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Inside in Full: InsurTech freefall – don't look down

If you went to an insurance conference in 2014, you would have heard about these newest entrants to fintech called InsurTechs...

These fintechs and accompanying seed investors would have excitedly talked about how they were going to disrupt the industry using machine learning and AI. The legacy industry was too slow to change and was still running on antiquated technology, and this created a huge untapped business opportunity.

When selling insurance, you are faced with the classic problem of figuring out the cost of goods sold. You write a policy today with an expectation of what the actual cost of goods sold will look like down the road. Often, these costs can be materially different to your initial expectations. Further, what you might foresee as profitable growth can very quickly turn into an adverse selection.

InsurTechs were supposed to change the world. But here we are in 2021 and it hasn’t quite turned out as expected in 2014.

Fast-forward and InsurTechs are dealing with trading multiple compression, elusive profitable growth, a cash crunch, large catastrophe losses, heavy dependence on reinsurance and an even more crowded list of entrants.

Legacy insurers were supposed to be running around in panic as the new class came after their total addressable market (TAM).

In our note last Friday, we talked about our somewhat cautious take on some of the factors that InsurTech seed capital providers look at when evaluating these investments.

That said, several InsurTechs did go public with much fanfare. It has been a rocky start. Yes, tech stocks are inherently volatile vs. stocks for a mature industry like insurance.

But something more seems to be going on here, with InsurTech names down 40%-60% from year-end, and seemingly in free fall – particularly relative to their still-higher February peak.

  

 

InsurTech stocks under pressure

InsurTech stocks continue to lag while legacy insurance stocks have already made up for the Covid-induced sell-off and are continuing to ride on stable business trends and benign loss costs. That said, these InsurTech names still trade at high multiples vs. the traditional peer group.

Tech as a disruptor is always an intriguing concept – but for every Tesla, Airbnb or Twitter, there is a Theranos, Moviepass or Segway.

Crucially, we are still in the prove-it phase for these InsurTech franchises.

We believe a combination of lofty valuations, sector rotation, unrealistic Street expectations, short interest pressure and a delayed path to profitability will result in several questions for this base.

These questions include:

(1) Will there be a need to raise capital if losses continue to impact balance sheets?

(2) How will this capital be raised without diluting existing owners?

(3) If capital is conserved, how will it impact the growth trajectory?

(4) If InsurTechs raise rates in the lines of business they write, how they will achieve their growth objectives?

(5) Will growth slow due to rate as well as competitive pressures from the legacy incumbents?

(6) Does the market force these companies into a reactive mode?

These are tough questions, and there are no easy answers. The time to answer these questions might be sooner than initially anticipated – with the InsurTech names off 40%-60% year-to-date.

Yes, macro changes are underway, which are adding to pressure on tech stocks. Traditionally, legacy insurance names fall under value investing, while tech and InsurTech names fall under growth investing.

Growth stocks are generally more expensive and trade at higher multiples to their sales, reflecting anticipated meaningful sales growth. They are also more volatile. Value stocks are perceived to be less expensive and trade at relatively lower multiples to their sales or revenue. They are less risky and the focus is on profitability.

Over the past five months or so, as shown in the chart below, there has been a shift from growth stocks to value stocks. This sector rotation is likely exacerbating the pressure on InsurTech names, but as we discuss later in this note, it is likely this is a smaller factor weighing over this space.

  

 

Growth stocks investor base might be having second thoughts

Lemonade trades at 40x forward revenue projections, Metromile at 10x and Root at 3.4x. These revenue multiples are materially higher than the value peer group such as Travelers at 1.3x, Allstate at 1x and Progressive at 1.3x.

What about some of the tech names in the growth sector? Using a sample of names cited in sell-side analyst notes: Zoom trades at 35x, Trupanion trades at 5.3x, Lyft trades at 8.2x, Carvana trades at 2.6x.

Comparing with some of the tech stocks makes these names look cheap!

Although seeing them that way will involve forgetting the pesky problem of goods sold.

Let us take this a step further. Comparing InsurTechs to new and established tech is an exercise rife with mis-steps and should be done with a dose of caution.

Unlike tech companies, carrier InsurTechs will be faced with estimating future losses. This lag and the difficulty in entering/exiting states and markets will differentiate the growth trajectory from the initially planned one.

This is not the InsurTech’s fault. This is how any regulated industry works.

So, there is a likelihood that growth investors lose faith in the original thesis as they struggle to deal with concepts such as adverse development, catastrophe losses and persistently high acquisition costs.

  

 

A recent refrain has been that InsurTech stocks have sold off because of poor results in recent quarters. That would make perfect sense if the investor base were heavily focused on insurance to begin with.

That is, in fact, not the case. Let us look at who owns the InsurTechs names to begin with.

An examination of Lemonade, Root and Metromile owners shows that it includes the usual who’s who of growth investors. On the other hand, Progressive and Allstate investors include the usual names one sees in financial shares.

So, what exactly is going on here? Who’s selling the InsurTech stocks? Are the growth investors beginning to have misgivings already?

We doubt the answer is that simplistic. However, there is a gnawing awareness that you cannot grow out of your troubles in a regulated industry. Nor can you easily abandon a regulated industry.

So, now you are trapped in this industry while you continue to fine-tune your model. It seems likely that growth investors are having some doubts on the grow-at-all-costs model in a regulated industry.

At the same, traditional insurance stock investors will continue to wait and watch and would likely dip in and buy these names when these companies have a clearer path to profitability.

  

 

Path to profitable underwriting remains elusive

If you compare underwriting performance of InsurTechs with the legacy insurance carriers, a huge disparity exists. InsurTech investors would be right to call this comparison unfair.

