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The First Quarter in Insurtech Financials

The three independent U.S. insurtech startups whose 2017 full-year results we profiled — Lemonade, Root and Metromile — continue to grow rapidly in early 2018. But so far that has meant more red ink: Results that are bigger and blacker remain elusive.

We’ve again analyzed publicly available financial results called statutory statements. The same caveats from our 2017 full-year analysis remain, and again we use only public data to write this post, which reflects only our personal opinions.

Our prior statements regarding the three companies also remain – we think highly of their management teams and long-term potential. All three have a lot of runway and time to perfect their business models. We think they will. We produce this analysis not to critique their management. We want to help investors, entrepreneurs and traditional industry insurers to understand what is happening in insurtech through a lens of insurance fundamentals and facts rather than dogmatic opinion-mongering.

Overall observations

Top line: bigger. All the three companies are growing at rates associated with successful early-stage startups. For a time, these rapid growth rates may sustain their impressive, rumored valuations. Root nearly tripled its top line in the last quarter, apparently without spending too much on customer acquisition, and now has closed the gap on Lemonade. We suspect that this narrowing may surprise a few people, considering the differences in the two companies’ “share of voice.” (Admittedly, we also give Lemonade a lot more attention, in part because its business model is less straightforward.)

Bottom line: redder. Underwriting results have continued to be consistently poor, even excluding expenses, which are influenced by scale and inter-company agreements. This is true even considering paid losses relative to premiums earned. It has been suggested that some of the poor underwriting results are because of exceptionally prudent or cautious reserving, but we find little evidence that reserving practices explain the high loss ratios. Auto and renters are well-modeled, short-tail lines of business where large absolute differences in estimates are less common than in lines where losses take longer to become known.

In between: A quarter doesn’t make much difference in insurance. Detailed breakouts of spending are only published annually. The most notable change: Lemonade materially reduced the potential giveback and made an accounting change that reduces the expenses reported by its insurance company. Lemonade Insurance Co. used to pay its parent a flat fee of 20% for various services rendered by the parent and affiliated companies. In March, this was raised to 25%, retroactive to 1/1/2018. The higher fee increases the slice going to Lemonade’s non-regulated entities by a quarter. Furthermore, Lemonade Insurance Co. no longer reports the true cost of the services provided by the parent, meaning that its expenses for 2018 will appear lower than they actually are. (We explain this later.)

Lemonade Insurance Co.

Love ‘em or hate ‘em, there’s something for you in Lemonade’s first quarter results. The gross loss ratio (excluding loss adjustment expense) of 116% is still almost double what it should be to have a sustainable business, but it is within the last year’s quarterly range (from 104% to 144%). A quarterly loss ratio with a small book like Lemonade’s ($2.9 million gross earned premium) is still quite sensitive to individual losses and reserve assumptions. The company reported $207,000 of gross adverse development in the quarter, which added seven points to the gross loss ratio.

Premiums earned continue to grow rapidly. Texas is actually Lemonade’s largest state, followed by California and then New York. Lemonade’s other eight states combined produced less premium in 1Q18 than New York. In the last quarter, direct written premiums have almost doubled in New York, but the growth in California and Texas has slowed to around 40%, quarter-to-quarter. This is extraordinary growth even if it is slowing. Lemonade has pointed out that it looks at different measures that aren’t published in yellow books – which we suspect include indicators of the sustainable long-term growth rate in the major states as well as seasonality factors in its renters’ insurance book.

Reinsurers continue to subsidize the company’s losses: Reinsurers incurred $3.53 for every $1 in premium they received in the most recent quarter. The aggregate XOL reinsurance contract normally runs another two years (through 6/30/2020), illustrating why reinsurers that back startups also consider having equity participation.

See also: Touching Customers in the Insurtech Era 

A homeowner’s company would typically aim for numbers something like the following (which are from a leading homeowner’s insurer), plus or minus a few points:

Compare with Lemonade’s numbers:

The Giveback

Lemonade’s giveback is one of the company’s most intriguing features. Customers join cohorts, and, if any premium remains after paying the cohort’s claims, fees and reinsurance, that money goes to a designated charity. Lemonade says that this “giveback” was 10% of “revenues Lemonade recognized” from its launch in 2016 until mid-2017. Another is coming in mid-2018.

