The Insurance Startup Funding Vacuum

There is always outsized interest in insurance startups, whether they be new reinsurers, the latest “insuretech”, a new MGA, etc.

But one topic that tends to go overlooked is that there is a big impediment today to getting a startup off the ground – financing.

Historically, new insurers were funded by private equity, insurance specific startup backers (e.g. StonePoint or White Mountains), or by their paper provider (e.g. reinsurers).

This worked well for a long time, especially when most startups had traditional balance sheets. Investors could put money in at book and cash out down the road at a premium to a higher book value.

It was very simple to understand and worked pretty well for most investors.

However, a number of trends have made this model outdated and the industry has struggled to find a better model.

Private Equity Goes Big And Went Home

Private equity has historically had two niches in insurance – one, funding startups during times of stress when expected future returns were high or two, acquiring and fixing broken insurers (buy below book and sell above later on).

While they still will do some of the latter, you rarely see them do the former anymore.

What changed? PE firms kept getting bigger and bigger. This meant they needed to find bigger and bigger deals.

It was no longer interesting to put $50M into a new insurer. They’d rather do $500M.

And if you’re going to do $500+M, it was easier to buy an existing company than speculate on an uncertain new venture.

Additionally, insurance startups have long horizons for investors to get paid when you consider all the inherent lags in the accounting (written premium to earned, then set a high initial LR on the earned and wait years for reserve releases to emerge, need more capital to grow, etc).

It’s a lot simpler to buy another industrial where you can cut costs, borrow a lot, and generate a high return on equity quickly than wait on a new insurer to build out a profitable book and have enough distributable earnings to pay you a big dividend.

We have even seen private equity balk at funding the $1B startups where they could deploy large amounts of capital quickly into a hard market for some of the above reasons.

Balance Sheet Hate

Given the historical success that PE has had with the $1B hard market startups from the past, it is surprising they have had no appetite for them in recent years.

That brings us to another big change – the antipathy of investors towards balance sheets as most participants now prefer MGAs or other “asset light” structures.

MGAs naturally require less upfront capital which makes private equity even less of a fit.

If you think about it, MGAs are largely funded by reinsurers. I realize most people don’t perceive it that way but that is the effective outcome.

Risk needs to be funded with capital. If the originator of risk doesn’t retain it, then they have effectively raised capital from their reinsurance provider.

The problem here is the reinsurer’s upside is capped (they only get underwriting profit rather than part of the equity upside) so this isn’t a smart way to allocate capital. Nevertheless, they continue to do so.

Most investors who claim that MGAs are a better model than balance sheets don’t understand they are dependent on the generosity (or, if you prefer, foolishness) of reinsurers!

If you want to commit money to a new MGA with no exit for a decade on the assumption the reinsurance market will continue to subsidize your returns while ignoring their own, you can make that bet, but you should at least be aware of it.

Personally, I think it’s a pretty dumb bet and, like all things cyclical, at some point the pendulum will swing back to reinsurers and MGAs (as well as specialty insurers with balance sheets but a large reliance on reinsurance) will be in a world of hurt.

If there is one thing you remember from this piece, there is nothing inherently better about passing along risk vs. retaining it.

There are times in the cycle where it is better to originate and other times when it is better to manufacture. Just because it has been better to originate for a long time doesn’t mean that it will be permanently.

Any student of financial history will tell you that when participants forget how things used to be that usually means we are closer to returning to that time period than leaving it forever in the past.

The Venture Capital Interlude

I can’t forget to call out the most ignorant participants in the whole insurance landscape – the venture capitalists!

When the PEs began to pull back because they needed bigger deals, the VCs smelled an opportunity to replace them and jumped in the pool without looking first.

While there was some justification that VCs provided a more appropriate check size for startups, there was (and remains) a fundamental misunderstanding of how value is created in insurance.

Growth is NOT good. 10Xing the top line is a horrible, horrible idea. Yes, there are insurance adjacent software businesses where that can work, but not for anything risk bearing.

While insurance brokerage could possibly fit, the PE guys have remained entrenched there, so VC has no room to enter.

Thus, they fell for bad math pitches around MGAs and reciprocals that, in a utopian world, would produce high returns on paper.

The problem is that world does not exist and anyone who did their diligence would have known the paper math was not going to work in reality.

Building an underwriting operation takes time and patience. Those are two things venture capitalists do not have.

So there is a fundamental mismatch between what a VC requires for a successful investment and what a successful startup insurer requires from its investors.

My sense is the VC invasion is over and there will be far fewer underwriting oriented VC investments going forward.

The Vacuum

So if VCs are fading away and PEs have moved on to bigger and better things, where does that leave underwriting talent looking to start ventures?

Out in the cold, it seems.

Even the great Brian Duperreault struggled to raise money for his new startup, Mereo. If it takes Brian over a year to raise $700M, what hope is there for the mere mortals of the industry?

The irony here is it’s not like we’re in a world awash with reinsurance options. Yes, there is plenty of reinsurance capital, but it is concentrated in fewer hands.

That is a big risk for cedants, not just because reinsurers could wise up and demand better terms, but also because if a reinsurer gets in financial trouble, there are few alternatives to move your program to.

Of all the startups created in the 90s and 00s, I think the only ones left as independent competitors are Ren Re, Arch, and Axis (did I forget someone?).

Many of those no longer with us had favorable exits for investors. It’s not like investors suffered poor returns.

There is certainly room for a new group of competitors today, perhaps specializing in reinsuring MGAs rather than cat risk. But there is a need for more diverse panels that isn’t being met.

The Future Crisis

It seems obvious where this all ends up. Whether out of weakness at a reinsurer (cat or investment losses) leading to strain or poor cedant results that finally drive reinsurers to demand higher returns on their capital, there will inevitably be a capacity crisis.

Then, there will be a mad scramble by MGAs to add a balance sheet while brokers mobilize to encourage investors to fund new reinsurers before a chaotic year end renewal.

Or the finance community can get over its irrational fear of balance sheets and start funding creative new entities ahead of time (and at more attractive valuations) that can capitalize on the future turmoil.

How might it do that? I have some thoughts on that, but I’ll save those for next time.