The daunting list of challenges facing the global insurance industry shows little sign of abating. From the lingering effects of the financial crisis and ongoing political uncertainty through to sweeping technological change and coping with significant disruption from the growth of aggregator price-driven websites, the industry giants are now left with important questions about their current business models and the industry’s future.

Given the fundamental role that technology plays in the sector, this is arguably the most pressing challenge that insurers need to address. While insurance was one of the first industries to embrace tech in the 1970s and 80s, paradoxically, major insurers have been very slow to go digital. Part of the issue is their very complex legacy IT infrastructure – switching it off and changing to a new system simply can’t happen overnight.

This lack of agility could leave insurance giants at threat from nimbler insurtech startups, such as peer-to-peer insurers, robo-advisers and telematics specialists. The growing presence of these new players has sent a clear message to the incumbents. According to PwC’s 2016 Global FinTech survey, 90% of insurers fear they will lose business to a startup, as investment in insurtech has increased fivefold over the previous three years.

From competition to collaboration

While some insurers see these startups as a threat, many are increasingly viewing them as a powerful asset to help deliver innovation at scale. As the game switches from competition to collaboration, the race is on to partner with the best innovators.

Our new economic study Close Encounters: The Power of Collaborative Innovation found that large insurance corporates took part in 504 deals with UK SMEs in the last four financial years, largely in the form of minority stake purchases (69%) alongside mergers and acquisitions (31%). £8.5bn is known to have been invested in these deals between the 2013/4 and 2016/7 tax years.

This makes insurance the industry with the third highest volume of deals between corporates and SMEs in the UK, behind only financial services and manufacturing.

Having already faced the disruption caused by price comparison websites some years ago, large insurers have found ways to embrace collaborative innovation, but what’s driving this trend, and how does it work in practice?

A match made in heaven

At first glance, traditional insurance companies and insurtech startups seem poles apart. One is well-established, powered by financial strength, multinational capabilities and scale. The other is free of legacy systems, built for optimised digital development and attractive to millennial talent.

But their respective strengths can also become weaknesses. Despite the scale and financial success of many leading insurance corporates, the majority are built to operate rather than innovate. Legacy IT systems and sheer size can prevent these large organisations from embracing digital and emerging revenue streams such as cyber risk. On the other hand, insurtech startups can be held back by a lack of regulatory expertise, access to a large customer base and financial muscle to take their ideas to market.

What one lacks, the other has in spades. As such these polar opposites have much to gain by working together.

The need for insurance corporates and SMEs to make the most of each other’s very different strengths, is demonstrated by the way in which they are choosing to collaborate. Our data shows that large insurance companies are increasingly opting for minority stakes in SMEs rather than full buyouts, with over two-thirds (69%) of insurance deals in the last four years being minority stake purchases.

While outright acquisition may seem like a fast route to growth for insurance corporates, and there is no shortage of these types of deals in this sector, it presents the big M&A challenge of integration. Accounting regulations often force larger owners to treat newly acquired companies as part of the wider group, which means that these startups could face the same restrictions, silos and corporate governance that can stifle in-house innovation.

As innovation is the ultimate goal for many large insurers, minority stakes could be a more effective way of incentivising the two parties. Rewards generally depend on capital growth, but the earn out could also be based on achieving innovation-related goals, such as new product launches or transformation of legacy systems.

Our study identified five key points of tension between startups and corporates when it comes to negotiating a successful collaboration. It is important to balance these for the best chance of motivating both parties and delivering valuable innovation:

The extent to which an SME can keep its original culture versus how much it must be controlled by the larger partner is a fraught issue that cuts to the heart of collaboration.

This goes much deeper than a clichéd clash of corporate suits and startup hipsters. Approaches to risk can be vastly different, with the compliance responsibilities of large organisations in direct conflict with the “ask forgiveness not permission” approach of many dynamic SMEs. Yet this dynamism is the very strength that makes startups essential partners for corporates.

Over and above the obvious need to negotiate a fair financial settlement consider how any conflict in motivation can play itself out down the line. For example one party may be seeking a fast turnaround while the other is interested in long-term value.

Understandably for an industry still recovering from trust issues sparked by the 2008 financial crisis, one of the biggest sources of concern over startup collaboration comes from risks to the larger party’s brand. Reputational threats add an extra dimension to all other risks - escalating the drama of a data breach or regulator’s fine in the way that only a PR crisis can.

The need for central brand control suggests a degree of conformity that goes against the desire to retain an SME’s autonomy.

On the one hand the larger company will want to maximise the tax efficiency of its investment by claiming R&D relief and to do this will push for a bigger stake. In contrast the SME’s individual shareholders will want to retain a sufficient equity interest for each of them to qualify for Entrepreneur’s Relief.

Reconciling these two conflicting objectives can be particularly challenging when there are a number of individual shareholders, for the simple reason that there is less equity to go round.

Recent years have seen a considerable shift in exit strategies. Fast-growth tech-powered startups are no longer designed to build up to an IPO, but a corporate sale, as seen in the decade’s lowest global IPO rate in 2016.

Other industries facing disruption could do well to learn from this tale of joining forces with the competition.