Lemonade has hinted at “an exponentially larger giveback in years to come.” We’re not so sure. There are two big headwinds. First, Lemonade raised the fee paid from its cohorts to the parent company from 20% to 25%, effective 1/1/2018. Such arrangements are common in the insurance industry and are approved by regulators, but not always gladly. Sometimes profit is moved to an affiliated agency that doesn’t have to pay claims, while losses remain in the regulated insurer.

The second headwind against the giveback is that Lemonade’s cohorts have to pay for reinsurance, the cost of which is almost certain to rise in 2020 if the company continues ceding several times more losses than premiums. The giveback will probably remain – someone’s cohort will have very low losses – but the combined effects of a bigger fee to the parent and more expensive reinsurance could greatly reduce the giveback “in years to come.”

This matters because the giveback is the crux of Lemonade’s business model for both its investors and customers. As CEO Daniel Schreiber has explained:

“If there is underwriting profit it is donated to non-profit – if it isn’t and there are insufficient funds the reinsurers have a bad day, not Lemonade.

“The 20% is insulated – we take 20% in good years and in bad and that is not really impacted by loss ratios – so we are indifferent to the level of claims.”

Set aside the line about being “indifferent to the level of claims.” The 20% is not insulated – it has already gone up – and reinsurers usually seek “payback” if they have a bad day. Payback means higher reinsurance fees such that, over time, reinsurers make at least a modest profit margin. That means a bad day may be coming for Lemonade, though perhaps not until late 2020. What would happen to the company’s vaunted social mission and behavioral incentives if the economics stop adding up?

Lemonade has the cash to weather a lot of bad days and maybe even a pivot or two. The company confirmed its shareholding structure in the first quarter, and the figures support (but do not precisely confirm) the rumored $600 million valuation when Softbank and other investors put in $120 million.

In the past weeks, Lemonade’s Policy 2.0 initiative has generated a relevant debate and raised challenges to regulators, who will have to examine the policy and deal with claims disputes. Ambiguity in an insurance contract typically is interpreted against the insurer, which could make it that much harder to get the loss ratio down. Lemonade remains a challenging company for regulators, and traditional agents are lining up to kill any regulatory flexibility given to insurtechs.

Lastly, we comment on a quiet but meaningful accounting change. The 20% fee paid by Lemonade Insurance Co. (now 25%) was far less than the actual cost of the services received. Lemonade Insurance Co. used to report consolidated figures that gave a true representation of the cost of running its operation. No longer. Effective in 2018, the consolidation is gone, and perhaps $3 million of expenses seem to be missing in 1Q18 – highlighted in yellow above. In terms of disclosure, throughout 2017, Lemonade used the language shown below. The highlighted language is the key bit that is missing in 2018.

Now in 2018:

Transparency….

Root Insurance Co.

Root has grown explosively, with gross premiums written having trebled since 4Q17, for a run rate exceeding $30 million. $2.9 million of $7.9 million of gross premiums written were in Texas, with Ohio and Arizona also chipping in more than $1 million each. Potentially most impressive is that Root apparently has achieved its growth without massive advertising spending. If ad spending as a percent of total expenses remained constant this quarter compared with last year (a big “if,” because overall expense are rising rapidly), then Root has greatly cut its ad spending as a percent of the premium. See the bottom line of Exhibit 2.

As with Metromile and Lemonade, Root’s loss ratio remains unsustainably high, but the company’s $51 million fundraising round in June gives it a few years of runway to make improvements. Following our previous article, the CEO of Root commented that his company’s loss ratio was high in part due to prudent reserving. Indeed, Root was the only of the three startup insurers to report favorable development in the quarter, to the tune of $239,000 of gross positive development, which would cut almost 10 points off the 2017 gross loss ratio. (In reality, Root cut about seven points from the 1Q18 loss ratio, because prior year results aren’t restated when reserves develop.) There could continue to be favorable development, but so far the 2017 loss ratio would be cut from 138% to 128% — still well above a sustainable level. Further, the company in 2017 paid $1.36 of losses for every $1 of premium earned (on a net basis).

Root’s reinsurance comes up for renewal at the end of June 2018 and currently consists of a 50% quota share and $1M XS $100K tower, which limits volatility in results.

