- Lemonade is attempting to disrupt the insurance industry. It offers insurance products using AI to set policies and facilitate the customer experience.
- The company's operating metrics are improving, and the company has a massive TAM ahead of it.
- The stock is expensive and Lemonade is incurring losses. However, the upside is tremendous if the business can scale to profitability.
Lemonade, Inc. (NYSE:LMND) is an insurance technology company or "InsurTech" company that offers insurance products to consumers via automated bots run by artificial intelligence. The insurance industry is enormous, with a global market size of roughly $6.3 trillion and is very antiquated. This presents an enormous opportunity for the type of disruption that a company such as Lemonade is trying to accomplish.
There are risks in an investment in Lemonade as the model is not yet profitable (and is a long way from becoming profitable). However, as a long term investment, Lemonade offers compelling upside in a huge TAM should the model reach its inflection point. We will dive into Lemonade below and outline our investment thesis.
Lemonade is an insurance technology company built on a digital footprint and utilizes artificial intelligence to slim operations and improve the customer experience. The AI system handles the customer experience from start to finish, which results in faster policy decisions, and payments on claims.
Lemonade operates on a smartphone app, which gives the business a convenient and simple interface. Customers can both sign up for insurance and file claims through the app via its AI powered chat bots "Maya" for customer service, and "Jim" for claims. This video demonstrates the customer experience.
Lemonade is a very young business for a public company, founded in 2015. The business generates just over $94 million in annual revenues.
Lemonade currently offers four types of insurance products in Renters, Homeowners, Term Life, and Pet insurances. The company plans to continue offering new types of insurance over time.
How Lemonade's Business Works
Lemonade has built its business model to improve the consumer's impression of the insurance industry compared to traditional insurance companies. Before we outline this, we need to review the core fundamentals of how insurance works.
Insurance companies sell policies to consumers, and price them by analyzing various risk factors that quantify the probability and extent that a customer may file a claim against the policy. Therefore an insurance company has incoming funds (premiums paid by customers), and outgoing funds (claims paid to customers).
There are a couple of important truths to this "balancing act" that insurance companies work with. First, insurance companies have to maximize the ratio between premiums and claims. The profitability of an insurance company depends on the company collecting as many premiums as it can while paying out as little claims as possible. This creates an inherent conflict of interest because there is financial incentive for an insurance company to not pay a claim.
Second, the insurance industry is extremely competitive. Consumers view insurance as a commodity, with pricing being the primary deciding factor in choosing an insurer. Therefore, a company needs to price its policies competitively while still making money in the end. This makes the insurance business a game of efficiency.
With this context, let's explore Lemonade's business strategy.
The company gets a flat take rate on the premiums that customers pay. Anything beyond this take is then donated to charities, often of the customer's choosing. In 2020, Lemonade donated more than $1.1 million. In fact, the company is a B-Corp, which is a designation that signifies the highest level of social and environmental standing. The fixed take rate also helps negate the financial incentive that an insurance company has to avoid paying out claims.
As part of this business strategy, Lemonade utilizes reinsurers to remove risk and capital intensity out of its business. Reinsurance is best thought of as "insurance for insurance". Lemonade surrenders 75% of its earned premium in exchange for a 25% commission.
In other words, $1 of gross earned premium is allocated as:
- $0.25 to Lemonade, and $0.75 to the reinsurer
- Reinsurer pays a 25% commission to Lemonade ($0.75 x 0.25)
- Lemonade receives total of $0.435, and reinsurer receives $0.5625
This fixed model stabilizes profit margins for Lemonade, putting more emphasis on the company's gross loss ratio to drive unit economics. The gross loss ratio is the ratio of claims paid to earned premiums. We will talk more about this next.
Artificial Intelligence Drives Operating Metrics & Customer Experience
As we will discuss next, Lemonade utilizes artificial intelligence and machine learning to drive its business model and customer experience. Let's start with the company's loss ratio.
