Before anyone asks, “is that some new insuretech I haven’t heard of? They’re literally building giant castles and insuring them”? No, nobody is insuring giant castles (…yet).
Today’s topic is unrealistic assumptions. Yes, that is often the topic when I discuss insuretech, I know. But this time it isn’t about optimistic assumptions. It is truly about unattainable ones. Like not understanding math unattainable. Like straight lining growth forever unattainable.
What’s the issue? These insuretechs think the reinsurance market is like the Federal government, meaning it has unlimited resources. Unless they have invented a printing press to make more reinsurers on demand, they are pursuing an unsustainable strategy. Reinsurance capacity doesn’t grow to the sky.
Tragedy of the Commons
I’m going to assume most readers have heard of the tragedy of the commons. You know, the one where the farmers have their cows graze on public land because it is a seemingly unlimited resource, but then they overconsume and eventually leave the land barren.
This situation is a little different in that one insuretech being too reliant on reinsurance doesn’t force another one to copy that model. The bigger difference compared to the textbook Tragedy is that the insuretech community is unaware that they are consuming a finite resource so remains unaware of the pending tragedy and thus will do nothing to prevent it.
You would think this would be blindingly obvious. Just as an army that marches too fast risks outrunning its supply lines or when Amazon grows too fast it risks outgrowing warehouse capacity, fast growing insurers risk outgrowing their infrastructure.
These are serious issues in other parts of the business as well, such as claims or IT processing capacity, but I assume the executives are aware of these issues and plan for them. Nobody even seems to be thinking about limits on reinsurance capacity as they grow even though it is arguably the biggest bottleneck they will face.
The Tradeoffs of Quota Share Reinsurance
Before we dive into the numbers, let’s do a quick review of why reinsurers might hesitate to sell too much personal lines quota share reinsurance.
First, it has cat risk. While not as much as an XOL cover, it is a material part of the risk. Therefore, before a reinsurer agrees to a QS, it is going to compare the returns to deploying that cat capacity in XOL treaties.
And there is very clearly a limit on reinsurer’s cat capacity given rating agency requirements. The only way to increase cat capacity is to increase capital.
Speaking of capital, quota share cover eats up capital because you have both cat and attritional risk. Thus, you’re probably writing it at about 1:1 premium/surplus.
If you were going to compare QS to writing cat XOL, depending on market conditions, you can write about twice as much GPW to take on the same amount of cat risk. (I’ll spare you the math but if someone vehemently disagrees with that, let me know and I’ll review the assumptions)
In other words, $100M of QS cat is equivalent to $50M of XOL cat GPW. By the way, that calculation assumes the primary writer is profitable, which isn’t currently the case for insuretechs, so that’s another negative.
Thus, there are clear limits on quota share capacity the reinsurance market can provide. To write more for someone new, they have to reduce capacity to an existing client.
I guess you could hypothetically argue reinsurers will raise equity to write more insuretech QS, but that would be pretty foolish when insuretech’s cost of equity is far lower than any reinsurer.
How Big is the Common?
Today’s market has one giant quota share treaty. Farmers has a 25% treaty that produces about $5B of ceded premium. Of course, that is a stable company with predictable results.
The largest cat heavy quota share I can recall was the one Universal had a number of years back which I believe peaked out at $350M of ceded premium.
By contrast, Hippo, in their slide deck for the SPAC announcement (sorry, I’m not going to have a deep dive on Hippo, partially due to the lack of an S-1 and partly for other reasons that will become apparent in due course), projected $2.3B of GPW in 2025…while still running a 75% QS. This would require nearly $1.8B in new quota share capacity!
So let’s go through the public insuretechs and try to figure out how big they need the Common to be in four years…
Metromile has projected $1.1B of GPW for ’24. Let’s assume that’s $1.5B for ’25 and they keep their 65% QS. That’s $1B of QS capacity they need.
For Root and Lemonade, I’ll use consensus estimates as I don’t believe they have made long term forecasts. Lemonade is ceding 75% to their QS. If they grow to $1.3B, they will need $1B of QS by ’25. Root has a 70% external QS with growth forecasts of $3+B for ’25 so that’s another $2B of QS need.
Thus, just these four companies alone will need $5B of capacity. That’s another Farmers! Oh, and we haven’t even gotten to the next wave of startups who are coming along, nor any of the small commercial entrants like Pie or Next.
We could be talking about as much as $10B of insuretech QS demand! If you use my 2:1 conversion, that is equivalent to the amount of XOL capacity dedicated to the entire state of FL!
Which is all a long way of saying, the Common will be totally consumed well before 2025. The cows will be looking for worms in the dirt!
The Greensill Narrative
What happens when one builds a model that is too dependent on reinsurance capacity? Good question. We recently got an answer. Greensill failed because they couldn’t renew their reinsurance.
Now, this was partly due to underwriting mistakes (which insuretech isn’t absent of), but the bigger issue was Greensill exhausted the trade credit Common.
Greensill grew too fast and assumed the reinsurers would always be there. Eventually, the reinsurers balked. They had too much concentration risk and couldn’t support Greensill’s growth anymore. Other markets weren’t willing to step up.
So did Greensill do the responsible thing and slow its growth? No, they decided to outrun their supply lines. They concentrated most of their insurance with Tokio Marine and hoped for the best.
Alarm bells went off inside of Credit Suisse asking them to diversify their insurance counterparties. Greensill didn’t do it. More likely, they couldn’t do it. They had consumed the entire Common. When Tokio finally had their fill and non-renewed, Greensill collapsed.
The Fable of Capital Light
This should be a giant lesson for every insuretech!!! More importantly, it should be a giant blaring alarm for every insuretech investor pressing their invesments to recklessly grow the top line without a sustainable plan for funding growth!
Note, this isn’t just a commentary on the poor underwriting results to date. Even if those improve and hit targets, the capacity is unlikely to be there. It certainly can’t be there for everyone.
“Asset light” is a wonderful idea on paper. If there were deep security markets like for mortgages or credit cards, then perhaps the grow at all costs philosophy makes sense. But there aren’t.
This is insurance. If you want to be capital light, you need support from reinsurers. Which means you need to make money for them and you can’t ask for all their capacity because they won’t give it to you.
Capital light only works if a) you are pretty much the only one trying to do it or b) you are OK being a smaller company to ensure you won’t exhaust the reinsurance Common.