I know what you’re all thinking. Here comes another version of all the reasons the overhyped insuretech names aren’t going to make it. Not so fast (said the tortoise)! Today, I will make the case for how the seemingly misguided strategy of the hare may be the better path to ultimate success.
The Two Paths to Startup Success
Most people in the insurance world are used to the tortoise path where startups focus their efforts on gaining acceptance in the marketplace and getting to underwriting profitability relatively quickly, while following the traditional carrier business model of a well capitalized balance sheet with aspirations of an A or A+ Best rating.
Contrast that to the hare who is motivated solely by achieving hyper growth. Polite references are made to achieving underwriting profitability, but it is clearly a secondary concern. Operational mistakes are expected while breaking things, but accepted as long as the growth trajectory is on track. Balance sheets are typically non-traditional (MGA, reciprocal) and growth capacity is reliant on the kindness of others (particularly reinsurers).
How The Tortoise Wins
The tortoise wins by identifying an attractive area of the market where they can profitably underwrite, usually due to a lack of capacity in the market. They often have a reason to think they can produce better than peer combined ratios due to better talent or new pricing methodologies.
The obvious examples of this are the Bermuda startups post 9/11 and KRW. Another good example is PURE who realized consolidation in the high net worth market created an opportunity for a savvy new entrant.
The tortoise is typically funded with a large initial capital raise from private equity and doesn’t need to raise capital again until it goes public. Thus, there is less reason to create “buzz” in the media. The eventual IPO is likely directed towards traditional insurance investors and the valuation is dictated by traditional metrics like ROE, book value growth, and CR.
How The Hare Wins
As I said, the hare is focused on hyper growth. Why? Because they have a greater risk tolerance. This is really the biggest difference between insuretech and insurance startups. It’s not necessarily the technology…it’s the risk appetite.
The most obvious place you can see this is in the different burn rates of the tortoise and the hare. The tortoise is disciplined at customer acquisition, typically relying on existing distribution channels like agents. The hare spends whatever is necessary to acquire customers (whether they will prove profitable or not) even if this spending seems irrational.
However, there is one thing the tortoise doesn’t consider. While the tortoise is taking cover in its shell, the hare is out generating excitement about it’s greater potential if it threads the needle and ultimately succeeds.
Investors get excited about the greater upside of the hare (even if the odds of success are low). This lets the hare continue to raise more and more capital. Most important, the capital is super cheap. In fact, it is cheap enough that all the $ spent on “irrational” customer acquisition, may actually be rational…if the super cheap capital never goes away.
Building a Business vs. Funding a Business
Now we’ve reached the point where the difference in strategies has becomes clear. The tortoise is focused on minimizing underwriting losses and ignores the cost of capital for the most part. The hare is focused on minimizing the cost of capital so that it can ignore the cost of acquiring customers for the most part.
I’m sure most readers are now thinking, that’s great but we know capital isn’t free forever. At some point, the hare (or coyote) runs off the cliff.
You’re right in theory, but, as we’ve seen, it can remain free for a long, long time. Uber, Tesla, and others have been able to raise free capital for a decade with no end in sight and without needing to show profitability.
On the other hand, there are stunning examples of crashes like WeWork and many other smaller companies that fail before they become household names.
Frequency vs. Severity
To put it in more familiar terms, the hare is running a low frequency, high severity strategy. Most hares will fail, but those who succeed will succeed massively as they can use the free capital to undercut traditional competitors and keep driving growth.
Tortoises have better odds of becoming a “real” company, but they are also less likely to achieve breakout success. They are more likely to be above average, but not top decile. They will almost certainly be smaller than the best hares and they will have less optionality in their business model (e.g. M&A will be constrained by the higher funding cost).
They also ironically have less room for error than the hare because mistakes are punished by investors whereas the hare’s mistakes are largely ignored as long as they still represent a lottery ticket. In other words, fundamentals matter for the tortoise, but not the hare. The hare is all about psychology and sentiment.
There will always be some hares that win (just like some companies that bet on no cats win…see those who have written CA quake for the last 25 years).
Because human beings are irrational, they respond to the winners in one of two ways: assume that because one hare won it must be a winning strategy or otherwise they complain how unfair it is that a hare won because they didn’t do it “the right way”.
Both groups miss the simple truth that the hare pursued a more aggressive strategy with greater risk of ruin but a chance at a great reward.
Is the Hare Rational or a Thrillseeker?
I guess it may be both, but there are times when it is rational to be a hare. Note most of the famous hares (Uber, Tesla, etc.) are in businesses with high entry costs and large capital needs where there is a race to capture market share.
If you are starting an E&S carrier whose growth plan is based on being relevant to wholesale brokers, none of the above applies. There is no reason to be a hare.
However, if you are in a space like auto with large incumbents who spend $1B/yr on advertising, it is extremely expensive to enter that space. Pursuing a grind it out approach likely leads to failure. The cost to fund customer acquisition is way too high.
The only real way to succeed is to have free capital that allows you to spend like mad. This requires hype generation about how you will change the world while also drawing derision from industry experts who think your business model is vapid.
So, yes, one can argue Root is acting rationally to focus on a low cost of capital over underwriting profits. There will always be the question, like with Uber and others, of whether they can ever transition to profitability, but you can build a successful brand at a minimum with this approach and that’s very valuable.
Is the hare playing “greater fool theory“? Of course they are! But longtime investment professionals can tell you that many fortunes have been made selling things to the greater fool whether you think it’s “fair” or not.
Is It Better to be the Hare or the Tortoise?
It’s not a question of better. The hare is harder to pull off. If you can pull it off, the low cost of capital is extremely valuable. It allows you to make a lot of other mistakes and creates opportunities that the tortoise will never have. It also allows you to be extremely long term focused which can be beneficial (though is often an excuse for being a bad operator who can only sell the ever elusive future).
On the other hand, the tortoise never has to worry about the music stopping. The hare is always on edge that the willingness to believe could be suspended before the next required fund raise, otherwise known as the WeWork nightmare.
The point of this missive is to show that both are viable. While it may be fashionable to pick on the “insuretech unicorns” (yes, I’m guilty too), it doesn’t mean they’re destined to fail. They are similar to investors who are good traders but don’t always know what business the stock ticker is in.
Those of us who are purists like to see the companies with the best fundamentals and strategies win. However, one only has to look at the broader stock market to see that isn’t always relevant. Just because the hare isn’t your cup of tea doesn’t mean they can’t succeed.