Lemonade Aftertaste: Will Reinsurers Keep Covering Unprofitable InsurTechs?

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By Russ Banham

Carrier Management

The IPO of Lemonade in July highlights the value of leveraging ample reinsurance to move from startup phase to a public company, which the online provider of renters insurance pulled off in a scant four years.

In its IPO registration statement, Lemonade revealed a substantial quota share reinsurance agreement with seven reinsurers, in which it would begin ceding 75 percent of its premiums and losses to the reinsurers on July 1, with reinsurers paying a 25 percent ceding commission to Lemonade for every premium dollar ceded.

Since many InsurTech companies hope to go public, ceding large losses to reinsurers helps spruce up their balance sheets, offering more revenue and profit predictability to investors. As Lemonade stated in the registration statement, the quota share agreement “largely eliminates the bottom-line volatility inherent in traditional insurance companies…making us capital-light, buffering our gross margins from the vicissitudes of claims and leaving room for our gross margins to grow.”

Lemonade is not alone among InsurTechs in cutting deals with reinsurers to assume much of their risk. Some startups also have successfully enticed reinsurers to fund the company by taking a stake in the business through an equity or debt investment.

ll insurers spread their risks through reinsurance, but nowhere near a 75 percent quota share. The InsurTech phenomenon has ushered in a new role for reinsurers, as significant venture capital investors in innovative startups presenting the possibility of long-term profitable growth. As one reinsurance broker said off the record, “Reinsurers are to InsurTech startups what bars are to COVID transmission: a primary catalyst.”Now, with the reinsurance market hardening for the first time in a decade, the question is: Will reinsurers continue to deploy their ample capacity to the next wave of InsurTech startups, or might it be a good time to take a breather and see how the current investments pan out?

Tossing the Dice

At present, none of the U.S. InsurTech carrier startups has turned a meaningful profit, Lemonade among them. (Editor’s Note: An NAIC online consumer information document indicates a few thousand dollars of profit for Clearcover in 2019 on a statutory basis. The statutory bottom lines for the others—Lemonade, Metromile, Next and Root—were all reported in red ink.) Lemonade acknowledged a deficit of $234.8 million at the end of March 2020 in its registration statement and projected that net losses will continue as it focuses on market expansion and growth.

Still, three startups available for interviews with Carrier Management—Metromile, Next and Clearcover—are confident in their future. (Lemonade was in an IPO quiet period.) All were launched with a novel value proposition delivered through innovative technology. And all attribute their success in subsequent years to their reinsurer partners.

“Reinsurance has been very important to us; we’ve used reinsurance pretty heavily since the beginning,” said Kyle Nakatsuji, co-founder and CEO of Clearcover, founded in 2016 to provide low-priced AI-based online automobile insurance in eight states.

Dan Preston, CEO of Metromile, a provider of pay-per-mile automobile insurance launched in 2011, said reinsurance “has been an absolutely critical part of the InsurTech growth story, acting as a really important capital source for InsurTech across the board. In our case, reinsurers have been partners through quota share agreements and as investors.”

Sofya Pogreb, chief operating officer at Next Insurance, a provider of small business insurance products that raised $250 million in funding last year from Munich Re, sang the same praises. “Reinsurance has been a key enabler for innovation in the insurance space,” Pogreb said. “We and other InsurTech startups have been able to take extensive advantage of reinsurance capacity to go to market quickly and manage the risks of a very volatile book of business.”

Pogreb questions if the same scenario will play out for newer InsurTech entrepreneurs. “The market is shifting,” she said. “InsurTech players that have built a reputation for being vigilant about their loss ratios will be in a better position to procure reinsurance capacity than those with less positive historical results, or someone just entering the markets with no history of doing business.”

Other InsurTech experts share this opinion. “Reinsurance markets have gotten much harder, with capacity limited or decreasing,” said Adrian Jones, who runs reinsurer SCOR’s InsurTech investment facility P&C Ventures. “The companies most likely to be affected are recent InsurTech startups without the benefit of a long-term reinsurer relationship.”

