“The paradox of teaching entrepreneurship is that such a formula necessarily cannot exist; because every innovation is new and unique, no authority can prescribe in concrete terms how to be innovative.”
― Peter Thiel, Zero to One
Whether we’re talking about telematics, Artificial Intelligence (AI), digital distribution or peer-to-peer, investing in insurance related technology (commonly termed insuretech or insurtech – I prefer the “e”***) is no longer considered boring. In fact, insuretech is one of the hottest investable segments in the market. As a 20+ year veteran in insurance, it seems surreal that insurance has become this hip. Twenty years ago, I gulped as I sent an email to the CFO of my company where I proposed that there was a unique opportunity in renters insurance. That particular email was ignored. Today, that idea is worth millions of dollars.
Insurance seems to be the latest in a string of industries caught in the crosshairs on venture capital. With the success of Uber and AirBnB, VCs are now looking for the next stale industry to disrupt, and the insurance industry carries the reputation of being about as stale as they come. They view the needless paperwork, cumbersome purchasing processes, dramatic claims settlement and overall old-school look and feel of the industry as an easy target to push over a cliff and siphon those trillions of dollars of premium over to Silicon Valley. It seems like a reasonable thesis.
The problem is, it’s not going to happen that way. Insurance will NOT be disrupted. While insurance looks old and antiquated on the exterior, it is actually quite modern and vibrant on the interior. The insurance industry is actually the Uncle Drew of businesses; it’s just getting warmed up!
Much of the reason I think VCs are unaware of their doomed quest for insurance disruption is that they are looking at the market from a premium standpoint and envisioning being able to capture large chunks of it. $5 trillion is a lot of money. Without an appropriate model, an outsider coming into insurance can naively think they can capture even a fraction of this. But premium is strongly tied to losses. Those premium dollars are accounted for in future claims. I once had a VC ask me what the fastest way to $100 million in revenue was. The answer is easy, “slash the premium”. I had to quickly follow up with, “and be prepared to be go insolvent, as there is no digging yourself out of that hole”. He didn’t quite get it, until I walked him through what happens to a dollar of premium as it enters the system. And it was this that became the basis of the model I use to assess new product formation and insuretech startups.
There are four basic components to my model. Regardless of new entrants, new products, or new sources of capital, these 4 components remain ever present in any insurance business model. Even if a disruptive force was able to penetrate the industry veil, that force would still need to reflect its value proposition within my 4 components.
Component 1 – EXPOSURE
This is the component that deals with insurance claims; past present and future. Companies or products looking to capture value here must be able to show the ability to reduce, prevent, quantify or economically transfer current or new risks or losses. Subcomponents in this category include expenses arising from fraud and the adjustment of claims, both of which can add substantially to overall losses.
Startups such as Nest are building products that increase home security by decreasing the likelihood of burglary (or increasing the likelihood of capturing the criminals on video) and thus reduce claims associated with burglary or theft. Part of assessing the value proposition of Nest is to first understand the magnitude of the claims associated with burglary and theft and then quantify what relief this product could provide (along with how that relief should be shared among stakeholders).
Another company that is doing some interesting things in this model component is Livegenic (disclaimer: I have become personal friends with the team). Livegenic allows insurers to adjust claims and capture video and imagery using the mobile phone of the insured. This reduces the expenses associated with having to send an adjuster out to each and every claim. Loss adjustment expenses can be in excess of 10% of all claims, so technology that reduces that by a few basis points can be quite valuable to an insurer’s bottom line and ultimately its prices and competitiveness.
Component 2 – DISTRIBUTION
This component focuses on the expenses associated with getting insurance product into the hands of a customer. Insuretech companies in this space are typically focused on methods to drive down commissions. This can be done by eliminating brokers and going directly to customers. Savings can also be achieved by creating efficient marketplace portals that allow customers to easily buy coverage. Embroker is one of many companies trying to do just that in the small commercial space by creating a fully digital business insurance experience. Companies such as Denim Labs are providing social and mobile marketing services to companies in insurance. And then there is Lemonade, who is developing AI technology that will hopefully reduce the friction of digitally purchasing (their) insurance and making the buying process “delightful”. Peer-to-peer (P2P) insurance is a fairly new insuretech distribution model that attempts to use the strength of close ties via social methods for friends and close associates to come together to make their own insurance pools.