An insurance company's loss ratio is essentially the metric that determines how efficient the business is. It is expressed as a percentage, and the lower the figure is the better. If the metric is 100%, it means that outgoing claims are as high as earned premiums. Therefore the lower the percentage, the wider the gap between claims paid and premiums earned (a good thing). The average for the insurance industry as a whole averages between 65%-70%.
We can see in the graphic above that Lemonade's loss ratios have been terrible, but have steadily improved over the past eight quarters. This is because as the company's AI is fed more data, the better the system functions. Lemonade's system was able to go from terrible to "average" between Q2-Q3 in 2020.
A critical part of an investment thesis is that Lemonade is able to continue lowering and maintaining a satisfactory loss ratio. The long term viability of the business model (profitability) is dependent on this metric's strength. Failure of this is the largest risk to investors.
In addition to driving the back-end of operations, the company utilizes AI and its digital user interface to provide a strong customer experience. Users can sign up for insurance in as little as 90 seconds, and can get paid on claims in as little as three minutes. The AI bots remove layers of costs, labor, and customer inconvenience by removing the deep network of agents that are intertwined into the model of traditional insurance companies. This is why Lemonade has a net promoter score of 70, which is very high for the industry.
Long Growth Runway Ahead
One of the attractive qualities of an investment in Lemonade is the enormous and growing space that it plays in. With IFP (in force premium) of just over $200 million, Lemonade is a microscopic player in a global industry worth more than $6 trillion. The scale of the insurance industry means that Lemonade doesn't even need to become the largest player in the field to be an exceptional long term investment. Even more, the industry is growing. Over the coming years, premium volume will grow significantly as emerging markets with growing economies begin seeking insurance.
Lemonade will benefit from these tailwinds over time, but the most impactful growth will come from product and geographic expansion. The company has been steadily stretching its legs. Lemonade recently added term life insurance, and has discussed entering automotive insurance in the future.
And while the company is still growing rapidly in the US, Lemonade has begun to penetrate international markets. Lemonade is currently in Europe, having entered Germany, the Netherlands, and France most recently. These levers will combine to drive strong top line growth for the foreseeable future.
The Long Path To Profitability Is A Risk
While top line growth is exciting for investors, Lemonade's largest risk to investors comes from its lack of bottom line production. Lemonade is currently an unprofitable business and faces a long path to turning a profit.
Even if we look ahead to 2023, analysts are expecting the company to lose almost $3 per share that year. The structure of Lemonade's fixed take rate and current costs require a large ramp up of volume to generate the scale needed to lower customer acquisition costs (will also be helped by entering premium insurance categories) and reach the inflection point that turns Lemonade profitable. An investment in Lemonade is a bet that the company will succeed in executing this. Because of the company's current long path to profitability, Lemonade is an admittedly risky stock.
Looking At Valuation
Lemonade has been a highly volatile stock. Over the past year, the stock has traded between a wide range of $44-$188 per share. The stock has pulled back from highs and currently trades at $81.
Based on its current enterprise value, Lemonade is trading at an EV to sales of 39.5X based on estimated sales for this year. When you consider the fact that traditional insurance companies such as Progressive (PGR) and Allstate (ALL) trade at an EV to sales multiple of 1X or less, Lemonade is clearly valued differently by the market. Whether you agree that Lemonade is a tech company would determine your view on the stock's valuation.
While I don't consider Lemonade to be "cheap" at these levels, the stock has pulled back a bit and the company's revenue growth will burn down the multiple over the coming years. If we use 2023 analyst estimates of $267 billion, the stock trades at an EV to sales of 17X. The company's long term runway makes the valuation palatable if you are bullish on the company's unit economics.
Great long term investments are born from innovation within large and stagnant industries. Insurance certainly fits that bill, and Lemonade has shown results (improving loss ratio) that signal the merits of Lemonade's model. The stock commands a premium and there are questions around profitability, but Lemonade's large TAM and long runway bring enticing upside. We are bullish over the long term.
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