Insuretech Act I: The Curtain Falls on the Hare

Informed Tip of the Week: If you’ve been affected by the winter weather on the east coast, be aware that just because the snow is over doesn’t mean your home isn’t still at risk. As the snow melts, ice dams and heavy snow on the roof may cause leaks. If you need help keeping your house safe, see these tips or send me a question.

The Hare has lost. It’s time for the referee to call the fight before somebody gets really hurt. With most of the public insuretechs now down somewhere in the neighborhood of 90%, it’s pretty clear that the hype cycle is over and there’s no need to pile on anymore.

Today, I will review how we got here and what we can learn. Think of this as the first draft of history (ok, that’s a bit melodramatic). I will come back next week with another post previewing what Insuretech Act II might look like.

Oh, and before someone complains “there are lots of insuretechs doing well that stayed away from underwriting models”, point taken, but people are more interested in the underwriters because they are the ones that promised to take over the world.

What Went Wrong

There was no plan. I’ll get into some of the specifics later, but literally, there was no plan. Everything was so shortsighted. Create buzz, raise money, write a bunch of business, raise more money, someday, hopefully, profits (sorry, can’t find a link for that).

You can’t be an underwriter where underwriting is an afterthought. Growth is not underwriting. It’s marketing. Profitable growth is underwriting. There was no (reasonable) plan for profitable growth.

Thus, these business models were reliant on cheap funding to continue funding growth and losses. Nobody put in their business model that their biggest risk was continuing to be able to fund cash burn. Normally, insurance companies risk of ruin is a large cat event or sustained poor underwriting, but for the public insuretechs funding the growth was as large a risk as funding the underwriting losses.

Amazingly, neither the companies themselves or their investors appeared to understand this paradox. They increased this risk when they went public thus increasing the risk of a negative spiral. Going public so early was a horrible mistake and completely avoidable.

Now, companies have reached the stage where they have to retrench. Cut expenses, stop growing, stop advertising, raise premiums. End the burn!

It is now time to grow up and become a real insurance company or try to get someone to buy you for the technology. Neither path will be easy. Valuations still have further to fall. Bottom is likely below traditional insurance companies, not above. Growth will slow to a trickle. Employees will leave. Unfortunately, the next year is likely to be harder than the last one.

Winners

While all of the above sounds pretty dour, there were some groups who came out net winners.

First, there were the founders who sold shares after their IPOs to monetize some of their wealth. If this was their reason for coming public (and I have no knowledge of whether it was or wasn’t), then kudos to them. It worked out perfectly. They were able to top tick their personal wealth before the company’s valuation nosedived.

Similarly, there were the early stage investors who took advantage of liquidity to fully or partially liquidate their position.

Finally, there are the big fat incumbents who can now rest at ease and laugh about how they always knew these “disruptors” would fail and go back to acting like they were right all along (spoiler: they’re not).

Losers

Well, in addition to the public investors who got left holding the bag, there were the late stage investors who thought they could navigate the bubble and pass the hot potato to someone else at a higher valuation.

Worst of these, of course, were those who came in for the SPAC PIPEs, but pretty much anyone who came in over the last three years has lost. Given what private investments have done overall, losing money over three years is a pretty awful outcome.

The currently private insuretechs are also losers given demand for these deals will naturally be weaker going forward and valuations lower.

But, unfortunately, the biggest losers are probably the employees who have seen their options turn from possibly life changing wealth to potentially hopelessly underwater.

Lessons Learned

I don’t mean these to be an Ian’s Greatest Hits compilation, but so many of these lessons are things I previously wrote about. That’s not meant as a pat on the back for me. Frankly, most of these things were easy to see. Others saw them too.

You shouldn’t congratulate me for pointing them out. You should be asking the people who made the mistakes why didn’t they figure it out?

Cheap Reinsurance Is Not A Business Model

I can’t believe I even have to point this out, but let’s be honest about it. None of the full stack models had a path to sustainability that didn’t rely on the generosity of others. If someone had a business plan that showed a path to profit without relying on cheap reinsurance, I’d like to see it…because it belongs in a museum for posterity.