Metromile Insurance Co.

Metromile, the oldest and the biggest of the three, continues to grow premium – achieving an impressive plus-25% quarter-to-quarter, nearing an $80 million run rate. California continues to be the largest state for Metromile, accounting for $11 million of $19 million of direct premium written this quarter, as compared with $5 million of $10 million in the first quarter of 2017, which suggests that the company relies on one state but has room to expand. The company appears to be losing money in each state.

As with other insurtechs, distribution has been easier than profitability. The gross loss ratio including LAE at 104% remains close to the results posted in 2017 but above a sustainable long-term rate. For comparison, Progressive’s personal lines loss & LAE ratio was 74% in 2017 (30 points lower), with a combined ratio of 93%. The gross loss ratio is affected by $1.5 million of adverse development at Metromile, which added about eight points to the loss ratio this quarter.

Does loss ratio scale?

We have been surprised to hear some investors comment that they expect loss ratios to decline with scale and to consider them as any other costs on the insurance income statement. There are some elements of loss ratio that scale, but only in a limited way, i.e. a few points, not cutting the loss ratio in half.

  • Claims: Taking claims in-house at the right time can reduce the loss & LAE ratio. TPAs get paid to manage and settle claims, which isn’t always exactly what carriers or MGAs want. (Claims is a moment of truth that drives loyalty, and insurance fraud is real.) Bigger insurers also have better ability to drive favorable pricing with repair shops, contractors and outside adjusters.
  • Portfolio management: Scale can enable the company to be more selective about risks underwritten, thus avoiding the worst risks. It’s hard to manage a portfolio (i.e. cut the worst risks) when also growing it rapidly from a small base.
  • Underwriting: Scale can help the company understand its own loss experience and adjust its underwriting accordingly. When companies start, they assess what risks are good or bad using industry data and place bets that certain segments are more attractive, thus targeting those segments or distributors that target them. As the company gathers data on the performance of its own book, through time and scale, the company can adjust underwriting and pricing to attract customer segments that perform particularly well for its particular business model. Again this has a trade-off against growth.
  • Mathematics: The law of large numbers will cause actual loss ratios to converge closer to the expected loss ratio. This isn’t really the loss ratio scaling down, but rather limiting the probability of a single really bad loss poisoning a year’s results.

However, when an insurer says that “we are indifferent to the level of claims” and then turns in a loss ratio that is double a sustainable level, investors should ask themselves, “What if they really are indifferent?”

See also: Why Financial Wellness Is Elusive  

Conclusion

We have been grateful for the positive feedback on our first article covering 2017 results, with both startups and incumbents featuring highly on the list of companies whose employees read the article. So far, 2018 results do not lead us to change our conclusions from 2017.

The three companies we’ve analyzed have several years of cash on hand, during which time they will probably continue to grow rapidly. They will probably improve their loss ratios, and expense ratios will scale down. The question is whether the figures get to a sustainable level. We won’t know for a few years whether these daring start-ups are really ground breakers or just expensive follies – as long as they are not acquired in the meantime. We’re cheering for them and think that we will see rapid growth and also profitability improvements in future quarters.

We were asked a few times about other companies, particularly in non-U.S. markets. Many countries have similar filings to the U.S. statutory filings, but we’ve not published anything on them yet. Also, agencies and brokers typically do not file public financials. We have begun to observe a trend, such as with Next Insurance, of insurtech agencies converting to carriers or at least exploring the idea seriously. There are many reasons why this makes sense at a certain point in a company’s development, and it will provide more insurtech carriers’ financials to analyze in years to come.

To be notified of future articles, please follow Matteo and Adrian Jones on LinkedIn or subscribe to Insurance Thought Leadership’s Six Things weekly newsletter. You can also find us at the leading conferences, including:

Adrian: Plug and Play Summer Summit in Silicon Valley, InsurTech Insights in London, Rendez-Vous de Septembre in Monte Carlo and InsureTech Connect in Vegas.

Matteo: InsiderTech London, Connected Insurance Summit in London, InsurTech Insights in London, NAIC Insurance Summit in Kansas City, Rendez-Vous de Septembre in Monte Carlo, Annual North America Re/Insurance Conference in New York and InsureTech Connect in Vegas.

