How’s that for biting the hand I am asking for food? But I think any investors reading this will hopefully realize this is valuable advice that will be helpful to them.
After spending a few years now comparing how I look at investing in insuring companies and how VCs look at it, it’s apparent we have very different perspectives.
And while I have had fun in the past mocking the seemingly illogical strategies some of the early insuretechs took, I have also reached some pretty important conclusions about why startup investing in insurance keeps hitting walls.
Before I go too much further, let me clarify I am primarily talking today about underwriting driven models. If you are developing data to sell to carriers or admin systems to improve productivity, those are different models and some have proven very successful (though they have some of the same limitations on potential valuation upside noted below).
I know some VCs have realized this given the many who tell me they only are interested in B2B ideas now.
But nobody has cracked the code yet on how to succeed at underwriting, even thought it’s really so simple. Want to know the secret?
Focus on underwriting. That’s it! There’s nothing more to it. But how many startups have led with their plans to be world class underwriters (and could credibly back it up)?
Before I expand upon this, I think it’s only appropriate to do a walkthrough of the history of insuretech to date. Maybe you’ll see the same repeating pattern I do?
Running In Circles
Underwriting focused insuretechs keep finding new and exciting ways to make the exact same mistakes!
First, there was the “disruption” thesis where new insurers would displace old, stodgy insurers by following the software model of “grow fast and break things” which, of course, ignored that breaking your loss ratio is harder to recover from than sending out a buggy beta.
So then some wannabe financial engineer came up with a “brilliant” insight that the problem wasn’t bad underwriting, it was those cursed balance sheets.
And yes, balance sheets aren’t conducive to early stage venture capital. But their replacement – MGAs – brought new problems as I’ve talked about ad nauseum.
MGAs work best when you have great distribution and great underwriting. Then, reinsurers line up around the block to offer you paper. They don’t work so well when you continue to grow too fast and write at 100+ loss ratios.
Around the same time, there was a realization that part of the reason these new companies wrote so much bad business was because they were getting the bottom of the barrel customers, whether it be those who responded to online ads from companies they never heard of or getting picked off by agents who sent them their worst risks they couldn’t place elsewhere.
Somebody declared the answer to this problem was convincing other retailers that including insurance at their point of sale was a master stroke, because, hey, look at how successful buy now, pay later has been in retail!
This new approach was called embedded insurance. And yes, I have panned that ad nauseum now too. Oh, and the idea that this was “new”…it’s only hundreds of years old.
Embedded insurance has been around forever. Sometimes it works (Allstate when they were in Sears) and others it doesn’t (every failed attempt to sell auto insurance at the car dealership).
Unfortunately, none of the converts to embedded insurance seem to have studied the history of why it works and why it doesn’t.
Somebody rushed in and a whole bunch of others followed. This is also a repeating pattern in startup land.
Cyber to ?
Finally, we have cyber. There is at least a thesis here that better mitigation will lead to better loss ratios. However, the companies raising big rounds sure seem a lot more interested in rapid top line growth than any other metric and the jury is still out on their underwriting capabilities.
They have also chosen to take on the hardest line in insurance, as it is actuarially impossible to model cyber (as I have noted before, past cyber attacks are not indicative of the future). If you want to argue that with me, tell me how AI will or will not change the pace of cyber attacks?
Maybe it will work out, but if the losses spike, they will face the same capacity problems as other MGAs.
The Common Link
What do all these approaches have in common? They continue to focus on making it easier for buyers to purchase insurance to enable market share growth. There is no correlation between ease of buying or pleasant consumer experience and loss ratio.
Well, actually, there may be, but it would be an inverse correlation!
The Contrarian View
Believe it or not, I am not contrarian just for the sake of being contrarian. I just happen to find every popular strategy taken by insuretech underwriting startups to be nonsensical! And so far, I have been right.
What’s puzzling to me is I don’t feel I am doing advanced level calculus to debunk these approaches. This is all fairly obvious stuff to me (and many others in the insurance world).
I’m just saying out loud what a lot of other people think quietly.
Which brings me back to my opening statement. I look at investing in insurance companies very differently.
In my world, there are two ways to build a successful insurance company:
- You create a sustainable underwriting advantage that produces better loss ratios.
- You operate at a lower expense ratio that competitors can’t match.
Notice, I didn’t mention growth.
