Crypto Comes to Life

Following a disastrous year for backers of cryptocurrencies, Matt Sitzmann, co-founder and board chairman of investment firm Castle Funds, announced what he says are the world’s first crypto-invested, private-placement, variable life insurance products.

It was a bold proposition.

Within 10 days of the Nov. 11, 2022, bankruptcy filing by FTX, the third-largest cryptocurrency exchange, the crypto industry had plummeted from a peak $3 trillion in value in November 2021 to $788 billion. Five months later, an April 2023 survey by the Pew Research Center found that 75% of Americans were not confident in the safety and reliability of cryptocurrencies.

Yet Sitzmann and Castle Funds may be on to something. Bad news has a way of shaking out an industry’s lesser players, elevating the prospects of survivors like Bitcoin and Ethereum, two blockchains with their own cryptocurrencies. As of New Year’s Day 2024, the price of Bitcoin registered gains of approximately 160% year over year, and Ethereum had jumped an admirable 85%. The 2023 “crypto winter,” the industry term for a prolonged period of depressed prices, had thawed. Industry valuation stood at $1.7 trillion.

On Jan. 10, the U.S. Securities and Exchange Commission, in a decision few would have imagined a year before, cleared the way for a reported 11 asset management firms, including BlackRock and Fidelity, to launch spot Bitcoin exchange-traded funds (ETFs), permitting average investors to buy and sell Bitcoin as easily as stocks and funds.

Sitzmann, a 25-year insurance veteran, had no doubt that crypto would someday go mainstream. “My mission over the last five years has been to bring the crypto and insurance worlds together,” he says.

These plans took root in 2018 when Sitzmann launched Castle Funds. Although he is the firm’s leading investor and owner, the business is run by his co-founders, Peter Eberle, president and chief investment officer, and Dan Hoover, chief operating officer and chief compliance officer. “I came up with the idea to create the first-ever crypto-based insurance dedicated fund, which Dan and Peter went out and made a reality,” he says.

Castle’s insurance dedicated fund (IDF) for privately placed variable life insurance and annuity products is composed of an index of the five largest digital assets as measured by market capitalization: Bitcoin, Ethereum, Solana, Polygon and Chainlink. Each month, Castle rebalances the index to account for the possibility of larger digital assets displacing one or more of the top five.

At press time, two variable life annuities underwritten by A-rated Crown Insurance Group and using the IDF had been privately placed for separate investors who met federal wealth and income thresholds to invest in securities not registered with the SEC. These threshold definitions include “Accredited Investor” under the Securities Act of 1933 and “Qualified Purchaser” under the Investment Company Act of 1940. “The definitions ensure that the IDF is only available to investors with substantial economic means and financial sophistication, typically a net worth in excess of $5 million,” Hoover explains.

EPIC Insurance Brokers & Consultants, where Sitzmann is a managing principal, sold the first private-placement variable annuity to Sitzmann himself. Winged Keel Group, an independent life insurance brokerage, sold the second one to an unidentified buyer, Sitzmann says, adding that registered investment advisors also can sell the products. Winged Keel and Crown Insurance Group were unavailable for interviews.

Private-placement variable life insurance differs from more conventional variable life insurance in several ways. While the insurance provides the typical death benefits, asset protection and compelling tax advantages of customary variable life insurance and annuities, investors in a private-placement policy can select from a wider range of both registered and unregistered investments, including hedge funds, real estate funds, commodities, currencies and other alternative assets. Crypto, thanks to Sitzmann, is among these alternatives.

Castle’s Hoover paints a picture of the sophisticated investors likely to be interested in the firm’s insurance dedicated fund. “They’re very tax sensitive, typically investing for very longtime horizons (where) taxes are a substantial drag on their investment performance,” he says. “By investing in the IDF as an option within existing insurance products like privately placed variable annuities and privately placed life insurance, the invested capital can be left to grow for longer periods of time before taxes are ultimately assessed.”

Sitzmann adds that life insurance is a popular means for high-net-wealth people to diversify their portfolios, given its tax advantages. “We’re bringing in a product where there is no other product like it.”

That’s true, but Castle Funds is not alone in seeing gain in this area. Another novel life insurance product involving assets invested entirely in Bitcoin also recently debuted. (See Sidebar: Bitcoin-Based Life Insurer Opens for Business.)

Delaware and Beyond

At present, Castle’s IDF can be offered only by admitted carriers registered in the state of Delaware. Nevertheless, insurance brokers and registered investment advisors in any state can sell the private placements. As Hoover illustrates, “Matt was the launch client, and his policy was sold through a California broker. The second client’s policy also was sold through a California broker who is part of the Winged Keel Group. The only slightly unusual part of that process was that both California policy buyers needed to retain a lawyer in Delaware to receive the policy documents on their behalf.”

