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Lemonade Plans to Disrupt the $5 Trillion Insurance Market. Can They Pull it Off?

12 min read. By the end of the article, I hope to convince you they can.

Caleb Dismuke

That's bullshit.

I first heard of Lemonade on a podcast hosted by two insurance industry veterans.

They were saying bullshit to what Lemonade claimed they were trying to do — build a peer-to-peer insurance company that allowed members to get money back at the end of the year if they didn't file any claims.

To be fair to the hosts, Lemonade doesn't use the phrase peer-to-peer anymore. I can't find it on their website or S-1 filing. And instead of giving unclaimed money back to customers, they now donate that money to a charity of the customer's choice.

But their tone (sarcastic) stuck with me. Other articles from insurance insiders expressed similar skepticism towards Lemonade.

Their snarky commentary reminded me of one of my favorite quotes:

First they ignore you, then they laugh at you, then they fight you, then you win.

Large incumbents like State Farm and Allstate did all the above. And we’ll get to that later.

With that said, let's dig in!


What They do

Lemonade sells renters and homeowners insurance directly to consumers through its website.

Their stated mission is to "harness technology and social impact to be the world's most loved insurance company."

And beloved they are👇

But instead of selling insurance through a network of agents like Allstate and State Farm, they sell policies and pay claims directly from their website with the help of two AI bots.

See Lemonade in action👇

See how the Lemonade app works.

As much as possible, they want to use code and algorithms to replace functions typically performed by humans.

  • AI Maya-Sells policies and handles everything from collecting information and personalizing coverage to creating quotes and facilitating payments.
  • AI Jim-Handles the "first notice of loss" for 96% of claims. And in a third of cases can manage the entire claims process without any human involvement.
    • In 2019, AI Jim handled ~20,000 claims and paid out ~$2.5 million with no human involvement.
  • CX.AI-Their customer support bot. It handles a third of customer inquiries.
  • Forensic graph-Their fraud detection platform.
  • Blender-An insurance management platform that facilitates collaboration throughout the organization.
  • Cooper-An automation bot that handles repetitive tasks.

Further reading: Lemonade’s about page.


How They Make Money

Insurance is a straightforward business.

Customers pay a fee (premium) to the insurance company. And in return, the insurance company agrees to pay for claims covered under the customer's policy.

Lemonade has two revenue streams. (Technically, they have a third — investment income. It's small and clocked in at $3.4 million for 2019.)

  1. They retain a fixed fee, currently 25% of premiums. They cede the remaining 75% of the premium to their reinsurance partners.
    • For example: If Mr. Prescott's yearly premium is $100, Lemonade keeps $25, and the reinsurance company gets the remaining $75.
  2. They earn a ceding commission of 25 cents for every dollar ceded.
    • In the above example, Lemonade earned $18.75 for ceding the $75 to their reinsurance partner.

👉A ceding commission is the fee a reinsurance company pays the ceding company for administrative, underwriting, and other expenses.

Reinsurance and maximizing capital efficiency

Reinsurance is a financial instrument in which one insurer, the "reinsurer," agrees to cover a portion of the claims of another insurer, the "primary insurer," in return for part of the premium.

Using reinsurance allows Lemonade to maintain gross margins while reducing their capital requirements. Lemonade recently entered into a structure called proportional reinsurance or quota share reinsurance.

Beginning on July 1st, 2020, they will have proportional reinsurance for 75% of their business. This means they cede 75% of premiums collected to reinsurers. In return, the reinsurers pay Lemonade a ceding commission of 25 cents for every dollar ceded, in addition to covering 75% of all Lemonade’s claims.

For more details about their reinsurance contracts, see pages 9-10 of their S-1.

Key financial and operating metrics

$ in millions, except for premium
per customer
Three months ended March
31, 2020
2020 2019
Customers (end of period) 729,325 371,571
In force premium (end of period) $133.3 $57.2
Premium per customer $183.0 $154.0
Operating revenue $30.5 $12.5
Adjusted gross profit $5.4 $1.8
Adjusted EBITDA -$22.4 -$21.6
Adjusted gross margin 18% 14%
Adjusted EBITDA margin -73% -173%
Gross loss ratio 72% 87%
Net loss ratio 72% 75%

We'll define three of the above metrics. For further explanations, see pages 92-94 of their S-1.

In force premium (IFP): Aggregate annualized premium for Lemonade's customers. It's calculated as the sum of In-Force Written Premium and In Force Placed Premium.

  • In force written premium is the annualized premium written by Lemonade.
  • In force placed premium is the annualized premium placed with third-party insurance companies for which Lemonade earns a recurring commission. This type represents less than 1% of IFP.

Premium per customer: The average amount of money customers spend on their products.

  • In their S-1, they emphasized that this metric helps drive strategic decisions.

Loss ratio: Total losses, plus adjustment expenses, less the amount ceded to reinsurers, divided by premiums earned. The lower the ratio, the better.