The Great Irony of Insurance
See, here’s the great irony. When you choose to pursue growth first, you will fail to grow.
Oh, you may grow for a period of time, but you ultimately crash and burn because your losses eat you alive.
No, the way you grow in insurance is to have better margins. When you have an inherent loss (or expense) ratio advantage, you will be able to rationally offer lower prices than peers. This will lead to more growth.
That’s right, you grow more by prioritizing the combined ratio. Premium growth is a symptom of better underwriting.
If a former Bernstein analyst happens to be reading today, he may still have the charts he can send over from 20 years ago showing the correlation between growth and margin.
Progressive grew faster because its margins were sustainably better and that allowed them to price more competitively. Margins lead growth, not the other way around.
VC investors apparently don’t appreciate irony?
Margin Focused Startups
So what should a startup focus on if it wants to have better margins?
On the expense side, you either have to have a distribution advantage or more efficient systems that allow you to write more premium with fewer people. Hey, that sounds like Progressive!
Are there opportunities to do that in commercial lines? Probably. Are there any startups trying to take 10 points out of workers comp or commercial property expense ratios? Not that I’ve seen.
How about losses? How do you create an advantage there? Certainly data plays a key role. If you can better segment risk, you can price more efficiently and focus on your best cells while competitors take those you don’t want.
Will someone come along and be the Ren Re of med mal or D&O? Haven’t heard of any startups doing that either.
You can be better at preventing losses like a FM Global or Hartford Steam Boiler. As mentioned, this is part of the cyber strategy and there are some workers comp entrants here, but TBD on how successful it will be.
You can also have a distribution edge. Plenty of successful MGAs have found niche areas of risk where they are the go to market because of their service capabilities. Think of Hagerty in classic cars.
No, I don’t think there are too many startups identifying undiscovered niches to own. TAM too small, you know?
The Pure Case Study
I would argue (and have before) that the most successful insurance startup of the last 15 years is PURE.
They were acquired four years ago for $3B and premiums have roughly doubled since. I don’t know if that makes it worth $6B but let’s say it’s worth $4-5B after 15 years.
The question before the house is…would any VC invest in the next PURE?
They didn’t participate in the original PURE. It was funded by private equity (Stone Point). The TAM was small (probably $10+B at the time) and there was a large successful competitor in Chubb. They had newer tech than legacy companies but nothing groundbreaking.
Five years in, they had “only” $175M of GPW. What a dud, right? Ten years later, they had 10X that and are the second largest player in the space.
But even still, would VC have funded a company that would take 15 years to reach $2B in premium and be worth “just” $5B? That doesn’t seem like enough upside to overcome all the zeros elsewhere in the portfolio.
I look at PURE though and see a great outcome. I suggest VCs need to rebase expectations and realize PURE is a great outcome and what they should be aiming for.
Aim for $10B
While that may seem depressing for those looking for the next Progressive, even Progressive has taken decades to reach its current market cap. Berkley has taken 50 years to reach $15B. Kinsale isn’t at $10B yet and Ryan is just over $10B. Hagerty is $5B.
Realistic upside for a successful insurance startup is $10B, not $100B. No matter how much you want to wish otherwise, it’s not going to happen.
By the way, that holds for non-underwriting models too. Verisk took 50 years to reach $30B.
Math suggests if your upside is less than in other sectors, you have to reduce the downside as well. In other words, fewer flops. The best way to reduce flops is to…not invest in top line first growth stories.
If you look for ideas with sensible plans for better combineds, you reduce your risk measurably. This is the way.
The New Land Rush
For those wondering, while Informed isn’t an underwriter (we’re a personal lines agency), we have embedded these thoughts in our operating model.
We expect to have lower expenses than other agents. We will be using data to better match insureds with the appropriate capacity which will reduce volatility in loss ratios for our carrier partners thus improving their margins.
When you put those two together, that means we should receive commissions at or above industry levels while maintaining low expenses. This will generate the high margins which will – ironically – boost our growth.
If you want to know more, reach out and I’m happy to explain.
So yes, I’m talking my book, but I’m also putting my money where my blog is. These aren’t just idle thoughts to provoke conversation. They are twenty plus years of experience investing in insurance companies.
To my VC friends, now you know where the opportunity is. Someone has to make it cool and start a land grab where every startup realizes the path to funding is having an underwriting edge. Who wants to go first?