Long ago, I wrote about economic rents in insurance. It was actually my first insuretech post. I have to say it has aged very well. If you weren’t a reader back then, I humbly suggest, you go back and check it out.
Today, I want to expand on it. Because while the main theme still holds – that all the rents from innovation go the consumer, not the insurer – the last few years have shown there are others who benefitted too, largely as a result of misallocation of capital and poor incentive structures.
I will reveal some of those misguided incentives at the end, so make sure you stick around for the punchline (there’s even a fun chart!). The teaser is while you’ve likely heard of the Prisoner’s Dilemma, you may not have heard of the Founder’s Dilemma.
The Concept of Rents
Let’s first do a quick review of economic rents from the earlier piece for those who don’t remember your Econ 101.
Rent is a proxy for profit. It basically is profit above a market norm.
If you produce a commodity like corn and you sell it at the market price and your production costs equal that of the average farmer, you have created no rent. If you used technology to lower your production cost, that difference means you have created rent while your neighbor farmer still has none. Similarly, if you can find a way to sell above market, you have created rent (think of the gas station owner who raises prices before the hurricane hits).
Most good businesses have created rents. They either can produce cheaper or sell at a premium. Perhaps they have a distribution advantage or a popular brand.
If, on the other hand, your business produces no excess profit, this means all the rents went to the customer. Think of a business that introduces a new feature, but isn’t able to raise its price. In this case, the customer captured the rent.
Insuretech Rents
As we all now know, most of the original insuretechs didn’t create a lot of value for investors. They did create a lot of value for others though!
While my original article explored how economic benefits are competed away over time, so that little sticks to the insurer, a new form of rents also emerged. This one was straight wealth transfer.
Think of delivery services underpricing their service to gain market share. This land grab was all a straight transfer of rents from business to consumer.
One way to characterize it would be to say innovation creates rents that are competed away, while irrational growth plans create rents that are given away.
I think it’s fair to say, in insuretech, more rents were given away (thanks to free capital!) than competed away.
With that background, let’s assess who captured the rents from the insuretech value chain.
The Consumer
The most obvious beneficiary was the consumer, as I previously predicted. However, it didn’t occur in quite the same way as I expected.
I expected most of the rents to come through consumers finding value in the products being sold or the service being provided without having to pay more for it (i.e. competed away). Instead, we saw rents flat out given away through underpriced product as startups went on a land grab for market share.
This, unfortunately, muddied the value proposition of the innovation. Did customers buy because they valued the improved offer or because they got a crazy cheap price? Given the retention rates (especially after attempts to raise price in response to belated recognition of their mistakes), it certainly appears most customers were in it for the unsustainably cheap deal rather than belief in the value proposition.
The Vendors
Let’s not forget the other beneficiaries of cheap capital. As I’ll discuss at more length in the Founder’s Dilemma section, insuretechs raised a lot of free money they didn’t know what to do with. Some of this went to buying less than necessary products from service vendors.
It would be interesting to know how much of some of these vendors sales came from startups with cash to burn. One thing we saw after the first tech bubble is when the dot coms crashed, a lot of the service vendors crashed too because they lost their customers.
Will the same thing happen this time? I know B2B is now in vogue with insuretech investors but could they be facing an unpleasant surprise? This definitely bears watching.
Agile Founders
Some founders were able to cash out some of their holdings before everything went funky. The most high profile examples were the Lemonade founders selling around the last stock offering and the recent disclosure that the Metromile founder got a big payday before the company sold out to Lemonade.
I guess we would call this misalignment of interests? Regardless, some founders found ways to capture rents from their companies.
The Employees
Next is the group that has gotten the most attention of late: the employees. All the headlines about insuretech layoffs get a lot of reaction and for good reason. It’s obviously unfortunate when people lose their jobs.
Fortunately, we’re still in a pretty good hiring environment where people will hopefully land on their feet pretty quickly. That said, there was pretty obviously a hiring bubble that went along with the valuation bubble.
Much of the money raised went to adding employees, many of whom were never really critical to the business. The revenue per employee at insuretechs was abysmal by any standard and should have been a giant flashing warning sign.
I know I can’t be the only person who has heard stories from friends at startups who would say “I don’t know what half these people around here do all day”. I mean wasn’t tech supposed to create efficiencies? Shouldn’t tech innovation have resulted in fewer, not more, employees?
The truth is people were hired because founders had to tell investors why they needed more money. Unfortunately, the growth in headcount was a side effect of the valuation game I’ll describe momentarily. Many of these new employees were chess pieces used to improve valuations.
That may sound crass, but that does not make it less true. People’s futures were no more than game pieces on a board. But hey, at least they got paid well while the ride lasted! I’m not sure that is much condolence to them.
A Broken Game
If you’re wondering, how come nobody stopped this irrational behavior? Well, for one, people can be irrational and not be aware of it. But, the bigger reason is that it was short term rational for those playing the game, namely the investors and the founders.
It all goes back to the fatal flaw in how insuretechs are valued. The big secret is nobody has any idea how to value them because they have no profits or, in most cases, prospects thereof.
We have tried silly alternatives like revenues, customers, founder ego, and other nonsense, but the truth is insurance companies need to be valued either on book value or earnings.
Given the lack of a coherent valuation approach, often what happens is something equivalent to backsolving. Founders figure out how much money they need to keep growing. They then look at what the typical dilution is for the next round and back into a valuation (by dividing the raise size by the percentage of the company they expect to sell).
