Today’s topic is a bit of a capstone to several prior articles regarding different choices startup insuretech carriers face. You can imagine I have spent a lot of time thinking about these issues and how to prepare for them if I am fortunate enough to eventually face these same choices.
So today I will name the elephant in the room. Insuretech carriers that follow the grow at all costs playbook are, in most cases, dooming their long term odds of success.
If you want to skip all the detail below, the punchline is companies are going public way too early because of the constant need for more capital and being public raises the odds of failure because of heightened liquidity risk.
This happens because valuation is driven by revenue growth when it should be driven by margin growth because margin growth doesn’t require capital while revenue growth does.
Grow Fast and Break Things
Let’s start at the beginning. If you are selling say a video game in the app store, you want to grow as fast as you can. Yes, there are operational challenges to growing and there will be mistakes, but these can be rectified. The good news is your marginal costs to grow are low and largely variable.
Thus, by all means, grow as fast as you can handle operationally. Being the first to market and locking in users is very valuable and worth making some mistakes. Sure, there will be cash burn until you get to adequate scale, but, once you succeed, you will hopefully be producing oodles of cash.
This same approach obviously applies if you are pioneering a new category like Uber or Netflix. Underpricing the product to drive recognition is key to expanding the addressable part of the market and getting people to try the service.
While the capital intensity of these businesses has become higher than originally envisioned, there is still a story that can be told about the cash flow at maturity in a business with few competitors and being a leader in an oligopoly.
Capital Intensive Growth
It gets trickier when you’re a capital intensive business like an electronic car maker. In this business, the cash burn seemingly never ends and the risk from misexecution is high. One false step and it’s game over.
Let’s be honest. If Tesla weren’t a cult of Elon, it likely would have gone bankrupt years ago because they would have run out of capital.
Now, Elon was able to create a buzz around the company that countervailed the normal pressure to show progress in order to raise capital and became the original Hare who used cheap capital to turn likely failure into spectacular success.
Which brings us to insurance. Not only is insurance capital intensive, it’s highly regulated (which prevents you from being too profitable), you can’t increase the demand for it by building a better product, and most people don’t care who their insurance company is (ask someone who uses an IA who their insurance carrier is and see if they know).
The Hare strategy is much harder here than with a new category or even compared to reinventing an old category.
Yet early investors have the same growth strategy of grow as fast as you can, even though the outcomes can’t be the same. If this were just about the underwriting losses during rapid growth phase, we could solve for that. Unfortunately, there is a bigger issue, one which I have discussed before.
Growing your customer base requires capital. Regardless of the underwriting results. This is the big oversight investors make. The faster you grow, the more regulatory capital you need. Yes, you can fund some of that by being profitable, but we already know that’s not in the plans!
So, whereas Tesla only needed to fund its losses, startup insurers need to fund losses AND regulatory required capital. Read that again…and again…and again until it sinks in.
Sure, there are ways to get around elements of this. Be an MGA. Be a reciprocal. Buy lots of reinsurance. But those aren’t sustainable solutions. They are tactics, not strategies.
Believing reinsurers will fund your underwriting losses forever is not a business model. It’s a hope. Asking your customers to potentially fund your losses is disingenuous and arguably deceitful. Besides, as I’ve shown previously, there isn’t enough reinsurance capacity available to fund everyone’s growth plans. There is no free lunch.
Private Investors Disintermediate Themselves
What does this all mean for how insuretechs should fund themselves? We’ll get to that. Let’s start with the flip side of the issue.
When private investors fund breakneck growth businesses in other industries, they get to see a lot more growth before they lose capacity to fund the next round and need to turn to public markets.
Not so in insurance. Go look up the capital raised by the public companies and compare it to their premium levels. Not the market cap to premium. Capital raised to premium.
In every case I searched, capital raised is greater than premium. Actually, it is multiples of premium. It is the same story for the ones who haven’t gone public yet.
This isn’t just because CRs are 200%. It’s because of the growth stat strain on top of the bad combineds. And remember, most of these companies don’t even retain that much risk yet!
Compare insurance to fintechs and, while you’ll find a few that have similar large capital needs at big multiples of revenue (e.g. Robinhood), for the most part the successful fintechs needs much less total capital or have much higher revenues. For some context, Square has only raised $600M total…vs. $10B of revenue!
Really quick math for the sake of brevity. If you’ve raised $1B to write $200M of GPW, you need to produce something like $200M in profit to generate an acceptable return on that capital. The problem is to make $200M in profit requires something like $2B in premium!
But to add that extra $1.8B in premium requires as much as $1B in incremental capital! And that’s before any additional losses trying to get there!
Because the capital need is so much greater for insurance, private investors need to turn to public markets a lot sooner because the size of the capital raises gets beyond their means (or at least their willingness).
Why does this matter? Because this is where everything starts to go wrong.
What Matters to a Hare
The only thing that matters to a Hare is getting that next round of funding. That allows the music to keep playing. The easiest way to keep dancing is to stay private. Why? You only need to find one dance partner!
This is something I’ve discussed before. Private markets have one feature very advantageous to a capital intensive startup. They don’t have true price discovery. You only have to convince one new buyer to commit to a higher valuation and you now “trade” at that higher valuation.
Since it is a lot easier to convince one person to buy than a whole market full of participants, it is better for a richly valued startup to stay private as long as possible, especially when they already have current investors who are true believers (and perversely incented to support higher valuations to avoid writedowns in their own version of playing the Hare).
