Next year, Chubb (tracing its roots back to the birth of the Insurance Company of North America) will turn 230 years old, an extraordinary feat of longevity that partly explains why it’s the world’s largest publicly traded property/casualty insurance company. By contrast, startup Root Insurance made its debut as a public company on Oct. 28, 2020. Fewer than five months later, its stock trading at less than half the IPO price, the automobile insurer was named in a shareholder class action complaint.

Perhaps these growing pains should have been expected. Like other InsurTech insurer startups, Root Insurance was billed by its founders as a disruptive force in the insurance industry. Following its billion-dollar valuation in 2019, a newspaper headline stated that “Insurance Will Never Be the Same.”

Well, insurance remained as it was, and now the question is will Root be the same as it appeared in 2019. Recently posted first-quarter 2021 results showing $200 million in direct written premiums and $6 million in gross profits did not budge its stock price in early May from late March, when the class action complaint was filed.

Other InsurTech insurer startups that became public companies, such as Lemonade, also have endured a tough trek lately. The once-fizzy renters and homeowners insurer’s stock peaked in January 2021 at about $188 per share before sliding to around $79 in early May. Auto insurer Metromile’s stock in February 2021, nearly $20 per share, was trading around $8.40 in early May.

(Editor’s Note: This article was written in mid-May, when Root shares were trading at about $9.45 per share. In early June, Root shares climbed to nearly $13.47, with some analysts attributing the boost to meme-stock status. Root’s October 2020 IPO price was $27 per share.)

The story of these startups is a cautionary tale for early investors and future shareholders in InsurTech insurers, who may be reading the wrong tea leaves in assessing their prospects. As Lindene Patton, former senior vice president and in-house counsel at Zurich Insurance, put it, “Technology is cool, but insurance is difficult.”

Different Strokes

She’s got that right. The startups fall within a category of the insurance industry of companies using a tech innovation to improve operating efficiency and reduce prices—hence InsurTech. But there’s a big difference between the valuations for an insurance company versus a technology company.

“Insurance companies have a completely different economic profile than most any other industry,” said Nicholas Lamparelli, chief underwriting officer at reThought Insurance, a tech-centric managing general agency focused on climate and natural catastrophe insurance. “What’s getting InsurTech investors in trouble is that they’re using the same metrics to gauge a technology company’s future performance when gauging an InsurTech company’s future performance.”

Patton agreed. “Investors get blindsided by the ‘shiny new techy thing’ and forget to look at the fundamentals—things like attracting a market, generating revenues across a period of time, future growth plans, and whether or not the technology underpinning the insurer will make the organization more efficient over the long term, thereby disrupting the marketplace,” said Patton, a partner at Earth and Water Law Group, a Washington, D.C.-based law firm specializing in environmental advisory and litigation. “Investors are at risk of being misled.”

Her comments appear to align the allegations made by the seven law firms representing shareholders in the complaint against Root Insurance. As Carrier Management reported on March 23, the complaint alleges that Root’s IPO offering documents were negligently prepared and omitted important facts, asserting that traditional insurance competitors like Progressive and Allstate already offer the type of telematics platforms that Root believes set it apart.

The contention draws from a March 9 report by Bank of America Securities Analyst Joshua Shanker, which stated that the incumbent insurers enjoy a “sizable advantage over Root in terms of the amount of [telematics] data and engagement with the data” used to price auto insurance. The two insurers and GEICO will continue to impede Root’s profitability, the report maintained. “Root will require not insignificant cash infusions from the capital markets to bridge its cash flow needs,” one of the filed complaints stated.

As Root seeks to untangle the “mess in which it has found itself,” future investors in other InsurTech startups “need to heed its example,” said Mica Cooper, CEO and president of Aisus/InsureCrypt, a comparative quoting and policy administration InsurTech. He believes InsurTech insurers are valued on technology tools that offer process improvements that are not truly disruptive. A “disruptive technology,” he said, is “a solution to a problem that no one else has thought up. If InsurTechs actually delivered on their promise of market disruption, they’d have hit $1 billion in sales their first two years like a real unicorn.”

