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Intro to Insurance for Venture Capital Firms
Protection for venture capital firms comprises of different business insurance and protection items safeguarding the valuation of a portfolio company from physical, digital, and monetary misfortunes. There is an immediate relationship between the advantages of protection for venture capital firms and IRR. Such relationship turns out to be a lot stronger when protection is revamped and structured freely of any insurance broker, company, or lobbyist, so that it covers core risks and functional dangers of a portfolio company while delivering high payout proportions from insurance policies, which converts into quantifiable cash flow protection. After estimating the degree to which cash flow or income is secured, the dollar measure of safeguarded cash flow or income can be consolidated into the valuation models of a portfolio company influencing both liquidity and valuation of such portfolio company and at last IRR. There are a variety of commercial insurance products that can be reworded to protect the core risks of a portfolio company depending on the nature of its operations.
Impact of Insurance for Venture Capital Firms on IRR
The impact of insurance for venture capital firms is similar in principle to that of insurance for private equity firms. The difference being VC firms may use different valuations methodologies than PE firms. Nevertheless, the premise is the same in that VC metrics entail measuring the probability of occurrence along with the severity of specific risks, which will yield an expected value of risk (EVR*) for each risk measured. The total expected value of risk (TEVR), which is the sum of all EVRs across measured risks, will have an impact on cash flow consistency and protection of growth, and therefore have a direct impact on the enterprise value of the portfolio company vis a vis others.
The insurance bought by venture capital firms will essentially have an impact on TEVR. Specifically, the amount and payout ratio (or inversely the basis risk) of the insurance relative to a specific risk will influence the severity of such risk, which will then impact EVR. For example, a cyber risk that has a maximum severity of $10 million (without insurance) will have a net maximum severity of $5,100,000 with cyber insurance of $5,000,000 entailing a deductible of $100,000 and a payout ratio of 100%. In this example, severity was reduced by ~50%, which would translate into EVR being reduced by ~50% assuming the probability of occurrence of such risk has not changed. That is a significant reduction in the magnitude of a single risk. If multiple measured risks can yield similar levels of reduction in EVR, then TEVR will be substantially reduced and will have a noticeable impact on Enterprise Value.
This content is independent of any content coming from insurance brokers, insurers, law firms, or insurance lobbyists. Commercial insurance is rarely taught in schools, and when it is, it’s mostly done through the lens of brokers or insurers. There are many misconceptions around Insurance for Venture Capital firms, like many other topics in commercial insurance, due to bad habits acquired through over reliance on insurance brokers or insurers or information providers who are lobbied by them. It is also important to note that insurance has both an operational aspect and a legal aspect, on which we put weights of 95% and 5% respectively in terms of importance to protecting a business and its investors (the point is that going to court to enforce coverage defeats the purpose of buying insurance, so you want to make sure that whatever insurance you buy protects your organization right and pays out fast on large losses).