Delaware’s insurance commissioner is the first state regulator to give the green light to Castle’s IDF and its private-placement features. The end game is to have multiple life insurers in all states offer the products. “If a carrier were to approach us for access from another state, our fund would very likely be able to participate in that product as well, subject, of course, to routine regulatory approval by that state’s commissioner,” Hoover says.

Assuming wider interest in crypto as an asset class following the SEC’s spot Bitcoin ETF decision, life insurers in other states may find value in Castle’s IDF. Like insurers of conventional variable life products, issuers of privately placed insurance policies assume the mortality risk of the named insured but do not bear any investment risk. As Hoover explains, “The investments, such as the IDF in this case, are held in a separate account at the issuer for the benefit of a specific written policy.”

Castle has taken all customary steps to ensure the protection of its customers’ digital assets. For example, Anchorage Digital Bank, a respected nationally registered and regulated custodian bank, houses and protects the assets in public ledgers. The bank also safeguards and secures the private key that proves a customer owns the funds in its custody. Anchorage is the only crypto-native bank to hold a federal charter from the U.S. Office of the Comptroller of the Currency.

Bitcoin Stands Apart

Another factor in Castle’s favor is crypto’s sheer staying power. While crypto has not reached its previous highs, there is still robust demand, which explains the interest from “legitimate players” such as BlackRock, Fidelity and Schwab, Sitzmann says.

But that interest is primarily focused on Bitcoin rather than other cryptocurrencies. In an October 2023 report on why investors need to separate Bitcoin from other digital assets, Fidelity stated that Bitcoin is “fundamentally different from any other digital asset. No other digital asset is likely to improve upon Bitcoin as a monetary good because bitcoin is the most (relative to other digital assets) secure, decentralized, sound digital money.”

Asked why Castle Funds established an index of five crypto assets as opposed to just Bitcoin, Hoover, formerly director of product pricing and analytics at BlackRock, says that variable annuities and life insurance contracts are required to be diversified under Section 817(h) of the Internal Revenue Code. The federal tax code caps the largest position in a diversified portfolio at 55% of total assets, Hoover notes. The Castle index does not allow any one token among the five digital assets to exceed 35%. “Regardless of the tax requirements, I agree with Fidelity that Bitcoin, by design, is best positioned to be a store of value or, as Fidelity says, ‘monetary good,’” he says.

Glenn Morgan, senior vice president and digital asset practice leader at Aon, says the SEC’s approval of 11 spot Bitcoin ETFs is an important development in “changing the narrative” on crypto. “People want to see the industry growing up and be sure there are adults in the room,” he says. “Another resiliency test of sorts has been passed. Investors will be able to access Bitcoin without concern over custody or security.”

Hoover agrees the decision is a milestone that finally established a long-sought standard for investor protection. “Future projects, such as those establishing automated market-making platforms, now have more freedom to innovate without the fear that their work will be invalidated after the fact by a regulator.”

The SEC’s decision follows other positive developments for crypto. In September 2023, the Financial Accounting Standards Board (FASB) passed new guidance for companies to use fair-value accounting for Bitcoin, updating its previous guidance to mark the assets for unrealized losses. FASB is a nongovernmental standard-setting board overseen by the SEC.

Sitzmann perceives the amended guidance as opening the door to wider institutional adoption of crypto. “Most large corporations and Fortune 1000 companies use fair value accounting, including MicroStrategy and Tesla, which have put crypto on their balance sheets,” he explains. “By providing guidance on crypto to corporations, FASB is validating that it is an asset and that the regulators recognize this.”

The prior FASB guidance required companies that held Bitcoin or certain other digital assets to treat them as illiquid assets like real estate, which are valued at the lower of cost or current market value in financial statements. “This meant that the value of crypto on corporate balance sheets could only go down after purchase, until the crypto was sold and a gain realized,” says Hoover. “The revised guidance allows for the treatment of digital assets on an equal basis with other liquid assets, such as derivatives, mutual funds, bonds, or stock, which a company might hold.”

Another positive event, says Morgan from Aon, is the next scheduled halving of Bitcoin in April 2024. Halving refers to a reduction in the rewards Bitcoin miners receive and is designed to slow the speed at which Bitcoin is created. Following each of the previous three halvings, the price of Bitcoin surged. “It’s a catalyst for the entire industry,” he says. “If you look at Bitcoin’s track record since it was created in 2009, the returns on an annualized basis each year are higher than any other asset classes. Putting a small allocation of it in a fund has an enormous upside.” 

