Lemonade (NYSE:LMND) is one of the most popular companies to go public this summer. It came out on fire, with the stock up 139% in its first day of trading, but has since sputtered and is now down 14% since its debut. Investors may be hesitant about Lemonade's claims that it can disrupt the insurance market. Let's see whether those concerns are warranted.
Lemonade's business model
Lemonade offers home, renters, and pet insurance it claims is "built for the 21st century." Customers are quoted for monthly premium rates in as little as 90 seconds from the company's proprietary AI chatbot Maya, and claims get paid in as little as three minutes from its other AI chatbot, Jim.
Lemonade is able to get by with no physical branches or humans because it offers very standardized rates for all of its customers. Simplifying this process lowers overhead, allowing Lemonade to still make money even if its AI models are not yet up to par with traditional insurance underwriters.
One other unique feature of Lemonade's model is that it takes a maximum fixed fee to run its business, and any excess premiums get distributed to various charities throughout the year. These excess premiums are calculated on a per-person basis and distributed based on the charity chosen by the policyholder when they sign-up. This may put a ceiling on its profit margin, but it could end up benefiting the business in the long run by increasing the value customers place in getting insured by Lemonade.
Lower fixed costs (no branches, minimal-to-zero human interaction) give Lemonade a pricing edge over traditional insurers like Geico, Allstate (NYSE:ALL), and Progressive (NYSE:PGR). Like fintech companies vs. legacy banks, the established branches and human reps for these older insurers have increasingly become a cost burden instead of a benefit. And with the world moving more online every day, this headwind should only continue.
Lemonade also saves its customers time. Allowing someone to get an insurance quote in a few minutes all from their phone is a tremendous value proposition for consumers, especially young ones. It's estimated that 50% of people who rent are under 30, and that 37% of people who rent get renters insurance. Lemonade has had success targeting this younger demographic by trying to land a customer with renters insurance and then grow with them over time.
For example, it states in its S-1 that customers who joined three years ago now spend 56% more on renters insurance than when they first joined. This "land and expand" model is how Lemonade hopes to slowly work its way across the insurance industry and take market share from the legacy players.
So far, this strategy has worked beautifully. From 2017 to 2019, the number of premiums Lemonade brought in grew from $9 million to $116 million, while its gross loss ratio (claims paid divided by premiums) went from 161% down to 79%. That gross loss ratio trajectory is impressive and has likely put the entire industry on notice.
Is Lemonade's advantage overhyped?
One concern with Lemonade is that it has been able to grow so rapidly because it targeted young renters, whom the traditional players rarely go after. This may be for good reason, too. Renters pay on average only $180 a year for insurance (if they choose to even get coverage at all), while homeowners pay around $1,200 a year.
Lemonade's current strategy indicates it may have captured a lot of the easy money in the insurance market. But what happens when it tries to convince middle-aged homeowners who have already been with their legacy provider for a decade to switch over to an online-only option? It may be easier for Lemonade to capture new homeowners, but those come around a lot less often than new renters.
However, 2020 has seen a boom in housing activity because of the pandemic shaking up work, with over $1 trillion in loans given out over the last three months. This could be a tailwind for Lemonade to find more first-time buyers, at least in the short term.
Lemonade's claims it has a "data moat" vs. the competition may also offer more hype than substance. Insurers have been collecting and analyzing data for decades (it is the majority of the work an insurer does), so it is tough to see how Lemonade has any sustainable advantage besides low up-front costs and a friendly user experience. Those can't be easily replicated, and they do help Lemonade's brand, but claiming that Lemonade has a moat because of the data it takes in is a stretch.
Other digital-first competitors are growing quickly too. Root (NASDAQ:ROOT) just had its IPO and essentially has the same value proposition as Lemonade, but with car insurance. Considering that Lemonade trades at a hefty premium (around 10x book value vs. 1-2x for the average insurer), with new copycats joining the fray and well-capitalized traditional competitors, investors should be cautious about its long-term prospects at this moment.