  • A simple example: If an insurance company earned $100k in premiums and paid out $75k in claims, their loss ratio would be 75%. ($75k/$100k)
  • Lemonade's loss ratio is 72%, which is around the national average of 74%. However, the bulk of their policies is for renters insurance, which has a different loss profile than homeowners insurance.

How They Stack up vs. the Competition

Lemonade is small potatoes compared to the incumbents.

Rank Company Direct Premiums Written Market Share
1 State Farm $18,685,957 18.0%
2 AllState $8,723,238 8.4%
3 USAA $6,835,804 6.6%
4 Liberty Mutual $6,745,864 6.5%
5 Farmers $5,943,814 5.7%
6 Travelers $4,240,933 4.1%
7 American Family $4,057,499 3.9%
8 Nationwide $3,244,683 3.1%
9 Chubb $2,989,474 2.9%
10 Erie $1,746,390 1.7%
Lemonade $116,000 N/A

💥Important💥

The majority of Lemonade's gross written premium (GWP) is for renters insurance. Renters insurance makes up less than 10% of the broader 'homeowners' market.

If they want to jump into the Allstate, State Farm tier of insurance companies, they need to expand into the more competitive homeowners market.

They acknowledged this in their 2019 year-end review.

From their blog:

Becoming so well known for renters insurance came at the expense of homeowners insurance. We’ve been selling homeowners insurance since we launched, and think of ourselves as a multi-line business, but all too often we are thought of by others only as a ‘renters insurance company.

Being pigeonholed so narrowly always irked us, but it was a problem of our own making. In truth, it was more than irksome; it was a significant failure on our part, and it threatened our continued growth.

In August of 2018 we decided to right this wrong, and started to give homeowners the love and focus they deserve. It’s been rewarding work: in the past 12 months we’ve seen over 500% year-on-year growth in sales of homeowners policies – even as our cost to acquire them dropped 70%. Back in August 2018, 5% of our sales came from homeowners – now it’s about 35% and growing.

They are making progress:

The copycats

Despite snickers from incumbents, Lemonade must have made them squirm a little🤨

In 2017, Liberty Mutual, the fourth-largest writer of homeowners insurance, introduced their D2C product — Lulo👇

Lemonade’s copy (top) vs. Lulo's copy (bottom):

Yikes! Copying a competitor's product is nothing new, but cm' on, don't make it so obvious🙄

Liberty Mutual wasn't the only one to poke fun or copy Lemonade. Both State Farm and Allstate took shots at Lemonade. You can read about it here.


The Bull Case

Why would anyone settle for average returns?

That was a question posed by Ned Johnson of Fidelity Investments. Fidelity Investments made their bones with high-fee mutual funds. The idea of a low-cost fund that simply tracked the market could disrupt their business seemed absurd.

When Vanguard introduced the first index mutual fund in 1976, incumbent firms ridiculed it as "un-American" and "a sure path to mediocrity."

But despite its critics, the Vanguard 500 index fund grew from $11 million in AUM at inception (1976), to over $500 billion in AUM today.

How did that happen?

Fidelity vs. Vanguard

Counter-positioning: A newcomer adopts a new, superior business model that the incumbent cannot mimic due to anticipated damage to their existing business.

From Hamilton Helmer's book, 7-Powers: The Foundations of Business Strategy:

Fidelity possessed all the capabilities to develop and distribute passive funds. They were a mutual fund powerhouse, and one could argue that their capabilities were superior to their challenger Vanguard.

However, the impact of entry into passive funds on their remaining business of active funds would have been subtractive. Active funds carried a high expense ratio and had upfront sales commissions (loads). And Fidelity assumed that any gains made with new funds would have been offset by losses in their base business of active funds.

When I first read about Lemonade's approach to insurance, the Vanguard example immediately popped into my mind.

Vanguard parted with industry tradition in three ways.

  1. It's structured as a mutual company. Meaning, it's owned by the shareholders of their funds.
  2. In 1977, they quit offering their funds through brokers and went directly to individuals (D2C).
  3. They believed a low-cost, index-tracking fund was the best retirement option for most people. And trying to pick market-beating managers was a fools-errand.

Three ways Lemonade is similar.

  1. Lemonade is a Certified B Corp. A Certified B Corp is a new kind of business that balances purpose and profit. They are legally required to consider the impact of their decisions on their workers, customers, suppliers, community, and the environment.
  2. Unlike today's insurance companies that sell the majority of their policies through brokers and agents, Lemonde sells the bulk of its policies through its AI bot Maya.
  3. They believe collecting data and correlating it to the real world will give them an edge in underwriting and allow them to lower costs for their customers.

Some context

I don't like the word disrupt, even though I used it in the article's title. It often implies that a new company or technology completely supplants its predecessor.

Sometimes it happens, and a company goes to zero — RIP Blockbuster. But often it's a shift. And the pendulum, that for a long time favored incumbents, starts swinging towards what is to come, the upstarts.