Founder’s Dilemma
Which brings us to the Founder’s Dilemma. If that valuation is too low, they have two choices:
– tell investors they will sell a smaller piece of the company and ask for the valuation they think they deserve or
– decide they will raise more than they need to look more “normal” and justify the valuation.
In other words, if you say you only need $25M, you’re not going to get valued at $1B. You’re just not. If you say you need $100M, then you probably will.
This is the crux of our problem. The incentive is to raise money that will ultimately get destroyed.
And yet, you can guess most founders pick the top left quadrant as it’s easier to convince investors to believe your buffed up spending plan is legit than to convince them they should buy a smaller stake. Once they commit to this path though, they have to explain why they need all this extra money.
And that’s where you get all the faulty decisions laid out above. They either underprice the product to subsidize sales, they hire more people than they need, they buy third party products that are nice to have, not need to have, and so on.
In other words, they forget the key lesson of the Hare: if you are going to focus your business model on cheap capital, you need to spend that capital wisely to accelerate your development! If you waste it all on things you don’t need, you missed the whole point of the exercise!
Choosing the higher valuation and hoping for the best is not a strategy. It’s a gamble. And when the dice don’t fall your way, there are consequences.
Unfortunately, those consequences are often borne by the employees who were largely naïve to these games going on behind closed doors and didn’t realize their jobs were more tenuous than they appreciated when they signed on.
Rent Creating Innovation
I will finish with the thought that I ended the original piece with.
True innovation is the willingness to do something different and hard rather than copying what everyone else tells you is innovative but nobody can explain why it actually matters.
If you do that, you will create rents and those rents will lead to profits. And then, lo and behold, you can be valued based on your merits, rather than how much you commit to spend.
Over the last four years, I’ve saved over $3K in abnormally low insurance premiums. I didn’t purchase insurance from these companies because I valued innovation – I did it because I could see their rates were WELL below market. Thanks for the rents!
So true and well said. What baffles me is how investors got suckered into this and actually believed the valuations that the so called “Insurtech” showed translated to FinTech or pure tech type valuations. I keep going like a broken record, but if no principle of fortuity/no insurance needed. Sure, Insurtech did create some process improvements and bought down the expense side of the combined ratio a bit, and incumbents/traditional carriers worldwide heavily invested into technology and automated/automating their own processes, but they have the balance sheet strength to handle lot of that. Interesting times for sure.
Hi Ian, great post. one feedback point:
You don’t seem to factor the role that expected growth plays into valuation. Incumbent carriers are valued on current book because they are not growing at inflation (so 0% value growth). Insurtechs promise a ton of growth. Value is simple: its EBITDA X GROWTH against required return on capital (which is basically also what alternatives are out there) with a good dose of sentiment. What was out of the control of insurtechs is that the alternatives just got A LOT better (with the interest hike) and that sentiment is way down. What was in their control that made this much worse for insurtech compared to the field is that high loss ratios were proven not transitory (small book effect) which tells investors that (a) growth was artificial (rents were given) and (b) that EBITDA is not likely going to be there. Increase in reinsurance cost of capital (for a number of reason out of their control) further impact prospects of EBITDA or on ability to leverage cash for growth (instead of reinsurance you can use your own equity for reinsurance but than you can’t use it for growth).
But the basics remain: if you can prove strong growth in a very large market, with sustainable margins, you can still create a lot of enterprise value. Just be careful not to get over your skis.
Yes, very fair. I certainly agree that’s how they should be valued but most of these companies struggled to show any prospect of + EBITDA in any near to medium term time frame. Even before it became clear many were writing bad business, the spending was so out of control that + EBITDA was unlikely. So clearly investors were using something other than the prospect of future EBITDA growth.
It would be great if investors were demanding a path to + EBITDA and strong margins rather than the obsessive focus on revenues. I can tell you our internal models for Informed from the very beginning were always centered on getting to EBITDA + and maximizing our ultimate margins. I can’t tell you that any investor I have talked to has asked about those metrics, even now.
I agree – insurance industry is suboptimal for VC style investments (with corresponding growth expectations). A few rambling thoughts:
– ton of innovation is in taking costs out of the system (e.g. claim automation, desktop underwriting, etc) – it has a ceiling on how much savings is available and correctly stated, often passed on to the customer.
– Growth is tepid as a whole (related to products that help derive new business – majority of those help carriers take business away from each other, but it is a zero sum game) – the industry is heavily regulated in favor of customers for admitted lines, and non-admitted is just not that much of the total pie and spends too much on distribution. Organic industry growth through new product development is super slow and volatile (regulation and UW performance – e.g. Cyber)
Typically, trajectory of VC expectations associated with growth is never in line with speed of insurance company adoption of 3rd party services and products.
So it is all about timing the market and orchestrate a correct exit. The insurance metaphor is the carrier or reinsurer sector that covers FL property.. It is always a matter of time before a third of those companies go out of business, but still they pop up and if they hit a few quiet hurricane season – they get out and make a bunch of money.
There is a reason historically new insurance businesses were funded by PE, not VC. The trouble with that is it required a level of scale that wasn’t always necessary.
So it’s helpful that VC is now more active, but it does require a different mindset than they use in other industries and I’m not sure many of them have completely grasped that yet.
There is a realization that the growth at all costs model doesn’t work and needs to change, but I don’t think most have figured out what the alternative is yet (it’s pretty clearly maximizing growth over a medium rather than short term horizon but that realization has been slow).