The State of InsurTech: Watch the Insurance Cycle

Co-authored by Vikas Singhal and Adrian Jones, partners at HSCM Ventures. Personal views. See disclaimers at the end. Also posted here on Vikas's LinkedIn.

The insurance cycle matters more than a possible recession

Insurance is an industry populated by numerous companies that survived the Panic of 1873. Not to mention the Spanish-American War, Teapot Dome Scandal, and the entire 1970s (stagflation, Watergate, the disco craze). In our experience, successful insurers watch the economic cycle, but they act more on the insurance cycle. Historically, the insurance cycle looks little like the economic cycle:

(The first three charts in this post are adapted from the July 20, 2022 presentation titled The Covid Rollercoaster Continues by Dr. Robert Hartwig of the University of South Carolina Risk & Uncertainty Management Center. See all his presentations here. We have extended the most recent hard market shaded area through the present, whereas Dr Hartwig's original shows hard market shading only in 2020.)

The shaded areas above denote hard markets. Hard markets are periods of insurance volatility characterized by rapidly rising prices, entry of new competitors, and exit by weaker players. There is increasing evidence that we are currently in a hard market in several areas of insurance – especially catastrophe-exposed property lines, cyber, political risk, and other lines impacted by heavy recent losses or reserve deterioration.  Interest rate volatility is also creating challenges for life insurers and fixed and variable annuity insurers. 

The hard market is a result of many factors including rising interest rates causing losses on bond portfolios (albeit mostly unrealized because insurers often hold to maturity), 5 years of elevated property catastrophe losses, losses in specialty classes such as aviation war and political risk, rising loss costs in general (such as from inflation), rising social inflation (a euphemism for fraud, legal system abuse, and regulatory interference), rising medical costs (in part due to covid), and rapid consolidation of insurance distribution keeping pressure on expense ratios. 

Consider personal auto insurance. The line is being hit by a double whammy: People are driving more and hence getting into more wrecks (frequency), and the cost of fixing cars and settling lawsuits (severity) has also jumped sharply. Frequency times severity equals loss costs. When both rise together in an unprecedented way, the auto insurance business finds itself in a place not seen in the adult lifetimes of most people in the business.

In our observation, the best insurers (both incumbents and now the best startups) collect better data, analyze it faster, and react most effectively by increasing rates, tightening eligibility, managing lapse/churn, and restricting distribution. They are already showing better performance in the second half of 2022 on a variety of measures compared to their slower competitors.

The current hard market (mostly) benefits InsurTech

While some incumbents quickly recognized recent changes in the insurance cycle, the insurance industry also has many incumbents who style themselves "fast followers". Most are just followers. Many were caught flat footed by rapid recent changes in the cycle and now are attempting rear-guard actions to fix their books.

Incumbents’ raising prices and exiting certain lines of business can benefit new entrants. Customers either are forced to shop or decide to shop for better prices or coverage. Much of the discussion at this year's RIMS conference was about how large buyers are restructuring their insurance programs. In this environment, new entrants without legacy liabilities can take advantage of rising rates for new business without needing to “catch up” to achieve rate adequacy on renewal policies.  Customers who shop might also change their agent or run an RFP among brokers, creating opportunities for entrants. 

Further, when insurers see their business changing, they may be more willing to invest in data, analytics, and systems to seek a technology edge, which creates customers for leading-edge companies selling such solutions. 

Separately, the continued macro cycle in distribution is creating opportunities for carriers to more effectively integrate with brokerages who are making major investments in operations and systems as they integrate scores of recent acquisitions. 

The biggest risk for startup MGAs and carriers that we observe in the hard market is availability of reinsurance – which we discuss later. 

Despite the hard market, insurers are better capitalized than ever. U.S. insurers entered 2022 with over $1 trillion of policyholder surplus (statutory equity) for the first time ever – having doubled since the financial crisis. Policyholder surplus matters because it is capital that can be used to grow the business organically, make acquisitions, fund technology overhauls, and absorb unexpected underwriting or investing losses.

In short, now is a time of major change in insurance because of the insurance cycle more than the economic cycle, and changing industries have opportunities for new companies.

InsurTech: Reality outpaces sentiment

2016 marked the beginning of a secular change in insurance as people, capital, and technology entered the sector like never before. Insurers, brokers, and service providers began embracing the change. As with other areas of tech, sentiment began to run ahead of reality. Fervent founders eagerly preached the gospel of disruption despite their companies' business models needing work.

Many of the most hyped companies in insurance pursued direct to consumer business models in mass-market lines of insurance. We have written about the direct mass market business model since 2018, around the time that some of today’s larger insurtechs first started reporting meaningful numbers to state regulators.

The following chart illustrates how we see the hype cycle in insurance over the last 6 years. The chart is illustrative only and is not an opinion on valuation nor an investment recommendation.  The x-axis is not intended to be to scale.

The secular entry of technology into insurance continues 

Carriers, brokers, and others across the insurance ecosystems continue to recognize the need for digitization, modernization, development of new channels, cost reduction, and new business development. Insurers that fall behind are losing market share every day. AM Best has shown that nonlife insurers with higher innovation scores have outperformed competitors in terms of growth, loss ratio, expense ratio and stock price performance.  And most importantly, we are seeing policyholder expectations starting to change. How consumers discover, research, price, and ultimately bind policies looks different today than it did even five years ago, a rapid change in a conservative industry. 

Many insurance executives say they are not surprised that some of the most hyped companies of the late 2010’s have sold off by 90% or more from their all-time high prices. Far from discounting the whole sector, these same executives have been eagerly looking for ways to gain an edge on competitors by engaging with companies that are disrupting insurance – provided that the start-ups’ leadership understands how insurance operates. 