Despite Vanguard and passive investment vehicles dominating fund flows since the financial crisis, active managers still exist. In 2019, Fidelity earned a record $6.9 billion in operating profit.

But the pendulum swung from all assets being actively managed, to a large chunk going the passive route.  From 2014-2017, investors sank $823 billion into Vanguard funds. While the rest of the 4,000 funds that comprise the mutual fund industry took in a net $97 billion.

Thanks to Vanguard, Fidelity and other investment companies eventually capitulated. And started offering their own passive funds; often selling them at a loss. In order to get customers in the door so they can pitch them higher-margin products.

With insurance, the State Farms and Allstates aren't going away. But Lemonade is betting the pendulum swings from companies dominated by agents and paperwork to companies offering an end-to-end digital experience.

To conclude

The bulls are betting on three things:

  • The pendulum swings from companies dominated by agents and paperwork to companies offering an end-to-end digital experience. And, that incumbents can't go all-in on digital because it would supplant their current business of selling insurance through agents.

    • Allstate sells 91% of their policies through agents. Only 6% was sold through its Esurance brand, which they are folding and integrating into their central platform.
  • Over time, customers will spend more money with them on insurance. Increasing their Premium per Customer, one of their main KPIs we presented earlier.

  • Their ability to collect and correlate data to the real world will give them an edge in underwriting, acquiring, and retaining customers. (see image below)

Their flywheel:


The Bear Case

Lemonade is similar to WeWork in two ways:

  1. Both mission statements are cringeworthy.
  • WeWork-The We Company's guiding mission will be to elevate the world's consciousness🤮
  • Lemonade-To harness technology and social impact to be the world's most loved insurance company.
  1. Both companies largest investor is Softbank.

I understand the sentiment towards Lemonade with the WeWork debacle fresh on people’s minds.

Inside P&C lays out the bear case in their aptly titled article — Lemonade IPO: A unicorn vomiting a rainbow.

They ask three questions. Here's two of them:

  1. The business model is premised on expanding its TAM through "graduating" low-cost renters' policies into bigger-ticket items. Is that a good bet?
  2. Second, the firm appears to be building a reinsurance dependence that could be embed risk in its business model.

Let's go through both.

(1) The business model is premised on expanding its TAM through "graduating" low-cost renters' policies into bigger-ticket items. Is that a good bet?

Their two best points:

Homeowners' insurance is a more competitive industry than renters. It's occupied by well-financed, entrenched players, with long histories, more data, and big advertising budgets.

  • State Farm, Allstate, and GEICO have pounded us with commercials featuring Aaron Rodgers and Patrick Maholmes, Danger, and the gecko. Gaining brand awareness will indeed be a challenge for Lemonade.
  • Homeowners' claims are more complicated than renters and less well suited for AI triage (Lemonade's alleged advantage over incumbents).

(2) Second, the firm appears to be building a reinsurance dependence that could be embed risk in its business model.

Reinsurance companies are often willing to invest in reinsurance-dependant startups on the premise that, over time, they will have an opportunity to make money. Lemonade has consistently handed loss-making business to reinsurers (inclusive of a 25% ceding commission and underwriting expenses). With this market already tightening, it is hard not to see this source of capital arbitrage lessening over time as it rolls over.

  • Today, Lemonade is optimizing for growth (smart IMO). In the future, I would imagine they want to be less dependant on reinsurance companies as a key part of their business model.

Also from the article:

The company’s disclosed retention rates are not that impressive. Its filing stated its year-one and year-two retention rates were 75% and 76% respectively. This does not compare favorably to other personal lines products in auto or home where something in the mid-to-high 80s would be considered good.

Here’s how Lemonade describes its business model: Our business model is a direct, digital, customer-centric experience that delivers rapid growth and strong retention.

Having below-average retention rates is a problem when retention is at the core of your business model.

Read the whole article.


What I'm Doing

Again from 7 Powers:

The challenger’s approach is novel and, at first, unproven. As a consequence, it is shrouded in uncertainty, especially to those looking in from the outside.

The quote above sums up Lemonade's situation — unproven outside of selling renters insurance and uncertain if their AI, data-driven approach is BS or if it will lead to a meaningful edge in the years to come.

And here's the truth for both bulls and bears: Neither group knows if it will work. We probably won't know for years. But by the time it's obvious, the best time to buy will have passed (assuming you're a bull).

Maybe I'm getting snowed. Maybe the insurance guys are right. And Lemonade is just another flash in the pan startup that will eventually flame out. Perhaps they really are a unicorn vomiting rainbows.

But what if the pendulum starts to tilt ever so slightly towards companies like Lemonade and away from the giants that have dominated the industry for the last hundred years?

Ultimately, that's what I'm betting on.

Every month, for the next six months, I'm buying a small chunk of Lemonade. I'm treating it as an investment. And I plan to hold it a minimum of seven years to see how it plays out.

-Caleb


Nothing in this article is investment advice. Do your own research!