Insurtech Now Hits Corporate, Specialty

When insurtech sprang to prominence in 2015, most startups focused on personal lines disruption. Our August 2016 infographic showed that 75% of insurtechs were targeting personal lines and that 56% were focusing on distribution. Most corporate and specialty insurers concluded that insurtech presented no threat and only limited opportunity and continued with business as usual.

That was then, and now is now. Insurtech now matters for corporate and specialty insurers.

(Incidentally, we agree with the point Adrian Jones, head of strategy and development at SCOR, makes in this excellent article: it’s a myth that insurtech has been around only since 2015. We do, however, believe that there has been a new thrust since then, harnessing the pace and power of new technologies.)

2015-2017: The first wave of insurtech

It is not surprising that insurtech started as a personal lines disruption play. Entrepreneurs, buoyed by what was happening in fintech and other industries, saw huge opportunities to make insurance more customer-centric based on their own experiences. Entrepreneurs wanted to simplify insurance (e.g. Sherpa), offer more tailored propositions (e.g. Bought By Many) or change the whole insurance paradigm (e.g. Guevara).

But the truth is that insurance has not been disrupted over the last three years, and it’s hard to see that this is about to change. As Adrian illustrates in another article, even the most prominent disruptors in the U.S. (Lemonade, Metromile and Root) are finding the going tough and burning through a lot of capital, whether directly or via  reinsurance.

See also: Digital Playbooks for Insurers (Part 1)  

We argue in our insurtech Impact 25 paper (February 2018, page 7) that many distribution insurtechs are not scratching sufficiently major customer itches to be worth the switching cost for those consumers. As a result, the perceived potential is worrying incumbents far more than their actual performance to date.

2018: The second wave of insurtech

If we were to update our insurtech landscape infographic, supplier insurtechs would feature much more prominently. These companies are developing technology (or, as in the case of German insurtech Kasko, have repurposed consumer propositions) to help incumbent insurers, reinsurers and brokers operate more effectively. Supplier insurtechs have found getting traction in consumer markets tough and are developing technologies or techniques that they can sell to the established insurers.

Many of these companies are targeting corporate and speciality underwriters. This is perhaps not surprising – at least not from the U.K. perspective. U.K. personal lines insurers have been investing in pricing capabilities, efficiency and fraud analytics for years as competition has become cutthroat. They are mostly advanced in many areas.

This is in strong contrast to corporate and specialty classes, where much underwriting is still judgment-based, processes are manual and underwriters and risk managers are resigned to poor data quality. As such, we believe that many of the Impact 25 Members can be valuable for corporate and specialty underwriters in 2018. Some examples are below:

  • Insurdata was set up by ex-RMS executive Jason Futers and helps (re)insurers obtain more accurate building location information. This is helpful for underwriting (e.g. commercial property, reinsurance portfolios), risk management and portfolio reviews.(websiteImpact 25 two-pager)
  • Risk Genius uses AI to read policies and understand coverage. Founder Chris Cheatham noted recently. “[My trip to] London was amazing. It took two days for one very big learning to sink in: Underwriters in Europe are empowered to manuscript with little or no formal approval process.” His business allows corporate insurers to get a better understanding of their exposures.(websitetwo-pager)
  • Flock is an analytics platform currently used to price drone flights dynamically, for example taking into account hyper-local weather conditions and locale of flight. The technology’s ability to process big data quickly could be helpful for commercial IoT propositions, for example. (websitetwo-pager)
  • Cape Analytics and Geospatial Insight generate underwriting or claims insight from aerial imagery. This is useful, for example, in natcat losses when (re)insurers need to assess their exposures quickly. (Cape Analytics: website2-pager; Geospatial Insight: websitetwo-pager)

See also: Have Insurers Lost Track of Purpose?  

What it means for corporate and specialty insurers

Technology is not, of course, a new phenomenon in corporate and speciality insurance. However, the speed of proliferation of new vendors (of both technology solutions and data sources) is arguably unprecedented. It challenges the corporate clock speed of most incumbents and will present opportunities to successful adopters to tilt industry profits in their direction.

