Navigating the Digital Asset Advisory & Investment Management Liability Insurance Market

Digital assets have swiftly moved from a fringe speculative investment into the forefront of the Investment world. Especially with the recent approval by the SEC of a Spot Bitcoin ETF. As an RIA, whether you like it or not, these assets are here to stay, and you likely have multiple clients inquiring about them. The good news is that, as an advisor, there is now a wide spectrum of options available for you to track, advise, and allocate towards these assets. Consequently, risk management and insurance are top of mind for advisors. So in this article, we’ll look specifically at E&O insurance for digital assets and the level of risks advisors face when evaluating their options.

The most important thing to understand about the Investment Advisor E&O marketplace is all carriers have different coverage forms and underwriting appetites. There are two basic underwriting categories of carriers: conservative vs. liberal (i.e., digital asset friendly). Since digital assets have only recently become popular with the public, the insurance underwriting marketplace is still trying to determine how they want to cover or exclude these investments. This is ever-changing and evolving and not all digital asset advisory and allocation approaches are viewed the same.

Recently, we held roundtable talks with 10 key insurance carriers to talk through the spectrum of digital asset advisory options, grasp their current viewpoints and appetite, and establish some underwriting guidelines so we can all move forward successfully (the insured and insurers). Overwhelmingly, many of the key carriers open to higher-risk investment strategies confirmed – as our office interpreted in their contract forms – that digital assets are not excluded. Meanwhile, the more conservative carriers, who often already have specific exclusions surrounding digital assets, are open to covering these assets in specific scenarios based on how the RIA is managing or advising on assets in the space.

As an aside, overwhelmingly, the greatest concerns amongst underwriters were:

1. The type of custody
2. The regulatory environment
3. Safekeeping and the implications of using custodial platforms, and
4. The advisor or firm's experience and expertise in the asset class (i.e. are they qualified to manage this asset class?)

Now that you have an overview of the marketplace, you should consider the different levels of risk in your approach and the capabilities you want to offer to your clients before going out to seek coverage. We rank them from lower risk to higher risk below:

Option 1: Financial planning that incorporates your clients’ held-away or self-custodied digital assets into overall portfolio recommendations

In this case, you will find that insurance carriers, both conservative and liberal, are more comfortable covering this risk. Especially if you are not charging a fee, but simply tracking these assets, many of the conservative carriers have endorsements to provide affirmative coverage for financial planning recommendations. A solution like L1 Advisors provides the ability to track your clients’ held-away digital assets at no cost to you or your client.

Option 2: Investing into the asset class through a liquid security that tracks digital assets in some form (Spot ETF, Mining Stocks, companies that invest in blockchain assets, etc.)

Both conservative and liberal underwriters are willing to provide coverage for this approach. It's critical to understand the specific structure of the investment product(s) you are recommending. For example, some conservative underwriters will deem a Spot Bitcoin ETF as acceptable while they might not accept a vehicle of indirect exposure, like Grayscale Ethereum Trust (ETHE).

Option 3: Non-discretionary advisory on digital assets

This can be a natural progression from Option 1, where an advisor may be tracking a client’s self-custodied digital assets, and wish to make recommendations for the client to consider. These recommendations may include swapping into other tokens, borrowing against collateral, staking, lending, or simply tracking portfolio indexes. Under this approach, clients have full discretion to accept or reject a recommendation, as they are the only ones in custody of their assets. Conservative underwriters may only be willing to provide a sub-limit of coverage, or no coverage at all, depending on their risk appetite. Liberal underwriters will also be cautious, but with a sound compliance program in place, and no custody by the advisor, coverage can be secured. Many underwriters are going to prefer that digital assets represent less than 10% of total AUM, but depending on the specific situation, higher allocations may be acceptable. For example, if you are advising clients with existing holdings, rather than recommending an allocation of greater than 10% when they did not have any prior digital asset exposure. A solution like L1 Advisors provides the ability to advise on your clients’ self-custodied digital assets.

Option 4: Discretionary management of digital assets

This involves taking custody of your client’s digital assets at a qualified custodian. If you plan to take this approach, underwriting can be more complex. If you are insured with a carrier who is open to higher-risk strategies, they will typically still desire total AUM in this category to be 10% or less. If you directly manage your clients’ digital assets, carriers currently consider this a higher underwriting risk; expect more limited carrier options, additional underwriting questions, potentially higher premiums, and deductibles.

Regardless of how you plan to help clients invest, or plan, around digital assets, your insurance broker must understand what risk-management protocols are employed by the firm to help mitigate your exposure to client complaints. If you are proactively controlling risk, there is a higher likelihood that coverage can be acquired. For underwriters to consider offering coverage for digital assets, you should have the following proactive measures in place:

1. A sound compliance program surrounding these assets, including ADV disclosures.
2. A general maximum allocation to digital assets for specific clients and not rolling it out to all clients regardless of risk tolerance.
3. Additional client disclosures where clients acknowledge the risk/volatility within the space.

Even with the above, if insured by a conservative carrier, be prepared for additional premium charges to obtain a digital asset coverage extension, or potentially not being able to secure coverage.

Since carriers are still digesting and figuring out how they want to cover digital assets, any Investment Advisor must look into recommending digital assets work with a broker who understands this space. What was true six months ago can easily be different now and in the future.

This article was a guest contribution by Cameron Norris from Golsan Scruggs. For more information about Golsan Scruggs and the services they offer, visit their website.