Meanwhile, new entrepreneurs are emerging who have studied the industry in more depth than some who came before them, and they appear more interested in hiring experienced talent. Experienced talent continues to be attracted to InsurTech despite the public market challenges. Additionally, VCs are more carefully evaluating the insurance chops of companies they consider backing. The stage is set for a generation of great companies to emerge. 

VC investment volume: surprisingly robust

The first half of 2022 was marked by lower deal volumes in insurance venture capital compared to 2021. Currently it appears to us that high-quality companies (in the eyes of the market) remain able to raise funds on reasonable terms, while the others struggle. Venture markets have become more discriminating.

The statistics show a surprisingly robust second quarter for InsurTech. The number of global InsurTech deals in the second quarter, at 131, is comfortably within the historical range of quarterly deal volume since 2018 (min 100, max 176). Thus, the average and median deal size dropped – both figures are close to their respective 2019 and 2020 comparisons – which we see as solid considering the macro environment. 

Global InsurTech venture funding, 2018-2Q22, per CB Insights (pub. July '22)

Despite many negative headlines about growth equity and later stage investments, an impressive list of companies raised large rounds in insurance venture capital in the second quarter into the third quarter.  

Announcements in July and August slowed. Time will tell if this is a real slowdown or a summer calm before the fall conference season when announcements have traditionally been made. August did see at least one notable exit announcement.

As referenced in the opening, the steadiness of insurance can be an advantage. We have not seen major pullbacks by insurers either as customers or strategic investors, though reinsurers have become more discerning in whom they back and how.  With strategic investors present in almost half of InsurTech financings in recent years, the stability of strategics as a funding source could emerge as a ballast to steady InsurTech markets if economic volatility continues. 

For lower-quality companies, the market has indeed become worse. The first quarter saw little change in deal terms compared to prior quarters, but the second quarter trended a bit worse according to Cooley's analysis - notably the increase in recapitalizations to 1.5% of all venture deals (not just InsurTech). 

Public markets in InsurTech were weak in the second quarter, as were other sectors of the innovation economy.  Understanding public market pricing is one reason that we created the HSCM Public InsurTech Index ("HPIX", the "Index"). The HPIX aims to show the price movements of a basket of US publicly listed companies in the insurance sector who say they have novel business models differentiated by technology. (See the Index Guideline for details.) The HPIX declined approximately 24% in the second quarter and as of today (Sept 7) is about where it was at the end of the second quarter. For comparison, we show below the Solactive Tech 100, which has a similar methodology to the Nasdaq 100

Past performance is no guarantee of future results. Chart is updated through close on August 31, 2022.

Emerging challenges to prepare for

Setting aside the macro environment, we see two challenges for InsurTechs over the next year or two. Both are matters that we believe can be appropriate sources of discipline for good companies provided markets do not overreact. 

First, some insurance company and brokerage executives have told us of disappointment with some InsurTechs who act as enablers to traditional businesses. The most typical complaint is about insurtechs who overstated their capabilities and failed to deliver. This has led to some insurers being more skeptical of claims made by newer companies, more thoroughly vetting them as partners, and a general lengthening of the sales cycles. On the other hand, those same executives tell us multiple success stories that are inspiring continued work, particularly with more established start-ups.  Some young companies are reacting by hiring more experienced insurance industry talent rather than young swashbucklers from Silicon Valley. 

Second, companies that operate as carriers or managing general agencies (“MGAs”) typically require access to reinsurance, often in ever-larger quantities as they grow. We referenced above the benefits of the hard market. On the downside, reinsurance capacity has become constrained and reinsurance prices have risen – especially in property lines, especially when exposed to catastrophes. There are only about 60 reinsurers of notable size globally, and they appear to have relatively easily hit their 2022 premium targets and aggregate loss limits, resulting in some reinsurers being essentially closed for new business. At least one reinsurer announced plans to exit property reinsurance. Additionally, some of the high-profile InsurTechs of the late 2010’s ceded reinsurers material losses for several years, which has led to increased skepticism of InsurTechs as a whole by reinsurers, even as they continue to actively consider submissions from new companies. 

The disruptions in the reinsurance market have made it slower and more difficult for some companies to place their reinsurance. However, it appears to us that high-quality business plans continue to be reinsured, just not with the attractive terms on offer five years ago. This too will change when the insurance pricing cycle tops out and comes down.

The future rhymes with the past

Insurance has existed in its modern form since just after 1666. The oldest extant US insurer dates to 1752. The players might change, but the industry will continue to exist. As a $7 trillion industry, there are many big niches for new competitors, and many areas where digitization has not reached. In an industry this old, the future needs to be understood through the lens of the insurance industry’s own cycles – especially the insurance pricing cycle.

Where to meet us

We would be pleased to meet start-ups at one of the numerous conferences this fall. You may contact both authors via the contact form on the HSCM Ventures website.

The authors are grateful to Andrew Sagon, Brandon Baron, and Mariam Dawoud for their research assistance.

Disclaimer

The views expressed are the authors’ views as of September 7, 2022, and may not consider material economic, market, regulatory and other factors. Certain information has been obtained from sources believed to be accurate and reliable – any of which may be erroneous or change without notice. HSCM has no obligation to update or advise you of any changes or errors. There can be no guarantee that any prediction, projection, forecast, or opinion will be realized. Certain information discusses general information related to the specific industry, activities and trends, or other broad-based economic, market or other conditions and should not be construed as research. The information contained herein does not constitute an offer to buy or sell, or a promotion or recommendation of, any financial instrument or product or strategy. The views expressed may change at any time subsequent to the date of issue hereof. 

Unless noted, all data in this article are as of US market close on Aug 31, 2022.

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