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Inside in Full: InsurTech in 2022 – from hype to reality-check

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Topics: InsurTech Topical Trends

What a difference a year makes. In 2021, we saw buoyant appetite for financial technology firms, which in hindsight encouraged a flurry of “priced-for-hype” InsurTech IPOs and unprecedented levels of global investment...

But over the course of 2022, that scenario has completely flipped, and considering a looming recession, a hawkish Federal Reserve and dwindling access to capital, sentiment among market observers is that conditions are likely to get worse before they can get any better.

Taking a step back, a lot of the discussion this year centered around the cohort of newly public InsurTech carriers being battered. The stock price for Lemonade has nosedived 61.9% year to date and 42.6% plunge from its IPO price. For comparison, Hippo and Root’s stock have dropped 80.7% and 90.9% year to date, respectively.

  

 

The collapse of public market valuations happened on the back of a record-breaking prior year for global investment in the sector. But as the Fed this year began to hike interest rates to combat inflation, the cost of capital increased, and investors were forced to reassess their lossmaking companies.

For InsurTech, this meant that until-then-neglected unit economics were put under a magnifying glass, and outsized valuations for private InsurTechs began to normalize as early as February.

Just looking at figures for the most recent quarter, private company financing volume in Q3 dropped 24% to $2bn from Q2 2022, and 55% from the Q2 2021 peak of $4.6bn, according to a report by FT Partners.

InsurTech financing activity: annually

  

 

Source: FT Parners’ Proprietary Transaction Database

The bloodshed of the last few months has certainly taught InsurTechs and their investors important lessons. Notably, as extensively covered throughout the year, we have seen the “growth at all costs” mantra pivot to “the path to profitability” - a phrase that seemed to echo through the corridors of the InsurTech Connect conference this year.

That also materialized in more tangible ways as we saw companies aggressively trim down costs and revise their business models in response to investors re-evaluating priorities and seeking leaner structures.

But how did we get from cash-a-palooza to ‘tighten-your belts’?

  

 

What happened?

In November 2021, Inside P&C reported that paper providers and reinsurers had begun to tighten capital provision to InsurTech MGAs. Paper-seeking InsurTechs started to feel greater pressure to deliver results, as reinsurance panels became increasingly more selective in their capacity, and the focus pivoted from growth to profitability.

This marked the first sign of the market departing from a somewhat ‘nonchalant’ attitude towards profitability, as many early on had experienced a “fear of missing out” on new InsurTech opportunities.

But like I said earlier, 2021 was still the year of the ‘red-hot’ equity markets for private InsurTechs – lower interest rates acted as catalysts for growth, and venture capital remained abundantly available to those businesses – until it was no longer the case.

Cumulative financing of private InsurTech companies

  

 

Source: FT Partners’ Proprietary Transaction Database

Note: Data as of 10/17/2022, amounts represent cumulative funding for privately held InsurTech companies

It was early 2022 when tech stocks faced a major market sell-off, as investors became wary of higher inflation, interest rate hikes and an economic slowdown.

In January, Kin and TypTap pulled back on their planned public market debut, which pushed investors to look at private valuations, as they realized that an IPO or a SPAC exit were no longer on the table in the short term.

Against this backdrop, it did not take long for investors in the private market to take note, and companies that were once able to raise at sky-high valuations saw hype-driven multiples compress sharply. The VC gold-rush was no more, and companies started to scramble for cash.

We first saw headcount reductions among privately held InsurTechs in June, when Policy Genius announced a round of layoffs. It is understood that the bulk of layoffs occurred around that time, but certain companies had already been implementing headcount reduction programs by quietly managing out 5% to 10% of their staff and restricting hiring to critical roles.

The 2022 VC reversal

This year, a lot has been said about InsurTechs poorly managing their loss ratios. That is fair, as we have seen many start-ups relentlessly push for growth and sideline underwriting profitability. But less is said on how investors pushed founders to overhire and grow irresponsibly.

Historically, venture capital bull markets provide funding to too many companies, which do not necessarily have viable business models, while bear markets in venture capital can work to starve solid companies with strong business models.

  

 

InsurTech investors do deserve scrutiny for their role in promoting rapid growth over unit economics, even if that is the traditional VC ‘modus operandi’.

In a market where money is cheap, a venture capitalist could be willing to lose his money seven out of 10 times, because out of those three, they will score two big wins that will make many times the money lost.

