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Posted on Dec 07, 2021Read on Mirror.xyz

Fintechs > Incumbents? (Part 1)

Why should incumbents in the financial services industry be so concerned with fintech startups? To answer this question thoughtfully, let’s think about how financial services differ from other industries on a high level.

If we consider a manufacturing plant for example, each additional unit sold will lead directly to more revenue and more profit (putting aside fixed costs for simplicity sake). If the firm sells 1,000 units that’s better than selling 100 units which is better than selling 10 units.

Put more simply, 

More customers = more profits

This same general concept applies across most industries. Financial services, however, is not one of those. Why is that?

Let’s consider one vertical of financial services to explain the distinction.

Take an auto insurance company. How do auto insurers make money? They have enough good drivers who don’t get in accidents to subsidize the bad drivers who do get in them.

So these insurers have a pool of good drivers who are paying the same premiums each month as the average drivers & the bad drivers. This is inherently “unfair” to the good drivers — why should they be paying the same price even though they get in fewer accidents?

Well, the simple answer to that is, auto insurance companies wouldn’t exist if they were only writing insurance to bad drivers. They need to collect premiums from enough good drivers in order to cover all of the payouts from the bad drivers (and then some to be profitable).

Let’s return to the simplistic idea from our manufacturing example,

More customers = more profits

Is that the case for an auto insurer? Of course not.

Each new customer that an auto insurer (& more generally financial service provider) underwrites could be either a net gain or a net loss to profitability. Let’s say a huge swath of new customers are disproportionately bad drivers – the auto insurer is going to be worse off because it will need to make more payouts with fewer good drivers to offset those.

So where do startups come in & why is this especially disruptive for the financial services space?

For starters, the incumbents may feel protected because of their sheer size; the top 3 auto insurers in the United States (State Farm, GEICO, Progressive) wrote over $30bn EACH in premiums last year alone. The argument that it’s unlikely (if not impossible) for a startup to take all of these incumbent’s customers away is misguided. Startups need only take a select slice of the customer base away to inflict serious damage.

The example I gave earlier about a disproportionate number of bad drivers affecting profitability is true. The analogous argument is that a disproportionate number of good drivers leaving would have the same effect. Remember that the good drivers are paying the same price & in turn subsidizing the bad ones. What happens if fintech companies are able to poach the BEST customers?

For theoretical sake, let’s consider a fintech startup that is able to poach the cream of the crop. They offer a 50% discount to State Farm, GEICO & Progressive customers who have never been in an accident (and for purposes of this example will never be in one in the future). This is a win-win for the fintech startup (all of the premiums go directly to profit since there are no payouts) and the consumer (who pays a significantly reduced price & feels they are being treated more fairly). It is an absolute nightmare for the big auto insurance companies though. All of a sudden, they are losing the premiums they need to offset all of the poor drivers they insure. It becomes untenable very quickly if they’re losing their best customers to upstart fintech companies.

*(How a startup is able to identify the best customers in the above example is a topic for Part II of this piece)*

A great example of this is SoFi. SoFi initially started as a private student loan refinance provider that offered better rates for the most credit worthy segment of the population. These consumers were paying the same rates as borrowers likely to default because the federal government was handling most of the lending in this space. SoFi came around & offered much lower rates for what they called High-Earner-Not-Rich-Yet (HENRY’s) borrowers and it was able to effectively poach the best customers. There’s much more to be said here about how SoFi (and other fintech startups) was able to do this, which I’ll cover in part II.

The lesson here is that for many kinds of financial services, more customers doesn’t necessarily mean more profits. Similarly, startups don’t need to compete for all of an incumbents customer base to become highly profitable & simultaneously very disruptive.