As discussed on our Fall 2018 conference call, we owned shares of pet insurance company Trupanion in our core equity strategy. In July, we sold our shares prior to Trupanion’s earnings and wanted to provide an explanation of that decision.

Trupanion was an “emerging moat” position in our portfolio. With emerging moat businesses, we are looking to be early investors in companies that are in the process of establishing durable competitive advantages. Given the higher uncertainty around emerging moat companies, they are intentionally small positions in our portfolio.

The ideal situation is to own a Rule Breaker on its way to becoming a Rule Maker.

Netflix is a perfect example of this dynamic. For most of its history, Netflix was breaking the rules of traditional media on its way to becoming the first global scale media company. Having proven that model, legacy content creators like HBO and Disney are trying to replicate it.

With Trupanion, we expected something similar to happen over the next decade. In fact, we continue to believe that Trupanion offers a superior pet insurance product. Some of us are happy Trupanion customers.

In recent quarters, however, we grew concerned about Trupanion’s ability to communicate its value to pet owners and win market share. Over the past two years, for example, Trupanion’s subscription pet growth trailed the industry growth rate, as defined by the North American Pet Health Insurance Association (NAPHIA), after years of outperformance.

We anticipated an “S-Curve” in North America pet insurance as it becomes more accepted by vets and pet owners. And that seems to be happening. Yet, Trupanion’s subscriber growth has not accelerated in step. In fact, at Trupanion’s recent investor day, management slightly reduced its subscription pet guidance for 2019 and 2020. When there are industry tailwinds, emerging moat companies should further their lead from the pack.

Now, it could be argued that competitors are underpricing their policies to win share in an unsustainable fashion. (To be sure, Trupanion’s market share as a percentage of revenue held up.) Trupanion’s policies tend to be expensive – often much more so – when comparing quotes with other insurers.

The reason Trupanion is pricey, however, is it has more generous payouts – Trupanion’s loss ratio is 70% versus the industry average of 50%. Trupanion also uses its large database to determine monthly cost of care for a certain pet of a certain age in a certain zip code and then adds a 30% premium. It’s a straightforward and fair approach to pricing.

But this cost-benefit tradeoff is difficult to communicate to consumers, most of whom only realize the value of their insurance plan when they need to make a claim. It’s not like other consumer services where the value proposition is felt on a daily, weekly, or monthly basis.

For owners of “unlucky” pets, the Trupanion value proposition is fantastic, but it’s not as obvious for “lucky” pet owners who don’t file many claims and are paying high relative premiums. To this point, in Trupanion’s 2018 shareholder letter, CEO Darryl Rawlings noted that “general dissatisfaction” was the number one reason for policy cancellations and “90-day cancellation” was number three, behind pet death. And Trupanion, of course, needs lucky pet premiums to offset the unlucky pet claims.

A major part of our thesis was Trupanion’s advantage having “active” referral relationships with nearly 10,000 North American veterinary hospitals and its success at installing its automated claims software, Trupanion Express, at 4,000 hospitals. Other pet insurers have tried to replicate Trupanion’s vet-focused salesforce (Territory Partners) and failed, which was a sign to us that this could be a moat source for Trupanion.

While vet offices are not allowed to solicit insurance, Trupanion’s Territory Partners encourage vets and office staff to start asking new pet owners who their insurance is with and start a conversation about insurance. As discussed on our call, pet insurance can be a win-win for all parties, so it’s a healthy conversation to have.

Consequently, Trupanion is likely the first brand on many vets’ minds as they talk about pet insurance with new dog and cat owners. Indeed, Trupanion management said they believe they are generating most of the industry’s leads through vets starting conversations about pet insurance.

This made us even more concerned about the slowing unit growth rate. Why is Trupanion not outpacing the industry when it is the first name many pet owners hear? It could be that pet owners hear about pet insurance from their vet, go home, compare prices, and choose a more affordable option. It’s not an impossible problem for Trupanion to solve, but again, consumers don’t typically understand insurance value until they file a claim.

Additionally, while management is important at all companies, it is particularly important at emerging moat businesses where executives must proactively create a moat that does not yet exist. One reason for our previous confidence in Trupanion was founder Darryl Rawling’s mission-driven leadership. Darryl is a visionary leader who passionately advocates for responsible pet ownership, thinks long-term, and built a company with a wonderful corporate culture. His shareholder letters are always worth a read.

We had assumed that Rawlings would lead the company for at least another 10 years, as did Dan Levitan of Maveron (an early and ongoing Trupanion shareholder), who during a 2017 Motley Fool interview alongside Darryl said, “(Darryl will) do this for the next 15 or 20 years.”

But at an investor event we attended a few months ago, Darryl said that he was making plans to switch to an executive chairman role in 2025. While we understood Darryl’s choice on a personal level, it also sharply increased our uncertainty around whether company management will be able to successfully build a moat and transform pet insurance as we had hoped. In our opinion, Trupanion will continue to need a visionary leader in the CEO role and finding another visionary to replace Rawlings will be a massive challenge.

There were other concerns that led to our sale, but it’s worth noting that none of them were related to the popular short cases against Trupanion. (Trupanion is one of the most heavily-shorted companies in the U.S. market.)

As discussed in our call last autumn, many Trupanion short sellers think regulatory matters will bring down Trupanion’s business model. Pet insurance remains a tiny slice of the personal lines insurance industry – in fact, it’s so small it currently exists under the “Inland and Marine” classification.

Given the industry’s rapid growth, we think it’s perfectly normal for both regulators and pet insurance companies to have some growing pains. While Trupanion has been fined, faces more state investigations, and admits it should have paid more attention to regulators as a stakeholder, we considered these matters minor to our thesis. Regulators may require Trupanion’s Territory Partners to be licensed in all states, but this is more like a speed bump rather than a roadblock.

Ultimately, what brings down insurance companies is either they are insolvent or scamming their policyholders. Neither is the case for Trupanion or its profitable wholly-owned underwriter, American Pet Insurance Company. Our two visits to Trupanion headquarters made it clear that employees care about pets. Indeed, most of the customer service representatives had their own pets sitting next to them in their cubicles.

Trupanion is a good business and could very well make us look dumb for selling it. We lost faith, however, in the company’s ability to reach Rule Maker status in a highly-competitive and nascent market where value proposition communication is a challenge. As such, it no longer fit our definition of an “emerging moat” business and we decided to sell.

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