But identifying the correct response is challenging for incumbents and, as we argue in our Impact 25 paper, there is no single, correct course of action. Choices that need to be made broadly fit into three categories:

  • Strategy: Should we focus on customer experience/proposition or efficiency?
  • Technology: Do we build or partner or buy? If we partner, how do we create and protect differentiating IP?
  • Execution: Should we innovate within the business or in dedicated teams? What structures and processes do we need?

These questions – among others – need to be answered to ensure an effective corporate response.

5 Dispatches From Insurtech Island

This article was written with Adrian Jones, a #traditionalindustry guy and insurtech investor who writes in his personal capacity. The authors’ opinions are solely their own, and only public data was used to create this article.

***

All the insurance players will be insurtech,” as Matteo titled his recent book, but some insurtechs have chosen to be insurers. Real insurers. Which means they file detailed financial statements. These obscure but public regulatory filings are a rare glimpse into the closely guarded workings of startups.

Full-year 2017 filings for U.S.-based insurers were released earlier this month. Here’s what we found:

  1. Underwriting results have been poor
  2. It costs $15 million a year to run a startup insurtech carrier
  3. Customer acquisition costs and back-office expenses (so far) matter more than efficiencies from digitization and legacy systems
  4. Reinsurers are supporting insurtech by losing money, too
  5. In recent history, the startup insurers that have won were active in markets not targeted by incumbents

We explain and show data for each of these points in this article.

Context and Sources

The most notable recent independent U.S. property/casualty insurtech startups that operated throughout 2017 as fully licensed insurers are Lemonade, Metromile and Root.

Out of hundreds of U.S. insurtech startups, only a few have taken the hard route of being a fully licensed insurer. The lack of interest in becoming a regulated insurer is evidence against disruption evangelists who say that insurers are going to disappear or be killed by GAFA (Google, Apple, Facebook and Amazon).

Despite the lack of interest, being a fully licensed insurer may prove to be a more durable business model than the alternatives like being an agency or otherwise depending on incumbents, and the three carrier startups that we analyze all have strong teams with powerful investors. Adrian has previously argued that being a fully licensed insurer may actually be the best long-term strategy – See: Six Questionable Things Said About Insurtech.

The filings we reviewed are called “statutory statements.” and only insurers file them, not agencies, brokers or service providers. Statutory statements provide many of the traditional KPIs of insurance companies. Startups may use additional internal measures as they scale their company. Statutory statements typically do not include the financials of an insurer’s holding company or affiliated agencies, and companies have some flexibility in how they record certain numbers. But for all their limitations, statutory figures have the benefit of being time-tested, mostly standard across insurers and measuring critical indicators like loss ratio and net income.

See also: Innovation: ‘Where Do We Start?’  

Though the public can access statutory statements, it’s not always easy. Some insurers post them online, even private insurers. This is an area for improvement by both the #traditionalindustry and the startups that tell tales of “transparency” but don’t upload their statutory statement.

The statistics

Here are the key stats on three companies – from top line to bottom line:

*The company has gross paid-in surplus of over $31 million so this figure is probably low. **Excludes a write-in for “revenue from parent for administrative costs,” possibly a way of topping up the company’s surplus

A combined ratio greater than 100% usually means a loss. Combined ratio doesn’t include returns from investing insurance reserves, but the days of double-digit bond yields are long gone. In a low-rate environment, investment income can’t offset poor technical results. The ratios are typically calculated on net earned premiums, but we also show a row where the expense ratio denominator is total direct premiums written, which may be more appropriate for growing books.

Observations:

  • Lemonade
    • Considering the statutory top line before reinsurance of $8,996,000 of gross premium written, it’s unclear how Lemonade calculated that “our total sales for 2017 topped $10 million.” The premiums reported by Lemonade may already have deducted the 20% fee paid to the affiliated agency – the parent company’s only source of income due to the giveaway model. (This would also explain why there is no commission and brokerage expense showing.)
    • Lemonade claims to have insured “over 100,000 homes.” If we assume that this figure includes rented apartments, then it implies premium written per policy of $90, or $7.50/month, if premium written is based on an annual policy.
    • Lemonade’s giveaway does not appear to be separately disclosed. Nonetheless, one of the brilliant aspects of the business model is the fact that even with a 791% combined ratio, Lemonade still has at least one or two pools doing well and thus enabling the PR of a giveback.
  • Metromile
    • As the oldest startup in this group, Metromile has by far the highest premium, but the loss ratio is still nearly 100%. The expense ratio appears to have scaled down to a reasonable number, but the company puts $7 million of expense into “loss adjustment expense,” which may flatter the expense ratio.
  • Root
    • As with Lemonade, the loss ratio around 160% is cause for concern – is this a few volatile claims (bad luck) or a problem with pricing? Time will tell.