The only reason to pursue an alternative approach (e.g. going public or finding a strategic buyer) is if the capital calls get too big or if the private investor has lost faith in the company’s prospects.
Growing Up Too Soon
Let’s assume the issue is the former. The current group of investors have recognized that the ongoing capital needs are too high relative to the growth potential. Note, this is a problem they helped create by encouraging the startup to grow faster than it probably should have (since revenue growth drives valuation).
It’s like the mother bird pushing the chicks out of the nest too soon. Their odds of survival are a lot less than if the mom was a little more patient and willing to keep feeding them herself until they grew stronger.
If only these companies had grown a little slower, they wouldn’t have needed so much capital so soon! With a little more patience, these companies could have reached the same premium level later with a lot more confidence in the ultimate success of their business model, which may have led the private investors to stick with them for another round or two, or at least have made them more compelling to public investors.
So the model of “grow as fast as you can” forces startups to require too much capital too soon and forces them to go public before they are mature enough. Who thinks this is a good idea???
Certainly not the short sellers. As mentioned earlier, being private only requires one believer to get to the next round. All those who disagree have no way of expressing their view.
But when you go public that changes. Now short sellers can try to make money by convincing others your valuation is too high. That changes the whole dynamic…especially if you are a capital intensive insurer reliant on future capital raises to continue your existence.
We know insuretech short interest is high. This is the market’s way of confirming that these companies came public too early. They were not mature enough to withstand public scrutiny yet.
The greatest risk to any cash burning company is the market closes on them. Sure, private companies can find the window closed too, but there are generally more ways to buy time when you only have a small group of owners to negotiate with.
When you are public, if the market refuses to fund you, you are out of luck. Yes, there is always a price where you can get a deal done, but if it is a big down round to the IPO, you aren’t going to be able to fund as much growth as you planned.
And if you have to lower your growth plans because you raised capital at a low price, well, your stock typically will continue to go lower. Then, you enter capital preservation mode and start cutting expenses, non-renewing high loss ratio business, and so on which may help you stay solvent, but lowers your growth further and well, that’s why they call it a spiral. You are the failed Hare.
By the way, it’s worth mentioning short sellers make a living at sniffing out these situations. It’s the reason I have written about cash burn before. If the shorts don’t think you can raise capital to support the growth plans you’ve promised investors, they will press their bets and try to force you into issuing stock at as low a price as possible.
This is what happened to so many banks during the Financial Crisis. It is not a pretty thing to watch, but I have seen it play out real time and it is unlikely any group of Redditors will be able to save the day at that point.
Banking on the Meme Trade?
Speaking of which, there may be one more trick left in the Hare’s playbook. Become a meme stock before the spiral starts! I actually started writing this entry before Clover Health caught on fire momentarily, so I guess I wasn’t the only one with this thought!
I’m not sure that young investors care about their insurance company the same way they do about entertainment companies like GameStop and AMC, but if a company can convince their investors of their cultural importance, perhaps they can find a way to get their cheap cost of capital back!
From there, it’s only one giant leap to an opportunistic AMC -like capital raise to fund that growth. The public insuretechs do tend to have customers who are at least the right age, and maybe the same risk profile, to be on Wallstreetbets, so maybe it’s possible? The Hare is still breathing!
Still, it’s a flimsy thesis to fund a private company hoping it can someday sustain itself as a meme stock.
When It’s Time to Leave the Nest…
It’s worth mentioning also that part of the issue involved is a lack of aligned interests. Startup investors know their failure rate is high and are looking for the rare extraordinary success that funds all the losses.
You can think of it like buying out of the money calls (or buying 1 in 1000 PML cat cover). You don’t have to be right often. You just have to be really right when you are right.
On the other hand, an individual startup can’t play those odds. They have just one hand. Their goal is more likely to be to increase the odds of individual success even if it gives up some of the extreme upside.
This divergence of interests isn’t often discussed. However, if you believe much of the above, tactics can be recalibrated to suit both parties.
If private investors are unknowingly making value destructive decisions in pushing early stage insurance companies to need public capital too soon, thus lowering the odds of long term success, it is in their interest to modify their expectations as it allows these companies to stay private for longer rather than be kicked out of the nest too soon.
So, perhaps paradoxically, slowing growth somewhat increases the odds of building the Uber or Tesla of insurance rather than throwing them into the public markets before they are ready for it and creating undue risks.
When You Can Stand On Your Own Feet
An insurance startup should be expected to stay private until it is near the point of being able to self fund its growth. Then, the liquidity squeeze risk no longer exists. Investors and founders should work backward from this point and figure out how much capital needs to be burned to reach this point and develop growth plans that they can comfortably fund until that point.
This actually isn’t as hard a problem as it sounds. It just requires acknowledging that the rules that work elsewhere don’t work in insurance.
To be clear, I’m not trying to tell investors what to do. They can make their own decisions and I’m happy to be told what I’ve gotten wrong here, but I think it’s hard to support an argument that any financial with a balance sheet should be public when its cash burn is still high.
If you believe this, you have three choices: continue the growth and find a way to fund it privately (build a bigger nest), slow the growth to reduce the speed of required capital growth (give your chicks more time to grow), or cut spending to reduce your burn which will likely slow your growth as well (I guess that would be bring more food to the nest?). Just don’t force them to fly before they’re ready.