Why go on-chain?
Generally, insurers issue insurance-linked securities ("ILS") — securities whose value is dependent upon insurance-related outcomes, like catastrophe bonds and equity interests in a reinsurance sidecar — in order to reduce the capital the insurer is required to maintain, thus freeing up capital for other parts of the insurer’s business. Instead, the capital is provided by private investors, who, in exchange, participate in the premiums received in connection with the particular risk linked to the ILS. In addition to the potentially high-yields generated by ILS, private investors have been attracted to the lack of correlation between those yields and the yields available in traditional debt and equity markets.
Like traditional private investors, Digital Organizations can also benefit from the uncorrelated risk and yield offered by ILS. The vast majority of the assets held by Digital Organizations are digital assets. And digital assets are generally highly positively correlated with each other relative to traditional assets. Diversifying this risk has motivated some Digital Organizations to invest in or otherwise incorporate real-world assets into their project (see MakerDAO below). Traditional institutions may find Digital Organizations attractive capital providers as Digital Organizations may be willing to accept a lower return than traditional private investors, given the unique diversification benefit that Digital Organizations can derive from real-world assets as well as the added complexity (and, therefore, cost) of transacting with a Digital Organization.
Case study: MakerDAO, the Digital Organization responsible for one of the largest decentralized stablecoins, is representative of the general trend. Real-world assets collateralizing MakerDAO’s stablecoin have grown from a de minimis amount in the beginning of 2022 to over $2 billion in June 2023. Those assets include tokenized treasuries, real estate backed loans and other asset-backed securities.
How to go on-chain
Over the past few years, asset-backed securities ("ABS") — securities that are linked to the risks and rewards of a particular basket of similar assets (like real estate loans) — have been brought on-chain through a securitization process that would be familiar to structured finance lawyers. We expect that on-chain ILS transactions, as a special subset of ABS transactions, would be structured similarly to both on-chain ABS transactions and traditional ILS transactions. At a high-level:
- First, the specific insurance risk (and related premium) would be transferred to a special purpose vehicle (the “Reinsurer SPV”) through a reinsurance agreement.
- After the risk is reinsured, the Reinsurer SPV would create and issue a digital token to another special purpose vehicle (the “Purchaser SPV”) in exchange for capital, which would likely be either cash or a stablecoin. The capital would be deposited into a collateral account to support the Reinsurer SPV’s obligations under the reinsurance agreement. The digital token would entitle the holder to a claim on the assets in the collateral account and would function like a promissory note or preferred share in traditional ILS transactions.
- Once the digital token is issued, the Purchaser SPV would transfer the digital token to the Digital Organization that provided the capital.
- Lastly, if the Digital Organization is not associated with a legal entity, a separate entity would be established (likely an offshore foundation) to take direction from the Digital Organization and to give direction to the Purchaser SPV. This allows the Digital Organization to exercise control over the ILS.
Because an on-chain ILS transaction and a traditional ILS transaction can be structured similarly, both traditional investors and Digital Organizations could participate in the same ILS transaction. From the perspective of the ceding insurance company, the only difference between the two is the form through which the investors participate — a promissory note or preferred share, in the case of a traditional investor, or a digital token, in the case of a Digital Organization. Otherwise the substance of the transaction, from the perspective of the ceding insurance company, should be the same (or even more favorable to the ceding insurance company for the reasons described above).
Challenges
Despite the potential benefits to traditional insurers and Digital Organizations, there are a variety of legal obstacles (in additional to the commercial ones) that must be considered in order to make any on-chain ILS transaction a reality. Consider:
- What 'know-your-customer' and anti-money laundering obligations does an insurer have when ceding risk, even indirectly, to a Digital Organization?
- What rights, both legally and practically, does a Digital Organization have against an entity acting on its behalf to manage the ILS? Who has standing to enforce those rights?
- What type of assets can be held in the collateral account supporting the reinsurance?
Even where there are clear answers to these questions now, the legal and regulatory frameworks relevant to on-chain real-world assets, including insurance risk, are evolving rapidly across a variety of different jurisdictions. As always, Hogan Lovells remains at the forefront of that changing landscape. Please visit the Hogan Lovells Blockchain Hub to see our global guide to developing regulatory requirements within the insurance industry sector and beyond.
Authored by Dave Marley