That is a vastly different risk profile from a (re)insurer, for example, who will never make ten times the capital required in one program, and thus can’t afford to bleed.

The combination of unprecedented economic stimulus, overhyped markets, hungry-for-growth investors, and founders who lacked insurance expertise proved to be explosive for InsurTech. As result, many companies were actively encouraged to bloat, overoptimize for growth and became keen on outgrowing valuations that were already inflated in the first place.

But the Fed has now slammed the door on its “easy money” policy to fight inflation, and arguably, that is not changing anytime soon.

  

 

On 14 December, the central bank raised interest rates further by 50bps, noting a slowdown but not a full stop in rate increases. The central bank set its policy rate at a range of 4.25%-4.5% – the highest it has been since 2007. Since the beginning of the year, the Fed has raised short-term interest rates 4.25%.

In this scenario, many neophyte investors who took advantage of the hype/free money cycle realized that judging these businesses based on revenue can be misleading, and that pricing off gross written premium leads to outsized valuations.

The market completely switched its priorities overnight, and those same investors were no longer telling companies that growth is everything.

The pivot in rhetoric unleashed a domino effect, and InsurTech executives were propelled to scale back with a view to preserving cash amid newfound fundraising difficulties.

Yet, it is important to point out that the widespread workforce reductions that took place this year were not an absolute indicator of non-performance. Instead, they can point to prudent cash preservation at a time when companies are only able to raise new funds through down rounds – something no founder wants.

In another bear sign, raising venture debt became popular among InsurTechs looking to extend runway while avoiding a down round, with companies more prominently taking on debt to supplement an equity round or borrowing in between rounds to shore up liquidity.

The market has also seen several companies rely on insider rounds to move their businesses forward, as many investors, specifically on the early-stage side, don’t want to see their portfolio companies run out of cash.

But there is a question on what happens once “vintage” funds that began making investments in 2017 or 2018 become fully deployed and no longer can support their companies. How do you do an insider round if you have no more money to deploy?

Where do we grow from here 

The end of the year calls for a time of reflection. Circumstances were challenging in 2022 and considering the gloomy economic outlook and monetary tightening, things could get worse in 2023 before the sun shines again.

The mood is more positive among InsurTech executives than it is among investors, but both recognize the need to learn the lessons from their predecessors, generally referred to as InsurTech 1.0.

There is certainly less talk of disruption, however, and much more talk of partnership – a dynamic which we had already begun to see but was accentuated this year. This has been an interesting pivot given that all the initial hype was around the new tech-savvy kids disrupting companies stuck in the Paleolithic Period.

Alas, the change in interest rates and the increased cost of capital has been a bitter pill to swallow. But it has also highlighted the enormous need for the sector to correct itself. At the end of the day, InsurTechs are in the business of insurance, and insurance fundamentals matter.

The medicine needs to be taken, and I expect that companies will continue to struggle to get their funding requirements. Even though very few companies are going down at this point, more are expected to survive in zombie mode.

2022 has shown that while it may be easy to be a disruptor, being a profitable disruptor is a whole other story

Market sources have said that most neophyte investors have now left the market and those that have stayed are more educated, which in turn has raised the bar, with many of them acting like reinsurers, drilling down on loss ratios.

But what remains to be seen is whether companies, and their investors, have really learned their lessons. Or is the higher scrutiny and austerity just a function of a venture bear market, which could easily be overturned if capital becomes abundant again?

It is also important to recognize that another fundamental challenge has been the mismatch between investor expectations around returns, and the real timeframe of when these returns can be generated. Many investors who joined the space in the peak of the hype-cycle might have had short-term investment horizons and ultimately were not a good match for these companies in terms of funding.

Investors have told companies to “grow, grow, grow”, and a sudden reactive reversal of discourse will not immediately correct things - especially in an industry like insurance, which plays the long game. It is not an ‘easy in, easy out’. You are not going to get returns in the short term, that is not how this game works.

Some market participants have said they expect an uptick for M&A activity in the new year, but questions remain on how hard that wave is going to hit. The market will most likely see a combination of merger activity, and companies taking on expensive debt while others just disappear.

Companies are also struggling to find both underwriting paper and reinsurance capacity, and sources are watching closely for how this dynamic plays out.

InsurTech is not dead, this is just a reality check moment. Unsophisticated operators are going to leave the market and lessons from predecessors will need to be learned.

2022 has shown that while it may be easy to be a disruptor, being a profitable disruptor is a whole other story.

 

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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