Cooper should know what a “real unicorn” is. He helped build Hotels.com, working with two investors that put up $10 million each to launch the successful travel startup, he said. “The first 30 days, we chalked up $30 million in sales, and reached $1 billion [in sales] the first year,” Cooper said. “Two years later, we sold it [to Expedia] for $3.2 billion. No InsurTech startup has come close.”

Better Than Sliced Bread

InsurTech insurers have yet to live up to their promise because insurance is a business of consistent growth, and InsurTech founders are pitching breakneck growth. “Seasoning matters in insurance,” said Adrian Jones, managing director and a partner in the InsurTech venture investing group at Hudson Structured Capital Management Ltd.

Jones said that consistent year-over-year performance across insurance cycles is important. “The insurance business is typically not a land grab; it’s one of consistent and steady maturation,” he explained.

Tell that to today’s InsurTech insurance startups. “InsurTech founders keep repeating ‘disruption, disruption, disruption,’ but if the technology really doesn’t solve a big problem, it’s not disruptive,” said Cooper. “That’s just noise.”

The ballyhoo goes with the territory. “Tech founders do what they have always done, which is cause a stir and create drama to cull attention,” said Lamparelli. “They’ve been extremely successful attracting investors with what are little more than vanity metrics.”

He’s referring to puffed-up performance indicators that fail to suggest a realistic long-term strategy. Root’s recent shareholder troubles are a case in point, as is the downward stock trending of other InsurTech insurers. “Investors are either unaware of or disregarding the metrics that most accurately project consistent shareholder returns,” said PhD economist Robert Hartwig.

Hartwig, an associate clinical professor of Finance and Insurance at the University of South Carolina’s Moore School of Business, has studied the InsurTech sector since its sprouting more a decade ago. He is highly critical of the startups’ chances for success. In an email, he wrote: “Virtually all of the InsurTech insurer startups in existence today will fail. They operate in the ‘kill zone’ of the majors—whatever modest innovations they’ve developed can be quickly and less expensively replicated by the incumbent insurers.”

In a follow-up interview, Hartwig elaborated on his opinion, leveraging Lemonade as an example. “Lemonade was priced at $29 a share in July 2020 when it IPOed, opened at $50, peaked at $188 in January and is under $80 today,” he said, referring to the price on May 7. “That means the company’s market cap is about $6 billion. My question is, could it really have been worth nearly $12 billion just 90 days ago? The company has generated zero profits since its founding six years ago.”

Nevertheless, he does see value in InsurTech, insofar as the “outsourced R&D” service they perform for the rest of the insurance industry. Hartwig explained that the companies liberate incumbent carriers from having to spend as much capital on technology research and development, trying out and bearing the cost of innovations that insurers can acquire for their own use.

What he values much less is the concept of a tech company becoming an insurance company. “Investments in most InsurTechs have about the same degree of rational appeal as an investment in Dogecoin,” he said,

His point is well taken. InsurTech insurer founders often crow about the inventive technology underpinning the business, as if they were actual tech startups. In reality, each is an insurance company, albeit armed with an innovative technology tool like telematics or artificial intelligence deemed to differentiate it from legacy insurers. Many ordinary investors may not appreciate this distinction. “Investors are valuing InsurTech startups the wrong way,” Lamparelli said.

Wrong valuations have consequences, he said. “Insurance has a completely different economic profile than a technology company or any other industry sector. A retailer, for instance, can undercut its price on a product 10 percent, which is how much it now loses on that product,” he explained. “In insurance, you cut the premium 10 percent and you can lose multiples of the premium, as you’re committing to absorb hundreds of thousands of dollars in potential risk.”