Distribution expenses in insurance are some of the highest in any industry. As with the risk component, reducing expenses in this component by even a few basis points is incredibly valuable.
Component 3 – CAPITAL
This component focuses on the expenses associated with providing capital or the reinsurance backstop to a risk or portfolio. For many insurers, reinsurance is the largest expense component in the P&L. Capital is such an important component to the business model, that the ramifications of it almost always leak into the other components. This was one of my criticisms of Lemonade recently. Lemonade will have a lot of difficulty executing some of the aspects of their business model simply because it cedes 100% of its business to reinsurers. So, when it comes to pricing or its general underwriting guidelines, its reinsurance expenses will overwhelm other initiatives. Lemonade can’t be the low cost provider AND a peer-to-peer distributor because its reinsurance expenses will force it to choose one or the other. This is a small nuanced factor that many VCs will miss in their evaluation of insuretechs!
For those seeking disruption in insurance, we have historical precedent of what that might look like based on the last 20 years of alternative capital flooding into the insurance space. I will devote space to this in future articles but in brief, this alternative capital has made reinsurance so inexpensive that smaller reinsurers are facing an existential crisis. Companies such as Nephila Capital and Fermat Capital are the Ubers of insurance. Their ability to connect investors closer to the insurance customer along with their ability to package and securitize tranches or risk have shrunk capital expenses tremendously. Profit margins for reinsurers are collapsing and new business models are being created which are shrinking the insurance stack. It is even possible today to bypass BOTH veritable insurers and reinsurers and put the capital markets in closer contact with customers. (If you are a fan of Michael Lewis and insurance, you will enjoy this article, which ties nicely into this section of the article).
In the insuretech space, VCs are actually behind the game. Alternative capital has already disrupted the space and many of the investments VCs are making are in the other components I have highlighted. Because of the size of this component, VCs may have already missed most of the huge returns.
Component 4 – OPERATIONS
The final component, is often the one overlooked. Operations includes all of the other expenses not associated with the actual risk, backing the risk or transferring the risk from customer to capital. This includes regulatory compliance, overhead, IT operations, real estate, product development and staff just to name a few.
It is often overlooked because it is the least connected to actually insuring a risk but it is vitally important to the health and viability of an insurer. Mistakes here can have major ramifications. Errors in compliance can lead to regulatory problems, errors in IT infrastructure can lead to legacy issues that become very expensive to resolve. I don’t know a single mainstream insurer who does not have a legacy infrastructure that is impinging on its ability to execute its business plan. Companies such as Majesco are building cloud based insurance platforms seeking to solve that problem.
It is this component of the business model which allows an insurer to be nimble, to get products to market faster, to outpace its competitors. It’s not a component that necessarily drives financial statements in the short term, but in the long run it can be the friction that grinds everything down to a halt or not.
I have presented a simple model that I use when I assess not just new insuretech companies but also new insurance products coming into the market. By breaking the insurance chain into these immutable components, I can estimate what impact the solution proposed will provide. In general, the bigger the impact and the more components a solution touches the more valuable it will be.
In future articles, I will use this model to assess the insuretech landscape. I will also use this model to assess how VCs are investing their capital and whether they are scrutinizing the opportunities as well as they should, or just falling prey to the fear of missing out.
*Carly has accepted the more common use of #InsurTech while Tony and Nick are staunch holdovers who feel strongly that #InsureTech is the correct way to spell it!
InsureTech is hot right now, but most won't succeed. Here's a quick, sober model on how to analyze which ones might succeed:
VCs don't realize the reason the overall insurance market is $5T is because of an almost equal amount will eventually be paid in losses.
1. Exposure: Are they lowering the exposure and or lowering claims or adjusting costs somehow (example: Nest).
2. Distribution: Are they lowering the cost of distributing the insurance? This is probably the area with the most opportunity and thus the area we see the most InsureTech startups in.
3. Capital: Are they making access to needed capital cheaper or more efficient? Alternative capital has already brought a lot of efficiency in the last 20 years.
4. Operations: Are they changing a non-risk bearing part of the industry where tehy're allowing an insurer to be more nimble, to get products to market faster or to outpace its competitors?