After all, these are early-stage companies who will continue to fine-tune their businesses and eventually move to a mature phase of business. The problem is that you are depleting your capital base fast. And if that is the case will you run out of capital by the time you can learn how to profitably run your business.

  

 

Retention continues to be an uphill battle

In the past, we have talked about the discussion on lifetime value (LTV) and customer acquisition costs (CAC).

We have talked extensively about the problem with churn and how CAC can be notoriously hard to rein in if you continue to lose customers. Over time your LTV should be a multiple of your CAC or else in theory you are losing money on every customer and will continue to burn capital faster than you can reinvest.

So, retention becomes important once you have acquired the customer. Although Lemonade is in a different cohort, the gap is meaningful wide when comparing Allstate with Root and Metromile. Continuing to replace your base while growing is like walking and chewing gum at the same time.

There has been some debate in the industry on how similar the new InsurTechs are to non-standard auto players, picking up an insight first made by the Inside P&C Research team when Root was going public.

Non-standard auto consumers might be younger, look for minimal coverage, and churn at higher rates. It’s a tough business and some carriers have taken decades to get it right.

With many of these customers younger, and attracted by a quick turnaround and a better user experience, a key question is how this group will react as they get older?

A little segue here to Progressive might be warranted. It wouldn’t be wrong to say that Progressive is a tech company masquerading as an insurance company. It was one of the leaders in tapping the OBD port in a vehicle when it came out with its Snapshot product.

This was a pioneering product which enabled it to study driving behavior and move beyond the traditional risk selection metrics.

At that time it would talk about how it wanted to track individuals as they went about their life/got married/accumulated assets (cars), etc. If you got them early at the right price, they would stick around. Progressive did get it right, and its customers stay with it longer than any other insurer.

It would be tough to make a similar case for the customer base initially attracted to the InsurTechs.

It is unclear why they wouldn’t shift to the usual names such as Allstate, Geico or Progressive, or even look towards bundled auto/homeowners’ products as they go through their lifecycle and accumulate cars and homes.

If that is the case, pressure on retentions will remain unless InsurTechs figure out a way to grow retention, and grow it for the right customer cohort too.

  

  

 

 

Heavy dependence on reinsurance

Historically, when products are launched in the insurance marketplace, an insurance company relies on reinsurance to share the profits and losses. Reinsurance is also a form of capital relief.

Over time, as the product and book matures, an insurer can increase business retained on its own books. So, it would make sense for the new InsurTechs to have reinsurance support.

The reinsurance partners support new companies to build a track record. Over time a company will have a core reinsurance panel and then some opportunistic reinsurance purchases.

However, if reinsurers get hit with heavy losses right out of the gate and if the InsurTech partner is viewed as having less skin in the game, reinsurers will either start charging higher rates or abandoning InsurTech companies. Ceding commissions will also decline, making the metrics worse for the InsurTechs.

In the chart shown below it can be seen that many InsurTechs are barely crossing double-digit retentions – pointing to weak alignment.

 

 

We also compared the top five reinsurers using Schedule F data for 2019/20. It’s too early to see any significant swings in the partners. The story of Munich Re and Hippo is, however, worth considering.

Hippo is an InsurTech which was recently taken public via the SPAC route, merging with Reinvent Technology Partners Z (RTPZ). As an aside, RPTZ is trading at $9.95.

In 2019, Munich Re was Hippo’s reinsurer. Our news team had noted that Munich Re’s InsurTech unit, Munich Re Digital Partners had decided to abandon reinsuring Hippo since it was outside its risk parameter due to the rapid growth.

So it would not come as a surprise if there is a change in seller behavior from its reinsurance partners. As that happens, higher reinsurance costs will compress margins further.

  

 

Note: Mandatory/ voluntary pools were excluded. Root Reinsurance Co. is an affiliated captive in the Cayman Islands.

Double-digit growth expectations across the board

In the table below, we show some of the self-disclosed growth expectations for this group. This should not come across as a surprise since these companies are starting from a smaller base.

The point here is if losses continue to climb, InsurTechs will have to revisit their growth expectations, making them less attractive to the growth investor base due to the challenges of taking pricing and winning new customers, plus retaining existing ones.

  

 

Street expectations are lofty and InsurTechs face multiple pressure if they miss expectations

Related to above, the table below shows the average growth expectations from Wall Street analysts covering the stock. A downward revision to analyst expectations could lead them to revisit their thesis adding to the pressure on this space.

  

 

A continual missing of growth targets coupled with rising losses in the book will lead to likely lowing of target prices, which will go against the growth stock thesis.

  

 

Short interest remains high and has grown

No discussion on InsurTechs would be complete without a discussion on short interest. Apart from the usual long/short case prevalent for any publicly traded stock, InsurTechs also face pressure from dedicated short research firms.

With volatility in the results and the long trajectory involved in proving new tech, InsurTechs will face sustained pressure from other short sellers.

InsurTechs remain the most heavily shorted group within insurance. But how do they look versus some of the tech names discussed earlier?

These other companies do screen lower with Zoom having a short float of 3.8%, Trupanion 7.5%, Lyft 9.9% and Carvana 26.9%.

So, it would appear that our InsurTech cohort is facing greater pressure than some of the tech names out there.

  

 

In summary, InsurTechs continue to deal with lofty valuations, sector rotation, unrealistic street expectations, short interest pressure and a delayed path to profitability. Continued losses and capital depletion could force their hand, causing them to seek additional capital infusions – something which might further delay them taking off.

 

Inside P&C provides unparalleled market intelligence on the entire US P&C market – from small commercial and personal lines right through to reinsurance and Bermuda. Redeem your complimentary 14-day trial for more premium content from Inside P&C.

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