You don’t have to be a genius to know that cheap reinsurance eventually goes away. It happened to the original MGAs (back when we called them MGUs). It happened to life insurers. It happened to mortgage insurers. It always happen. And the amazing thing is…it hasn’t even gone away for insuretechs yet!

The current set of problems happened without reinsurance disappearing. That shoe is still waiting to drop! Don’t worry, it will. Reinsurers are nothing if not always last to leave the party.

Cheap Capital Is Not A Business Model

Similarly, cheap capital isn’t a business model. I’ve certainly written many times that it can make sense to take advantage of cheap capital when it’s available. However, that doesn’t mean you should waste the cheap capital on foolish adventures.

The goal is to use the cheap capital to accomplish something you couldn’t do in more normal times. Instead, many insuretechs used cheap capital to spend recklessly and then go back and… ask for more cheap capital. It became the norm instead of a means to an end.

Thus, there was no discipline and no need to answer for adverse selection or bloated staffing. Cheap capital never lasts. When the window is open, grab it, but don’t get addicted to it. Having a couple beers at happy hour is a good deal. Spending every night at the bar until closing time means you have a problem.

The financials need to be viable assuming a reasonable cost of capital and treat “free” capital as a bonus to accelerate plans. Instead, free capital was the plan.

Chasing Growth To Get More Cheap Capital Destroys Capital

This is a corollary to the lesson above. Free capital wasn’t necessarily free. It came with a hook. You had to hit the goals that allowed you to get more free capital…even if those goals were counterproductive.

Unfortunately, the goals set by investors weren’t improve the loss ratio or create a sustainable competitive advantage. They were to grow premium as fast as you can and don’t worry about adverse selection, cash burn, or profitability.

The investors were essentially the dealers feeding the addict’s habit. And it got them rich for a while, but it also led to the addict not having the cash to buy another growth hit.

Insurance as a top line focused business has never worked and never will. Sure, there are companies like Progressive that have grown impressively and been profitable…but note that “and”. It wasn’t only grow premium.

It’s not like this is a mystery. I mean everyone involved in the insurance world can read Buffett’s explanation of float. Negative float is not a desired outcome. The goal is to maximize underwriting profit, not premium.

Progressive has lived by “grow as fast as you can at a 96 or below“. That is how you create wealth in insurance. You have to balance the two conditions.

The Titanic Didn’t Need A Fresh Coat of Paint

Too many insurtechs focused on window dressing. Fast quotes and better user experiences are nice, but they’re not essential. What’s essential is that people get the insurance they need to protect themselves, without paying too much. And that insurers can provide that product at a price where they can make money.

The Titanic needed to be safer, not faster. It needed lifeboats, not an orchestra.

Insurance isn’t a blockbuster movie that tries to entertain you, but if it fails, all you’re out is ten bucks and two hours. When your insurance fails you, you may be out your life savings or your business may close its doors.

Turning it into another piece of instant gratification is manipulating the customer into doing something against their best interest. That isn’t innovation or disruption. It’s insulting and disturbing.

Cash Burn Is A Metric…Adjusted Gross Profit Isn’t

You can have all the fancy artificial metrics you like that you think help investors understand your business better. There’s nothing inherently wrong with that. What’s wrong is when you manage the company to those metrics and lose sight of the ones that actually matter like “can we make money” or “will we run out of cash”.

Cash burn is the one metric an early stage company can’t ignore. If you do, you may wake up one day and be told you have to shut the doors. And yet, no insuretech ever publicly talked about their cash burn and what they were doing to minimize it.

I hope they at least had these conversations privately, but if it is an important metric behind closed doors than certainly it should be disclosed to investors.

If you truly want to impress sophisticated investors that they should trust you to run a risky business, be open about how you are balancing growth and cash burn. Don’t ignore the elephant in the room.

Insurance Burns More Cash Than Other Industries

The main thing all the outsiders overlooked with regard to cash burn is you have two sources of burn: operating losses AND funding top line growth. Stat strain was widely overlooked by founders and investors. Financials need to set aside capital to fund their growth to guard against future unexpected losses.

