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InsurTech fortune-telling: Lessons from fintech’s failures

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InsurTechs have monopolized much of the attention in the insurance research and media space over the past few years.

Touted as the industry's future, a disruptor of the old systems, the David to traditional carriers’ Goliath, InsurTechs have built a narrative expectation of success for their tech-driven business models.

But with personal lines insurers facing a challenging third quarter, InsurTechs are bracing for similarly disappointing results next week.

Personal auto insurers are reporting rising loss cost trends borne from spikes in frequency and severity, while homeowners’ carriers are facing heavy cat losses for the quarter. In addition, inflation, social and otherwise, is compounding supply chain shortages and spelling difficulties ahead for the sector.

But while traditional personal lines insurers might have more robust balance sheets to fall back on, InsurTechs are tight on capital, favoring a nimble grow-at-all-costs strategy – making them particularly vulnerable to market volatility.

With InsurTechs more vulnerable to market downturns, sentiment is diverging. Some explain away InsurTech’s struggles as growing pains, while others suggest that they may be set to fail as the first phase of a larger market renewal.

Perhaps the best look forward is a look backward. Peer-to-peer digital lending platforms, once the vanguard of fintech disruption, offer a potential trajectory for InsurTech firms now.

First, a refresher. Peer-to-peer digital lending platforms connect investors willing to lend their funds with borrowers in need of financing, taking banks out of the equation altogether. P2P platforms use complex data analysis and algorithms to best match the risk profiles of individual borrowers and lenders.

P2P platforms were the most popular fintech firms in the early- to mid-2010s and were widely touted as a formidable challenge to traditional banking systems.

Since their heyday in 2015-16, P2P digital lenders have consolidated into traditional financial institutions, moved their strategy away from retail peer-to-peer lending, or folded altogether. The story arc of P2P platforms may mirror the possible futures of the InsurTech industry, which many now see in much the same way P2Ps were in their time.

Below, we enumerate the similarities between the two industries and explore what those similarities could mean for the future of InsurTech.

Firstly, innovation and vast growth trajectories led to heavy funding.

Like InsurTechs, P2P digital platforms were built with a younger demographic in mind. The thought was that a fresh concept and impressive user interfaces would allow P2P platforms to overcome the traditional banking institutions they were looking to replace.

Marketing themselves as the exciting, new alternative to the old way of doing things, the obvious demographic for P2P digital platforms was young people, and startup founders believed a more mature audience would follow over time.

The new approach garnered much hype, spawning big valuations that reflected its growth potential.

Over a dozen startups were developed in the early 2010s, with the most notable among these, such as Lending Club, Prosper, and OnDeck, raising hundreds of millions in funding.

Lending Club raised just under $400mn in 15 rounds of funding, including an IPO that valued the firm at $8.5bn.

Similarly, Prosper has raised over $400mn in 16 rounds of private funding, and OnDeck raised $230mn on a 2014 IPO, valuing the company at $1.3bn.

Although the funding of the InsurTechs has played out differently (partially due to the recent SPAC mania), the funding has been robust for both, with Hippo, Metromile, Root, and Lemonade raising between $480mn and $1.3bn each on the promise of game-changing innovation.

Secondly, pressure rises as firms have difficulty delivering results.

When the financial crisis (2008-9) forced traditional banks to raise borrowing standards and reduce lending as uncertainty clouded the economic outlook, P2P lenders should have been well-positioned to fill the market demand left by retreating institutions.

Still, P2P platforms’ unfavorable risk selection and reliance on individual third-party investors to provide capital liquidity would lead to failure for much of the sector. This is because the P2P concept was built on individual lenders providing (for the most part) unsecured personal loans to individual borrowers.

But the mismatch of high-risk borrowers who could not acquire funding through traditional means and small-time lenders looking to invest their savings while maintaining a reasonable risk appetite prevented the peer-to-peer dynamic from becoming mainstream.

For example, why would a wealthy retiree risk her savings on a business loan that a bank already denied?

Lending Club, one of the most prominent P2P digital platforms, is an example of how P2P lenders struggled to achieve profitability. Since going public in December of 2014, the stock is down over 60%.

The chart below illustrates Lending Club’s annual net losses, highlighting the firm's struggles in popularizing the peer-to-peer lending model.

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The downfall was also seen in the lack of liquidity of the product. For example, Funding Circle, another P2P platform, at one point, saw the wait for an individual “lender” to sell off an unwanted loan and get their money back rise from eight days to over 100 days.

It turns out that P2P start-ups underestimated the importance of liquidity and the ability to identify risks that traditional banks have successfully mastered. Where else have we seen institutions maintaining their competitive advantage through real-world experience and better risk management?

The less-than-subtle rhetorical question above leads us to the fact that traditional insurance companies utilize a tried-and-true system of identifying risk based on decades in the sector, while newcomer InsurTechs may be trying to reinvent the wheel.

InsurTechs are still fighting to justify their value add beyond the marketing/user interface, with underwriting results significantly underperforming more-traditional peers. The chart below shows that loss ratios remain elevated thus far this year.

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Further, just as P2P platforms left their fate to lenders, companies like Hippo and Lemonade are heavily reinsured (90% and 70%, respectively), leaving their future in the hands of the reinsurers.

Other privately held InsurTech firms chose to rely on outside institutions by setting up operations as MGAs. InsurTech MGAs include Next Insurance, Coalition, Buckle, Clearcover, Trov, Corvus, and Boost.

Finally, the way forward involves adapting strategy to the traditional market.

For P2P digital lending platforms, supply and demand for funding only stabilized when institutional outfits replaced high-net-worth lenders as the primary source of capital, which saved the start-up firms but defeated the purpose of excluding big players from the process.

Throughout the second half of the 2010s, the excitement of disrupting the system gave way to an “if you can’t beat 'em, join 'em” attitude. As a result, many of the first P2P firms shifted away from their original business model, failed, or were acquired.

One example of P2P platforms recalibrating their strategies and moving beyond their original business model is OnDeck. OnDeck was acquired in October 2020 by Enova International, another fintech firm focusing on providing capital to underserved communities, for $120mn, a fraction of its earlier valuations, after posting continued losses.

The acquisition brought OnDeck under Enova’s strategy, which utilizes funding sources including large institutions. Months before the announced acquisition, the company had reported that nearly 40% of its loan book was delinquent.

Similarly, Lending Club shifted away from the peer-to-peer lending platform that differentiated it from traditional banks and eventually decided just to become a bank when it announced the purchase of Radius Bank in February of 2020.

The transition to digital bank has been beneficial for Lending Club’s bottom line. On its third-quarter earnings call, the firm raised full-year net income guidance, something unheard of in earlier years!

The chart below illustrates the current state of the P2P digital lending platform space. Many of the firms have suffered in the stock market, shut down, or were acquired.

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Like P2P platforms, InsurTechs may find themselves having more in common with traditional insurance companies than they initially wanted to admit.

Announcements of new relationships, growth avenues, and products haven’t stopped flowing from InsurTechs.

Both Metromile and Root have recently announced that they are expanding their distribution networks into the independent agent space – much like more traditional insurance carriers. Lemonade announced that it is branching out into auto insurance. This shift is likely a belated acceptance of their initial models failing to deliver on the risk/reward matrix.

InsurTechs are likely to once again command attention in the upcoming earnings cycle with efforts to divert attention from their core business performance with new initiatives. But as we saw with P2P lenders, an unsuccessful business model can only hide by rolling out new initiatives for so long.

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