Bumps in the Road

Timing is everything in business, and right now it may be working against emergent InsurTech startups. In the early to mid-2010s, the reinsurance industry enjoyed record excess capacity on a global basis. Figuring out how to grow that capital in a stodgy industry like insurance was a dilemma. Then, a solution reared.

A smart, young and innovative bunch of Jeff Bezos wanna bes were in the midst of developing disruptive technologies targeting different links across the insurance value chain. For the reinsurers, the entrepreneurs offered a productive way to deploy their excess capacity and make a long-term investment in a company that theoretically could effectively compete against incumbent insurers.

“Reinsurers were sitting on an immense amount of capital with few opportunities to grow their business, when along came the InsurTech startups offering a way to get in at the ground level with a potentially disruptive technology,” said economist Robert Hartwig, an associate professor of finance and director of the Risk and Uncertainty Management Center at the University of South Carolina’s Darla Moore School of Business.

Comparative to their size, reinsurers could make relatively small investments in an InsurTech startup, helping them weather the inherent volatility of starting an insurance company with no loss history. The reinsurers also had ample capital to bide their time, giving the startups room to grow. “Investor patience is required when investing in a technology startup—the case with Amazon, which took years as a public company to record a profit,” Hartwig explained.

Waiting for the startups to turn a profit didn’t mean their cash registers weren’t ringing. Through smart branding and marketing campaigns—typically to younger generations of first-time insurance buyers—policies were sold and premiums generated. “Many InsurTech startups, in fact, are growing aggressively, generating decent revenues and OK loss ratios,” said Andrew Johnston, global head of InsurTech at reinsurance broker Willis Re.

Incurred losses and LAE recorded on the income summary in Lemonade’s IPO filing amounted to $45.8 million for full-year 2019 and $18.2 million for first-quarter 2020. Also contributing to bottom-line red ink in these periods were sales and marketing expenses of $89.1 million for full-year 2019 and $19.2 million for first-quarter 2020.

Johnston noted that branding and marketing campaigns differentiating startups’ value propositions have eaten into profits. “They’re spending boatloads of money for reasons that established insurers don’t need to,” Johnston said. “They’re trying to break the ice and need fuel to do it.”

Reinsurers have provided this fuel. From a ceding standpoint, Jones estimated that insurers and reinsurers will assume $1 billion of premium from U.S. InsurTechs this year. “Lemonade said in its IPO registration statement that having a lot of reinsurance is actually a good thing,” he said. “That’s very different from the way the industry has typically considered reinsurance, with carriers seeing it as an expense that has to be minimized.”

How Sweet It Is

For seasoned InsurTech startups like Metromile, Next Insurance and Clearcover, Lemonade’s IPO was greeted with a standing ovation. The newly public company’s stock opened at $29 per share and subsequently shot up 139 percent, establishing the best first-day performance of an IPO this year and rewarding the company with a $3 billion market cap.

“The success of Lemonade’s IPO brings additional awareness, credibility and excitement to investors considering the InsurTech space, benefitting all of us tremendously,” Pogreb from Next Insurance said. “We’re excited to capitalize on that as we continue to grow our business.”

Preston from Metromile also cheered the IPO’s grand debut, noting the upside it poses for an automobile insurance startup. “The lifetime value of a renters insurance product is eight times the amount of premium, whereas the lifetime value of an automobile insurance product is 10 times the premium,” he explained.

The excitement is understandable, given the positive prospects for the startups ahead. If a big payday arises, the founders can thank their reinsurers for providing a financial cushion in their early years.

“To develop their disruptive technology, they needed someone to back them, and reinsurers were there to take on the task,” said Chris Sandilands, partner at insurance advisory firm Oxbow Partners. “Direct-to-consumer digital models of providing insurance are very attractive for reinsurers looking for future profits.”

He added, “You can have a cup of coffee with an insurer to discuss an investment, but they’re not set up to do deals involving companies with radically new ideas and no loss history. That’s not an issue for reinsurers. They have patience to spare.”

Another reason why reinsurers have been eager InsurTech partners is the caché of aligning with a nimble tech startup. “If you’re the CEO of a large reinsurer, you’re able to send a message to investors that you’re doing cutting-edge things, putting a stake in a company with a new technology that appeals to younger buyers,” said Hartwig. “The theory is that these buyers will eventually get older and mature and have other insurance needs they can fulfill.”