Lastly, EDX Markets, a new cryptocurrency exchange developed jointly by major investment players including Fidelity, Charles Schwab and Citadel Securities that began trading in June 2023, may fill the void left by FTX’s disintegration.

“When FTX folded, people were asking is this the end of crypto. The answer is no, because the big boys kept building during the downturn, a testament to the resilience of this asset class,” Sitzmann says.

Tread Carefully

These varied developments have been important to countering the damage done to crypto following the FTX collapse and the November 2023 conviction of disgraced founder Sam Bankman-Fried for fraud and related crimes. Once ranked the 41st richest American in the Forbes 400, SBF, as he was known throughout the industry, now awaits sentencing that could put him behind bars for life.

Despite the recent positive signs, crypto critics abound, among them CEO Jamie Dimon at JPMorgan Chase, the largest U.S. bank by assets. During a December 2023 hearing of the Senate Banking, Housing, and Urban Affairs Committee, Dimon, under questioning by Sen. Elizabeth Warren (D-Mass.), expressed deep opposition to crypto and Bitcoin. “The only true case of it is criminals, drug traffickers…money laundering, tax avoidance.… If I was the government, I’d close it down.”

Economist Robert Hartwig, a clinical associate professor of finance at the University of South Carolina, shares this grim opinion. “Dimon is not incorrect in suggesting that crypto is the absolute favorite mode or store of exchange for criminal elements around the world,” he says. “Ransomware bad actors want payment in crypto. North Korea and other illicit states have found ways of dodging sanctions by using crypto. These are complicated matters for regulatory authorities around the world.”

Not all big asset management firms support the idea of crypto as an investment. After the SEC gave a thumbs-up to the 11 new ETFs, Vanguard said it had no intention of following suit. “Our perspective is that these products do not align with our offer focused on asset classes such as equities, bonds, and cash, which Vanguard views as the building blocks of a well-balanced, long-term investment portfolio,” the company stated in January.

But Coy Garrison, a former SEC counsel and career staffer, believes there is reason to commend crypto as an alternative investment. “We’ve seen high-profile frauds, blunders, hacks that would raise concern for anybody, but the promise [of crypto] is not going away,” says Garrison, now a partner in the blockchain cryptocurrency practice at law firm Steptoe, where he advises companies and institutions on how to navigate challenging legal and regulatory issues related to crypto and blockchain technology. “I think we will see experimentation across the board, whether life insurance, indexed annuities, mutual funds, ETFs and so on. Asset managers and financial services providers will continue to look for ways to provide access.”

In the meantime, variable life insurance products that are invested in digital assets are unlikely to go mainstream beyond wealthy and sophisticated investors. Hartwig, who advises his students to be wary of such investments, extends the same guidance to individuals with modest high net wealth. “Someone with $2 million, $3 million or even $5 million in net worth should be primarily concerned with managing traditional mortality and longevity risks rather than engaging in highly speculative gambles that require an enormous leap in faith,” he says.

Asked to evaluate Hartwig’s comment, Eberle, Castle’s chief investment officer, says he agrees with Hartwig’s premise that insurance policies are best suited for managing mortality and longevity risks. “However, we feel that the assessment of these risks, and accordingly the prudent management of them, is dependent on more inputs than a simple ‘net worth’ figure,” he says. “For example, we believe that, for the same net worth, a 25-year-old with no dependents has a different risk budget than a 40-year-old with three children between the ages of 8 and 18.”

Asked for his opinion on the subject, Garrison says, “If the risks are fully disclosed and people know what they’re getting into, this is an emerging asset class that a lot of folks are looking to have access to in a safe way. As federal regulation of the crypto markets takes hold—and we’re seeing indications of that—I see no reason why crypto should be excluded from mainstream life insurance.”

Scott Sinder, a partner at Steptoe who serves as chief legal officer to The Council, echoed his colleague’s remarks. “My personal view is it comes down to transparency and doing your best to ensure the customer understands the investments they’re making, especially when discussing a product with a higher-risk profile like crypto,” he says. “Agents and brokers are best served by doubling down on their compliance efforts.”

Assuming robust regulatory guardrails are erected, Hartwig says, his current pessimism could soften. “Look, if people want to invest in Bitcoin and do it through variable life insurance products, I don’t think anyone should stand in their way as long as the risks are well understood, regulators are satisfied that these products are not conduits for illegal activities like money laundering, and the tax bill is ultimately paid when funds are withdrawn or liquidated,” he says. “Presumably, sophisticated investors are operating through financial advisors. Could I see other states besides Delaware allowing such products like Castle’s to be sold, maybe with additional disclosure requirements or waivers being signed? Sure.”