This means a business producing $100M of losses a year off of $150M in premium doesn’t only need to fund the $100M in losses but also perhaps another $100M to provide capital to support the premium. While tricks like reinsurance or moving the bouncing ball to friendlier entities can help, these have their own costs. There is no free lunch after all.

This extra layer of funding is one more reason cash burn should have been a much bigger priority than promoting growth. That extra growth demanded extra capital in addition to producing extra operating losses. Growth made the funding math all that much harder.

Cheaters Never Prosper

Let’s be honest…there were a lot of shortcuts taken by the first batch of insuretechs. I already talked about the overzealous pursuit of growth and using cheap capital to escape making tough choices. These were effectively “cheat codes” that let companies skip steps one would normally take in building a business to try to get to the payoff faster.

Cheat codes may work in videogames, but they don’t always work quite as well in real life. One of my favorite cheat codes was the CAC (customer acquisition cost) calculations companies used. These may have been short term helpful in advancing a level (e.g. getting the next fundraise) but they meant you never learned the skills to beat the top level of the game (i.e. making a profit).

One of the most obvious ways companies misrepresented their CAC was to ignore their high loss ratios. If you intentionally underpriced your business, that is the equivalent of holding a sale. Offering a 50% off coupon goes in a retailer’s CAC, but not an insurer’s. Purposely mispricing your product and then bragging how little it cost you to acquire customers (in terms of traditional marketing costs) is highly misleading.

The other big CAC cheat code was the big pivot to the agency channel. If I pay $500 to acquire a customer through a direct channel and that customer pays me $1000 of premium, my CAC is obviously $500. Of course, the benefit of that is if I can retain them, I can collect another $1000 the next year at no incremental cost.

But let’s say my investors are complaining my CAC is too high (probably because my retention is terrible and I only collect the $1000 once before they leave), what else can I do? Invest in improving my product to improve retention? Too hard!

No, we use a cheat code. We pay agents 20% commissions to win business. That’s above market, but, hey, 20% of $1000 is $200 so I reduced my CAC 60%!

Yes, you have, if you expect to churn your customers every year and start again from scratch. However, if you plan to have a successful business, you will want to keep those customers which means paying another $200 the second year and another $200 the third and so on. Pretty soon, you’re better off with that $500 upfront acquisition cost through the direct channel.

There are certainly valid reasons to sell through IAs, but buying business with high commissions and unsustainable prices only made sense if you expected low retention and, if you expected low retention, you’ve got bigger problems than your CAC!

At the end of the day, if the cheat codes really worked, everyone would use them. The fact that others don’t should be a warning that taking shortcuts comes with risks you may not understand.

Going Public Too Soon

This is another one I’ve talked about many a time before. Financials should not go public unless they are self funding (or at least very close to it). You are putting your future in the hands of people you don’t know and who may not particularly like you (e.g. short sellers).

Is there any doubt that if Lemonade stayed private, that a) the others would have waited too and b) valuations wouldn’t have gotten as frothy because the VCs would know they needed to fund future rounds themselves and wouldn’t have wanted to climb up the ladder too quickly?

Things would have been more steady and, while the froth would have come out at some point, it’s reasonable to think private valuations would have been 50-100% higher than today’s public ones (that doesn’t mean private markets would have been “correct”, but they could have smoothed out the adjustment process).

There is a reason Hagerty is the most successful insurance SPAC. It can fund itself. We can debate it’s valuation, but if you own it, you don’t have to worry about a gun to the head capital raise 90% lower.

There was some really bad advice given by bankers and other advisers suggesting companies that needed this much ongoing cash could thrive in public markets. I wouldn’t be surprised to see E&O suits in addition to the D&O ones.

Unicorns Are, Indeed, Mythical Creatures

Your spidey sense should have started tingling when “unicorns” began appearing on every street corner after never being sighted before in all of human history. A unicorn is supposed to be rare.

Having a market value of $1B at an early stage doesn’t make you rare. Having a business model that creates real value and not just paper value…that’s rare!

The truth is these well known startups weren’t unicorns. They were candy corns. They were sweet at first and provided a rush of sugar but ultimately not satisfying. And after you’ve had too many, when the sugar wears off, you feel terrible and crash.