Insurance is one of the largest markets in the world, generating over $5 trillion in annual revenue . It's also one of the oldest; some of today's largest insurers have been around for over 100 years. By comparison, Lemonade (NYSE:LMND) was founded in 2015. But thanks to its brand-new approach to insurance, the company nonetheless has the potential to disrupt the entire industry.

Lemonade's competitive advantage

Unlike most insurance companies, Lemonade was built for a digital world, using big data and artificial intelligence to make its business more efficient. On the backend, Lemonade uses AI to manage workflow and predict fraud. And on the frontend, the company uses AI chatbots to interact with customers, underwrite policies, and pay claims . This allows Lemonade to provide a high-quality user experience at a lower cost than traditional insurers. For example, Lemonade estimates that its competitors employ one person per 150-450 customers, but Lemonade only employs one person per 2,000 customers . This type of efficiency reduces operating expenses and gives Lemonade an edge over its rivals.

Artificial intelligence

Image source: Getty Images

Lemonade also collects more customer data than its rivals. For example, to purchase insurance, customers interact with AI Maya, a chatbot who typically asks them 13 questions. During this quick process, Lemonade's platform gathers 1,700 data points. In comparison, typical insurance companies gather 20-50 data points per policy . This gives Lemonade another enormous advantage, enabling the company to use AI algorithms to more precisely quantify risk when underwriting insurance policies. Over the long run, the combination of reduced operating expenses and more precise underwriting could make Lemonade more profitable than traditional insurance companies.

Lemonade's reinsurance strategy

Lemonade recently transitioned to a fixed-fee business model based on proportional reinsurance, which is essentially insurance for insurance companies. This is another fundamental difference between the company and the vast majority of rivals . Here's how it works: When Lemonade receives premiums from customers, it keeps 25% (the fixed fee) and pays or "cedes" 75% to reinsurance companies; in exchange, those reinsurance companies take responsibility for 75% of claims. They also pay Lemonade a 25% commission for bringing them business.

This means, as long as Lemonade keeps its gross loss ratio (how much it pays out in claims, divided by how much it earns in premiums) under 75%, which it has done for the last four quarters, Lemonade will keep a minimum of 25% of gross earned premiums as operating profit, and Lemonade's reinsurers will also make a profit. Management believes this strategy will generate high levels of recurring revenue, while stabilizing gross margins within a ±3% range. That's impressive, considering the financial performance of many insurance companies can literally depend on the weather.

So far, so good

In the most recent quarter, Lemonade's net earned premiums fell significantly, causing a 6% drop in revenue. But investors shouldn't be worried. This boils down to a change in accounting standards , not a problem with the business. 

What investors should focus on is gross profit, which rose 83% in the third quarter. Additionally, despite a catastrophic wildfire and hurricane season, Lemonade's gross loss ratio dropped from 78% in Q3 2019 to 72% in Q3 2020. This compares favorably with the industry average of 82% , and indicates that the company's tech-driven strategy may be working.

Metric

Q3 2019

Q3 2020

Change 

Gross Written Premium

$38.0 million

$71.2 million

87%

Gross Profit

$4.0 million

$7.3 million

83%

Customers

562,251

941,313

67%

Source: Lemonade shareholder letter. Note: Gross written premium is the sum of all customer premiums for insurance policies sold during the quarter. 

Also of note, during the most recent earnings call, management announced plans to enter the term life insurance market. This will expand the company's offering (which currently includes renters, homeowners, and pet insurance), adding an estimated $2 trillion to its market opportunity by 2030. This is good news for investors, especially following last quarter's launch of pet insurance, as it emphasizes management's commitment to growing the business.

A final word

In the coming quarters, investors should pay attention to Lemonade's loss ratio, since it's the primary measure of how effectively the company is using AI to quantify risk. If the company's loss ratio trends upwards over time, especially at levels above 75%, it could mean trouble. Additionally, Lemonade is orders of magnitude smaller than market-leading insurers like Berkshire Hathaway or Liberty Mutual. These businesses generate much more cash, which is always an advantage. For this reason, investors should also monitor growth in Lemonade's customer base and gross written premiums. If these metrics decelerate significantly, it may indicate that Lemonade is unable to compete against these giants.

However, as an investor myself, I believe Lemonade's founder-led, AI-driven business is well positioned to disrupt this industry. If Lemonade continues to scale, growing its customer base and expanding its product offering into new markets and geographies, the company could achieve a high level of profitability in the future.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.