Last week I wrote about the premise of embedded insurance and why I feel, in most cases, it does not benefit the consumer. This week I am back to write how it’s also a bad idea for the insurers!

Why? Because you are doomed to be a commodity provider.

Dumb Capacity

What’s the worst area of insurance to be in over a cycle? Reinsurance. Why? Because (with rare exceptions) you are nothing more than capacity to your client.

You have little pricing power, no meaningful brand, and limited ability to set terms. You are a price taker. You observe where the market clears and choose whether you want in or out at those terms.

Conversely, the best place to be is a primary brand with wide name recognition and a good reputation that leads to high retention and less price sensitivity. While some of these companies may spend too much, and thus have low returns, their brands are impossible to replicate and have significant franchise value.

When you choose to be an embedded insurer, you are acting more or less like a reinsurer. You are a nameless, faceless entity. The customer doesn’t care who you are. They attribute all the value they perceive from the transaction to the retail brand that you partnered with. That brand gets all the goodwill.

You are nothing more than dumb capacity. Sure, there are some isolated cases where you have some technology strength that would prevent other insurers from replacing you easily, but, more often than not, the retail partner could care less if another insurer stood in your shoes.

Bargaining Power

If your distribution partner holds all the cards, what does that mean for your economics? It’s quite simple. It means they won’t be good. You, dear embedded insurer, need your partner way more than they need you.

If they stop selling your product, they lose some ancillary fees. Whoopty-doo. Maybe somebody’s bonus will be a little lower, but their business will do just fine.

On the other hand, you as the insurer, lose everything. You will do anything in your power to maintain that relationship.

You don’t have to be a game theory expert to understand how this will end. Distribution partners will demand bigger and bigger pieces of the pie. If you don’t cut them another slice, they will drop you for another partner.

You will also be expected to meet high service standards so you don’t provide a bad experience that hurts the partner’s brand. That is an expensive requirement.

Margins will be worse than reinsurance! Primary insurers need to keep buying reinsurance each year. Maybe they buy less if they don’t like the terms, but they still have to buy. Retailers don’t have to be in the insurance distribution business. It is the definition of non-core.

It will be a very low ROE business…if it’s even a positive ROE business.

Adverse Selection

The partner will want to sell your product to every customer since that is incremental fee revenue for them, even the ones with a high likelihood of a claim or willingness to commit fraud. Unless you demand they receive a healthy chunk of their payment as profit based contingent commissions, they won’t care about your loss ratio.

Given we’ve established the partner has all the bargaining power, the likelihood of insurers being able to tie distribution fees to underwriting profit is somewhere between slim and none.

Now, if the end customer is truly seeking insurance protection and you are providing a better solution than they can get elsewhere, this may not be much of a concern.

But if they are being pressured into a sale by a customer service rep or being pushed something online that they don’t understand, the odds are fairly high that most of the buyers will be those who suspect they have a high probability of a loss.

Poor Valuation

Given everything I just laid out, what would an investor pay for an insurance business with no franchise value, no name recognition, no pricing power, no leverage with its distribution, and a high possibility of adverse selection?

I wouldn’t pay more than book, if that. It’s a terrible business model. Reinsurers at least provide a service to their clients – they are smoothing volatility which reduces the primary’s cost of capital. That means reinsurers with strong balance sheets and better ratings will be able to ask for bigger allocations and have some influence over terms.

Why would a distribution partner choose one insurer over another besides price? Maybe some service or technology capability that provides a better experience? Possible, but that comes with a higher expense structure so your overall returns are no better.

Embedded will be the ultimate commodity industry. It’s like store brand credit cards. Shoppers care about the name of the store on the card, not whether Chase or Citi provides the funding.

A Matter of Expediency

So why did so many startups decide to go in this direction? Besides the cynical answer that it was easy to raise capital for the flavor of the day?

Because insuretechs still focus too much on top line growth and ignore long term economics. Sure, you can grow quickly doing an embedded deal. But you’re not going to grow profitably or have an exit multiple you’re going to be happy with.

It’s the easy button. Going direct was too hard. Building a true specialty distribution capability takes too long. Selling through agencies might work for a while but you have to burn your way in through pricing and you’ll get book rolled anytime you raise price.

With that set of choices, embedded looked like the one way out of the maze – if your goal was to grow top line in order to raise the next round.

If, on the other hand, you’re trying to build a lasting business, being completely beholden to your distribution partner is nothing more than a dead end.

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