Where The Capital Markets Have Failed: E&S Home Insurance

This will be the final thematic piece around capital structures for startups. Previously, I discussed when traditional balance sheets could make more sense and alternative avenues for new ventures to raise money for a de novo balance sheet.

Today, I’ll focus on an example of a large unmet need in the industry that the capital light model has failed to solve – new capacity for home insurance.

Given the challenges in the home space and, specifically, the struggles of some of the market leaders, this would appear to be a very opportune time for a new entrant.

The obvious impediment is you’d have to be insane to form an admitted home insurer given the regulatory framework in many of the bigger states.

But there is a compelling alternative. While E&S has gained tremendous share across commercial lines, it has been much slower to penetrate personal lines.

This is confounding given most of the challenges in home insurance are regulatory, whether it be adversarial regulators or the constraints of the HO-3 and HO-5 forms.

I’ve thought about creating an E&S home insurer for at least 10 years, but the events of the last few years have made it much more practical.

Buyers in coastal states are having trouble even getting quotes, while even more benign states have seen increased underwriting restrictions and large price hikes.

Thus, the customer is primed to look for alternatives such as E&S paper. Yet, it’s been crickets out there.

Nobody at State Farm or Allstate has gone out looking to raise $1B for a better, more sophisticated approach. No E&S property big shot has decided maybe they can write residential. You haven’t even seen an existing admitted insurer try to create an affiliated E&S home entity.

Why not? The most obvious reason is what I have been writing about in recent weeks. There is no funding available for a big balance sheet in today’s market.

The Benefits of Non-admitted Home

Before going deeper into the funding issue, I should probably spend a little more time making the case for why E&S paper is a big advantage in the home market and why it requires a balance sheet.

As alluded to above, most of the problems in home insurance trace back to it being an admitted line. Everyone uses the same basic form with antiquated coverage included (fur coats? cameras?) but necessary coverage excluded (flood, quake, etc.).

While there have been some attempts to add new riders or restrict long time coverages (roof), these are mainly on the margin and don’t benefit the average homeowner.

Furthermore, your home is different from my home is different from our neighbor’s home. Similarly, individual homeowners all have very different preferences for coverage levels, risk appetite, loss mitigation, etc.

There is thus vast opportunity to better underwrite individual homes (and homeowners) relative to the mean to produce better loss ratios.

However, this cannot be done in a regulated market due to take all comers laws.

But on non-admitted paper, an underwriting box can be customized to only attract certain preferred types of homes or, perhaps, to seek high risk homes (flood zones, old roofs, etc.) if the price is high enough.

This is a gigantic advantage and, arguably, this alone justifies a move to E&S paper. After all, flexibility of form is far more important than level of rate in homeowners.

But that’s not all… E&S carriers don’t have to worry about rogue insurance commissioners forcing them to renew loss making business or to have capped annual price increases or veto your cat model or to cover losses not in the contract.

I should also note this isn’t just about coastal homes in a few states. The ability to customize forms and expand or contract coverage around roof, flood, fire following, etc. applies nationwide.

There is no reason an E&S home carrier with demonstrated strong underwriting performance couldn’t grow to $5B of GPW fairly easily and likely produce a 90 or better CR.

Who wouldn’t want to fund that???

Capital Light E&S?

So I bet some of you who think this is a good idea are immediately saying, “this is great. Let’s start a MGA or reciprocal to do this!”.

No!!!!!!!

Sorry, that’s not going to work. Yes, I’m aware some people are trying home MGAs. It is not a long term solution.

If you want ordinary homeowners – who aren’t sophisticated about insurance – to buy from a company without a big brand name and long operating history, then you need to have demonstrated financial strength and a willingness to pay claims.

There is no room for debate here. Homeowners, more than most lines, is a trust business. If you develop a reputation for paying claims fairly and quickly, you will do well. Ask Chubb if you don’t believe me.

A MGA needs to have the resources to pay promptly after a large hurricane and to control how it pays routine claims without it being subject to oversight from its capacity provider.

It also can’t have its business survival contingent on being able to renew its reinsurance at reasonable terms next January.

As for reciprocals, while they make sense in theory, it requires a very homogenous book where one block of customers isn’t subsidizing the others.

Furthermore, the purpose of a reciprocal isn’t to generate large fees for the manager but to minimize costs for the policyholders. Recent reciprocal startups have developed amnesia about this inconvenient fact.

The Funding Need

The good news here is there is no reason to raise $1B or more on day one. It takes time to roll out states and thus grow premium.

However, there does need to be a plan to raise future capital as needed. This brings me back to one of the earlier ideas about staged capital raises.

If say $1B is needed by year 5, but only $250M upfront, work with a private equity firm who can give you the first $250 and then $150M every 12 months thereafter.

This allows the PE to limit its outbound cash while getting paid fees from its investors on the full $1B commitment.

A well thought out state rollout plan makes it fairly easy to model out incremental growth and capital needs. I would advise having future state launches contingent on hitting profitability goals in the existing states to avoid expanding before the underwriting is sound.

I would also suggest starting with some “easier” states rather than running straight for the coasts. Sure, there is more demand there but, even with an E&S form, there are a myriad of underwriting challenges.

Prove out the model in NJ or TN or AZ before moving to FL, TX, and CA.

The other benefit from this approach is there is less need for top layer cat reinsurance and results should be less volatile, so there is less risk of one bad cat straining surplus.

There is also a brand benefit to avoiding the harder states initially as it lowers the risk of an inexperienced claims organization performing poorly and hurting the reputation of the company.

Finally, while the coastal states offer faster premium growth they also have higher capital charges which, when combined with the fast growth, leads to asking your sponsor for more capital sooner which they won’t be pleased with.

Slower growth in less capital intensive states allows the company to better string out the need for more funding.

Why Hasn’t This Happened?

So if there is such a glaring need for E&S home capacity, why have no startups been created? I would have suspected two years ago there would be three to five launched by now.

The only answer I have is lack of capital availability. There could arguably be a talent issue in that it does require a more thoughtful underwriting approach and there aren’t many credible leaders with direct experience in E&S personal lines.

However, I kind of doubt that’s the issue when you see how often inexperienced management teams can raise money for MGAs to compete in challenging markets.

So, I think it’s more about capital access than credible business plans.

There is also likely some hesitancy about allocating capital to a notoriously unprofitable sector like home. Yet, we see plenty of startups in commercial auto, cyber, and other difficult lines.

More importantly, the main reason home insurance hasn’t been profitable is because of the constraints of writing it admitted! Take away those shackles and there is no reason it can’t produce much better results as we’ve seen in areas of commercial E&S.

So I keep coming back full circle to…it’s about access to capital. There are compelling business models that can add a lot of value but aren’t being funded due to lazy thinking among private investors.

It isn’t just E&S home insurance, but that’s the one that’s most obvious to me.

If anyone out there agrees (and has the background to execute it), reach out and I’m willing to provide some further thoughts on how to develop the business plan, but you’re going to have to figure out where to find the capital.