A few other notable companies are worth a mention:

  • Berkshire Hathaway Direct Insurance sells online via biBERK.com but isn’t a venture-backed startup. They wrote $6.4 million in premium last year, their second year of operations, most of it workers’ compensation. Their loss ratio gross of reinsurance was 124%.
  • Oscar is a startup brought to you by Jared Kushner and others who have plowed in $728 million already, with more funds being raised currently. Oscar shows no signs of profitability in its three main states:

1. Underwriting results have been poor

All three companies have a gross loss ratio of near 100% or higher. (For reference, the industry average in 2016 was 72%). That means they have paid $1 as claims for each $1 earned from policyholders in the last 12 months.

An insurance startup has to prove two critical things:

  • Does the underwriting model work?
  • Does the distribution model work?

We’ve been in debates over which is more important, and we always start with underwriting, because it takes no special talent to distribute a product that has been poorly underwritten (i.e. selling below cost). Underwriting quality/discipline is one of the “golden rules” of the insurance sector. Disrupt it at your investors’ peril.

Underwriting returns have generally been poor, in some cases awful (double the industry average counts as awful in our book). Poor results are to be expected at first, even for the first several years. A single big loss can foul a year’s results in a small book. It can be hard to tell if that single loss is an anomaly or a failure in the model. Building an underwriting model is like playing whack-a-mole with a year’s time lag. Sometimes it’s difficult or impossible to address even widely known underwriting issues.

2. It costs $15 million a year to run a startup insurtech carrier

All three companies incurred right about $15 million in run-rate expenses last year, of which $5 million to $6 million is headcount expense. It may be possible to keep the overall expense total closer to $10 million if one is especially lean, but the cost of operating in a regulated environment and building a book quickly mount.

Some startups have organized as a managing general agency instead of a carrier. Thus they pay a “front” a fee of around 5% to produce their policies. However, even MGAs are state-licensed entities that are subject to most of the same regulation as carriers, so the expense saving of being an MGA is only a true savings at small volumes.

The upshot: The capital raises of around $20 million to $30 million that we have recently heard about may only be good for around two years of operating expense, before any net underwriting losses.

See also: Insurtech Is Ignoring 2/3 of Opportunity  

Scale matters in insurance and venture capital, but it’s a double-edged sword in insurance. Scaling too quickly without underwriting excellence magnifies underwriting losses, but staying too small leaves the book volatile and the expense ratio high. Some startups have been active for several years and have not yet scaled, or even saw a reduction of premiums in the last year, but this may be better than scaling without sustainable underwriting results. Future financial statements will tell if any of the new players will gain a sustainable market share in a major business line in the U.S., or at least in a niche.

3. Customer acquisition costs and back-office expenses (so far) matter more than efficiencies from digitization and legacy systems.

Insurance investors need to understand back-office expenses and distribution expenses, both of which are typically fixed costs for startups distributing directly to consumers. Here’s a look at what the three property/casualty insurance startups are spending money on. Beware that holding company expenses and affiliated agencies may or may not be reflected in the figures below, depending on the intercompany arrangements in place.

*Likely included in commission and brokerage expense, which is net of $2.1 million ceded to reinsurers **Largest write-in item is “other professional services” at $891,000. ***Includes $1,958 of unpaid current year expenses and write-ins like “other technology” and “contractors”

Observations:

  • Lemonade:
    • This startup is spending almost $1 in advertising for every $1 of premium they wrote ($7.7 million of advertising for $9 million of premium written). Again, if we assume Lemonade has insured 100,000 homes and apartments, then the customer acquisition cost (CAC) assuming only advertising expense is around $77. This is probably a measure that encourages the company’s backers, because the CAC of a renewal policy written directly is minimal, and the industry-average churn rate is single digits in U.S.
    • The regulatory and overhead costs are considerable – notice lines like legal and auditing; taxes, licenses and fees; and some of the salary expense.
    • The volumes have to continue to grow exponentially for some years to get the cost base (also net advertising) lower than the 20% of the premium required to make a profit for the parent company (for reference, the market average expense ratio was 28%). Recall that Lemonade’s parent or affiliates take a 20% flat fee up front for their profits and expenses and gives to charity anything left after paying claims and reinsurance.
  • Metromile:
    • Has the highest tax expense, perhaps because it is selling the most, with many states charging premium tax as a percentage of the policy value.
    • Their “legal and auditing” expense is probably much higher but is put into “other.”
    • Note the absence of advertising expense but large commission and brokerage expense, partially ceded to reinsurers. Accounting treatments, as ever, can vary by company.
  • Root
    • The company’s small volume makes it difficult to run the same absolute expenses as Lemonade and Metromile, but it might not be wise to grow a book running a loss ratio of more than 150%.
    • Has no telegraph expense (woo-hoo!).
    • Unclear why the company has almost $2 million of unpaid expense.

Advertising expense vs. pricing. Old-fashioned insurance agents are a variable cost that scales up with the business – the agent absorbs fixed advertising, occupancy and salary costs in exchange for a variable commission. But in the direct distribution models favored by many startups, variable costs and agents’ costs become fixed costs borne by the startup. (True, some can be kept variable, as we discuss below.) Fixed costs need to be amortized over more premium volume, which requires yet more fixed costs (e.g. advertising) to solve.

Insurtech carriers from the dot.com era like eSurance and Trupanion are still investing heavily in advertising and producing losses or barely breaking even. They would probably argue that they could eliminate much of their expense and “harvest” an attractive book of business for years to come – which may be true. The U.S. churn rate in personal auto and home insurance can be as low as single digits, far lower than many Western countries. Because customer-retention cost is much lower than customer-acquisition cost, loyalty is absolutely critical to non-life insurers, particularly in a direct distribution model. (Bain & Co. – both of us are alumni of this consulting firm — has done excellent work on loyalty in insurance.)

It is tempting to acquire insurance customers by underpricing and later transforming them into profitable customers. A loss ratio of more than 100% implies a pricing problem, not a problem with the underwriting model. Insurers with a customer base that came for cheap insurance and expects it to continue will find their market vanishes when they begin repricing to bring loss ratios to acceptable levels, destroying any value from customer loyalty and forcing a pivot to a new value proposition. In some cases, it may be necessary to double prices before underwriting price adequacy can be achieved, even ignoring expenses. (Most U.S. state regulators also have broad powers to disapprove, block or roll back rate increases – for more on the maze of state regulation, see this study from the R Street Institute.)

The API approach – a B2B2C model based on distributing the product through the digital fronts of third parties – has become “the new black” to transform fixed acquisition costs in success fees linked to the volumes. This model shows promise, provided that distribution partners do not extract too much value from the competitive insurance market.

The point for founders and investors today is to be prepared mentally and financially for a long road to profitability with tens of millions sunk before it becomes apparent whether the underwriting works and whether the relationship between CAC/distribution, fixed expenses and customer loyalty can produce a sustainable and profitable business.

4. Reinsurers are supporting insurtech by losing money, too

Some members of the #traditionalindustry have strongly supported the development of insurtech through investment in equity, providing regulatory capital, providing risk capacity and sharing technical expertise. Startup insurers typically are reliant on reinsurance as a form of capital because (1) it can be cheaper than venture capital, (2) startups typically need reinsurance to hold their rating and (3) the strong backing of a highly rated reinsurer shows validation of the company’s business model, just like the backing of the best VCs provides.

The carrier model has real advantages concerning reinsurance: reinsurance is easier to arrange and more flexible than an MGA relationship. Many successful agencies find that their economics would be better if they were able to retain some of the risk they produce instead of writing on behalf of a licensed carrier and ceding that carrier all but a commission.

Here is a look at results disaggregated for reinsurance:

(Source: Schedule P; subject to minor variations compared to prior tables)

Observations:

  • Lemonade seems to have a great reinsurance scheme, but they have to hope that reinsurers continue to take $5 in losses for every $1 in premium ceded to them. The amounts ceded are small, and Lemonade has a big panel of reinsurers.
  • Metromile and Root do not appear to get much loss ratio benefit from their reinsurance.

