The (Opt) Ins and Outs of Embedded Finance
Piggybacking is an effective way to reduce customer acquisition costs, but picking the right strategy and partner is a critical first step.
- Caribou Honig
- June 2021
When the global financial system imploded in 2008, it marked the beginning of the Great Recession. It also kicked open the door for entrepreneurs to launch a revolution in fintech, with resulting success stories such as Credit Karma, Robinhood and Remitly, to name a few. That revolution expanded into insurance with the rise of insurtech companies.
Yet one of the persistent challenges for these companies, as well as for incumbents, has centered on customer acquisition costs. Whether you're a century-old insurance carrier or an insurtech startup with a clever new product, getting customers can be expensive.
But it doesn't have to be.
Embedded finance has generated buzz lately as a brilliant solution. Simply put, embedded finance is the distribution of a financial service product through someone else's customer experience. This practice has been described as “the future of financial services” and “one of the most transformative trends in fintech,” as well as a “game-changing opportunity.” The same holds true in terms of the insurance industry. You cannot hold back the tide on this.
To understand the real opportunity and what is driving the recent excitement, we should peel back the layers of the embedded finance onion.
Embedded distribution is best understood as part of a wide spectrum for getting a product to market. On one end—not embedded in any sense of the word—is direct-to-customer. Whether it's through a radio ad promising you can save 15% in 15 minutes or a piece of direct mail offering a balance transfer on your credit card, some great financial services businesses have been built by going direct.
The same can be said for using third parties such as agents, brokers and investment advisers. Not only have long-standing incumbents succeeded through these traditional channels, but many startups have as well. Insurtechs such as Beam Dental and Hippo have grown, at least in part, through brokers.
Embedded finance is the distribution of a financial service product through someone else’s customer experience.
As the chart below suggests, embedded strategies take partnering with third-party distribution to the next level. The lightest version can be called soft-embedded. As a working definition, think of this as offering a product to another company's customers, often during their purchase experience, where it is explicitly presented as an opt-in for the customer.
Examples abound as this is by far the most common way to embed a product. Car dealerships are long-standing experts: They deftly offer you, the car buyer, the opportunity to finance the purchase and to bolt on an extended warranty. Embedded finance is so deeply ingrained in the automotive sector that entire businesses such as Dealertrack have grown as enabling middlemen.
Soft embedding gets the product in front of the right prospect at the right time. It drives efficiency around acquisition cost and enables scale. And it's not usually a stretch to convince potential partners.
For insurers, this could mean offering tuition insurance as an option on a university's website, a product warranty as an e-commerce option, or accident insurance as part of renting a pair of skis.
By comparison, let's use the term hard-embedded when the offering is presented as an opt-out (i.e., where it is included with the primary purchase by default). The consumer can choose not to take the embedded product, but they must affirmatively take action to do so. One obvious benefit is that this delivers a much higher take rate and scale.
Less obvious, and perhaps a bit more profound, is that hard embedding dramatically mitigates adverse selection. The soft opt-in is vulnerable to adverse selection as customers who believe themselves most at-risk decide to take the offer. If only 10% of consumers opt in, there's a good chance they're among the riskiest to underwrite. The hard-embedded opt-out changes the dynamic: When the product attaches to 80% or more of the customers, the low-risk and high-risk customers are all in one big risk pool. Hard embedding dramatically mitigates adverse selection.
LeaseLock illustrates this well. The company enables landlords to replace the traditional upfront security deposit with a much smaller monthly lease insurance policy. If this were a soft-embedded, opt-in product, it would beg adverse selection: Higher-risk prospective tenants likely would be the ones to opt in. But as a hard-embedded opt-out offering, LeaseLock is brilliant. As the vast majority of tenants stick with the default option of LeaseLock to avoid the security deposit, loss rates fall because adverse selection is nearly eliminated.
There are cases where embedded finance goes beyond the opt-in and opt-out. There are situations where an insurance product is so firmly embedded within the primary product that it's mandatory, and the customer has no ability to opt out. Over time it goes beyond embedded finance and becomes invisible finance.
Fittingly, examples of this might be hard to see at first. Yet examples can be found. Go back to the car dealership. The extended warranty is soft-embedded, an option recommended to the purchaser. In contrast the typical three-year bumper-to-bumper warranty is invisible insurance. The customer can't say, “I'm really good with car repairs myself, so I'll sign a waiver on the standard warranty if you take $400 off the sticker price.”
Malpractice insurance provides another example. Malpractice insurers distribute their product through medical providers, ultimately for the benefit of the consumer. It's not an option for the patient to say, “If you waive my copay, I promise I won't sue you if this appendectomy goes bad.” The underlying cost of malpractice doesn't show up on the medical bill as a separate line item—that's the point; it's invisible—but the patient is paying for it all the same.
Based on these examples, one could wonder if banking is only suitable for the soft embed, while insurance products span the entire range of distribution models. It's a fair question, and likely one that will be answered over the next few years, as embedded finance fulfills its promise to be the future of financial services.
Best’s Review contributor Caribou Honig is chairman and co-founder of InsureTech Connect, as well as a partner at SemperVirens Venture Capital. He can be reached at firstname.lastname@example.org.