policy.



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