Metrics That Matter

Obviously, the onus is on investors in any public company’s stock to separate hype from reality. The interviewees offered several suggestions on how to appropriately value an InsurTech insurer, downplaying the tech novelty to evaluate the metrics that really matter.

Jones cited four metrics an investor must examine before plunking down a single penny: projected premiums, profits, capital and the return on capital. “A company can suboptimize any of these four metrics for a short period but not forever,” he said. “The numbers need to grow in a balanced way. Fixing one metric can unexpectedly throw the others off; long-term businesses optimize across all four metrics.”

Cooper offered a similar perspective, citing three metrics: gross written premiums, combined ratio and surplus. “Those are the numbers investors need to look at to know how much cash a company has on hand to operate and the point at which it will become profitable,” he said. “Root is so far out before it realizes a profit, it will need more cash [from shareholders] to get there.”

Rating agencies like AM Best keep a particularly close watch on insurer surplus. “What we’re looking for is consistency—an insurer’s ability over a five-to-10-year period to consistently grow their surplus organically each year to absorb any risks they’re exposed to,” said Robert Raber, AM Best director, Rating Services.

Other factors under review at the agency include an insurer’s year-over-year operating profitability and investment returns. “Investors should understand that with market dynamics being what they are, top-line growth isn’t always the best measure of an insurance company,” Raber said. “Consistent growth that’s supported by the capital base is a more reliable metric.”

Other metrics that investors need to evaluate include customer acquisition costs, customer lifetime value, technology capabilities that other insurers lack, and the quality of the executive team and skillsets within the company, Jones said. “It’s also important to understand how the company plans to expand very rapidly across geographies and markets,” he added.

In addition to these metrics, investors need to ask tough questions of InsurTech management, such as the probability of a one-in-100-year loss, Lamparelli said. “Wouldn’t you want to know the kind of event that would put a company out of business, not to mention the powder keg underneath to keep the business going in such an event?” he said. “Instead, investors ask if the company has a ‘capital-light structure,’ which is nice when you’re an actual tech company. But it’s an insurance company, which should cause them to run for the hills.”

Read other articles from Carrier Management’s June 2021 digital magazine. Click the title for a free PDF. “Midyear Update-What’s Next?”

He explained that “capital-light” in an insurance economics context means the company is outsourcing plenty of capital to reinsurers—a very different connotation. “Long-term, the reinsurers have the leverage in the relationship, not the InsurTech,” Lamparelli said. “If the reinsurers decide they don’t want to do business with the InsurTech anymore, the company has no more capital.”

All the interviewees cautioned investors to appraise performance across longer time frames and not to expect quick wins. Raber provided the example of an InsurTech insurer that decides to enter the small business insurance segment.

“It takes about a year to study the market and another year to figure out how to enter it,” Raber said. “It then takes at least 18 months to develop an insurance policy in line with regulators. Add another six months to a year to put together the distribution strategy, another year to start writing the business, and a year or two to put premium on the book. Then tack on five more years to get traction in the market…That’s a lot different than an InsurTech that rolls out an app today and expects everyone to be using it in six months.”

Hartwig concurred. “Innovation is a wonderful thing, but when it comes to an insurance company, investors should be looking for KPIs that show a modest rate of return over an extended period of time,” he said. “A valuation focused on the ‘tech’ suffix (of an InsurTech) and not the ‘insur’ prefix is unjustifiable.”

Added up, the interviewees are in lockstep that investors are making foolhardy bets that an InsurTech without a truly disruptive market strategy will become the next Amazon, which completely upended the retail industry over a period of many years. As for Chubb, Allstate, GEICO and other incumbent insurers, they have shown stamina over decades of multiple financial crises, economic meltdowns and natural catastrophes. “In insurance, staying power is everything,” said Hartwig.

So is a basic understanding of the business by investors. “Does the management team really know how the business will perform as it grows, or are they flying a bit blind?” said Jones. “Because when you’re flying blind, you might run into a mountain.”