Satisfying future insurance needs is on the radar for Lemonade, Clearcover, Metromile and Next. Fresh from its IPO, Lemonade announced it would enter the pet insurance market.

Next Insurance presently provides general liability, commercial automobile, workers compensation and professional liability lines of insurance to small businesses like contractors, fitness centers and beauty salons, among others. But it, too, has an end game of “adding additional lines to become a one-stop-shop,” Pogreb said.

Preston also sees value in cross-selling Metromile’s products, noting the insurer is exploring adding renters, homeowners and commercial automobile insurance lines. “Our customers are looking for that holistic experience. It’s certainly helpful for consumers to have a one-stop experience,” he said.

More arrows will be put in Clearcover’s quiver, as well. “It has always been our intention to offer multiple products to our customers,” said Nakatsuji. “We saw automobile insurance as the beachhead market to build a multibillion-dollar insurance company. If you look at the example of Progressive and GEICO, they entered automobile insurance first and then grew with the customer over time (selling homeowners, renters and other insurance products).”

A Very Bright Future

Reinsurers share the same high hopes as the InsurTech founders and leaders. The companies are seen as being at the forefront of what many consumers want from insurance—frictionless research and buying experiences, low-cost products, and rapid claims services.

“The InsurTechs are farther ahead in their development of digital, AI and data tools than incumbent insurers stuck with legacy technology,” said Michael Forman, InsurTech expert at TigerRisk Capital Markets & Advisory, an investment bank specializing in insurance-linked securities. “There’s no question that reinsurers are looking beyond current profitability toward what they see as a future growth story.”

Jones agreed. “Reinsurers have been willing to take some early losses, seeing it as the price of admission to support the customer of the future,” he said. An example is Lemonade’s reinsurers, which collectively have lost “around $27 million from the launch of Lemonade through the first quarter of 2020,” he added. “Had the reinsurers collectively taken that $27 million in losses and instead invested it evenly in Lemonade’s Series B and C offerings, they would have experienced an 8X return at a stock price of $60 per share.”

Hence the wisdom in partnering with a reinsurer that will reinsure and make an investment in an InsurTech startup. “The problem with reinsurance alone is you have a guaranteed premium but confront the possibility of an unlimited loss, which sometimes is capped and sometimes not,” said Jones. “With venture capital, the downside is limited to the investment, but the upside is infinite.”

These many factors explain the exuberance of reinsurers to back startups in the InsurTech space, but with capacity fast shrinking and opportunities to price traditional reinsurance much higher to maximize profits, a more conservative approach may be in order.

“Like more traditional venture capital firms, reinsurers invest in hundreds of startups in the hope that one or two might make it big,” said Hartwig. “But relatively few wind up with an IPO like Lemonade, which is the exception rather than the rule. With market prospects improving for reinsurers, there are other ways to increase profits.”

Another factor not in play a decade ago when entrepreneurs with innovative technologies sprouted to capture insurance market share is much smarter and tech-savvier incumbent insurers. “InsurTechs were put on this pedestal because they were doing all these interesting things with technology,” said Sandilands at Oxbow Partners. “But now there are plenty of incumbent insurers doing the same thing.”

He’s right. Five years ago, very few if any incumbent insurers employed a chief digital officer or chief data officer. Now, many insurers have one or both. And the insurers have provided them sizable war chests to invest in cutting-edge technology tools.

This is not to say the current and next generation of InsurTech entrepreneurs won’t be ringing the bell at the New York Stock Exchange like Lemonade’s founders. But the idea of Lemonade or another InsurTech startup becoming a Chubb in five, 10 or 20 years is a long shot, indeed.

“Reinsurers are hoping for the insurance company equivalent of another Amazon, but there are very few Amazons out there,” said Hartwig. “If you superimposed the Amazon model on Lemonade 25 years from now, it would be the largest, most profitable multiline insurance company in history. That’s a tall order for any company yet to turn a profit.”

Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.

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