It is a great experience for a giant reinsurer to work with a small and innovative startup. The expected losses in dollar terms are negligible if compared with the value of the lessons learned, the culture created and the halo the reinsurer may partially claim. Startups need to find reinsurers that are both flexible and prepared for losses, potentially for several years. But startups cannot count on reinsurers to take losses forever.

5. In recent history, the startup insurers that have won were active in markets not targeted by incumbents.

Since 2000, at least 34 property/casualty insurers were formed in the U.S. without the aid of a powerful parent and earned more than $10 million in premium in 2016.

Of these 34 startup insurers:

  • 21 specialized in high-volatility catastrophic risk like hurricanes or earthquakes. Incumbent carriers have largely stopped or greatly limited their new business in certain catastrophe-exposed regions, sometimes because they felt that regulators or competitors (often government-run pools) did not allow them to charge adequate premiums.
  • Nine were motor insurers, mostly non-standard motor. Non-standard means bad drivers, exotic cars or other risk factors that “standard” carriers avoid.
  • Two don’t have a rating.
  • Two remain: Trupanion (a pet insurer) and ReliaMax (which insurers student loans).

Adrian readily acknowledges that some carriers aren’t picked up by his screen, such as financial lines companies like Essent. Essent is a Bermuda-based mortgage re/insurer that wrote $570 million of premium at a 33% combined ratio in 2017 after a standing start in 2008 – which might be the most successful U.S.-market insurance startup in the last decade. Other startups were sold along the way, were sponsored by a powerful parent or purchased an older “shell” and inverted into it.

The point is that successful insurers have rarely won by attacking strong incumbents in their core markets. They have won by figuring out ways to write difficult risks better than incumbents, have created markets (like pet insurance) or have entered seriously dislocated markets with good timing (like writing mortgage insurance in 2009).

This leads to several questions:

  • Are urban millennials actually a new market that is being ignored by incumbents?
  • Are direct and B2B2C distribution really new markets that incumbents cannot penetrate? Can “platformification” be profitable over the long term?
  • How quickly can new/digital systems show cost and pricing benefits over legacy systems that incumbents are retooling aggressively today? How long before the new systems become a legacy for the newcomer that created them?
  • Are new underwriting and claims techniques like the use of big data sufficiently disruptive to allow entry to tightly guarded markets?

There are early signs that all of these questions will be answered favorably for at least a couple of startups but not without some bumps along the way.

See also: Insurance Coverage Porn  

Previous waves of technological changes have allowed new competitors to rise to prominence – think of the big multi-liners that dominated the skyline of Hartford CT with mainframe technology in the ‘50s and ‘60s, the specialists like WR Berkley built on personal computers in the ‘70s and ‘80s and the Bermuda CAT specialists of the ‘90s and ‘00s. Will the next wave of technology-driven insurers include the ones today putting up 150%-plus loss ratios? Perhaps.

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Conclusion

Technology changes a lot, but it doesn’t change fundamental facts that make insurance hard. As we said at the start, we admire and support the companies that choose to become fully licensed insurers. They have taken the harder path to market but may be more durable in the long term. We think commentators should be very careful before criticizing startup insurers for not having great performance on the loss ratio and expense ratio in the first few years. We also think companies need to be careful about overselling the awesomeness of their business model too early.

To use Matteo’s 4Ps framework to judge any insurtech initiative – from startups or incumbents, we have yet to know whether/how new challengers can leverage technology to outperform incumbents on technical profitability, productivity, proximity with the clients and persistency of the book of business. Whoever is capable of doing this will survive and may be the next big winner in insurance. Insurtech startup carriers, their investors and their reinsurers need to be prepared for a long and expensive startup phase. Insurance is a get-rich-slowly business, but it is also a durable business that rewards patience, wise risk-taking, data analysis and operational excellence.

And for the futurists, disruption evangelists, black swan hunters and anyone who just learned more about insurance than you ever wanted to know, we hope these dispatches from insurtech Survival Island have been informative for examining startup financials in insurance or other markets where you operate.

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